Lars Klemmer/picture-alliance/dpa/AP Images
Employees on the site of a natural gas storage facility in Jemgum, Germany, August 26, 2022
The foreign-policy crisis produced by Russia’s invasion of Ukraine has turned into a European energy crisis, which in turn could trigger a global economic crisis. Putin responded to Europe’s military and economic sanctions with energy sanctions—first by reducing, then eliminating, Russian flows of natural gas to European nations. This move leaves Europe disastrously short of needed electricity for its homes, businesses, and factories, and no quick replacement is available.
Putin’s strategy exploded two long-standing naïve premises of EU policy: first, the idea that Europe could rely on Russian gas supplies for a major portion of its energy needs, and second, the assumption that free-market principles could govern the price and distribution of energy, which is far from a free market to begin with.
In the long term, this rude awakening will accelerate the long-overdue transition to renewable energy. But in the short run, with cold weather approaching, the consequences are dire. Beyond higher costs and potential shortages for consumers, large numbers of factories are already cutting production or even closing due to drastic increases in energy costs.
Europe relies on natural gas for about a quarter of its energy needs. Gas prices in Europe are now more than ten times the average of what they have been over the past decade. But even with increased conservation, demand for electricity is relatively inelastic. The drastically higher prices caused by Russia’s boycott will not cause consumer demand to shrink much, nor more supply to materialize.
Unlike crude oil, which has a global price, gas markets are segmented. With Russia cutting off Europe’s natural gas, the price of gas on the continent is now about $34 per MMBtu, compared to just $8 in the U.S. The U.S. has ample supplies for its own domestic needs and even exports some gas, via pipelines, to Mexico and Canada, as well as some liquefied natural gas transported by ship.
Energy traders have been making windfall profits exporting LNG to Europe, but there are practical limits to how much they can export. As recently as 2016, the U.S. exported no LNG. Today, LNG exports are about 10 percent of U.S. production. But there is no transatlantic pipeline, and specialized LNG ports on both sides of the ocean are at capacity, though more are being built. So, contrary the assumptions of standard economics, U.S. and European gas prices will not converge in the foreseeable future.
Last Friday in Brussels, Secretary of State Tony Blinken urged Europe not to drop its sanctions against Putin’s war, declaring, “We will not let our European friends freeze.” But that pledge was empty. There is no large source of energy that the U.S. can call on to replace Putin’s gas.
Europeans are prepared to temporarily shelve climate goals in favor of keeping power plants running. But Europe lacks the capacity to shift to other sources of energy supply at adequate volume anytime soon. Germany decommissioned most of its nuclear power plants two decades ago. Germany will defer shutting down the three remaining ones, but that will provide only a small fraction of German energy needs. European generators that run on gas cannot readily be shifted to oil or coal. Enhanced conservation can help but cannot fill the gap.
Even more than in the U.S., Europe’s inflation is not the result of overheated demand but the consequence of supply shocks.
Europe’s quandary is worsened by the fact that the EU is comprised of 27 member states, each with a different mix of energy sources and national interests. An emergency policy that served the needs of one nation could worsen the hardship of another.
Last Friday, EU energy ministers met in emergency session in Brussels to work out a common policy. For now, it appears that the strategy will be a mix of capping gas prices, subsidizing costs to consumers, and using windfall energy profits taxes to defray some of the expense. But first the strategy needs to be approved by the European Commission and then by a supermajority of member nations. In the meantime, major nations are developing their own national policies.
Even if Europe does everything right to address its energy crisis, some knock-on economic effects are inevitable. Even without this latest gas boycott from Russia, Europe is on the brink of a crisis of stagflation.
Unlike the U.S., where unemployment has been near record lows, average EU unemployment this year has been over 6 percent. While it has been just 2.8 percent in Germany, it has exceeded 7 percent in France, 8 percent in Italy, and 12 percent in Spain. With the pressure of higher energy prices, EU inflation, at over 9 percent, now exceeds U.S. levels.
This crisis echoes the stagflation crisis of the 1970s, which began with a response to a foreign-policy conflict that raised energy prices and then spilled over into a general economic crisis mismanaged by central bankers. In that instance, the OPEC nations, enraged by the West’s military aid to Israel, quadrupled the price of oil. The Federal Reserve worsened the crisis by panicking about inflation and raising short-term interest rates to over 20 percent, deliberately creating a recession.
In the current crisis, triggered by the Russian weaponizing of natural gas flows, the American Federal Reserve and the European Central Bank are in a kind of duel to hike interest rates. The U.S. rate increases pushed the dollar to new highs against the euro. Last week, the ECB defensively raised euro rates by three-quarters of a point. This was partly to protect the currency and partly out of the same misguided inflation phobia that has afflicted the Fed.
Even more than in the U.S., Europe’s inflation is not the result of overheated demand but the consequence of supply shocks. Higher euro interest rates will not cause Putin to release supplies of natural gas. Central bankers on both sides of the Atlantic should know better. The risk is that Europe’s energy crisis, compounded by bad central-bank policy, will push both Europe and the U.S. into recession.
The foreign-policy question is who will blink first. Suspending natural gas exports to Europe is costing the Russian economy a lot of money. Meanwhile, Ukraine has been making surprising gains on the battlefields, repelling the Russian threat.
The problem is that Putin has staked his presidency on continuing his war of attrition against Ukraine, and there is no face-saver that could allow Putin to relent and let the gas flow. Putin would have to conclude that the war is not worth it in terms of loss of domestic support and agree to some kind of peace settlement. Possible, but not likely. Losses on the battlefield could lead Russia into cyber warfare, including against power plants, which could worsen the energy crisis.
Meanwhile, Europe is in for a very rough winter. I can think of only two rather faint silver linings. One is that this crisis will accelerate the shift to renewables, with new public policies and citizen support. The other is the welcome end of the premise that energy is anything like a free market.
Last Friday’s New York Times report, lamenting the European move to more regulated energy markets, included this howler: “The question, though, is whether Europe is heading toward a cumbersome, state-controlled system that might be a turnoff for investors.”
In fact, energy is no free market, and deregulation has been a notable failure. Oil prices are manipulated by OPEC and by the refiners’ cartel; oil production in the U.S. has long been subsidized by tax preferences; gas prices are subject to geopolitical manipulation; and the shift to renewables has been promoted by feed-in tariffs, renewable portfolio standards, and tax subsidies.
The sooner we get over the illusion that energy operates by market forces, the better. In a few years, Europeans may appreciate that Putin did them a favor. They are not likely to feel that way this winter.
