Rock, Paper, Schism. Digging for Victory or Printing for Victory?
There is an inconvenient truth emerging for those sanctioning Russia for its invasion of the Ukraine. Europe’s reliance on Russian energy exports has revealed President Putin’s hand to be a stronger one than it might have initially appeared when the West went shock-and-awe on Russia’s central-bank reserves and SWIFT membership at the onset of the conflict.
The absolutely critical nature of fossil-fuel supply and consumption is also starting to reveal some profound cracks in the logic of the green energy transition as well. As nuclear energy all of a sudden becomes a more viable option in the developed world, and as the UK for example starts to um-and-ah about new North-Sea oil exploration and onshore fracking (both of which were beyond the pale even a few months ago), the war has acted as a salutary reminder that the economy runs on real stuff now not paper, promises and platitudes about the future.
Europe’s problem is that it relies on external sources of energy. This has been the case for that last century, and it is not coincidental that this is the period in which oil replaced coal as the dominant global energy source 1 . While some countries like France have a higher proportion of nuclear energy in their overall mix, on average, 40% of Europe’s gas comes from Russia.
Last week, the CEO of the German chemical giant BASF suggested that if Russia were to cut off the gas supply to Europe, there would be an economic collapse. This warning was precipitated by mumblings in Berlin and Paris about gas rationing and restrictions as a response to Russia’s President Putin demanding that energy exports amongst ‘unfriendly’ nations would now have to be paid for in rubles or possibly gold.
At the start of the Ukrainian war, Russia’s central-bank reserves held abroad were seized as part of the sanctions programme imposed by the West. President Putin has made it clear that while Russia will continue to export energy, he now wants it paid for in a currency which cannot be seized (ie rubles/gold etc). While European government’s cried breach of contract, it is arguable that the seizure of Russia’s central-bank reserves might act as a situation of force majeure, allowing a change to the terms of trade. That is one for the courts though. One thing is certain - Putin has said Europe can’t have the oil and gas for free.
If Russia cuts off Europe’s gas because European governments refuse to pay in rubles, these same governments are likely to have great difficulty in explaining to the average Joe (or Jo) on the street that the energy crisis isn’t actually one of supply but of payment currency. Nothing is more likely to foment civil unrest than an energy and food crisis. Big talk from Europe doesn’t automatically mean they’ll take a stand on principle - Slovenia has already indicated it’ll pay in rubles to keep the lights on.
Putin has effectively linked the ruble to gas and oil. The price of the ruble against the dollar collapsed to 150 as the Ukrainian war started but has since bounced to 85, and is almost back to pre-war levels. In addition, from the 28th March to the 30th June, Russia’s central bank will buy gold at 5,000 rubles per gramme from Russian banks. This then links the ruble to gold as well energy.
The rally in the ruble may look like sleight of hand - artificial demand created by forcing European energy providers either to buy rubles to pay for gas or deposit euros at Gazprombank which will then be converted to rubles. This move of insisting on energy payments in a particular currency is an exact mirror of Henry Kissinger’s push in 1973-4 to have the major Arab oil exporters (Saudi et al) only accept dollars for oil in exchange for promises of US security protection. The US dollar was unpegged from gold in 1971 and then de facto pegged to oil usage (as the petrodollar) in 1974. Putin is going one further by linking the ruble to energy and also gold. How very nineteenth-century of him.
If the ruble is now a genuinely hard commodity currency, then it’s rally against the dollar can be explained in these terms. Russia is the world’s second largest commodity producer, has a very small national debt and a low, flat-rate of tax. The effect of sanctions notwithstanding, the rebound in the ruble may in fact reflect a deeper trend in currency and commodity markets in an era of resource scarcity and high inflation.
In the UK, energy prices rose sharply on the 1st April (the start of the new financial year). After a budget with no tax cuts or any real help to households, Chancellor Rishi Sunak is under extreme political pressure as the country wakes up to a cost of living crisis. There are promises of tax cuts ahead of the election, but little else in the near term.
UK CPI inflation hit 6.2% in February 2022, and the proximal cause was the massive deficit spending resulting from the lockdowns of 2020-2021. With interest rates being raised to fight inflation, the government finances are already in a parlous state, so tax cuts and subsidies to help households might succeed only in weakening the pound, forcing interest rates higher, and causing inflation to rise more. Deficit financing at this stage, even if it is only to help the most needy deal with inflation, will likely only create the perception of economic weakness, possibly even raising the spectre of Britain’s old problem from the 1960s and 1970s of a balance-of-payments crisis.
The cure for high prices is high prices - at higher price levels, more supply comes to market, and this ultimately limits further price rises. But because government-sponsored fuel-price caps and subsidies keep demand elevated while doing nothing to improve supply, they tend to increase inflation over time even if they appear to be popular with voters in the short term. The problem is made worse if the source of the subsidies comes from deficit financing which worsens the health of the public purse.
Super taxes on oil companies are the same - they tend to reduce funds available for investment and therefore new supply, exacerbating shortages. the US decision to make a monster release from the strategic petroleum reserve (SPR) last week falls into a similar category - a short-term palliative, likely with an eye on mid-term elections in November, but one which discourages exploration and which therefore doesn’t improve supply and which may be the cause of further inflation in the future. This is notwithstanding the question of whether the current situation is even the sort of emergency for which the SPR was created.
The imposition of price controls, energy subsidies and even capital controls are all policy outcomes which will be tried, and which will fail, just as they did in the past. You can cure inflation through aggressive monetary policy which causes big recessions, just as Paul Volcker did in the early 1980s when he was Chairman of the US Federal Reserve. The difference now is the huge stock of debt and the risk of financial collapse resulting from the effect of rate hikes on the bond and equity markets.
Energy spikes cause recessions, and we may yet see western central banks forced to intervene to support the bond market via quantitative easing or even yield-curve control even while inflation is uncomfortably high. To this backdrop, we have the problem of war. Beyond the ‘kinetic’ war in the Ukraine, the propaganda war in the press and social media, there is a burgeoning economic and monetary war over commodities and how they are paid for.
This economic war is ultimately a matter of who owns the stuff, and especially in what currency that stuff is valued and transacted. The tectonic plates of the monetary system have shifted in the past few months. When is a dollar not a dollar? When it’s a Russian central-bank reserve. Russia has responded with a move to backing its currency by energy and gold. The West is responding with sanctions, subsidies, tax breaks, enhanced entitlements and hints about rationing. These are are all costly moves which won’t help their fiscal positions. In this instance, rock (commodities) tends to beat paper (debt). Will this be true for money too?
‘Disorder - Hard Times in the 21st Century’, Helen Thompson, Chapter 1-2.