The euro, energy and Europe - the rule of three?
The late Christopher Booker’s brilliant 2004 book ‘The Seven Basic Plots’ borrowed from Jungian psychology to categorise all fiction into seven archetypes. These were (in no particular order) comedy, tragedy, rebirth, voyage and return, overcoming the monster, rags to riches, and the quest. Interestingly, while its elves and goblins tend to excite either adoration or anger, Tolkien’s ‘The Lord of the Rings’ was the only work which Booker felt accommodated all seven of his plots.
Another of Booker’s literary tropes which economists have unknowingly co-opted is the rule of three, where the third event in a series becomes a final trigger for plot transformation. These three events can be cumulative (think of Mark’s gospel and Jesus suggesting Peter will betray him when the cock had crowed three times), contrasting (the three little pigs and their different taste in building materials) or dialectic, which is the one economists have plumped for in terms of their Goldilocks view of inflation which, like baby bear’s porridge, is neither too hot, nor too cold, but ‘just right’.
Sadly for Europe, there seems to be a three-part plot unfolding in its response to Russia’s invasion of the Ukraine. Economically this is clearly causing a transformation, but sadly not a dialectic one which involves a resolution. We have seen monetary sanctions on Russia’s foreign-exchange reserves, economic sanctions on some of its commodity exports, and now the European Commission, along with the G7 more broadly, is in the process of announcing price caps on energy exports from Russia, thus addressing a conspicuous loophole in the sanctions architecture which has allowed Russia to profit despite trade embargos on other commodity-related exports.
The West’s logic is clear - sanctions need to bite, and there have been various rounds of sanctions directed against both individuals and the state since Russia’s invasion on the 24th February. History recalls the League of Nations’ feeble sanctions following Italy’s invasion of Abyssinia in 1935 where the goods under embargo excluded materials of war such as iron, oil and rubber. There is a clear sense in which Europe’s continued reliance on Russian gas has undermined its overall moral opposition to Russia’s acts of aggression.
Yet history also recalls the embargo enforced by Britain’s Royal Navy in the First World War where the blockade which began in 1914 really began to bite in Imperial Germany by 1916, a year which saw the ‘great swine slaughter’ as the dearth of animal feed and fertilizers saw agricultural productivity collapse. The Brits meant business and were in it for the win, hence playing this long game. The German home-front suffered as people began to starve, and the subsequent unwillingness of politicians to continue the war is where the germs of the pernicious ‘stab in the back’ theory of the German military defeat in 1918 sprang from.
The logic of sanctions must involve the resolve to continue whatever the cost. These were sentiments propounded last week by Germany’s foreign minister, Annalena Baerbock, when she said support for Ukraine would continue even in the face of voter opposition. The long-term effect of a lack of access to Western oil services, shipping and shipping insurance may well undermine Russia’s ability to continue pumping oil and re-routing it to Europe through back-door means, but as with the Italian sanctions in 1935 where the USA’s absence from the League of Nations meant it could avoid sanctions and still export to Italy with impunity, so there are routes by which oil and gas can make their way to Europe via non-sanctioning countries.
Friday’s G7 announcement of price-caps on Russian oil exports was immediately followed by a suspension of gas flows through the Nordstream 1 pipeline by Russia. The stakes have never been higher. While the graph above shows German 1yr forward electricity prices halving on the week, they are still up around four and a half times year-on-year.
Purchasing Price Indices (PPI), which measure input costs to businesses, are starting to hit the +40% year-on-year levels in various European countries. If they cannot pass on cost increases of this magnitude, businesses simply start to fold. Social democracies (and energy-reliant industrial economies like Germany’s) cannot function with input-price increases like this without risking severe economic disruption, rising unemployment and associated social dislocation.
In Europe, the third part of the sanctions plot which so far involves an intention to cap prices on Russian oil imports is likely to be accompanied by a series of inter-related measures orchestrated by the European Commission involving energy rationing, retail energy-price caps and also caps on prices received by non-gas related energy producers on their output. A possible suspension of the European energy derivatives market also appears to have been discussed. Along with ongoing bail-outs for European energy producers, this combination of actions is clearly not very good for GDP or government deficits when taken as a whole.
The logic of social democracy, particularly given what happened in the recent pandemic, is to support citizens and businesses whatever the cost. In the UK, the maintenance of the energy price-cap at pre-Ukraine war levels is supposed to cost £100b per annum, a figure higher than the pandemic furlough bill of £60b. Britain’s new Prime Minister is going to be tasked with ‘doing something’, but in the meantime, the pound has been tanking while gilt yields have been rising.
The same is true of Europe, only with the risk of a bond-market crisis in Europe’s periphery very much in the market’s focus, especially in Italy where elections are due on the 25th September. If the ECB is forced to step in to support the bond market even as it tries to hike rates to fight inflation, will the euro, which is currently lingering around parity with the dollar, be the main casualty? A falling euro will only further increase the price Europe pays for commodities, even as governments step in to provide help. A plot transformation in terms of the rule of three, but certainly not a fairy-tale ending.
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