A crisis is coming to Europe. The only question is, what type?
Note that the size of the recession is usually larger than the size of the initial price shock. When certain sectors begin to contract, they drag other sectors with them. Asset prices will also fall, which in turn will hurt investment and consumption. Economists sometimes call this “real business cycle theory,” a branch of knowledge that studies how an initial negative event can spread.
This is not just an imaginary economic tale. Recent data indicates that German exports are being hit hard, although part of this decline is due to non-energy related issues.
That sounds grim, but it’s important to realize that there is a different but equally grim path: Governments could take this energy price shock and turn it into a fiscal shock instead.
If a government recovers a sufficient share of the increased energy bill, it would be as if the energy price shock had never happened. In its polar form, such a policy would be difficult to put in place, but there have already been some steps in this direction. The UK government is committing a possible £200bn to insulate the UK economy from energy price shocks, although much of the energy price shock continues to ripple through the economy. The German economy also unveiled a spending plan of around 200 billion euros to shield the economy from energy price shocks.
Governments can try to limit energy price shocks in different ways. They can try to restore integrity to consumers and businesses with subsidies and income transfers, for example, or they can cap prices and then try to restore integrity to energy companies. Regardless of the exact combination of policies, the added cost will put a significant dent in government budgets.
If a government covered all of the additional energy costs, it would cost between 6 and 8% of GDP – and this cost would have to be incurred every year that energy prices remain high. This would require more government borrowing, higher taxes, more money printing, or some combination of these options.
The good news is that turning an energy crisis into a fiscal crisis does not propagate high energy costs throughout the economy. The bad news is twofold: first, keeping energy prices low does nothing to encourage conservation. Second, and more importantly, a fiscal crisis is still a crisis. Even if a government avoids additional borrowing, what is the leeway to raise taxes, given economic and political constraints?
In the late 1970s, there was no general movement to turn the energy price crisis into a (possible) fiscal crisis. Governments then did not think they could get away with the levels of borrowing they now routinely tolerate.
It is therefore a moment of political innovation: call it the fiscalization of economic problems. The pandemic is another very recent example. How long can the world tax its problems? Can taxation help the world avoid major economic crises?
This may be just the beginning of a very high level of debt as a form of insurance against bad luck. Or maybe the bond markets are about to rebel against such continued borrowing – and such debt will destroy the fiscal pact behind the European Union, given the common view that at least some of these countries will end up by abusing their borrowing privileges. Remember, real interest rates have been rising lately.
In short: none of these scenarios are particularly bullish, no one really knows what they are doing, and the end result will likely be dictated by the bond market. Have a nice day.
More from Bloomberg Opinion:
• Europe failed its first winter test of energy savings: Javier Blas
• The reworking of the Truss fracturing will not be seismic: Thérèse Raphaël
• The European “way of life” does not look too sweet: Lionel Laurent
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the Marginal Revolution blog. He is co-author of “Talent: How to Identify the Energizers, Creatives and Winners in the World”.
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