Wonking Out: Europe and the Economics of Blackmail

Four decades ago I spent a year working in the U.S. government, on the staff of the Council of Economic Advisers. (For those wondering: Yes, this was the Reagan administration; no, I wasn’t a Republican.) It was a technocratic job. I was the chief international economist; the chief domestic economist was a guy named Larry Summers. What ever happened to him?

Anyway, I spent most of my time in the office, crunching numbers. I did, however, sit in on a few cabinet-level meetings, and I recall in particular one involving European plans to build a pipeline that would greatly increase gas imports from the Soviet Union. Some officials were searching for ways to deter the project, but nobody had any good ideas.

But those officials weren’t wrong to worry that dependence on Soviet — later Russian — gas would create strategic vulnerability. Indeed, Europe’s dependence on Russian gas has arguably become the biggest risk now facing the world economy.

Russia is a third-rate economic power, but it and Ukraine are, or were, major suppliers of some important commodities. When Vladimir Putin invaded his neighbor, prices of wheat — a lot of which is grown in the “Black Earth” belt that stretches across Ukraine, Russia and Kazakhstan — and oil, much of which is extracted in the Ural Mountains, soared.

More recently, however, much of the price shock from the war has receded. According to the U.N.’s Food and Agriculture Organization, world food prices have given up most of their wartime surge:

And oil prices have also come down substantially from their peak:

What’s happening in these cases is that both agricultural commodities and oil are essentially traded on world markets, which for better or worse allows a lot of flexibility. For example, Russia can sell its oil to India instead of Europe, and Europe can in turn buy Middle Eastern oil that would otherwise have gone to India. Add in a good U.S. wheat harvest and factors like weak oil demand from a troubled China, and the overall commodity price shock is turning out to be smaller than many feared.

There is, however, one exception, and it’s a doozy: European natural gas.

Unlike the markets for oil and wheat, the market for gas isn’t fully global. The cheapest way to ship gas is normally via pipelines, which breaks the world into separate regional markets defined by where the pipelines run. The main alternative is to ship gas in liquefied form, which is how it gets to markets not served by pipelines, but this requires specially designed shipping and terminals, which can’t be added rapidly in a crisis.

Which brings us to the current moment. Russian gas deliveries to Europe have plunged about 75 percent from a year ago. The Russians claim to be experiencing technical difficulties, but nobody believes that; this is clearly a de facto embargo intended to pressure the West into cutting off support for Ukraine. And the result has been an incredible surge in European gas prices:

If you want a historical comparison, the roughly tenfold recent surge in European gas prices dwarfs the oil price shocks of 1973-4 and 1979-80, which played a big role in the stagflation of the 1970s.

It’s probably not a coincidence that the latest price surge began in mid-June. That’s more or less when it became clear that Russia’s second offensive in Ukraine — the one that followed its disastrous initial attempt to seize Kyiv — wasn’t going to achieve decisive results, and that the military balance was likely to shift in Ukraine’s favor as Western weapons arrived. So Russia turned to economic warfare instead.

Europe is making up for the shortfall in part by importing liquefied natural gas, especially from the United States, which produces a lot of natural gas from shale. But the capacity for L.N.G. shipments is limited, which is why U.S. natural gas prices, while up, haven’t surged nearly as much as European prices:

How is this all going to play out? Sophisticated, advanced economies have enormous capacity for adaptation, and Europe has been building up its gas stocks to get through the winter; the continent will find ways to manage even if it’s receiving very little Russian gas. But a bout of high inflation is inevitable, and a European recession seems extremely likely.

That said, macroeconomic considerations are probably secondary to the question of how Europe will cope with the extreme hardship many families will face from soaring energy bills. Governments will have to find ways of alleviating that burden — a tricky problem when they also want to preserve incentives to conserve energy. The politics of gas prices are likely to be extremely turbulent over the next few months.

Will Putin’s economic blackmail succeed in undermining Western opposition to his aggression? Probably not. Among other things, the countries that seem least resolute in the face of Russian pressure — hello, Germany — have also been doing the least to support Ukraine, so it doesn’t matter much if they lose their nerve.

But whatever happens now, we’re getting an object lesson in the dangers of becoming economically dependent on authoritarian regimes. Economists have long been skeptical about national security arguments for limiting international trade, which have often been abused in the past. But Russia’s actions have given those arguments much more force.