Dario Perkins of TS Lombard, and Paolo Maldini of sales economists, wrote a
bleak as hell An interesting new report on the predicament Europe is facing this winter.
Perkins estimates that governments trying to cushion the economic blow from higher energy prices could cost “at least” 5 per cent of GDP. Perkins argues that if this law seems prohibitive to some governments, the alternative is worse. Our focus is below.
Inevitably, governments are under tremendous pressure to support their economies during this difficult period. They have already announced several financial interventions, including liquidity provisions (for utility companies facing extreme margin demands), income transfers, and even energy “price caps.” The final fiscal bill could be huge, with a successful intervention likely to cost at least 5% of GDP per year (depending on what happens to energy prices). But Europe’s politicians have no alternative, especially since they – unlike central bankers – will eventually seek re-election. Many low-income families face real poverty this winter, while the rapid rise in input prices is set to destroy the profitability of European companies (especially small and medium businesses in the region, which are already operating at relatively meager margins). Unless governments act quickly and decisively, they could find themselves facing an economic crisis similar to the one they averted during the pandemic: massive pressures on corporate balance sheets, leading to a wave of bankruptcies and a sharp increase in unemployment. In short, another economic crisis along the lines of COVID requires a political response of the magnitude of COVID.
The problem, Perkins points out, is that all central banks currently seem to see uncomfortably high inflation. Although the European Central Bank does not act as aggressively as the Federal Reserve, the direction of travel is very clear.
So, there is currently a tug of war between European governments that are opening the fiscal taps in various ways to cushion the blow from rising energy costs – what Perkins calls “save everyone” – and monetary policy that is essentially trying to stifle economic growth gently but firmly.
As Perkins notes, this is largely a complete reversal of policy over the past decade, when monetary policy has historically been easy and fiscal policy has been arguably tighter than it should have been. The question is where this leads us.
Of course, massive financial expansion is in direct conflict with the philosophy of monetary custodians in Europe. Governments are, in effect, trying to protect the economy from an adjustment that central banks say is inevitable. But is the public sector’s response to the energy crisis necessarily inflationary?
The answer depends on the persistence of the shock. If energy prices quickly return to their pre-2022 levels – or governments quickly withdraw their support – governments will have introduced a one-time increase in public debt, which is unlikely to generate persistent inflation. However, problems arise if the energy crisis continues. Wholesale energy prices could remain high in 2023 and possibly beyond, making it very difficult for governments to reduce their subsidies to households and businesses.
Instead, the public sector will be under tremendous pressure to continue to support private standards of living, leading to large and persistent deficits and higher inflation in the medium term. If there were periodic power outages and sectoral shutdowns, we could face another COVID-style dynamic, where governments simultaneously subsidize income and constrain supply. Central banks will not be happy, especially since the longer inflation stays high, the higher the risks of “de-fixing” expectations.
Fasten seat belts.