An inflationary blow to the Europeans as an effect of the Kremlin strategy

The New York Times. Special

You probably have to be a senior citizen to remember the fuel shortage of 1979. Back then, as now, outside of some major cities, America was a nation heavily dependent on cars and waiting in long lines, not knowing if it could fill up. , it was deeply disconcerting. What caused that shortage?

The precipitating event was the Iranian revolution, which caused world oil prices to skyrocket. But an increase in the price of oil does not necessarily mean a shortage of gasoline; it could, as we have seen recently, simply mean higher prices at the pump. The problem was that politicians were unwilling to see the global price increase completely passed on to American consumers, as only about 40% of the oil we consumed was imported. So they tried to limit the hit with various price and distribution controls; we don’t need to go into details.

The point is, as any economics book will tell you, price controls often (not always) lead to excess demand over supply, and that’s where queues and shortages come from. Sometimes there are good social reasons not to collapse markets, even if government intervention comes at a cost. This is why a number of countries are likely to intervene heavily on energy markets in the coming months. The United States, where falling gasoline prices temporarily reduced inflation to zero, will not be one of those countries.

But Russia has drastically reduced natural gas shipments to Europe and as a result European households are facing a huge inflationary shock. You may be wondering why Russia’s de facto embargo is so important. After all, Russia is not the only supplier of natural gas, and gas is only one of Europe’s energy sources.

Consider, for example, British electricity generation. Gas accounts for only around 35% of British electricity and currently none comes from Russia. Yet the energy bills of British households are skyrocketing, why? Part of the answer is that natural gas markets are basically defined as regions served by private pipeline networks and, while it doesn’t import gas directly from Russia, Britain is part of the European gas market.

Russia’s sneaky embargo has pushed prices up in that market. However, isn’t gas just part of the British picture? Yes, but as textbooks tell us, the price of an asset does not normally reflect its average cost of production, but rather its marginal cost: the cost of the last most expensive unit.

In Britain, the marginal kilowatt hour is produced by gas. So it’s on, on and off, unless the government intervenes. Without government intervention, energy prices would rise so much that millions of households would be financially ruined. Something has to give.

In Britain in particular, the political landscape is somewhat murky as Liz Truss, Boris Johnson’s most likely successor, refuses to announce his energy policy until he takes office. At this point, it appears that the preferred policy may involve financial aid to households rather than the price caps that have been imposed by, among others, France and Spain. In practice, however, this may not be enough, because the needs of families will be very different. Even among people with similar incomes, some will live in houses with good insulation and low energy bills; others in buildings with energy-intensive systems. In the long run, the policy should encourage everyone to improve their energy efficiency. But in the long run, we are all very impoverished in the face of this gigantic price shock.