Europe’s governments face a choice when it comes to crises

European governments are facing a choice of which kind of crisis to have: an energy crisis or a fiscal crisis. The global economy may hang in the balance.

Estimates of the size of the energy price shock vary, but one plausible assessment runs in the range of 6% to 8% of GDP for Europe. One response to this shock would be to let energy prices rise and allow the private sector to adjust. This would mean higher costs for manufacturing, higher home heating bills, and lower disposable income to spend on other goods and services. In broad terms, it would be like the energy price shock of 1979 and the following recession.

Note that the size of the recession is typically larger than the size of the initial price shock. As some sectors start to contract, they bring down other sectors with them. Asset prices will fall as well, which in turn damages investment and consumption. Economists sometimes call this “real business cycle theory,” a branch of knowledge which investigates how an initial negative event can spread.

That is not just an imaginary economic tale. Recent data indicate that German exports are taking a severe hit, although some of this decline is due to problems not related to energy.

That sounds grim, but it is important to realize that there is a different yet equally grim path: Governments could take this energy price shock and turn it into a fiscal shock instead.

If a government picks up enough of the increase in the energy bill, it would be as if the energy price shock never happened. In its polar form such a policy would be difficult to pull off, but there have already been some moves in that direction. The U.K. government is committing a possible 200 billion pounds toward insulating the U.K. economy from energy price shocks, though much of the energy price shock still will still make its way into the economy. The German economy has also unveiled a plan to spend about 200 billion euros to protect the economy from energy price shocks.

Governments can try to limit energy price shocks in different ways. They can try to make consumers and businesses whole again with subsidies and income transfers, for example, or they can cap prices and then try to make the energy companies whole again. Whatever the exact mix of policies, the extra cost will put a big hole in government budgets.

If a government picked up the entire extra energy cost, it would cost something in the range of 6% to 8% of GDP — and that cost would need to be incurred every year that energy prices stayed high. That would require more government borrowing, higher taxes, more money printing or some mix of those options.

The good news is that turning an energy crisis into a fiscal crisis doesn’t spread high energy costs through the entire economy. The bad news is twofold: First, keeping energy prices low does nothing to encourage conservation. Second, and more important, a fiscal crisis is still a crisis. Even if a government eschews extra borrowing, how much room is there to raise taxes, given economic and political constraints?

In the late 1970s, there was no general move to turn the energy price crisis into a (possible) fiscal crisis. Governments then didn’t think they could get away with the levels of borrowing they now routinely countenance.

So this is a moment of policy innovation: Call it the fiscalization of economic problems. The pandemic is another very recent example. For how long can the world fiscalize its problems? Can fiscalization help the world avoid major economic crises?

Maybe this is only the beginning for super-high debt levels as a form of insurance against very bad luck. Or maybe the bond markets are on the verge of rebelling against such continued borrowing — and such debt will wreck the fiscal compact behind the European Union, given the common view that at least some of those countries will end up abusing their borrowing privileges. Real interest rates, remember, have been rising lately.

In short: None of these scenarios is especially upbeat, no one really knows what they are doing and the eventual outcome will probably be dictated by the bond market. Have a nice day.