Seize the Moment - Europe can afford an embargo on Russian gas

While an embargo on Russian gas would be costly, Europe can afford it.

As the heavy bombardment of Ukrainian cities continue, the Russian invasion could yet prove to be Putin's biggest own goal. 

​The internal conflicts within America and Europe in recent years - caused mainly by the shambolic regimes of Donald Trump and Boris Johnson - were the perfect backdrop to Putin's  invasion from a Russian perspective. Indeed, President Biden’s seeming lack of appetite for war in Afghanistan and the subsequent withdrawal of US troops from the region in late 2021, must have signalled to Russia that Western hegemony in geopolitics had reached an historical low point. 

The war in Ukraine, however, has managed to reignite Western influence on the world stage, galvanising a united response to Russian brutality against a European state. Putin may have underestimated this. 

Europe, including Great Britain, seems far more aligned now than in recent years, collectively buoyed to defend one its own from a Russian invasion. Since the war broke out less than a month ago, the EU has committed €1.2 billion in financial and military aid to Ukraine. America has pledged $6.5 billion in defence spending and other measures. More may follow. 

While the West rightly refuses to engage in military conflict with Russia, its economic sanctions have been brutal and could prove fatal to the Russian economy. No other country including Iran has received tougher sanctions from the West than Russia.

The most effective of these sanctions has been the cutting off of the Russian central bank from international markets. Approximately 50% of Russia’s $600 billion war chest of gold, dollars, and other foreign reserve assets have been seized by US and European banks. As the Russian economy falters and its currency weakens, Russia may soon run out of ammunition to defend the Rouble. Central banks maintain exchange rates by buying or selling domestic currency with foreign reserves. When the domestic currency falls in value relative to another currency, the central bank buys more domestic currency using its foreign assets, mainly US dollars.

The Rouble has been in free fall since sanctions began and on February 28th when the West first announced it was cutting Russia off from SWIFT, the global banking messaging system, the Rouble tanked losing 26% of its value. 

Domestic inflation in Russia currently stands at 11%, twice the EU average. But most economists predict Russian inflation could reach 20% by the end of the year. Russia’s central bank has raised interest rates from 9.5% to 20% to stem capital flight and prevent a collapse of the Rouble. Interest rates are likely to rise much higher, however, should sanctions continue. Such high interest rates are a massive burden on ordinary Russian citizens who could yet default on loans and mortgages and cause an internal banking crisis.

The glaring weakness of the West’s economic war with Russia, however, is how badly dependent Europe is on Russian oil and gas. 40% of German energy, for example, is sourced directly from Russia. It is estimated on a daily basis that $1.5 billion flows into Russia from Europe, providing Russia’s central bank with vital supplies of foreign reserves. If the West has any chance of toppling Putin’s regime in the long term without military conflict, it must put an end to buying Russian oil and gas.

Headline inflation in the EU, which includes food and energy prices, now stands at 5.8%, the highest in over 40 years. Taken on its own, energy inflation is 30% on an annual basis when compared to this time last year.

If Europe, like the US, were to stop its consumption of oil and gas from Russia, the estimated increase in energy prices in Europe could treble given the likely delays of sourcing energy elsewhere in the world.

Oil, which is mostly transported by tankers, could be supplied by Norway, the US or the Middle East. Natural gas however, which is the predominant source of energy in Europe, is mostly supplied via fixed pipelines from Russia and constitutes 40% of the continent's energy requirements.

European refineries that convert crude into gasoline are designed for denser Russian oil and would face challenges switching to other kinds of oil sourced from other regions. Countries such as Poland and Hungary who purchase 60% and 90% of their gas from Russia respectively could find any such changeover especially challenging.

Further supply constraints on top of existing shortages could cause a devastating hit to disposable incomes in Europe, which are already feeling the pinch from current inflation. A deep recession could follow. 

But Europe has options. Its co-ordinated and unprecedented fiscal response to the pandemic is an indicator of its financial might and the strength of its currency. The vast majority of the EU’s €2.3 trillion covid fund was spent on furlough schemes and business supports. Mass unemployment on the continent was subsequently avoided. Despite entire industries and businesses closing for the the best part of 2020 and beyond, the global economy rebounded from the deepest economic contraction in recorded history after just 2 months.

The difference in Europe has undoubtedly been the power of its central bank, the ECB, and its commitment to print vast amounts of money and buying government bonds. In the latter stages of the financial crisis 10 years ago, and most recently during the pandemic, newly printed money flowed into financial markets preventing interbank lending from freezing and allowing European governments to borrow cheaply on financial markets.

The idea of excessive borrowing and money printing in the face of existing inflation may seem reckless. The current inflation issues in Europe, however, exist primarily from an explosion of consumer demand and a shortage of goods including oil and gas. 

Even countries as poor as Afghanistan whose government spent only a fraction of its GDP (2.2%) on the pandemic relative to richer countries are experiencing the same inflation as the rest of the world. According to the World Bank, the Afghan currency, the Afghani, has remained broadly stable relative to the US dollar meaning its 5% inflation rate cannot be blamed on a currency crisis either. 

Current inflation, therefore, is largely supply driven. When too much demand meets too little supply, inflation is the result. In good times, consumers spend more than they save. In a war scenario, consumer demand evaporates. Add in higher energy prices and the knock to consumer confidence could be detrimental.

Instead of stoking the inflationary fire, further fiscal support from governments would avoid a massive deflationary shock during an economic depression. Should Europe boycott Russian oil and gas, large state subsidies in response to rising energy costs could soften the blow to European households and businesses. We’ve seen how effective these measures have been during the pandemic. There is little reason to suggest these measures can’t be as effective again.

While further government borrowing would cause deficits to rise and worsen the existing debt pile within the EU, member states can roll over debts if required. The US and Japan have been doing this for decades. If no buyers are willing to lend to these countries (which has yet to happen), their central banks pick up the tabs.

Since the start of the pandemic, 70% of Irish government borrowing has been directly facilitated by the ECB. The EU will never allow smaller nations to be locked out of capital markets again. The so-called ‘PIGS’ of the financial crisis over a decade ago, Portugal, Ireland, Greece, and Spain, are unlikely to ever experience the same economic indignity and isolation at the hands of their own neighbours.

The pandemic has brought much needed fiscal union among member states. It’s hard to imagine that the EU will revert to old austerity policies and risk a collapse of the Euro.

The war itself is likely to delay the ECB's plan this year to raise interest rates. Pinning rates down allows government’s to continue borrowing at very low costs. Despite inflation, raising rates would only worsen the economic environment by making borrowing and investment more punitive on consumers and businesses. Politically, this would be extremely unpopular during a crisis.

For reasons beyond the scope of this article such as demographics, technology and the slowing down of the Chinese economy, the long term outlook for future inflation is that it is likely to remain low. The bond markets seem to agree. 

The yield curve on long US treasuries started to flatten before Russia’s invasion of Ukraine. Many analysts now believe yield curves in the West may actually invert as the risk of a recession seems greater. A yield inversion is when short term interest rates rise above long term rates. Put simply, investors have been increasing their lending to governments in the long term despite receiving very low yields and interest rates. If they believed inflation was here to stay, they would reduce their holdings of long bonds until interest rates rise high enough to compensate for higher inflation and economic growth. But this is not the case.

In war times, even in the face of soaring inflation, investors rush to safe havens such as government bonds. There will be no shortage of buyers of government debt so long as the conflict continues. Europe has the financial wherewithal, therefore, to significantly soften the blow of rising energy costs. 

In Ireland, if the Irish government decided to subsidise all household energy bills by 50%, the rough costs to the exchequer would be €456 million per annum based on the average monthly bill of €160 trebling. That's less than half of what is spent on national defence every year or 0.4% of Irish GDP. The government can well afford it. 

In many regards, recent events have brought nations closer together in solidarity for the greater good. Europe in particular has been made stronger by its adversaries. Brexit, a pandemic and now a war. The solidarity and support shown to Ukraine is a timely reminder of this. 

​One of Putin’s biggest miscalculations may have been to assume the US and Europe would lack the stomach for war. While current sanctions have been bruising to the Russian economy, Europe’s greatest ever show of solidarity would come from its boycotting of Russian oil and gas. That it could be led by Germany, a country where war and inflation are so deeply woven into its past, would be the sweetest of ironies. This would be a monumental moment in European history and one that would surely crush Putin’s regime and bring an end to war without violence. 

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