Europe and its Math Problem
European leaders keep ignoring basic math and economic principles. This will cost Europeans dearly.
“Prices are important not because money is considered paramount but because prices are a fast and effective conveyor of information through a vast society in which fragmented knowledge must be coordinated.”
Thomas Sowell
Price is a signal. When the price of something goes up, people will consume less of it. Demand adjusts to higher prices. It’s what you learn during your first lesson of economics. Price is how limited resources are allocated in the capitalist system. It’s why not everyone can fly business class, even though everyone would love to!
Unfortunately for Europeans, their leaders seem to be blissfully ignorant of the law of supply and demand.
Europe is facing a severe shortage of natural gas this winter that has translated into natural gas prices skyrocketing to prices equivalent to $500 per barrel of oil. The contracts for electricity prices in France and Germany trade at 10x their price 18 months ago.
In France, the increase of retail electricity tariffs has been capped at four percent this year, while in the UK, the newly elected Prime Minister has capped gas and electricity bills for the average household at £2,500 ($2,900) a year for the next 2 years, reversing an earlier proposal to raise the cap to more than £4,000. The cost: An astonishing $172 billion.
There is just one problem with this plan: It will actually make the situation worse for everyone in the UK. Because households won’t be paying anywhere close to the actual price of gas and electricity, they will consume much more than they would have if they were paying the actual price, which will result in a much higher cost for the UK. If you suppress the price signal, demand cannot adjust to its level of equilibrium with supply.
If you suppress the price signal, demand cannot adjust to its level of equilibrium with supply.
Can’t the government just borrow, and the central bank print the money needed? This was the playbook used during Covid, and the reason why the world is dealing with high inflation now. But there is another more fundamental problem: Commodities trade in US Dollar, not in British Pound (or in Euro). This means that billions of British Pounds will have to be sold for US Dollars to buy natural gas and other energy commodities. Can you guess what the impact will be? Yes, the British Pound will likely continue to depreciate against the US Dollar.
Since the UK imports pretty much everything it needs to survive, a weaker British Pound means higher import prices for everyone in the country, and hence higher inflation for everyone. It is, therefore, an illusion to think that the UK government’s plan will protect households. While the price of energy may remain artificially low for two years, the price of everything else will increase sharply. Once you understand that, you won’t find it surprising that Goldman Sachs is now expecting inflation to top 20% in 2023 in the UK.
If you want to know how the rest of Europe is doing, you can just replace “UK” with “European Union” and “British Pound” with “Euro” in everything written above.
In economics, there is always a feedback loop. There is no free lunch. In Europe, governments have decided to punish savers rather than making their citizens pay for the real price of energy. Anyone saving in Euro or British Pound is paying a very high price through the erosion of their purchasing power and the depreciation of their currency. Inflation in the eurozone is 9.1 percent and the European Central Bank just raised its benchmark interest rate to 0.75 percent. If you are receiving a one percent yield on your savings and inflation is nine percent, the purchasing power of your money has decreased by eight percent. This is called financial repression, and it’s what Europe is doing on a large scale.
Most of the pain currently experienced in Europe is self-inflicted. It is the direct consequence of the sanctions imposed on Russia. There is just one problem: The sanctions are not huring Russia, they are enriching it! Just look at the numbers below. Europe paid Russia more in the first half of 2022 than in the same period last year!
When demand for a basic good like energy is inelastic (meaning demand changes very little with price), the last thing you want to do is restrict its flow. But of course, it’s exactly what Europe did. The worst is yet to come, however, with the European ban on Russian oil imports scheduled to kick in in December. The cost for Europe is projected to be astronomical.
Russia is producing about ten million barrels of oil per day (10 percent of global production). If Russia decided to cut its production in half, it isn’t unrealistic to assume the price of oil would double. Russia would still generate the same revenues, but the energy bill for the rest of the world would double (listen to the Macro Voices episode if you want to hear more about this, link at the end of the newsletter).
European leaders greatly miscalculated where the economic leverage was between Europe and Russia, and the cost of this miscalculation will be very high for Europe.
Remember the 2020 hit “flatten the curve”? Well, the head of the EU Commission is bringing it back (because it worked so well, right?) Probably because it sounds better than “energy rationing.”
After decades of lecturing the rest of Europe on green energy, Germany’s number one source of electricity in the first half of 2022 was… coal! So much for the energy transition! Germany is reopening its coal-fired power stations as fast as it can.
Fortunately, there is seems to be a solution coming from Australia: Use your solar panels… at night!
Best Article I Read this Week
Arthur usually writes long and very well-researched articles. This one is no exception. In it, Arthur goes back in time to look at ways to protect your wealth in the event of a war (cold or hot) and what you can do now.
Links to Best Recent Podcast Episodes
The Grant Williams Podcast This Week In Doom Ep. 9 - What’s Next For Europe? Dream panel with Doomberg, Luke Gromen and Marko Papic to discuss the energy crisis in Europe.
The "What is Money?" Show The Nature of Discrimination | The Aneesh Karve Series. Fascinating episode that explains why government measures often achieve the opposite effect of what was intended.
Macro Voices MacroVoices #340 Dr. Anas Alhajji: Erik has the Energy Crisis story all wrong. If you want to learn how bad the situation is about to get in the oil market.
Something Different
After seven decades as Queen, Elisabeth II died earlier this week. The video below about her went viral and it is indeed a funny story. British humor at its best!
If you made it this far in this week’s newsletter, here is a bonus for you: The reason why there was no edition of Vincent’s Corner for five weeks! I’m happy to introduce you to my daughter, Chloé! She joined us on July 30!
