TS Lombard’s Dario Perkins, the Paolo Maldini of sellside economists, just wrote one
fierce as hell interesting new account of the predicament Europe is facing this winter.
Perkins estimates that the cost to governments trying to mitigate the economic impact of rising energy prices could be “at least” 5 percent of gross domestic product. If that bill seems steep to some governments, the alternative is worse, argues Perkins. Our emphasis below.
Governments are bound to be under tremendous pressure to support their economies during this difficult time. They have already announced various fiscal interventions, including liquidity provisions (for utilities facing extreme margin calls), income transfers and even energy “price caps”. The ultimate bill for public finances could be huge, with 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 – unlike central bankers – they will eventually seek re-election. Many low-income households face real poverty this winter, while rapidly rising input prices will destroy the profitability of European companies (particularly the region’s SMEs, which are already operating on relatively low margins). Unless governments act quickly and decisively, they could face an economic crisis similar to the one they have successfully avoided during the pandemic: huge strains on corporate balance sheets, triggering a wave of bankruptcies and a sharp rise in unemployment. In short, another COVID-style economic crisis requires a COVID-sized political response.
The problem, Perkins says, is that all central banks seem to be seeing uncomfortably high inflation right now. Although the European Central Bank is not acting as aggressively as the Federal Reserve, the direction of travel is pretty clear.
So there is currently a tug-of-war between European governments, which in various ways are opening up the tax loopholes to cushion the impact of higher energy costs – what Perkins calls “The Everybody Bailout” – and monetary policy which is essentially trying to moderate economic growth but firmly to throttle .
As Perkins notes, this is pretty much a complete reversal of policy over the past decade, when monetary policy has historically been easy and fiscal policy arguably far more restrictive than it should have been. The question is where this leads.
Of course, a major fiscal expansion runs directly against the philosophy of European monetary authorities. Indeed, governments are trying to protect the economy from an adjustment that central banks believe is inevitable. But is the public sector response to the energy crisis necessarily inflationary?
The response depends on the duration of the shock. If energy prices quickly return to pre-2022 levels – or governments quickly withdraw support – governments have created a one-off increase in public debt that is unlikely to generate sustained inflation. However, problems will arise if the energy crisis continues. Wholesale energy prices could remain high in 2023 and possibly beyond, making it extremely difficult for governments to scale back their support to households and businesses.
Instead, the public sector would be under enormous pressure to continue subsidizing private living standards, leading to large, persistent deficits and higher inflation in the medium term. Add in periodic power outages and sectoral lockdowns, and we could face another COVID-style dynamic, with governments simultaneously supporting incomes and curtailing supplies. Central banks would not be happy about this, given that the longer inflation remains high, the greater the risk that expectations will be “unanchored”.