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 non-energy-related problems.
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 UK government is committing a possible £200 billion toward insulating the UK 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 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.
(COMMENT, BELOW)
Cowen is a Bloomberg View columnist. He is a professor of economics at George Mason University and writes for the blog Marginal Revolution. His books include "The Complacent Class: The Self-Defeating Quest for the American Dream."
Previously:
• 09/06/22 What is the purpose of public policy?
• 08/15/22 The future of travel is less exotic
• 08/01/22 Welcome to the era of antisocial media
• 07/25/22 Biden's COVID diagnosis is a wake-up call for America
• 05/12/22 A nuclear strike might not prompt the reaction you expect
• 03/22/22 Doomscrolling has ruined our sense of time
• 01/22/22 Wokeism has peaked
• 01/31/22 The latest bias to worry about
• 01/17/22 America's loneliness epidemic
• 01/07/22 Some of America's top universities just revealed they're not morally serious
• 12/29/21 America would be more happy with more people
• 12/10/21 Bill Gates, Jeff Bezos, Elon Musk . . . and Paul McCartney
• 12/08/21 The only two pieces of advice you'll ever need
• 11/29/21 Nuclear fusion is close enough to start dreaming
• 10/27/21 America's national mood disorder
• 06/10/21 Lifting of mask mandates poses a challenge for Libertarians
• 05/28/21 Why economics is failing us
• 04/19/21We need green energy. We don't need green jobs
• 04/14/21 Libertarianism isn't dead. It's just reinventing itself
• 04/05/21 What does the world need? More humans
• 02/10/21 If Biden goes big now, he may have to go small later
• 01/12/21 Covid improved how the world does science
• 12/07/20 How to make sure your complaint is heard
• 10/27/20 It's getting better and worse at the same time
• 09/14/20 How to be happy during a pandemic
• 09/04/20 Trump is winning the vaccine debate with public health experts
• 07/01/20 Why Americans are having an emotional reaction to masks
• 05/20/20 Covid-19 will expose the ghosts in the U.S. economy
• 05/07/20 Are aliens visiting us? US military seems to think so
• 05/06/20 America's reopening will depend on one thing --- trust
• 04/22/20 How the covid-19 recession is like World War II
• 04/15/20 America is returning to 1781
• 04/08/20 Covid-19 is is upending everything for status seekers
• 03/17/20 The coronavirus will usher in a new era of entertainment
• 01/28/20 Social Security isn't doomed for younger generations
• 01/08/20 Why 2020 is harder to predict than 2019 was
• 12/02/19 Equality is a mediocre goal so aim for progress
• 11/25/19 Inflation inequality creates winners and losers
• 11/09/19 OK kids. This boomer has had enough
• 10/20/19 Would you bet against Trump in 2020?
• 09/25/19 The right industrial policy for America
• 09/24/19 Harvard's legacies are nothing to be proud of
• 09/02/19 Yes, the Fed could still stop a recession
• 08/20/19 A trade deal with China wouldn't change much
• 07/29/19 How your personality traits affect your paycheck
• 07/16/19 Internet 101 should be a required class
• 05/28/19 How Dems actually are the ANTI-immigrant party
• 04/23/19 Want to help fight climate change? Have more children
• 03/22/19 America isn't as divided as it looks
• 03/12/19 The Twitter takeover of politics: You ain't seen nothing yet
• 03/04/19 How to tell which Dem dreams won't come true
• 02/07/19: Now the Dems want to end America's nuclear first strike option. How clueless is that?
• 01/29/19: The shutdown hit a lot of government workers --- hard. But, ultimately, who is responsible for their unfortunate circumstances?
• 12/12/18: The West is abusing its legal power to punish people or institutions that do things it doesn't like. It better stop
• 10/23/18: The US needs Saudi Arabia, and vice versa
• 10/19/18: The right finds the perfect weapon against the left
• 07/24/18: The drive for the perfect child gets a little scary
• 06/04/18: Side effects of the decline of men in labor market
• 05/14/18: Proving Marx's theories right
• 05/08/18: Holding up a mirror to intellectuals of the left
• 05/01/18: Virtual reality will make lives better ... mostly
• 04/16/18: It's hard to burst your political filter bubbleIt's hard to burst your political filter bubble
• 04/09/18: The missing key to grasping why American politics seems to have become more polarized, with no apparent end in sight
• 04/05/18: Two American power centers are about to clash
• 03/22/18: We fear what we can't control about Uber and Facebook
• 03/08/18: How to stop the licen$ing insanity
• 01/10/18: Polarized Congress needs to bring back earmarks
• 12/27/17: The year when the Internet collides with reality
• 11/07/17: Would you blame the phone for Russian interference?
• 10/23/17: North Korea is playing a longer game than the US
• 10/12/17: Why conservatives should celebrate Thaler's Nobel
• 08/02/17: Too many of today's innovations are focused on solving problems rather than creating something new