How would an energy embargo affect Germany’s economy?

RUSSIA’S DECISION to halt the supply of gas to Bulgaria and Poland has added fuel to an already heated debate in Germany, which is heavily reliant on the commodity. For weeks the country’s economists and officials have argued over just how much a ban on Russian hydrocarbons would harm the economy. Now it seems imaginable that Russia itself could turn off the taps. What toll would an embargo take? A wide body of research, which examines a range of past disruptions, sheds light on the question.

The relationships between modern firms are not simple links connecting one producer with another, but a tangle of complex interactions. The breakdown of a seemingly insignificant link in the chain can disrupt firms that are either upstream or downstream of it, causing wider damage. In a paper published in 2019 David Baqaee of the University of California, Los Angeles, and Emmanuel Farhi of Harvard University used a model of complex supply networks to study the oil shocks of the 1970s. Linkages between firms and sectors meant that the overall economic effect was quite a bit larger than the direct impact on sectors that used oil. Recent research on the effect of social distancing on America by Jean-Noël Barrot, then of HEC Paris, and his co-authors finds that ripple effects through production networks accounted for more than half of the total economic impact.

Another much-studied instance of disruption is the earthquake that struck north-eastern Japan in 2011. As the worst-hit areas only accounted for less than a twentieth of GDP, local disruption should not have had a noticeable nationwide effect. But it did. In a review Vasco Carvalho of the University of Cambridge and colleagues disentangle the impact on the affected areas from the ripple effects along supply chains, and find that the latter accounted for more than half the hit to Japanese growth.

Researchers have also uncovered the types of links and mechanisms that enable shocks to propagate widely. The shutdown of a company altogether is one way in which a jolt can create a much bigger economic hit, according to a paper by Daron Acemoglu of the Massachusetts Institute of Technology and Alireza Tahbaz-Salehi of Northwestern University (as well as another study by Mr Baqaee). That explains why Alan Mulally, then the chief executive of Ford, a carmaker, urged American lawmakers to bail out his competitors during the global financial crisis. Ford feared the collapse of the auto sector’s suppliers, which would cause severe disruptions at its own plants, too.

Intimate commercial relationships, such as those within firms, tend to be especially affected, because they are harder to replace. Another study of Japan’s 2011 earthquake by Christoph Boehm of the University of Texas, Austin, and others finds that the American subsidiaries of Japanese firms also suffered, as did their suppliers. Other research also concludes that the more customised the relationship between firms and their suppliers, the bigger the ripple effects. Mr Barrot and Julien Sauvagnat of Bocconi University examine 30 years of American natural disasters and find that disruption to just one supplier leads to a loss in sales for a downstream firm of two to three percentage points, which, considering that most suppliers provide a small portion of a firm’s production inputs, is a sizeable fall.

Such findings provide fodder for opponents of an energy embargo in Germany. And some estimates of the impact of an embargo also suggest that the short-term disruptions could be large. Six leading German research institutes conclude that an embargo could lead to a GDP loss for the country of around 1% this year and 5% in 2023. The Bundesbank estimates a hit of 5% in 2022.

Yet there are two reasons why things need not be so bad. For a start, just as past experience shows that supply disruptions can have sizeable near-term effects, it also shows that the economy in aggregate has a great ability to adjust. In 2010 China banned the export of rare-earth metals to Japan, one of the world’s biggest users of the minerals. Japanese firms were able to quickly substitute away from previously cheap rare earths and find alternative supplies, according to research by Eugene Gholz of the University of Notre Dame and Llewelyn Hughes of the Australian National University. In a study of the potential effects of a Russian energy embargo on Europe, Rüdiger Bachmann of the University of Notre Dame and his co-authors find that while the hit could be large, it would be partly offset by the economy’s ability to adapt. The overall impact, they reckon, could be in the region of 0.5-3% of GDP.

Production, interrupted

Moreover, it is within the gift of governments to mitigate the short-term pain of supply disruptions. EU officials, for instance, are mulling stricter sanctions on energy imports from Russia. The more notice firms receive about the measures, which could include a tax on Russian energy, the easier adjusting to them is likely to become. Past episodes suggest that if policymakers do want to change regulations or trade relationships, they should do so consistently and carefully. A liberalisation of Indian trade in the 1990s led to little wider disruption because it was gradual, helping firms adjust. A recent study by Alessandra Peter of New York University and Cian Ruane of the IMF points out that Indian firms were able to find substitutes for inputs.

Governments could also take into account the fact that businesses may not do enough to ensure that networks are solid in the near term. Matthew Elliott of the University of Cambridge and others find that firms might invest in the robustness of their supply chains if they have a business case to do so. But they might not seek to ensure the resilience of the wider network, because they do not stand to reap the rewards from such investment. Encouraging firms and households to shift away from using fossil fuels, as a tariff would do, could enhance that resilience. Managed well, Germany’s supply disruptions need not be quite so disruptive. ?

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