Letter from Germany: The energy crisis and the German model

13 Jul 2022

Michael Burda on supply shocks, inflation, and German competitiveness in the Eurozone

Alas, our world faces yet another challenge. Just as we were recovering from global and sovereign debt financial crises, Brexit, and the pandemic – and starting to take on climate change – Europe is seeing armed conflict which, in its senseless brutality and wanton destruction, is unrivalled since the middle of the last century. The intransigence of the aggressor signals that the war has the potential to be long and drawn-out, recalling that the First and Second World Wars lasted respectively four and almost six years. The economic consequences are likely to be severe and persistent. One can only hope that economic sanctions can stop the madness, although there is little evidence that they have in the past.

Russia’s barbaric and unjustified invasion of Ukraine, a sovereign nation that most of the civilized world recognizes as such, will have particularly severe consequences for Germany. A highly open economy for its size, it has made outsourcing, offshoring, and supply chain management key elements of its business model. In addition to cars and machine tools, the “German model” is also particularly steeped in chemicals, metallurgy, and pharmaceuticals, all particularly energy- or gas-intensive sectors. Just as Italy, Spain, and Portugal did in the 1990s in apparel, footwear and textiles manufactures, Germany has steadily lost ground to China, and to stem this erosion, it built up and defended its “Exportweltmeister” status in a Faustian bargain: extensive outsourcing into cheap foreign labour markets and tapping into cheap energy sources from Russia. In particular, natural gas is essential for the heating of households as well as a raw material for the chemical and pharmaceutical industries. An expanding network of pipelines – many built long ago – promoted an outsized reliance on cheap gas. Oil is also piped in from Russia right into Germany via Schwedt, an East German refinery town built in the days of the German Democratic Republic especially for high-sulphur-content oil from the east.

The Ukraine war has changed all this. Spot prices are more than 500% higher and oil prices are double their levels a year ago. Much of this energy is delivered under long-term contracts. When these expire, the extent of relative price changes will be fully felt. Germany imports two-thirds of its energy and most of this in the form of fossil fuels – partially a consequence of its disengagement from nuclear energy in 2011.These price increases are large in historical experience and remind us of the infamous “oil shocks” of the 1970s (April 1974: 184% y. o. y.; May 1980: 118% y. o. y.). The key difference: Back then, industrial countries were uniformly dependent on imported fossil fuels. In its quest to retain its industrial base, Germany became increasingly specialized in energy- and hydrocarbon-intensive manufacturing, combining abundant human and physical capital with outsourcing and just-in-time methods, in the framework of an energy-intensive value-added chain system.

In the third week of June, Russian deliveries of gas were reduced to Germany for “technical reasons” – allegedly because Siemens was unable to use normal maintenance equipment in Canada due to the boycott – and the summer is the time when natural gas reservoirs are filled. Characterizing this as an assault on German industry, Economics Minister Habeck invoked the second stage of an emergency gas plan, a mental preparation for quantitative rationing. The third and final stage involves releasing natural gas retailers and quantitative limits on industrial use – in favour of households. Remarkably for a member of the Green Party, Habeck also proposed auctions to allocate gas in short supply – meaning that those 500% price increases may soon have immediate relevance for exporters.

A crude indication of looming relative price shifts in the real economy can be seen in the recent behaviour of the PPI and CPI relative to its largest continental trading partners. The figure above plots one version of the bilateral real exchange rate of Germany vis-à-vis France, Italy, and the Netherlands based on the Harmonized Consumer Price Index (HCPI). In the past twelve months, Germany has suffered a notable deterioration, and much of this originates in energy; France currently gets 70% of its electricity from nuclear sources, compared with about 12% in Germany, soon to be zero.

A full-blown “battle of the markups” is on the horizon as workers claw back lost purchasing power and firms raise prices to cover higher costs. Inflation is the product of this process, as it shifts the burden from one set of economic actors to another. Someone will end up bearing real price changes in the end, and in a world with capital mobility, it is likely to be labour. Steep drops in stock markets and rising interest rates worldwide suggest that a recession will be part of the adjustment. Yet nominal wages are growing again, and the minimum wage will be raised to €12/hour in October. In addition to structural shifts and foreign competition, Germany is struggling with demographic change and the labour supply consequences of the pandemic. All this suggests competitiveness vis-à-vis its European trading partners will continue to deteriorate – ditto for the Netherlands.

This may have a silver lining: it could help correct massive internal payments imbalances within the Eurozone that I have mentioned before – the infamous Target2 accounts between Euro central banks – and that have ballooned in the past 15 years. My greatest fear, expressed elsewhere, is that higher interest rates needed to fight inflation will also raise default premia for highly-indebted southern European countries and, without sufficient solidarity or bailout, could break up the Eurozone before this corrective can take effect. Scary indeed.

Michael Burda, 27 June 2022

For more on Michael Burda’s fears, see (in English and Italian)