06 July 2022
Have they thought this through? UK edition.
In our main story we argue that the fate of Boris Johnson and that of Brexit are more intertwined than you might think; we also have stories on Germany's coming bailout of its gas industry; on Russia's war economy; on Macron's purchasing power bill; on the EU's attempt to revive the capital markets union; and, below, on what happens when crises come in series.
Today's free story
Next comes the drought
One crisis is often followed by another. In Europe, we experienced the Covid-19 pandemic and its lockdowns, the war in Ukraine and its ramifications for migration as well as supply chains for energy and grains. And climate change has produced a severe drought not only in India and Africa, but in southern Europe too.
In Italy the government announced a state of emergency in five regions over water shortages until the end of this year. Scarce winter rain and spring droughts lowered the water level of the Dora Baltea and the Po, the largest river in Italy, down to eight times lower than usual. Both rivers feed one of the most important agricultural regions in Europe, with 30% of production currently threatened by drought. In about 100 cities water use is restricted to reserve enough for drinking.
Portugal is small by comparison and comes better prepared for water shortages. They already started preparing for a dry season in the winter, restricting the use of hydroelectric power plants to two hours per week, thus saving water reserves. The drought hit in May, when 97% of the country was affected. Local farmers' organisations also rolled out emergency plans to limit irrigation of some crops.
Spain is the third largest producer of agricultural products in the EU. At least 70% of all fresh water is used for agriculture. Some communes have been restricting the use of water since February, after the second driest winter since 1961. At risk of desertification, the country still needs to come up with a plan on how to preserve its water reserves.
This drought is certainly nothing compared to east Africa, which has barely had any rain for four years. Millions of people face dire water shortages. Food prices have risen rapidly, worsened with the fallout of grain imports from Ukraine.
Those different crises have taught us to live with constraints. The pandemic restricted our social interactions, and the war in Ukraine triggered an energy and grain shortage, both flagging up supply chain shortages for our industries. There are restrictions on how people use water in their daily lives, and how farmers are using it.
Those crisis have redistributional effects: young people who had to stay in under lockdown to save the lives of the more fragile in society; poorer households affected most by the rise in energy and food prices as measured in proportion to their income; a south afflicted by drought, heatwaves and wildfires versus the green northern EU countries.
The upshot is that these serial crises are forcing a big rethink about solutions. It could, for example, force European farmers to learn techniques usually applied in Africa to adapt to new climate patterns and become more resilient in the long term. Crises often come in clusters, but so do policies and technologies to overcome them.
5 July 2022
Three reasons to distrust Sir Keir on Brexit
Sir Keir Starmer last night pledged pledged that a Labour government would not return to the EU, or try to re-enter the single market or customs union. It was as clear and unambiguous as such a pledge can be. We have three reasons to distrust it.
The first is that he shifted his policy position on Brexit before. Labour-supporting Brexiteers still remember this vividly. The Labour Party went from an official position of accepting the referendum result during the 2017 election campaign to open advocacy of a second referendum in 2019. Sir Keir, then Labour’s Brexit shadow secretary, was the most prominent voice in the second referendum movement, and instrumental in persuading Jeremy Corbyn to accept it as the party’s official campaign promise. Yesterday’s news broadcasts were full of pictures with him on pro-second-referendum demonstrations.
We recall the flimsy argument on which that shift was based: the Conservative government had not delivered a viable withdrawal agreement. The argument was dishonest because Sir Keir was instrumental in frustrating a compromise offer by Theresa May, shortly before her downfall. We recall this period vividly, and argued at the time that the Labour party should have kept to its previous pro-customs-union position. The second referendum crowd entered a period of delirious delusion that they could win. When the situation changed, Sir Keir changed his mind. And we all know that situations keep changing all the time.
The second reason to distrust the statement is that Labour, like the Conservatives, does not have a strategy for Brexit Britain. We don’t mean a good strategy. We mean any strategy at all. A strategy would require a focus on new sources of economic growth to compensate for the fall in trade. All the trade shocks currently recorded in the statistics are not due to Brexit. Oil price shocks and the global supply chain crises, and transitional Brexit-related red tape shocks are muddying the picture. But there can be no doubt that Brexit will have a lasting impact on trade. A promise not to reopen the Brexit debate would have been more credible had it been accompanied by a strategy for a post-Brexit growth model. There are interesting parallels between the UK’s paralysis on this issue and Germany’s failure to deliver an alternative business model, as discussed in our lead story. Old instincts are kicking in. The Labour Party, once in power, will realise that the only source of an economic recovery will be the only one they have ever known.
The third reason we distrust the pledge is that it might not survive a coalition or confidence and supply agreement. Sir Keir also recently stated categorically that he would not enter into a formal agreement with the SNP. It is possible, but unlikely based on current polling, that Labour would win an absolute majority outright. The Liberal Democrats would be mad if they supported a Labour government programme without ironclad guarantees for proportional representation, and possibly a second referendum. The SNP will ultimately also want a second referendum, either if they don’t get a Scottish independence referendum, or if they get one and lose it. From an opposition perspectives, Sir Keir’s new found clarity on Brexit is as understandable as it is not credible.
4 July 2022
Russia, a counterfactual
In our infrequent series about plausible counterfactual scenarios relative to our base case, here is one about the war in Ukraine. We can offer no insights on military scenarios: we leave that to the armchair generals. But there is a specific counter-factual scenario we have to take seriously. Previously, we presumed that a long war would benefit Russia. Our base case, as so often, is from a macro-finance perspective. The western sanctions have driven up the price of oil and gas, as a result of which Russia’s current account position is stronger than ever. The physical sanctions, in our scenario, would constitute a Brexit-type shock, large but frictional. Eventually money always finds it way to the goods its owners want to buy.
We can, of course, not be sure that this gravity theory of Russian surpluses will work out that way. When you look under the hood of the Russian economy, things look different. What often happens after a political shock, as in Germany and Japan after 1945, or the UK after the 1970s, is that countries adopt new business models. The Russian economy, by contrast, may not be flexible and resourceful enough to develop an entrepreneurial bunker spirit.
We know that Germany is hopelessly dependent on Russian gas. But Russia, too, is dependent on the west, perhaps even more so. We heard the story of a car assembly company in Kalingrad, which suffered from the cancellation of contracts of western car suppliers and is now heading into commercial and financial oblivion. It gave its idle workers set-aside land to grow their potatoes. So it's potatoes, not microchips. The problem with countries in the grip of industrial mafias is that they are not very innovative. Vladimir Putin bet the house on fossil fuels. This was already a non-sustainable strategy for the 21st century, considering the global transition to renewable energy.
What about the idea of Russia circumventing sanctions through reliance on Asia? FAZ reports that even the Russians no longer believe that sales to Asia can compensate for the loss of European business. It quotes Valery Yazev, the head of the Russian national committee of the World Petroleum Council, as saying that the Russians were deluding themselves if they thought that India and China would buy up all of their oil and gas. He has been personally involved in negotiations with China over the Power of Siberia gas pipeline. Once the Chinese become the main buyer of Russian gas, he says, they will turn on the screws.
One of the few top Russian officials who understand the sheer enormity of the crisis facing the country is Elvira Nabulliana, the central bank chief, who told the Duma that the western sanctions necessitated a structural transformation. As this article explains, there are not many options for Russia. The following are so not much an alternative strategy, but a brainstorm list of things that spring to mind:
- diversion of commodity flows to new customers;
- reorientation of feedstock exports to new customers;
- setting up an alternative financial architecture, including payment systems, to reduce the financial dependency on the west;
- measures to provide to technological import substitutions.
The latter is crucial. There has been very little progress in the past on import substitution. The best option appears to be parallel imports from third countries that do not participate in the sanctions. But experience has shown that many companies in those countries fear secondary sanctions, and are therefore reluctant to deal with Russia.
Herein lies probably the best reasons for optimism about the long-term effect of western sanctions: that Russia’s system of state-capitalism, suitable for a fossil-fuel based exporting economy, is the worst possible economic system to enable the creative destruction that is necessary to regenerate the economy in a time of crisis. Germany, Japan and the UK were very different in that respect.
1 July 2022
Erdogan's yes, but moment
Accession of Sweden and Finland to Nato is not a done deal yet, warns Recep Tayyip Erdogan. Turkey withdrew its veto against accession talks to start with the Nordic countries in return for extensive anti-terrorism assurances that require changes in domestic legislation, and the extradition of suspected terrorists.
What matters are not the pledges they gave but the delivery of those pledges, Erdogan insisted. Both governments bent over backwards to give Turkey its anti-terrorism assurances. One of the pledges is facilitating the extradition of 76 Kurds, deemed as terrorists by Turkey. But this is not so easy. The question is whether the courts in Finland and Sweden have the same definition of a terrorist as Ankara does.
Theoretically, their Nato membership could still be stopped or delayed if the Turkish parliament votes against it. So, indeed, their membership is not a done deal. We also know that Joe Biden’s call to and his meeting with Erdogan played a role in what looked before like a deadlocked situation. Some argued that this is less about the F-16 fighter jet programme than about Erdogan having his meeting with the US President. Jens Stoltenberg was also instrumental in forging a compromise. But Erdogan’s warning and rumblings on the left in Sweden are a reminder that those deals may be easier announced than implemented.
30 June 2022
Where 'don't know' is the correct answer
In our irregular series on scenarios that are not our base case but plausible nevertheless, we will focus today on the impact of a Russian gas embargo on Germany. Our base case sits somewhere between the most extreme estimates of German economic institutes, as juxtaposed by Handelsblatt. But it is worth looking at those extreme scenarios in some detail. It is not what they predict that is revealing but how they think about the evolving situation.
Prognos predicts a drop in GDP by 12.7% in the second half of this year, around €200bn, if the gas stops flowing. The premise is that once the Nord Stream 1 pipeline gets serviced on July 11, and the gas flows stop during the maintenance period, it will not come back afterwards. Prognos writes that an abrupt stop would mean that half of German demand would not be met by supply. The main economic impact is through a domino effect, the kind of which Robert Habeck talked about recently. Prognos has taken a detailed look at industry supply chains to come to this conclusion. A steel company does not use much gas, and in any case is likely to be exempted from rationing. But a rolling mill needs a lot more energy, and is not exempted. The secondary effects outweigh the primary by 3 to 1 in their calculation. This is why their forecast is so pessimistic.
During acute crises, we think it is a good idea for economic analysts to try to gain a deeper understanding of dynamic effects, rather than stare at useless models. We think Prognos's method is quite good, but are moderately more optimistic because dynamic effects work in both directions. There will be offsetting trends, in terms of energy efficiency, and alternative supplies, some of which could kick in immediately.
The other study cited in Handelsblatt comes to a diametrically opposite conclusion. A joint prognosis by Germany’s leading economic institutes says the governments' efforts to diversify energy supplies were already bearing fruit, and that the effect of an embargo would be minimal. In their most probable scenario, there would be no shortages whatsoever during the winter even if Putin were to cuts the gas. They argue that the improved gas storage is the main reason. In April the gas tanks were 30% full. Now this is up to 58%. They put the probability of a shortfall of supply at only 20%. In that scenario, they arrive at a similar direct economic impact as the Prognos Institute, but they don’t go into the domino doomsday scenarios. In that scenario we are looking at a normal recession. Their most pessimistic scenario, very improbable in their view, would see output slashed at 9%.
We never cease to be amazed by how economists, and professional investors too, fool themselves by attaching precise percentages to future scenarios. There is, of course, no valid statistical or probabilistic basis behind this practice, but it is very common nevertheless.
When it comes to the future, we can rank our scenarios, and express subjective views, but that is about it. In our own subject base case, Russia will continue to supply gas at reduced volumes until the autumn. Depending on the war, and the size of their current account surplus, they might at this point take a decision to cut supplies altogether. A total cut-off in July, followed by an acute shortage in the winter and an industrial domino effect, is, however, not an improbable scenario.
What we find most useful about these extreme scenarios is not what any of them predict, but the sheer range of expectations between the two. That is telling us that we are dealing with real, raw uncertainty.
29 June 2022
Why they hate Scholz
Armin Laschet’s bid to become German chancellor ended the day he was caught giggling on stage during a meeting with victims of the 2021 floods. Olaf Scholz had such a moment yesterday at the end of the G7 summit. A journalist from Deutsche Welle asked him the following question:
“Could you say what security guarantees the G7 has agreed on for Ukraine for the period after the war?”
Scholz's response consisted of three words only:
“Yes, I could.”
The men’s arrogance, and his coldness, has to be seen to believed. We have seen milder versions of this before. Scholz is the most dangerous sort of politician: a man with an inferiority complex.
The journalist, Rosalia Romaniec, put it well in her tweet following this incident.
“What a pity, Herr Bundeskanzler. When I learned German, I was taught to use polite questions during press conferences. This was meant as a serious question.”
28 June 2022
A Rubicon, crossed
One of the lessons during the global financial crisis was the need to avoid binary outcomes, as in defaulting on all of your debt. The Romans, of course, have known this for much longer. When Julius Caesar and his army crossed the northern Italian river Rubicon into Roman territory, he could not go back.
Russia’s default, together with the freezing of central bank assets, is the financial market equivalent of a modern Rubicon crossing. There is no way back now. Or to put this into modern geopolitical jargon: there is no off-ramp for Russian finance.
Russia’s default is not a matter of can’t pay or won’t pay. They have the money, and they want to pay. What happened is that western sanctions have made it impossible for western bondholders to receive payments through the banks. Joe Biden hailed Russia’s default a sign that western sanctions are working. This statement is absolutely correct. If you cut off the financial flows, then surely a default is an inevitable, almost minor consequence.
The default relates to interest payments of $100m on two bonds. In normal times, a default cuts you off from the financial markets, but Russia is cut off anyway. That Rubicon has been crossed with the financial sanctions. The default has therefore no further short-term consequences. But it might become a problem later. If the west ever agreed to lift the sanctions, for example as part of a Russia/Ukraine peace agreement, the default cannot be reversed. You can unfreeze assets. But you can’t un-default. In warfare, diplomacy, and financial regulation, Rubicons are to be avoided if possible because they narrow your choices afterwards. Sometimes, of course, you have no choice.
The problem with crossing the Rubicon is not only that you can’t go back. It is that the best option at that point is often to double down and go forward. This is what Caesar did. If you default on one part of your debt, you might as well default on the rest. As a direct result of financial sanctions, Russia has started to diversify its foreign reserves, and is working on a parallel payments system infrastructure. We are entering a period in which the US may lose its global financial monopoly, which is at least in part due to a lack of alternative infrastructure. The dollar won’t be easily displaced as a global currency, but there is no reason why the countries known as the Brics should transact among each other by channelling flows through the US jurisdiction.
Yesterday, Russia crossed another Rubicon with the bombing of a central Ukrainian shopping centre. The timing is probably no coincidence as G7 leaders met in the surreal picturesque setting of Elmau in the German Alps. The only meaningful agreement struck in the lush surroundings of one of Europe’s most exclusive resorts is an increase in the number of troops on Nato’s front line states to brigade level, which in most cases involves a doubling or trebling of existing numbers to about 3000 and 5000. There will also be an increase in the numbers of troops on high alert. What is less reported in the media this morning is the total failure by Jens Stoltenberg, director general of Nato, to persuade Turkey to drop its veto on Swedish and Finnish Nato accession. We recall Stoltenberg boasting at one point that Nato enlargement could be get done with in an hour after Sweden and Finland applied. This is a very long hour.
From our admittedly skewed perspective another Rubicon has been crossed since the start of the Ukraine war: the de facto abandonment of European strategic autonomy. The chronic lack of defence spending combined with naiveness about what strategic autonomy would involve, may have left Europeans with no alternative. We recall Angela Merkel’s words after the US presidential elections that Joe Biden’s victory, while welcome, should be no excuse to abandon strategic autonomy. She said the narrow election result in the US demonstrated a lack of consensus in favour of continued support for Europe. The mid-terms will probably serve as a reminder to complacent Europeans that Trumpism is not defeated.
The things about Rubicons is you can’t go back later when you want to. We are crossing a lot of them right now with consequences that will outlast the war in Ukraine.
27 June 2022
Hydrogen for dummies
As the EU is struggling to meet its own deadline to phase out fuel-driven cars, we are wondering whether the EU should actively consider, and support, hydrogen as an additional source of fuel.
One of the reasons we are interested in hydrogen is because we see a need for more diversification, the lack of which would put the EU’s ambitious emissions reductions targets at risk. For example, we see big problems for some industries such as aviation and cargo, for which hydrogen might be more suitable.
Hydrogen is not necessarily the better technology, but it might be a useful additional source of power for the next generation of electric vehicles, if we think beyond just passenger cars. Hydrogen has several advantages.
Hydrogen cars are electric. Their fuel cells convert hydrogen and oxygen to water and electricity to power the engine. That is why they are called hydrogen electric vehicles (HEV).
Batteries are a suitable technology for cars, or urban buses, but not for long-distance lorries, shipping, and aviation. Hydrogen offers a higher driving range than batteries and faster refuelling.
The first stage of the process is the production of hydrogen. Virtually all of hydrogen production currently is through methane, which has an efficiency of 70 to 85%. The remaining hydrogen is produced via electrolysis, which involves breaking down water with electricity into hydrogen and oxygen. This process has an efficiency of 60-80%. The methane process is economically efficient, but results in large amounts of CO2 emissions.
In the second stage hydrogen needs to be converted to power. This takes place in a fuel cell where oxygen and hydrogen are combined to create electricity, heat and water. The efficiency of a hydrogen fuel cell is between 40 and 60%. Taking together, this means that around one half of the energy is lost in the entire process.
Right now, hydrogen accounts for less than 2% of Europe’s present energy consumption, and is primarily used to produce chemical products. There are only 144 hydrogen recharging stations for HEVs across Europe. The UK government has committed only £240m for low-carbon hydrogen funds. There are only around 5000 km of hydrogen pipelines today, most of them in the US (2600 km), Belgium (600 km) and Germany (400 km), compared with some 3m km of natural gas pipelines.
It is possible to channel hydrogen into the gas grid. This is a potentially interesting option because the gas pipelines may soon be running empty as a direct consequence of the war in Ukraine. This would also reduce the upfront capital costs of hydrogen projects.
But there are potential problems. Renewable hydrogen could increase the operating cost. Domestic production of renewable hydrogen in the EU will probably not be enough to meet demand. Also, if pipeline transport is not possible, hydrogen must be liquefied for transport. Here are some obvious parallels to gas.
The EU has a two-stage plan for hydrogen investments. The first is increasing manufacturing capacity. In the second phase, which will run from 2024 until 2030, the focus is on infrastructure, starting with local networks on islands and remote areas where hydrogen would be used not only for renewable energy but also in industry, transport, and for heating. In this phase, the EU is planning a pan-European hydrogen network. The goal is to get at least 6 GW of hydrogen electrolysers rising to 40 GW in 2030.
An interesting part of the strategy involved Ukraine. The total plan had been for 40 GW capacity in the EU, and another 40 GW in Ukraine and North Africa. But that was before the war. A large portion of the country’s installed renewables capacity lies in war zones, including most of the wind farms. The EU will need a plan B.
24 June 2022
A historic moment for the EU - or not
Beware when politicians refer to their own decisions as historic. Awarding candidacy status comes cheap. Waving blue and yellow flags also comes cheap. Tweets cost nothing.
But nothing is quite as cheap as EU candidacy status. Turkey has had it since 1999. North Macedonia has had candidacy status since 2005, Montenegro since 2008. What really matters is the start of negotiations. And from there a long road still waits ahead, paved with good intentions mostly.
The deal reached in the European Council is a classic EU fudge, high on symbolism with the purpose of allowing EU leaders to indulge in fantasies about their own historic role.
Kid yourself not. Ukraine will not be in the EU for a long time, if ever. The biggest obstacle to Ukrainian membership is probably not even Ukraine's readiness, but the EU itself. Ukraine, a large country, would become a significant net recipient of EU funds, at the expense of other net recipients, like Poland. Under the so-called Copenhagen criteria from 1993, enlargement also goes hand in hand with reforms in the way the EU operates. Voting rights and the number of MEPs would have to change, as we reported yesterday. Voting rights are a zero sum game. This is not just about the number of raw votes in the EU’s qualified majority voting system, but also the ability of countries to form coalitions. How many small countries does it take for coalitions to form that have the power to outvote Germany and France? With the accession of so many smaller countries, we would be getting close to this point. Germany already staked a claim for more proportional representation to reduce the probability of being outvoted.
Together with Ukraine and Moldova, there are now seven countries that have candidate status, all of them in the east and the south east of Europe. Bosnia and Georgia have made applications, and Kosovo is another potential candidate.
The accession of so many countries, combined with the departure of a large western country, is shifting the balance. There is no way that France and Germany can maintain their current power in an enlarged EU, or even their informal role as agenda setters. The geographical centre of an EU that includes Ukraine would be somewhere to the east of the German border. With a population of 44m, Ukraine is larger than Poland, and just behind Spain. Ukraine and Poland together would be bigger than Germany. The total population of all candidates and applicants is close to 80m, without Turkey, with whom membership talks are frozen. If you include Turkey, the total would rise to 150m.
EU membership is a binary option. You are in or out. Norway and Switzerland have their deals, and so does the UK. But these deals have mostly not given rise to happiness. One route forward for the EU would be differentiated integration, a term we prefer to variable geometry, where the emphasis is not so much on opt-outs as opt-ins. Amid all the mutual backslapping and self-congratulation in Brussels yesterday, we heard the voice of Alexander Schallenberg, Austria’s foreign minister, who suggested that Ukraine should join the single market as a first step, as he said, to avoid disappointment. We think this is a sensible proposal, for disappointment is otherwise guaranteed.
Behind the decision to award immediate candidacy status to Ukraine was a bitter fight over the beginning of accession talks with North Macedonia and Albania, the two countries that have lingered in the EU’s antechamber for years. Accession talks with North Macedonia and Albania are blocked by Bulgaria, but we read in Euractiv this morning that the Bulgarian parliament could unblock its veto today in time for the Council to save itself the embarrassment of having to say no to those two countries once again.
Austria wanted the EU to grant candidacy status to Bosnia, but was promised that the Council would deal with this issue on another occasion.
23 June 2022
Ionesco would have been proud
The theatre of the absurd has a long European tradition. But even the famous dramatists in this genre would have struggled to come up with anything quite as absurd as the story of Germany and gas sanctions.
The priority at the beginning of the war was clearly to keep the gas flowing. So the German government and the EU agreed to sanction coal and oil, and then flouted their own sanctions by paying Gazprom in roubles. As a result, Vladimir Putin is now so awash in cash that he can afford to use gas sanctions against the EU.
Norbert Röttgen, the former chairman of the Bundestag’s foreign affairs committee, made the point that it would have been better to have embargoed gas immediately. The situation Germany finds itself in today was not only foreseeable. It was foreseen. He asks why has Robert Habeck, the economics minister, did not make preparations when the war started, and avoided immediately taking measures to reduce gas consumption. Habeck kept on saying that a gas embargo would lead to mass unemployment and recession. Did he think that Vladimir Putin would not hear this? As so often in politics, we are once again in a situation in which complacency gives rises to panic. We are more vulnerable now than if we had imposed the gas sanctions ourselves, on our own terms. Another story in our ongoing series of complacency giving rise to panic.