MUNICH: Since Russian President Vladimir Putin launched his invasion of Ukraine, the German government has been under mounting pressure to join a proposed European embargo on Russian energy. It is widely believed that stopping Russia’s war will require cutting off its financing, which is coming in the form of billions of dollars of payments for oil and gas exports.

The German government opposes an energy embargo, with Minister of the Economy Robert Habeck arguing that it would lead to mass unemployment, poverty, and widespread social unrest. But are these concerns valid?

Germany is certainly heavily dependent on Russian energy. It sources 55 per cent of its gas, 34 per cent of its oil, and 26 per cent of its coal from Russia. But finding substitutes for Russian oil and coal would not be particularly difficult.

In fact, Germany has already agreed to join a European embargo on Russian coal, and it has announced plans to diversify away from Russian oil by the end of this year (though that may be too late to make a difference for Ukraine). Unlike pipeline-delivered natural gas, oil and coal have global markets and can be purchased from pretty much anywhere. Moreover, Germany has strategic reserves of both.

Gas poses a greater challenge, because it can be delivered only through existing pipelines. The question, then, is whether Germany can find short-run substitutes for imports from Russia. For an answer, we can consult a new ECONtribute policy brief by a group of top German economists who have sought to quantify the consequences of ending Russian gas imports. The authors’ results are highly credible. They use a state-of-the-art multisector macro model to account for the complexities of modern supply chains, and they bring to bear detailed knowledge of the German energy market.

The study finds that an immediate end to Russian gas would cost Germany 0.5-2.2 per cent of GDP. That is a potentially sizable reduction in growth, but it is by no means catastrophic. Even in the worst-case scenario, the contraction would be less severe than the fallout from the COVID-19 pandemic in 2020, when German GDP fell by 4.6 per cent.

The estimated output loss varies widely, depending on how well the German economy can reallocate resources to other sectors and find substitutes for gas. The study assumes that the “elasticity of substitution” is very small, but not zero, meaning that while Russian gas is difficult to replace, German households and firms could still switch to other energy inputs and import more gas from the Netherlands or Norway in the short term.

The output losses would be modest (below one per cent of GDP) even if the elasticity of substitution is very small, because in an economy with complex supply chains, there are more possibilities to find alternative suppliers. One risk to consider, however, is what economists call the O-ring feature of supply chains (a reference to the catastrophic failure that caused the 1986 Challenger space shuttle disaster): if one crucial link in the chain breaks, all the links below it can collapse, too, generating fallout that propagates across the whole economy.

In any case, German Chancellor Olaf Scholz dismissed the paper in a widely watched interview, arguing that its models do not account for the realities on the ground. He contends that basic physics – such as the time it takes to build a new pipeline – stand in the way of mitigating output losses as much as the paper envisages. Moreover, he insists that the government is more familiar with the relevant constraints than the study’s authors are, because it is in constant contact with major businesses such as Siemens Energy and the chemical giant BASF. Both argue that a Russian gas stoppage would be ruinous.

But during major upheavals, when things break down, we should listen to economists before industry leaders, who naturally prefer business as usual. Businesses might know their own day-to-day operations better than anyone else, but economists can incorporate deeper historical experience into their models, leaving them better equipped to analyze all the ways an economy might adjust.

The ECONtribute paper, for example, incorporates the experience of the 1973 oil price shock in its modelling of a potential cut-off of Russian gas imports. Moreover, Scholz is wrong about macro models: they do respect physics, by accounting for resource limits and other economic constraints.

Ultimately, Germany’s reluctance to follow through on an energy embargo is about more than logistical issues. The country’s long-standing business model of 'Wandel durch Handel' ('change through trade') also will need to change. The task today is not just to manage the effects of lost trade, higher energy prices, or lower growth. It is to navigate what Scholz recognises as a historic turning point – a Zeitenwende. And, as his response to the ECONtribute paper makes clear, Germany is not there yet.

Dalia Marin, professor of international economics at the School of Management of the Technical University of Munich, is a research fellow at the Centre for Economic Policy Research and non-resident fellow at Bruegel.

Copyright: Project Syndicate, 2022.

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