How would an energy embargo affect the German economy?

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RTHE USSIA DECISION cutting off gas supplies to Bulgaria and Poland has fueled an already heated debate in Germany, which is heavily dependent on the raw material. For weeks, economists and officials in the country have argued about how much a ban on Russian hydrocarbons would hurt the economy. Now it seems conceivable that Russia itself could turn off the taps. What would be the outcome of an embargo? A large body of research, which examines a range of past disturbances, sheds light on the question.

Relations between modern firms are not simple links linking one producer to another, but a web of complex interactions. The breaking of a seemingly insignificant link in the chain can disrupt businesses either upstream or downstream, causing greater 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. companies and sectors meant that the overall economic effect was somewhat larger than the direct impact on the 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 find that ripple effects through production networks accounted for more than half of the total economic impact.

Another much-studied case of disturbance is the earthquake that struck northeastern Japan in 2011. As the worst-affected areas were less than one-twentieth of GDP, the local disturbances should not have had a noticeable effect on a national scale. But he did. In a review, Vasco Carvalho of the University of Cambridge and his colleagues untangle the impact on affected areas of ripple effects along supply chains, and find that these account for more than half of the blow to Japanese growth.

Researchers have also discovered the types of links and mechanisms that allow shocks to spread widely. According to a paper by Daron Acemoglu of Massachusetts Institute of Technology and Alireza Tahbaz-Salehi of Northwestern University (as well as another study by M. Baqee). This explains why Alan Mulally, then chief executive of Ford, an automaker, urged US lawmakers to bail out rivals during the global financial crisis. Ford feared the collapse of automotive suppliers, which would also cause severe disruption at its own factories.

Intimate business relationships, such as those within companies, tend to be particularly affected, as they are harder to replace. Another study of the 2011 Japan earthquake by Christoph Boehm of the University of Texas, Austin, and others, finds that American subsidiaries of Japanese companies also suffered, as did their suppliers. Other research also concludes that the more personalized the relationship between companies and their suppliers, the greater the ripple effects. M. Barrot and Julien Sauvagnat of Bocconi University examine 30 years of natural disasters in the United States and find that the disruption of a single supplier results in a loss of sales for a downstream company by two to three percentage points, this which, given that most suppliers provide a small portion of a company’s production inputs, is a significant drop.

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

Still, there are two reasons why things don’t have to go so badly. To begin with, just as past experience shows that supply disruptions can have considerable short-term effects, it also shows that the economy as a whole has a great capacity for adjustment. In 2010, China banned the export of rare earth metals to Japan, one of the world’s largest users of minerals. According to research by Eugene Gholz of the University of Notre Dame and Llewelyn Hughes of the Australian National University, Japanese companies were able to quickly replace previously inexpensive rare earths and find alternative sources. 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 significant, it would be partly offset by the ability adaptation of the economy. The overall impact, they estimate, could be in the range of 0.5 to 3% of GDP.

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Moreover, it is the responsibility of governments to mitigate the short-term pain of supply disruptions. EU officials, for example, are considering tougher sanctions on energy imports from Russia. The more companies know about the measures, which could include a tax on Russian energy, the easier it will be to adapt. Past episodes suggest that if policymakers want to change regulations or trade relations, they must do so consistently and carefully. A liberalization of Indian trade in the 1990s caused little wider disruption as it was gradual, helping businesses adjust. A recent study by Alessandra Peter of New York University and Cian Ruane of IMF points out that Indian companies have been able to find substitutes for inputs.

Governments could also take into account that companies may not be doing enough to keep networks strong in the short term. Matthew Elliott of the University of Cambridge and others find that companies could invest in the robustness of their supply chains if they have a business case for doing so. But they might not seek to ensure the resilience of the wider network, as they are unable to reap the rewards of such an investment. Encouraging businesses and households to move away from fossil fuels, as a tariff would, could build that resilience. Managed well, Germany’s supply disruptions need not be so disruptive.

Learn more about Free Exchange, our column on the economy:
Does high inflation matter? (April 23)
What Bigger Military Budgets Mean for the Economy (April 16)
China has a famous history of political experiments (April 9)

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