Rising Inflation Remains an Acute Geopolitical Problem

Dr Ivanovitch - MSI Global
Dr. Michael Ivanovitch

Economic historians know all about inflationary finance to pay for wars and power politics.

In the post WWII period, French analysts argued that Anglo-American efforts to sustain their global dominance led to the subversion and death of the gold standard. That, they claimed, ushered in uncontrollable inflation engines – the gold-exchange standard, followed by the dollar standard -- with myths of “magic money” and “deficits without tears.”

It was perhaps an accident of history that another French analyst warned the world last week that geopolitical tensions were driving inflation “higher and longer than expected.”

Omitting to mention the demise of the international monetary system correctly forecast by Jacques Rueff and Charles Rist, Christine Lagarde, France’s former finance minister and the current president of the European Central Bank (ECB) focused her remarks on security problems that were causing soaring energy prices and the euro area’s 5.1% inflation rate.

That’s indeed what the numbers are showing. From an annual decline of 4.2% in January 2021, energy prices in the euro area were rising last month at an annual rate of 28.6%.

Over the same period, the euro area consumer prices, excluding energy costs, nearly doubled to 2.6%, but remained well within the ECB’s medium term inflation target.

EU and Russia are worlds apart

Energy costs, therefore, present a very serious problem for the macroeconomic stability in the monetary union. They account for only 11% of the consumer price index, but their sharp acceleration now represents one-half of the euro area’s headline inflation.

Undeterred, the ECB still sees a declining euro area inflation in the months ahead. Although not explicitly stated, that forecast must be based on an unreasonable assumption of falling energy prices in an environment of withering security tensions.

What are those tensions?

They are twofold. The first issue is a deep disagreement between the EU’s and Russian energy policies. The second and a much more important issue are strategic and security clashes between the EU and Russia.

At the heart of the policy dispute is the EU’s attempt to dictate the terms of Russia’s energy supplies. Apart from unbundling the transportation and the actual supply provisions, the EU eschews long-term contracts in favor of spot pricing of energy trades. And then, in order to maximize the buyer’s leverage, the EU Commission wants to deal directly with Russian energy suppliers, instead of leaving that to individual member countries.

That policy led to a rapid depletion of EU gas reserves. They were half empty at the beginning of winter months, and they are currently estimated at 38% of capacity.

As a result, the EU energy prices began shooting up last spring, and by mid-November they were rising at annual rates of 27%.

To deflect the criticism of their mismanagement of energy supplies, the EU Commission blamed it all on Russia. According to the Commission, Moscow did not want to pump more oil and gas; it just continued the “minimum service” by fulfilling its contractual obligations.

ECB will walk back its inflation forecast

That’s a short and probably the wrong story of what was going on. The key point, though, is that Russia was living up to its contracts. And given the EU hostility, and its relentless sanctions against Russia, Moscow’s refusal to play up to EU orders is par for the course.

On top of that, the EU has done everything it could to block large energy supplies through the Nord Stream 2 gas pipeline that was completed and ready to operate last September. The EU rigmarole is such that nobody knows when that pipeline could get on stream. Worse, it is currently threatened by destruction – assuming that Russia would allow that -- in case of war in Ukraine.

All that makes sound the ECB’s forecast of declining energy prices and the euro area inflation like a lighthearted joke.

Ominously, the EU is at the forefront of Russia’s ongoing – and most probably worsening – clash with the U.S. and a NATO military alliance.

Barring a foolhardy provocation with Ukrainian lives, Russia will just boost its own defenses. But tensions, hybrid and proxy clashes -- and dangerous information warfare like Bloomberg’s false news of Russia’s attack on Ukraine -- will continue in the EU theater.

And whether any of that will change as a result of next April’s elections in France and Hungary remains to be seen.

Meanwhile, the EU’s allegedly frantic search for lowering the dependence on Russia’s energy supplies will run against the lack of more attractive alternatives and will also be resisted by German businesses and some German states.

A meaningful and a sustainable decline of EU energy prices is impossible without a radical change of EU energy policies toward Russia. And tensions will only grow unless the European security architecture is amended to satisfy Moscow’s recently reaffirmed red lines along its western borders.

The ECB will have to walk back its receding inflation forecast. The euro area’s cost and price pressures can only be tamed by slowing growth and rising unemployment.