Geopolitical uncertainty continues to test the global economy and markets. Events in Ukraine and developments in Iraq and Syria are front of mind, but geopolitical risks are rising globally. These events have hurt the global economy, particularly Europe, and they are coming at a particularly unhelpful time, as the European Central Bank is already trying to fend off disinflationary forces.
While solving these protracted problems is extremely complicated, we believe these events point to clear policy tools to address the economic vulnerabilities:
- Coordinating efforts among European governments and central banks to offset the negative economic effects,
- Developing European policies aimed at weaning off energy dependence on Russia, and
- Revisiting the long-standing U.S. policy against oil exports, signaling the role the U.S. ultimately plans to play as an energy supplier.
While these policy responses do not minimize the human suffering, we believe they would broadly benefit the global economy and help rectify some power imbalances.
Recent developments are a headwind to the European economic recovery
At the start of 2014, optimism was growing that Europe – although still facing disinflationary forces – had passed the trough of the economic cycle. European peripheral economies were growing again, and our early cyclical forecasts had acceleration in European GDP of nearly 75 basis points (bps) from 2013’s rather anemic levels of only 50 bps of growth. Fast-forward six months, and European growth has slipped, consumer and business confidence have taken a significant hit and disinflationary forces remain extremely problematic. While geopolitics is by no means the sole reason for the economic disappointment, developments over the spring and summer are clear headwinds to an already fragile economic recovery in Europe.
In our baseline economic scenario, effectively a frozen conflict, we believe the negative impact of events in Ukraine on European growth going forward will be around 0.3% of GDP, mostly through direct trade linkages. However, if the military conflict escalates and sanction pressure increases with commensurate retaliatory actions, the impact on GDP could become much bigger as the negative effects spread through the energy price and supply effect, hitting market confidence and deepening trade drag. Although a near-infinite number of scenarios can be constructed with many economic outcomes, it is clear that both proactive fiscal and monetary policy should be considered to combat deflation and support the fragile economies.
We believe the best approach for Europe would be to relax fiscal budget constraints to allow for fiscal stimulus to offset any economic drag, while maintaining extremely accommodative monetary policy, most likely including quantitative easing to stimulate the flow of credit to the economy. Allowing Europe to fall back into recession and allowing disinflation to increase is in no one’s best interest.
Energy politics should be central to Europe’s policy response
Although Ukraine is not a material producer of oil or natural gas, the country plays a critical role as a transit state for Russian oil and gas to reach Europe and the world markets. Because of this, energy “politics” has played a central role in past conflicts and should be a central factor in the policy response. In fact, the signing of a natural gas supply deal between China and Russia this summer, after nearly a decade of discussions, reflects Russia’s reorientation eastward, partly in response to declining European demand for Russian natural gas and growing pressure from Azerbaijan and potentially Eastern Mediterranean producers, but also because of the new political contention.
Europe should respond by revisiting plans to phase-down nuclear power, continuing to develop renewables supplies and technologies to enhance energy efficiency, and supporting greater integration and connectivity so that energy can flow across regions to prevent any one member from being held captive to any one supplier. In addition, Europe should expand drilling and exploration and strongly reconsider the rather broad antipathy toward hydraulic fracturing (also known as “fracking”), which has helped dramatically change U.S. energy balances and could, at least on the margin, help Europe reduce import dependence, support economic growth and reduce the industry’s structural disadvantages. However, reports are suggesting Russia is in fact supporting anti-fracking environmental efforts in order to hinder European energy independence from Russia.
What the U.S. can do
The U.S. and its relatively newfound energy renaissance can also play an important role in supporting Europe and the global economy by signaling its intention to compete for energy market share. Developers are already progressing with liquefied natural gas (LNG) exports, with the first plant scheduled to begin exporting at the end of 2015. By the end of the decade, the U.S. will be one of the largest exporters of natural gas. Unfortunately for Europe this winter, there is little the U.S. can do to help replace any lost supplies. Speeding up the approval process and creating a blanket authorization for all plants to export anywhere (not just free-trade countries), plus eliminating time-consuming and expensive hurdles to development, would send a signal to the world that the U.S. plans to compete for natural gas market share.
In addition, the U.S. should revisit its now long-standing restrictions on crude oil exports. While exporting petroleum products, processed condensates (but not field condensates), petrochemicals, coal and nearly any other product derived from petroleum is permissible in the U.S., crude oil remains absent from the list, and this is increasingly tough to reconcile. Although the U.S. is still a net crude oil importer, it is rapidly moving toward balance and may reach market saturation in the next few years for light crude oil, suggesting some U.S.-produced oil would struggle to find a home without significant discounts or even reduced production. Allowing for crude oil exports would support continued investment in exploration and midstream development by ensuring market outlets for new production, a condition that, in our opinion, would be net negative for prices of global oil and U.S. gasoline, which are currently traded freely on the global markets and whose prices are not directly linked to those of U.S. crude oil.
Those opposing energy exports argue that keeping energy domestically will support industry at home – but while some of the discount will narrow, the U.S. energy advantage would not go away. We view increasing U.S. exports as net supportive of the U.S. economy, likely depressing global prices in time and providing allies with some certainty over the security of supply.
A policy trajectory that reflects the current reality
With the hope that deepening the integration of European and Russian economics would have ushered in an era of peaceful coexistence now thoroughly quashed, Europe and European allies should frame the policy trajectory to reflect the current reality. In the short term, Europe should proactively work to shore up the local economy through supportive fiscal and accommodative monetary policies. In addition, long-term planning should begin today to reduce Europe’s energy dependency on Russia, and the U.S. should revisit current export policy to send a powerful signal to the markets and allies over the security of future supplies.