In March 2022, a group of high-level economists published an article analyzing the economic effects on Germany of a halt in energy imports from Russia (Bachmann et al. 2022). Using a large multi-sector mathematical model, the authors concluded that if prices could adjust, even a substantial shock would have relatively small costs. On the other hand, the German Chancellor warned that if the Russians stopped selling oil to Germany, “whole branches of industry would have to shut down” and, when asked about business models, he claimed that:
[the economists] misunderstood! And it’s honestly irresponsible to calculate with mathematical models that don’t really work. I know absolutely no one in business who isn’t sure what the consequences would be.
The Chancellor was not the only one to predict big economic losses; some studies have estimated production cuts of 6-12% and millions out of work. The main distinction between economists and others was in their understanding of elasticities of substitution. When the Chancellor and the average citizen think of a 40% reduction in natural gas supply, they implicitly assume that every industry dependent on natural gas must reduce its consumption by 40%. They then examine the resulting drop in production and the cascading effects on downstream industries. It’s easy to get very worried using this framework.
When economists responded that there were possibilities for substitution, they were generally met with disbelief and incomprehension. The disbelief stemmed from a lack of appreciation of the many substitution opportunities that permeate an economy. In our manual, Modern principles, Tyler and I explain how the OPEC oil shock of the 1970s led to an increase in brick driveways (replacing asphalt) and the expansion of sugar cane plantations in Brazil (for ethanol production ). Surprisingly, the oil shock also spurred flower growers to move production overseas, as reduced fuel oil costs from growing in sunnier climates offset increased fuel expenses for transportation. Although these examples highlight long-term changes, short-term substitutions are also possible, although their precise details are usually hidden from central planners and economists.
The misunderstanding has come from thinking that we need every fuel user to find substitutes. No way! In reality, as fuel prices rise, those with the lowest substitution costs will change first, freeing up fuel for users who have more difficulty finding alternatives. A single industry with favorable substitution possibilities, combined with a few moderately adaptable industries, can produce a significant overall effect. Additionally, there are almost always industries with viable substitute options. To see why reverse the usual story and ask, if fuel prices fell by 50%, could your industry use more fuel? And if fuel prices fell by 50%, could their industries switch to the now cheaper fuel?
People often find it easier to imagine new uses rather than ways to reduce existing consumption. However, it’s usually the new uses that are reduced first. Tyler and I illustrate this with our jet and rubber duck graphic. Although jet planes do not shy away from oil, even at high prices, rubber duckies (actually plastic), which are made from oil, can find substitutes – wood, for example – when oil prices are rising. And if rubber duck manufacturers can’t find substitutes, they go bankrupt, freeing up more oil for other uses. In this way, the market identifies the less valuable goods to cease production, another type of substitution.
Substitution is a more nuanced concept than many people realize. Here is another example. Imagine that an economy has an energy-intensive goods-producing sector and there are few substitutes for the fuel used in this sector. Disaster? No way. We don’t need a fuel substitute, if we can replace imports of energy-intensive goods with domestically produced versions. Storage is also a substitute and note that the more you substitute a fuel in end uses, the more efficient storage is. If you use 1 gallon per day, a 10 gallon tank lasts 10 days. If you use a quart a day, it lasts 40 days. Everything is connected.
All these myriad changes occur under the direction of the invisible hand, that is, the price system. Remember that a price is a signal wrapped in an incentive. Thus Bachmann et al. wisely recommended letting energy prices rise to transmit the signal and not ensure energy users so that the incentive effects are fully felt on the margin.
So what happened? Gas from Russia was indeed cut very substantially, but the German economy did not collapse and instead proved to be as robust as expected, perhaps even stronger. (The chancellor’s predictions were wrong but, to be fair, the government has also done a good job of sourcing new supplies and building up reserves.) Moll, Schularick and Zachmann revisit the analysis and conclude:
The economic results confirm the basic theoretical argument that macro-elasticities are more important than micro-elasticities and that “cascading effects” along the supply chain would be mitigated instead of destroying the whole industrial sector of the economy. As expected, producers have partly turned to other fuels or fuel suppliers, have imported products with high energy content, while households have adjusted their consumption patterns… Market economies have a tremendous capacity to largely underestimated adaptation. In addition, the German Ministry of Economics (BMWK) has been very successful in quickly sourcing gas from third countries and developing LNG capacities. Finally, it probably helped German policymakers to refrain from imposing a price cap on natural gas (as in many other European countries) and opt instead for lump-sum transfers based on historical gas consumption of households and companies.
Hat tip: Alex Wollman.
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