The big fall in stock markets poses the question: is there any reason for optimism? The answer is yes.
Traders don’t expect the war and squeeze on oil and gas prices to last long. As I write, futures markets are pricing in Brent crude prices dropping $20 per barrel by early 2023, and the price of UK natural gas falling from 440p per therm now to 168p next summer.
Of course, predictions for the duration of wars have an unhappy record – “it’ll be over by Christmas” – and futures markets are poor predictors of actual prices. Nevertheless, these prices offer some hope – that the squeeze on real incomes and hence economic growth will be short-lived.
In this context, we must distinguish between the two reasons why equities have fallen. A fall due to lower future earnings should be permanent. But if energy markets are right, the earnings hit will be only small and temporary. Instead, it’s likely that the fall is in part due to heightened risk aversion. But this should see shares bounce back if risks don’t materialize: not all wars last longer than feared – the first Gulf war and Six Day war didn’t, for example.
Better still, if higher energy prices are only temporary, governments can do something about them. They could borrow to boost incomes, thus mitigating the pain they are causing. This is not to say we should subsidize oil consumption. Quite the opposite; the war highlights our need to wean ourselves off dependence on the devil’s excrement. It is general income support that’s needed, such as simple one-off payments of the sort paid by the US Treasury in 2020-21.
Not only would this mitigate the harm done by higher oil and gas prices, but it would also make it more feasible for the west to impose an oil embargo on Russia – something which would otherwise hurt us by sending prices spiralling. That would help bring an end to the war. In effect, the cost of higher oil prices could be spread over many years. Because real interest rates are still negative, this cost would decline over those years. And if futures markets are even roughly right, the intervention need be only short-lived.
So, why don’t governments do this? It’s not just because of silly deficit fetishism. It’s because it would be inflationary.
Although higher oil prices will have the immediate mathematical effect of adding to inflation, they are disinflationary in the longer run. This is simply because if we are spending more filling up our cars, heating our homes and eating (the war is also raising the prices of wheat and sunflower oil) we’ve little left to spend on other goods and services. Shops and restaurants will thus have to keep their prices down. Policies that support real incomes would offset this and so prolong inflation.
Herein lies the problem. The surge in oil and gas prices is a textbook supply shock: higher costs of production tend to raise the overall price level and cut output. Policy-makers can choose whether we see the pain in higher inflation or lower output. But they cannot escape the dilemma. All we can do is hope that we don’t have to face it for very long – and that futures markets are right.