European governments are facing a choice of which kind of crisis to have: an energy crisis or a fiscal crisis. The global economy may hang in the balance.
Estimates of the size of the energy price shock vary, but one plausible assessment runs in the range of 6% to 8% of GDP for Europe. One response to this shock would be to let energy prices rise and allow the private sector to adjust. This would mean higher costs for manufacturing, higher home heating bills, and lower disposable income to spend on other goods and services. In broad terms, it would be like the energy price shock of 1979 and the following recession.
Note that the size of the recession is typically larger than the size of the initial price shock. As some sectors start to contract, they bring down other sectors with them. Asset prices will fall as well, which in turn damages investment and consumption. Economists sometimes call this “real business cycle theory,” a branch of knowledge which investigates how an initial negative event can spread.
