Reuters: As the war in Ukraine continues, the European financial crisis intensifies

It was expected to be a good year for Europe. A post-pandemic consumer euphoria, supported by abundant government spending, was expected to boost the economy and help households regain a sense of normalcy after two dire years, Balazs Koranyi reports for Reuters.

But all that changed on February 24 with the Russian invasion of Ukraine. Normality was lost and the crisis became permanent.

A recession is now almost certain, inflation is nearing double digits and a winter of energy shortages is fast approaching.

Although ominous, these prospects are still likely to worsen further before any significant improvement by 2023.

“The crisis is the new normal,” said Alexandre Bompard, Carrefour’s chief executive. “What we’ve been used to for the last few decades – low inflation, international trade – is over,” he noted.

The change is dramatic. A year ago most analysts were predicting economic growth for 2022 close to 5%. Now, the winter slump is becoming the main scenario.

Both households and businesses are suffering, as the war’s effects – high food and energy prices – are now compounded by a devastating drought and low river levels that limit supply transport.

At 9%, inflation in the euro zone is at levels not seen in half a century and is eroding purchasing power as excess money is used up on petrol, natural gas and food staples.

Retail sales are already falling, months before the start of the heating season, and shoppers are cutting back on purchases. In June, the volume of retail sales fell by almost 4% from a year earlier, peaked by a 9% drop recorded in Germany.

Consumers are turning to discount chains and abandoning premium products in favor of discount brands. They have also begun to avoid certain markets.

“Life is getting more expensive and consumers are reluctant to spend,” Robert Gentz, co-chief executive of German retailer Zalando, told reporters.

Businesses have so far coped well thanks to their exceptional pricing power due to persistent supply constraints. But energy-intensive sectors are already suffering.

Almost half of Europe’s aluminum and zinc smelting capacity is already out of service, while much of fertilizer production, which relies on natural gas, has been shut down.

Tourism has been an exception, with people looking to spend some of their accumulated savings and enjoy their first carefree summer since 2019.

But even the travel sector is constrained by capacity and labor shortages, as workers laid off during the pandemic have been reluctant to return.

Major airports such as Frankfurt and London Heathrow were forced to curtail flights simply because they did not have the staff to handle passengers. In Amsterdam’s Schiphol, waiting times could reach four or five hours this summer.

Airlines are also struggling to cope. Germany’s Lufthansa has been forced to apologize to customers for the chaos, admitting it is unlikely to ease any time soon.

Recession and the cost of energy independence

This situation is likely to worsen, especially if Russia further reduces natural gas exports.

“The gas shock today is much bigger – it’s almost double the shock we had in the 1970s with oil,” said Caroline Bain of Capital Economics. “We’ve seen a 10- to 11-fold increase in the spot price of natural gas in Europe over the last two years.”

While the EU has unveiled plans to accelerate its transition to renewable energy and wean itself off Russian gas by 2027, making it more resilient in the long term, supply shortfalls are forcing it to aim for a 15% cut in gas consumption this year.

But energy independence comes at a cost.

For ordinary people it will mean colder homes and offices in the short term. Germany, for example, wants public spaces to be heated to just 19 degrees Celsius this winter, compared to 22 degrees previously.

In the longer term, it will mean higher energy costs and therefore inflation as the bloc has to give up larger and cheaper energy supplies.

For businesses, this will mean lower output, which further reduces growth, especially in industry.

Wholesale gas prices in Germany, the bloc’s biggest economy, have quintupled in a year, but consumers are protected by long-term contracts so the impact so far has been much smaller.

However, they will have to pay a compulsory levy and once the contracts expire, prices will shoot up, suggesting that the impact will only be delayed, exerting persistent upward pressure on inflation.

That’s why many, if not most, economists see Germany and Italy, Europe’s No. 1 and No. 4 gas-dependent economies, entering recession soon.

While a US recession is also likely, its origins will be quite different.

As it grapples with a hot labor market and rapid wage growth, the US Federal Reserve (Fed) is raising interest rates quickly and has made clear it is willing to risk even a recession to tame rising prices.

By contrast, the European Central Bank has raised interest rates only once, back to zero, and will move cautiously, mindful that rising borrowing costs for over-indebted eurozone countries such as Italy, Spain and Greece could to fuel concerns about their ability to continue paying their debts.

But Europe will enter recession with some dynamic trends.

Employment is at record levels and businesses have been struggling for years with a growing labor shortage.

This suggests that companies will be willing to keep workers, especially as they head into the recession with relatively healthy margins.

This could then support purchasing power, indicating a relatively shallow recession with only a slight uptick in the now record low unemployment rate.

“We see continued acute labor shortages, historically low unemployment and a high number of job vacancies,” ECB board member Isabel Schnabel told Reuters. “This likely means that even if we enter a recession, businesses may be quite reluctant to lay off workers on a large scale.”