For this week’s look at the Day After, we once again delve into the global risks facing today’s leaders, examining how the pressure on the global system is squeezing out old methods of problem-solving. We begin with Europe’s mounting energy crisis, which is set to worsen as the continent moves into the winter and gas prices show no signs of relenting. From there, we pivot to China, which has been beset by three “dangerous D’s” of debt, disease, and drought. We then launch into an examination of how the Federal Reserve’s policy is effectively playing “catch-up” with itself after a period of expansionary policy during the pandemic. Finally, we conclude by returning to Europe’s power producers, investigating how a liquidity crisis among electricity producers may lead to another “Lehman moment.” In the midst of these and other crises, it is important to maintain a historical perspective. The problems we face today have unique elements, but they are no worse than those faced by our predecessors. Let us then trust their wisdom where they succeeded, forge new paths where they failed, and move forward into the future with humble hope.

You Have No Idea How Bad Europe’s Energy Crisis Is

Christina Lu, Foreign Policy

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Spiking natural gas prices are pushing Europe to the breaking point, fueling inflation, shuttering industry, and dramatically increasing the cost of living for most citizens. With so much pressure already in the system, the prospect of a demand increase as the continent moves towards winter has European leaders scrambling to find solutions to keep the heaters on. The UK has permitted an 80 percent spike in the maximum allowed household energy cost, while Germany has seen its energy bills increase by nearly five hundred euros. The reason for this shortage is largely Russia’s invasion of Ukraine; in response to European sanctions, Putin has strangled Russia’s exports of key energy commodities, which account for as much as 40% of European supply in peacetime. As Europe has turned to other sources, the price of natural gas has skyrocketed to ten times the historical mean. The inevitable inflation and slowdowns in economic activity accompanying such moves indicate that Europe is in for a hard and long recession.

Ignoring China’s Disastrous ‘Three Ds’ Could Be a Global Risk

Megan Greene, Financial Times

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China’s economy is at risk of a severe slowdown due to debt, disease, and drought. Despite global inflation on a massive scale, China’s central bank recently cut its interest rates, indicating that its economic planners see a significant risk of further contraction, even as manufacturing, retail sales, industrial output, and investment all slowed in July. The first of the “dangerous D’s” – debt – has rocked China’s real estate sector, which accounts for 20-30% of GDP and the lion’s share of personal wealth, local government revenues, and bank loans. More than thirty real estate companies have defaulted on their international debt as the sector struggles to meet its obligations. With additional lending likely to create a moral hazard, the CCP has turned to consumer spending to drive growth, an area challenged by the other two D’s – disease and drought. Covid lockdowns have kept an estimated 13% of GDP inside, while a drought has brought the Yangtze River to its lowest level on record, creating blackouts as the country’s water-dependent power supply literally dries up. The interest rate cut does little to mitigate the underlying issues at play for China, which may spell disaster – not only for China’s 1.4 billion people, but also for the world.

Tough Economic Times Lie Ahead

Martin Wolf, Financial Times

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Central banks are “playing catch-up” after promoting loose monetary policy for far too long, according to Martin Wolf. As clearly evidenced by Federal Reserve Chairman Jerome Powell’s remarks at the Jackson Hole Symposium last month, central banks are determined to control inflation. However, they have been unsuccessful thus far as both headline and core inflation (excluding energy and food) have been above target for a prolonged period of time. Inflation is spiking due to a number of factors including unexpected supply shocks, constraints on energy supply, and the war in Ukraine. Moreover, Wolf argues the Fed’s ultra-loose policies during the pandemic lasted too long and US fiscal policy was too expansionary which has put the US Federal Reserve in the predicament that it finds itself in today. Now, the central bank fears losing credibility and is concerned about a wage-price spiral. Though being tough on inflation will bring slower growth and therefore some pain to businesses and households, the Fed is keen on restoring price stability by tightening monetary policy. As Wolf explains, there is the risk of doing too little and doing too much, “yet ‘determination’ to act is a better choice than ‘caution’.”

Why are Europe’s Power Producers Running Out of Cash?

Tom Wilson and Philip Stafford, Financial Times

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The European power industry is entering a liquidity crisis. Despite the fact that electricity is selling at record-high prices, European electricity companies are running out of cash to cover the skyrocketing collateral requirements. These electricity companies take short positions in futures markets before actually selling the physical electricity in order to “de-risk” their power sales in the case that power prices fall. Market rules dictate that anyone taking a short position must post additional collateral (margin) if the price of the underlying asset (in this case electricity) rises. The recent surge in electricity prices means more profits but it also means that collateral requirements have ballooned. The positions will be profitable once the physical energy is sold, but many of these contracts will not mature for months or even years, so companies are exhausting their existing credit lines to cover their short positions. The Finnish economy minister Mika Lintilä is warning that this liquidity crisis could create the European energy sector’s version of a “Lehman Brothers” moment. Leaders in the European power industry say governments have two primary options for responding to the crisis: “prepare to provide utilities with billions of euros of state-backed credit or modify the rules around margining.”