April 27, 2022 - 2:15pm

Russia has announced the suspension of gas exports to Poland and Bulgaria after the two countries refused to make payments in roubles. In response, the EU has stated that they will offer support even though Russia has said that any attempts to channel Russian gas through other countries to Poland and Bulgaria will be met with further embargoes. Following the announcement, European gas prices rose 20% and the euro fell further against the dollar.

It is unclear what the EU expected to happen. The Russians stated clearly that they would not make deliveries if payments were not made in roubles. Failure to do so will hurt Europe more than Russia; recent price action suggests that the price increases of gas will more than make up for the lost deliveries — confirming modelling I ran at the start of March. So, why did the Europeans think that Russia would back down?

This brinkmanship is particularly damaging to the countries that are on the frontline of the economic war. Bulgaria and Poland both have their own currencies — the lev and the zloty respectively. Neither country is particularly rich. If their internal energy markets collapse, they will face energy price hikes and rolling blackouts, which is a recipe for very high inflation. There is then a risk that this inflation leads to their currencies collapsing — a situation that, in the worst-case scenario, could lead to hyperinflation.

The motivations behind the European energy war appear chaotic. From a game theory perspective, risk aversion on the part of the Europeans seems remarkably low. One way to explain that is to assume that the Europeans are not aware of the risks that they are taking. Certainly, it is quite possible that the Poles and the Bulgarians are unaware of the magnitudes of risk involved here.

Both countries have energy grids dominated by coal. Coal provides 45% of Poland’s energy and 37% of Bulgaria’s. Meanwhile, gas provides 17% of Poland’s energy and only 6% of Bulgaria’s. There is a possibility that Bulgaria could live without Russian gas, but if almost a fifth of Poland’s energy market is impacted it will have a knock-on effect on the economy.

Still, if the countries continue to refuse to pay in roubles, Russia will presumably then choke off other energy sources. Even in the case of Bulgaria, which does not rely much on oil and gas for energy production, they still need access to petroleum for their vehicles. There is simply no way around it: if Russia provides the fuel, they hold all the cards.

Perhaps they have convinced themselves that allying with more powerful countries will ensure that these countries will (and can) come to the rescue. That is an unfortunate foreign policy mistake that many small countries have made in history.

If Poland and Bulgaria dig in and more energy sanctions come down the pipeline, their economies will likely collapse. At that point, the more powerful European countries will have to look at the resulting mess and see if they want a part of it. There are already indications that Europe is getting ready to make the rouble payments to Russia. In truth, it is difficult to see this playing out any other way. Which leads one to ask: what was the point of all this? All we got was volatility in the energy markets and yet more inflation.

Philip Pilkington is a macroeconomist and investment professional, and the author of The Reformation in Economics