Inflation: why prices soared across all of Europe?

Post-Covid 19, inflation has become globally pervasive and reached an all-time high in Europe compared to past decades. Such a meteoric rise in European inflation results from the combination of cyclical and structural shocks that have stroked all European countries.

The main structural factor driving inflation is the energy crisis. After the pandemic, oil and gas production did not keep pace with consumer demand causing energy prices to soar. Presently, energy represents the main component of the inflation rate in the euro area (35%), far ahead of food (13,5%), industrial goods (6%), and services (4%) inflation.

The re-opening of economies after the pandemic, and the Russian invasion of Ukraine figure among the cyclical shocks that drove inflation up. Pandemic-related changes are crucial to explain the current levels of inflation. After the lifting of Covid restrictions, household and business demand for certain goods and services increased – as they spend some of the money they did not during lockdowns – compared to lockdown periods. This demand faced a supply that remained the same or was even reduced due to global supply chain disruptions, leading to higher prices. War in Europe considerably exacerbated the energetic crisis. It fueled worries of a global stoppage of oil and gas supply from Russia – Europe’s first natural gas exporter – which has concretized, driving up energy prices even further. More, the sanctions against Russia are compelling many European countries to reorganize their energy supplies which is costly. The war in Ukraine also created market disruptions leading to a sharp increase in food inflation as Ukraine and Russia are among the leading wheat, corn, and barley world exporters.

Inflation in the European Union averaged 11,5% in November 2022. Yet such a European inflation average hides considerable discrepancies. Historically, inflation in Europe is heterogenous, highlighting the economic divergence that characterizes the EU. Whereas inflation skyrocketed above 20% in Eastern European countries, it remained, until now, below the European Union average in Western countries such as France, Spain, and Norway. Odder than the eternal divide between Eastern and Western countries is the significant fluctuation among the most important European economic players’ inflation rates. Germany and the UK are neck and neck with respective inflation rates of 10,05% and 10.7% in November. France is much more resilient. Its inflation rate, one of the lowest in Europe, averaged  6,2%  over October and November.

It is rather clear that the biggest challenge European countries face, and which contributes the most to inflation is the sharp increase in energy prices. The energy crisis which has been intensified by the war in Ukraine, impacted countries differently, largely explaining divergences among the UK, Germany, and France in terms of inflation.

France: why inflation is so ‘low’?

It seems France remains much less impacted by inflation than the major European economic powers because it is more resilient to the energy crisis. The inflationary situation in France is mainly explicated by France’s diversified and favorable energy mix but also and mostly by the tariff shield it implemented last year. France has a sizeable nuclear fleet – 70% of the country’s electricity production comes from nuclear power – which is the second-largest behind the United States. More, nuclear accounts for 40% of primary energy consumption in France, far ahead of oil (28.1%) and natural gas (15.8%). This heavy reliance on nuclear power ensures France is less dependent on fossil fuel imports and thus on Russian’s gas imports than its neighbors. More, the French government established in October 2021 a tariff shield, which froze electricity prices, and capped the gas ones. This law allowed for a contained upsurge in inflation as the French Minister of Economy and Finance, declared that without this government measure, French electricity and gas bills would have increased by 60% and 45% respectively. Although France’s nuclear fleet is currently somewhat weakened, with some of its plants shut down, France’s nuclear gamble, criticized by many, finally seems to be paying off as economic forecasts predict a recession in the coming months in Germany and the UK but not in France. Still, the current shutdown of some nuclear power plants in France could make the situation more complicated for France in the future.

Electricity generation by source (in %), France 1990-2021 (IEA)

France, Germany, and the UK: Explaining the gaps in inflation rates

Compared to France, the share of nuclear in the primary energy consumption in the UK and Germany is considerably lower. The European bloc’s largest economy’s energy policy is France’s counter model. As Germany is orchestrating its exit from nuclear power for several years now, its energy mix consists essentially of oil, gas, and coal. Whereas Germany’s energy prices had already soared considerably– as in all other European countries – before the Russian invasion of Ukraine, since then, they have only gone up to record highs. Additionally, and in contrast to France, Germany did not yet establish a tariff shield – currently considered for 2023– but favored financial help to its citizens by granting them vouchers and discounts on fuel. If Germany finds itself in this hellish inflationary spiral, it has itself to blame for a lot. For several decades, Germany has voluntarily decided to maintain a close energy relationship with Russia: in exchange for low gas prices, Russia was almost Germany’s sole gas supplier. Before the war, Russia accounted for 55% of Germany’s imported gas.

Whereas heavy reliance and/or relative independence from Russia for energy supplies as well as the implementation of a tariff shield seem to have much ground to explain divergences in inflation rates between the Franco-German couple, it seems to be more to the story to explain how the UK compares. Though oil and gas also account for the biggest share of primary energy consumption in the UK, the latter is much less reliant on Russian energy than Germany, as Russian imports of gas made up only 4% of the UK’s gas consumption, and 9% of its oil consumption in 2021. It goes without saying that the UK has suffered from disrupted markets for its energy supply, driving its inflation rate up, but on a much smaller scale than Germany. Yet the UK’s inflation rate is approximately the same as Germany’s, and even a few tenths higher.

Though criticized, many have stressed the importance of Brexit as the leading driver in explaining the inflation rates differential between the UK and the other European largest economies, namely Germany and France. Brexit would have dwindled the UK’s labor supply size and its elasticity, reduced purchasing power and imports through the implementation of new trade barriers and created uncertainty for investors. This is why these economists stress that Brexit has decisively damaged the UK’s economic foundations, in particular by weakening the anchor for anticipated inflation, making the UK more vulnerable to external supply shocks.

To conclude, one can be sure that the role of the energy crisis, exacerbated by the war in Ukraine, has a certain explanatory power in accounting for the divergences in European’s largest economies’ inflation rates. As for Brexit, only time will tell whether its role is primary or secondary in explaining levels of inflation in the UK.