A functioning system of flexible prices is at the heart of a market economy. Adam Smith, the founder of economics, already knew this in the 18th century.
As if controlled by an “invisible hand”, market prices ensure that scarce goods are distributed efficiently. In market equilibrium, supply and demand are in balance in all markets. The market reacts to a lower supply, for example as a result of poor harvests, with price increases, which lead to a drop in demand. In the new equilibrium, the price is higher and the demand lower than before.
However, a free market does not take social aspects into account. People who cannot afford higher food prices have to starve in a free market economy, while the well-off have no problem maintaining their standard of living. In a social market economy, this is prevented by a redistribution of income.
Just as the price of bread was an indicator of (perceived) inflation in earlier centuries, so are energy prices today – and they are literally exploding at the moment. According to the Federal Statistical Office, energy was 22.1 percent more expensive at the end of 2021 than twelve months earlier. Heating oil and motor fuel even cost around 50 percent more. The price increases for electricity, gas and other household energy were only moderate at twelve percent because many customers had concluded contracts with a price guarantee.
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There are various reasons for the current jumps in prices, such as geopolitical tensions, rising prices for emission rights, a rebound in the global economy, the hunger for energy in large emerging countries, the reversal of the temporary reduction in VAT in Germany and the new CO2 tax.
Some of these factors are certainly of a temporary nature, but one thing should be clear to everyone: If politicians are serious about climate protection and rely on market-based mechanisms, then energy generated from fossil fuels must become more expensive – and so much so that it becomes obvious behavior changes occur.
One problem with this is that many people are unable to react quickly to higher prices. In rural areas, many workers rely on the car to get to work. And if you live for rent, you cannot insulate your apartment yourself or install an economical heating system.
Söder supports energy “price brake”
That is why politicians are thinking in the opposite direction: they want to weaken the power of the market. For example, the Bavarian Prime Minister Markus Söder (CSU), who is presumably more concerned with his re-election than with climate protection, calls for a “price brake” on energy. The commuter allowance should be made dynamic and the value-added tax for natural gas, geothermal energy and district heating should be reduced to seven percent “at least temporarily”. “We have to prevent rising energy prices and inflation from becoming a poverty trap,” warned Söder in an interview with the Handelsblatt.
What is correct about these words is that rising energy prices are driving inflation, hitting people with lower incomes more than high earners. Climate protection organized in a market economy goes hand in hand with considerable distribution effects at the expense of low-income earners.
It is therefore a requirement of the welfare state to pay those in need a surcharge on top of their state support, as has now been decided by the federal government. However, it is also true that if many of those affected are reimbursed by the state for the additional costs, the desired incentives to save energy will decrease.
Prof. Bert Rürup is President of the Handelsblatt Research Institute (HRI) and Chief Economist of the Handelsblatt. For many years he was a member and chairman of the German Council of Economic Experts and an adviser to several federal and foreign governments. You can find out more about the work of Professor Rürup and his team at research.handelsblatt.com.
If there were a wise climate dictator who had complete information and only pursued the maximization of benefits for society without any self-interests, he would ensure that energy obtained from fossil raw materials became noticeably more expensive and the social cushioning would be designed in such a way that the price signals would still have an effect . This would most likely be possible with per capita payments.
If the demand for energy is price-sensitive, rising relative prices mean that consumers demand less energy and instead more of other goods; and per capita reimbursements can prevent people from becoming poorer. Only if the demand for energy is not very price-sensitive does this calculation fail.
The question remains as to who should pay for the restructuring of the economy. The private sector should finance the necessary private investments, as these will pay off in the future through higher yields. The state would have to take out loans for the green conversion, the debts of which would have to be serviced by future generations.
Because if the green conversion succeeds, they would be the main beneficiaries of the future cost-effective energy from renewable sources as well as a modernized capital stock and the stabilized global climate. Credit financing of state environmental investments would therefore be justified, which even vehement advocates of the debt brake would have to concede.
Monetary policy faces a dilemma
But even if this well-meaning dictator did everything right, he would run the risk of coming into conflict with the independent central bank – rising energy prices are driving inflation, after all. The German ECB Director Isabel Schnabel recently indicated that rising energy prices could force the European Central Bank to correct its course. Monetary policy cannot afford to ignore energy price increases if they pose a risk to medium-term price stability.
This could be the case if expensive energy leads to general expectations of higher inflation, or if a strong pickup in private sector investment leads to overheating of the economy as a whole.
Monetary policy is faced with a dilemma: on the one hand, it is committed to monetary stability, on the other hand, it cannot be its task to torpedo the democratically broadly legitimized policy that deliberately makes energy more expensive.
Ideally, the central bank would have to calculate two inflation rates in the future: the rate actually collected by the statistical offices and a rate adjusted for price-increasing decarbonization effects. However, since almost all products contain energy that is required for production and transport, calculating such an adjusted inflation rate would by no means be trivial.
Distribution effects are politically and socially explosive
Conclusion: Decarbonization in the interest of the global climate is by no means just a technical problem that can primarily be solved with investments, engineering skills and digitization. Rather, the enormous distributional effects – which have been suppressed in the discussion so far – are politically and socially explosive. Because inflation is always primarily at the expense of those on low incomes.
An independent central bank that only looks at monetary stability would thwart the ecological restructuring. Because interest rate increases resulting from the surge in inflation would slow down the propensity to invest and thus slow down the ecological conversion.
Ultimately, it is a matter of making political decisions: for a stable climate or for stable prices. Achieving both at the same time will, to put it mildly, be extremely difficult – probably impossible.
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