The Power of Substitution: The Great German Gas Debate in Retrospect

The Russian attack on Ukraine in February 2022 laid bare Germany's dependence on Russian energy imports and ignited a heated debate on the costs of a cutoff from Russian gas. While one side predicted economic collapse, the other side (ours) predicted "substantial but manageable" economic costs due to households and firms adapting to the shock. Using the empirical evidence now at hand, this paper studies the adjustment of the German economy after Russia weaponized gas exports by cutting Germany off from gas supplies in the summer of 2022. We document two key margins of adjustment. First, Germany was able to replace substantial amounts of Russian gas with imports from third countries, underscoring the insurance provided by openness to international trade. Second, the German economy reduced gas consumption by about 20 percent, driven mostly by industry (26 percent) and households (17 percent). The economic costs of demand reduction were manageable with the economy as a whole only experiencing a mild one-quarter contraction in the winter of 2022-2023 and then stagnating. Overall industrial production decoupled from production in energy-intensive sectors (which did see large drops) and declined only slightly. We draw a number of key lessons from this important case study about the insurance offered by access to global markets and the power of substitution, specifically that supply shocks have dramatically smaller costs when elasticities of substitution are very low (but nonzero) compared to a truly zero elasticity.