• In a biannual Joint Economic Forecast, published Wednesday, Germany's biggest economic institutions reduced their GDP forecasts as the war in Ukraine slows the recovery from Covid-19.
• The RWI in Essen, the DIW in Berlin, the Ifo Institute in Munich, the IfW in Kiel and the IWH in Halle now expect German GDP to grow by 2.7% in 2022 and 3.1% in 2023.
• "If gas supplies were to be cut off, the German economy would undergo a sharp recession," said Stefan Kooths, research director for business cycles and growth at the Kiel Institute.

German economists are forecasting a recession in Europe's largest economy if Russian gas supplies were to stop, and the effects could spread through the continent.

In their biannual Joint Economic Forecast, published Wednesday, Germany's five biggest economic institutions sharply reduced their gross domestic product forecasts as the war in Ukraine slows the recovery from Covid-19.

The RWI in Essen, the DIW in Berlin, the Ifo Institute in Munich, the IfW in Kiel and the IWH in Halle now expect German GDP to grow by 2.7% in 2022 and 3.1% in 2023, assuming that there is no further economic escalation related to the war in Ukraine and gas flows to Europe from Russia continue. The institutes had previously projected growth of 4.8% in 2022.

Ukrainian President Volodymyr Zelenskyy and the European Parliament have called for the European Union to impose a total embargo on Russian oil, gas and coal imports in light of atrocities against civilians by Russian forces in Ukraine.

The EU plans to ban Russian coal imports and is working on sanctions against Russian oil as it looks to ostracize the Kremlin from the global economy, while Russian President Vladimir Putin has also on numerous occasions threatened to cut off the gas supply to Europe.

However, such a move is expected to have dire economic consequences for both sides. Germany bought 58.9% of its natural gas from Russia in 2020, according to the European statistics agency.

The Nord Stream 2 pipeline, the $11 billion project designed to double the flow of gas between Russia and Germany, is now unused and abandoned. Germany halted certification of the pipeline altogether after Russia officially recognized two pro-Russian regions in eastern Ukraine, setting a pretext for the invasion that would ensue.

In the event of a total stoppage of the Russian energy supply, the German institutes predicted a cumulative loss this year and next of roughly 220 billion euros ($238 billion), equivalent to over 6.5% of annual economic output. This would result in growth of just 1.9% this year and a contraction of 2.2% in 2023.

Inflation headache

"If gas supplies were to be cut off, the German economy would undergo a sharp recession. In terms of economic policy, it would then be important to support marketable production structures without halting structural change," said Stefan Kooths, vice president and research director for business cycles and growth at the Kiel Institute.

"This change will accelerate for gas-intensive industries even without a boycott, as
dependence on Russian supplies, which have been available at favorable prices up to now, is to be overcome quickly anyway."

Kooths advised governments to avoid providing "poorly targeted transfers" in order to cushion higher energy prices.

"If such support schemes are handed out on a wide front, it will further drive up inflation and undermine the important signaling effect of higher energy prices. This in turn exacerbates the problems of low-income households and increases overall economic costs," he said.

The European Central Bank faces the uniquely conflicting challenge of reining in record-high inflation without stomping out already weakening economic growth, which is likely to be hit further by supply shocks as the war in Ukraine persists.

Euro zone inflation came in at 7.5% for March on an annual basis, according to Eurostat, and the German institutes forecast a full-year average in 2022 of 6.1%, the highest print in 40 years.

In the event of an energy supply cut-off, they forecast an increase to a post-war record high of 7.3%. Next year's projected rate of 2.8% will also remain well above the average since reunification, and would rise to 5% in the event of an energy blockade, the report said.

"The shockwaves from the war in Ukraine are weighing on economic activity on both the supply side and the demand side," Kooths said.

"Government stimulus packages during the pandemic already had an inflationary effect. Increasing prices of critical energy commodities following the Russian invasion further fuel the upward pressure on prices."

Geraldine Sundstrom, portfolio manager at PIMCO, told CNBC on Friday that the risk of recession in Europe is far greater than that in the U.S. at this stage.

"The European economy is not in the same strong position as the U.S. one and potential industrial recession could be on the doorstep of Europe, depending on the disruption from the conflict, from what is happening certainly in Asia, and we have seen – especially in the automotive sector – a number of factories having to shut down, because of lack of parts and this has reintroduced furlough of some workers in Germany," Sundstrom said.

"Europe is also facing a very important supply shock and inflationary shock, and if anything, the ECB seems to be more willing to normalize policy despite the fact that the risk of a recession in Europe is way bigger than in the U.S."