The European Union has shown remarkable – and, for many people, surprising – political unity in responding to Russia’s invasion of Ukraine. From suspending the Nord Stream 2 gas pipeline to excluding some Russian banks from the SWIFT financial messaging system for international bank payments to revoking Russia’s “most-favored nation” trade status, EU members have taken decisive action to squeeze Russia economically. But Europe has yet to take adequate action to protect its own economy from the fallout of Russian President Vladimir Putin’s war.
At an informal meeting in Versailles last week, French President Emmanuel Macron urged his fellow EU leaders to focus first on what they must achieve, and leave discussions of how to get there for later. It was a wise suggestion from a leader who understands that new policy instruments, which may imply greater burden-sharing among member states, tend to be far more divisive than common goals.
So, EU leaders expressed their commitment “resolutely” to bolster investment in defense capabilities. Germany, for example, will allocate an additional €100 billion ($111 billion) toward defense this year. And the EU has unveiled a plan for reducing imports of Russian gas by two-thirds this year, and ending its dependency on Russian fossil fuels entirely by 2030 – a process that will demand an accelerated green transition.
But EU leaders did not acknowledge fully the common effort that will be required to achieve their goals, especially at a time of rapidly gathering economic headwinds. In fact, European policymakers seem to be grossly underestimating the economic challenges ahead.
EUROPE IN DENIAL
European leaders’ silence about the tasks ahead is puzzling, because the Ukraine war is so obviously transforming the global macroeconomic landscape. In the EU, more than anywhere else in the world, national governments will need to increase public spending significantly, as they attempt to bolster their defense capabilities, build new energy infrastructure, support households and businesses facing soaring energy costs, and cope with a large-scale refugee crisis. To meet these needs, governments will take on more debt, and they will do so at a time when their balance sheets are already weighed down by the debts incurred after the 2008 financial crisis and during the pandemic.
Rising inflation will compound the problem. The war is exacerbating and prolonging the commodity-price spikes and supply bottlenecks that have fueled inflation over the last two years. The result will be heavier public-debt burdens, upward pressure on the equilibrium real interest rate, volatility in output growth, and a likely surge in risk premia in some countries, which could lead to financial fragmentation.
So far, the European Commission is doing little to mitigate these risks. It has been discussing an economic package with three pillars: the repurposing of loans issued under the Next Generation EU pandemic-recovery fund, fresh debt to raise money for loans in case of energy-price spikes, and new guidance on fast-track approval of state subsidies. But after the Versailles meeting, it seems that only the third measure will receive support. It is not even clear whether EU leaders will agree to postpone the reinstatement of the Union’s fiscal rules, which had been suspended during the COVID-19 pandemic.
A similarly alarming complacency can be seen at the European Central Bank. On March 10, it announced the timetable for rolling back asset purchases and published remarkably optimistic macroeconomic projections for the eurozone.
The ECB expects 3.7% average real GDP growth this year, just 0.5 percentage points lower than its assessment from December 2021. In 2023, it projects a still-robust 2.8% growth rate, reflecting a downward revision of just 0.1 percentage points. Meanwhile, policymakers expect inflation to reach 5.1% this year, then drop to 2.1% in 2023. Clearly, the ECB does not anticipate a steep trade-off between inflation and output in the near future, let alone for the eurozone to be gripped by stagflation.
But the ECB’s forecasts are optimistic, to say the least. Consider the projection that inflation will decline sharply next year, which is based on an analysis of market interest rates and pre-supposes no change in policy stance. Consequently, the ECB’s projected decline is driven entirely by a forecast of energy price developments based on oil futures prices. But, at the one-year horizon, the oil futures market is very thin and therefore an unreliable guide. Moreover, one may ask the question of why the ECB is tightening its monetary policy if inflation is projected to decline because of an exogenous decline in oil prices.
A SOBERING REALITY
Financial markets are certainly not convinced by the ECB’s assessment. The inflation-swaps market implies an expectation that the Harmonized Index of Consumer Prices – the index that the ECB uses to target eurozone inflation – will stand at 4% in February 2024.
Such forecasts seem rather more plausible than the ECB’s predictions. European companies are already struggling with supply shortages and spiking commodity prices. While the real economy is not yet showing clear signs of a slowdown, all signs point to a massive supply shock that will lead to significantly higher production costs.
It is worth remembering that, in the period since 1945, most economic recessions were preceded by an oil shock associated with a war. If the oil price reached $200 per barrel, the world would probably face a recession as severe as that of 1979. While the inflation of the 1970s was eventually reined in, thanks to former US Federal Reserve Chair Paul Volcker, growth suffered considerably along the way.
The ECB may not expect a sharp tradeoff between growth and inflation, but before long, that grim choice may well become unavoidable. Will the ECB take tough action on inflation, even if the eurozone is mired in recession? And will it do so even as fiscal authorities increase public expenditure by an estimated 1.5-2% of GDP, most likely financed by national debt? It is not difficult to see that the combination of fiscal loosening and monetary tightening would strain both public finances and economic performance.
A NEW ECONOMIC REALITY
The challenge the EU confronts today is exceptional. Solutions pulled from the same old playbook, focused on inflation targeting and fiscal rules, will not work. And the measures on which the bloc has agreed – including temporary relaxation of state aid rules (so that governments can help companies facing liquidity problems resulting from the sanctions imposed on Russia) and the efforts to reduce dependence on Russian energy – are not enough. The sooner Europe’s leaders recognize this, the better.
The good news is that the EU has proved that it can rise to an exceptional challenge, implementing novel instruments and accepting the need to share risk. When the pandemic began, the bloc rapidly devised and agreed on Next Generation EU, which, financed by the issuance of common debt for the first time ever, channeled more than €800 billion toward economic recovery and reconstruction. The scheme, supported by the ECB’s €750 billion pandemic emergency purchase program (PEPP), enabled a potent combination of fiscal and monetary support.
But the EU is not a federation, and its ability to deliver unified policy in a crisis is subject to political and legal limitations. This could impede the action that is needed today. Less than two years after the exceptional response to COVID-19, many Europeans might find a call for yet more special measures suspicious. Exceptional or not, what is repeated, in their view, could become permanent.
The measures the EU needs to cope with the Ukraine war do indeed have much in common with those implemented in response to the pandemic. The EU needs a new contingent facility to finance the emergency spending that will be required, along with a commitment by the ECB to introduce a PEPP-like program, if necessary, to provide liquidity to the market and fight financial fragmentation. Under such uncertain circumstances, the ECB should consider flexibility in the geographical distribution of asset purchases and exercise a great deal of caution in withdrawing monetary support.
Above all, the EU’s monetary and fiscal authorities must coordinate and calibrate the instruments they use in responding to the crisis. Fiscal tools are better equipped to cope with a trade-off between inflation and output, because they can be more precisely targeted than monetary policy. And monetary policy is needed to support market functioning and prevent heterogenous country risks from driving financial fragmentation within the eurozone.
The historical record clearly indicates that building the capacity to conduct a common defense and foreign policy, as EU leaders have pledged to do, will require building common economic capacity. The EU must now adapt its economic governance to this imperative. After a decade in which the only certainty has been heightened volatility, the EU must be able to implement the measures it needs – regardless of how “exceptional” they may seem to be – in a timely and coherent way.
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