Eurozone: Lack of discipline puts it at risk

Posted on June 5, 2022

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Annual inflation in the eurozone continues to rise, from 7.4% in April 2022 to 8.1% in May, beating expectations of 7.8%, reaching the highest level since the creation of the euro. Energy rose 39.2% – from 37.5% in April – and food, alcohol and tobacco 7.5% – from 6.3% in April – but even without energy and food prices, inflation rose from 3.5 to 3.8%.

The culprits are well known: the unbridled monetary expansion of central banks, supply chain distortions due to the coronavirus, raw material shortages due to the war in Ukraine and the long-term effects of years of experimentation with European energy supplies.

The difficult budget of the European Central Bank

Barclays has warned That, in response, the European Central Bank (ECB) may need to raise interest rates more than markets expect to overcome banks’ reluctance to pass on higher borrowing costs.

European Central Bank Not But without a rush as it continues to keep interest rates at negative levels. Even the supposedly more “hawkish” European Central Bank governors, such as the head of the Dutch central bank, Klaas Knott, You have He endorsed European Central Bank President Christine Lagarde’s plan to exit negative interest rates only at the end of the third quarter of 2022.

The main reason for this decision is, of course, concern about the financial situation of a number of eurozone governments. Italy’s 10-year yields now have Achieve 3.2%, the highest level since 2018. Although fiscally weaker eurozone governments do not immediately need to fear getting into trouble again, as they only need to refinance a small portion of their debt burden at higher interest rates today, prolonged inflation It might be a game changer, if combined with higher interest rates.

The European Central Bank may be able to control the expansion of the money supply, but it cannot control how much people trust the euro to retain its value. Of course, in theory, the ECB could still refuse to raise interest rates too much, but then the euro would depreciate even more – because that would cause it to fall further against the US dollar than it otherwise would. case for a year. This happened not only because of the Fed’s tougher anti-inflation stance, but also because the US dollar remains the world’s reserve currency. Regardless of what those who believe that Russia will soon challenge the dollar’s dominance with a gold-backed currency say, that is still a long way off.

A weaker euro would in turn contribute to higher prices. In short, the European Central Bank will have to raise interest rates, which will, at least at some point, have an impact on the ability of eurozone governments to take on more debt, which will also eventually limit their ability to spend.

Since the creation of the euro, the European Union has instituted debt and deficit rules, to ensure that governments do not overspend or take on excessive debt. These rules set the public deficit and public debt at 3% and 60% of GDP. Currently, there are 17 countries in the European Union that violate the deficit norm and 5 countries that violate the debt norm – Belgium, France, Italy, Hungary and Finland.

In any case, these rules were not properly implemented. Shortly after the creation of the euro, in 2003, France and Germany publicly violated the rules, even uniting to ensure that they were not penalized for this, thus completely destroying the rules known under the name of the “Growth and Stability Pact”. Unfortunately, it was the UK and its finance minister, Gordon Brown, who ruined them. It came two years after a small member state, Ireland, was reprimanded by the European Commission for slightly breaking the rules. Equally infamous, European Commission President Jean-Claude Juncker explicitly stated in 2016 that the European Commission had given France a deadline on tax rules “because it is France.”

EU tax rules suspended

EU tax rules were then suspended in March 2020, with covid used as an excuse. Last month, the commission, which had planned to reactivate the rules at the end of this year, decided to extend the suspension for another year, until the end of 2023, this time citing Russia’s invasion of Ukraine.

The European Commissioner for the Economy, Paolo Gentiloni, justified this comment as a means To facilitate the transition from comprehensive support to a more targeted and cautious support time. » He called on EU member states to use the funds allocated under the EU’s recovery fund, known as “EU Next Generation”.

This fund, jointly funded, could be a very tempting way for EU member states to keep going in the water. Why implement unpopular economic reforms – such as spending cuts to fund tax cuts, or asking more people to get jobs – in order to generate economic growth and thus tax revenue, when there is another way – to burden citizens with more debt, co-financed with countries Other members of the European Union in order to avoid paying high interest rates?

Perhaps you need not explain that getting into debt with other countries, which are financially weaker, transfers part of the risk to more financially responsible countries. To the extent that they are still fiscally responsible countries in the European Union or the Eurozone. As the French economist Frédéric Bastiat said: “The state is the great imagination with which everyone strives to live at the expense of others.” When everyone thinks they are living at everyone’s expense, everyone may end up in a worse situation.

The breakup of the Eurozone could, of course, be the result of all this, when long-running tensions prove too high, but all this could also take a long time. In fact, Croatia He has a good chance to enter the eurozone in January. The country’s currency is already pegged to the euro, but effective membership means Croatian banks will benefit from cheap financing from the European Central Bank, which they can then inject into Croatian government bonds or real estate, thus bursting a new bubble. As always, the currency of the Eurozone is: “When we have problems, we multiply.”

So, will the European debt circus continue unabated?

Jamie Dimon, Chairman and CEO of JPMorgan Chase & Co., described the challenges facing the US economy as a hurricane:

The Fed needs to deal with it now by raising interest rates and QT (quantitative tightening). In my opinion, you need to make a quantitative tightening. They have no choice because there is a lot of liquidity in the system. »

The CEO of Wells Fargo & Co also warned that the Fed would find “Very difficult” Manage a soft landing of the economy while trying to fight inflation by raising interest rates. Let’s hope they’re wrong, but if they’re right, how much easier would things be in Europe?

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