The longer the Eurozone avoids budgetary discipline, the more painful the awakening

By
Pieter Cleppe
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Annual inflation in the Eurozone continues to increase, from 7.4 percent in April 2022 to 8.1 percent in May, beating expectations of 7.8 percent, hitting the highest level since the creation of the euro. Energy increased with 39.2% – up from 37.5% in April – and food, alcohol and tobacco with 7.5% – up from 6.3% in April – but even without energy and food prices, inflation increased from 3.5 to 3.8 percent.

The culprits are well-known: rampant Central Bank monetary expansion, supply chain distortions due to Covid, commodity scarcity due to the war in Ukraine and the long term effects of years of experimenting with European energy provision.

Barclays has warned that, in response, the European Central Bank (ECB) may need to raise interest rates more than markets anticipate in order to overcome the reluctance of banks to pass along higher borrowing costs.

The ECB is however in no rush, as it continues to hold interest rates at negative levels. Even supposedly more “hawkish” ECB governors, like Dutch Central Bank chief Klaas Knot, have endorsed ECB President Christine Lagarde’s plan to only exit from negative rates by the end of the third quarter of 2022.

The ECB between a rock and a hard place

The fundamental reason for that is of course concerns for the financial situation of a number of Eurozone governments. Italy’s 10 year yields have now reached 4%, the highest level since 2014.

Even if financially weaker Eurozone governments do not need to immediately fear getting in trouble again, as they only need to refinance a small share of their debt burden at today’s higher interest rates, prolonged inflation may change that, if combined with increased interest rates.

The ECB may be able to control the expansion of the money supply, but it cannot control the extent to which people trust the euro to keep its value. Surely, in theory, the ECB could simply continue to refuse to materially hike interest rates, but then the value of the euro would fall even more – as this would make the euro fall even more versus the U.S. dollar than has been the case over the last year.

This has not only happened because of the Fed’s slightly more firm anti-inflation stance, but also due to the fact that the U.S. dollar remains the world reserve currency. Whatever those believing that Russia or China will soon be challenging dollar hegemony with a gold-backed currency say, this is still a very long way off.

A weaker euro in turn contributes to even higher prices. In sum, the ECB will need to hike interest rates, and this will at least at one point have an effect on the ability of Eurozone governments to take on more debt, ultimately also constraining their spending capacity.

Widespread violations of EU fiscal rules

Since the euro was founded, the EU has EU debt and deficit rules in place, in order to make sure that governments do not excessively spend or take on debt. These limit government deficit and government debt to 3 percent and 60 percent of GDP. At the moment, 17 EU countries are violating the deficit rule and 5 are violating the debt rule – Belgium, France, Italy, Hungary and Finland. 

These rules were never properly applied anyway. Not long after the euro was created, back in 2003, both France and Germany openly violated the rules, even uniting to make sure that they wouldn’t face sanctions for doing so, effectively destroying the rules, known as the “growth and stability pact”, altogether. Unfortunately, they were thereby aided by the UK and its Finance Minister Gordon Brown. That was two years after a small member state, Ireland, was reprimanded by the European Commission for only a slight violation of the rules. Also infamously, in 2016, European Commission President Jean-Claude Juncker openly stated that the European Commission had given France leeway on fiscal rules “because it is France”.

EU fiscal rules then were suspended in March 2020, with Covid as the excuse. Last month, the Commission, which was planning to reactivate the rules at the end of this year, decided to prolong the suspension for another year, until the end of 2023, this time invoking Russia’s invasion into Ukraine.

In this context, it should be noted that as much as budgetary discipline is a good idea, it is not sufficient to prevent financial crises. A decade ago, both Spain and Ireland ended up virtually bankrupt, despite having conducted relatively sober fiscal policies. What happened was that as a result of their entry into the Eurozone, banks in Spain and Ireland no longer received financing from their national central bank but could enjoy much cheaper funding from the European Central Bank. A lot of that cheap cash was pumped into the real estate markets of both economies, with overinvestment in real estate as a result, which contributed to the virtual bankruptcy of both countries, after their governments had taken over all that private banking debt from real estate investments gone sour.

Will new bailout action save the euro?

European economy commissioner Paolo Gentiloni justified the suspension of EU debt and deficit rules as a means “to make easier the transition from universal support to a moment of more targeted and prudent support.” He thereby invited EU member states to use the money allocated under the EU’s recovery fund, known as “Next Generation EU”.

The jointly financed “Next Generation EU” may well be a very tempting avenue for EU member states to use to continue to kick the can down the road. Why implementing unpopular economic reforms – like spending cuts, to finance tax cuts, or telling more people to get a job – in a bid to generate economic growth and therefore tax revenue while there is another way – burdening citizens with even more debt, jointly financed with the other EU member states as a means to avoid paying high interest rates?

It probably should not be explained that taking up debt with other, more financially weaker countries, shifts part of the risk to more financially responsible countries. That’s to the extent that we still have financially responsible countries in the EU or the Eurozone. As French economist Frederic Bastiat has put it: “Government is the great fiction, through which everybody endeavors to live at the expense of everybody else.” When everyone thinks they are living at the expense of everyone else, in the end, everyone may be worse off. In other words: even if there would no longer be any opposition to further indebtment in the more responsible Eurozone member states, due to the lack of responsible Eurozone member states, a game whereby everyone is ripping off everyone else can only last so long.

A Eurozone break-up could of course be the result of it all, when all these long lingering tensions ultimately prove too much, but the whole thing may also take a long time to play out. Actually, Croatia now stands a good chance to enter the Eurozone in January. The country’s currency is already closely aligned to the euro, but actual membership would mean that Croatian banks would enjoy cheap ECB funding, which they can then pump into Croatian government bonds or real estate, blowing yet another bubble. As always, the Eurozone’s motto is: “when in trouble, double”.

Then will the European debt circus simply continue unabated? Jamie Dimon, Chairman and Chief Executive of JPMorgan Chase & Co described the challenges facing the U.S. economy akin to an “hurricane”, stating: “The Fed has to meet this now with raising rates and QT (quantitative tightening). In my view, they have to do QT. They do not have a choice because there’s so much liquidity in the system.” Also the CEO of Wells Fargo & Co has warned that the Federal Reserve would find it “extremely difficult” to manage a soft landing of the economy while trying to fight inflation with interest rate hikes. Let’s hope they are wrong, but in case they are right, how much easier will things be in Europe?

Ultimately, there is only one way for financial stability to be restored, and that is governments engaging in budgetary discipline. At that point, the ECB no longer needs to engage in all kinds of monetary experiments that contribute to inflation, and all kinds of politically controversial transfer schemes are also no longer needed.

In a speech at the Austrian Economics Conference in Vienna last year, featured hereunder, I provide an overview of the many fiscal and monetary transfer schemes within the Eurozone and the EU. Time will tell whether these schemes will only be further developed over time, or whether there is a perfect storm going on – global supply chains disruptions, due to the Covid lockdowns and the war in Ukraine, energy boycotts, the fall-out of experimental energy policies and excessive monetary expansion by central banks – which will bring the Eurozone house of cards down. That may well take the whole EU down with it.

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