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The EU economy in crisis: Can we learn from past mistakes?

Eurozone governance / COMMENTARY
Philipp Lausberg

Date: 03/10/2022
The economic situation in the EU has deteriorated quickly in the past few months, with a recession becoming more likely. Although comparisons to previous economic crises are easy to find, not all of them hold up. The most promising way out of the crisis is to tackle the root cause of the current downturn: high energy prices. 

With the Eurogroup meeting today and the Ecofin Council tomorrow, all eyes in Brussels are on the state of the EU economy. The economic situation has deteriorated significantly since the last Council meeting in July. Since Russia’s full-scale invasion of Ukraine, energy, raw materials and food prices have skyrocketed, compounded by substantial supply chain disruptions. In August, the gas price in the EU reached an all-time high. With winter in sight, gas futures are currently at €189/MWh and electricity prices at €369/MWh - about double the levels compared to a year ago. Exploding prices have fuelled inflation, which has reached record levels, with prices rising by 10% per year. On 9 September, the European Central Bank (ECB) reacted with an unprecedented 0.75 basis point hike, increasing interest rates to 1.25%. Meanwhile, the euro has continuously been losing value, trading at 0.96 dollars at the end of September.

The EU economy is sliding into a recession. For this year’s last quarter, some expect a 1.7% contraction, and the OECD’s baseline scenario predicts a meagre 0.3% growth for the eurozone in 2023, lower than any other region of the world.

Historical analogies to the current crisis are easy to find. The mix of high inflation, exchange rate volatility and low growth has conjured up comparisons with the 1970s crisis of stagflation, while rising public debt levels, low output and deteriorating lending conditions have raised the spectre of a new sovereign debt crisis. Others have warned of increased risks to the EU’s financial stability, potentially causing a financial crisis like in 2008. But how far does the current turmoil fit such comparisons – and what will be our way out this time?

Another financial crisis in the making?

Unlike the current crisis, the 2008 financial crisis and the 2010-2015 eurozone sovereign debt crisis originated in an overinflated and under-regulated financial sector. Uncoordinated and light-touch banking regulation and supervision were largely responsible for the outbreak and spread of the crisis starting in 2008. Poorly coordinated government bailouts of large banks led to a surge in public debt, ushering in the sovereign debt crisis.

The same scenario is unlikely to happen now, as the EU banking system is much more resilient than ten years ago. Banks’ capital buffers have been increased and risk levels reduced, mainly due to more effective regulation and supervision by the ECB’s Single Supervisory Mechanism – established in 2014 as part of the new European banking union. This can help explain the good performance of financial institutions during the Corona crisis.

But this relative stability could be shaken if high energy and commodity costs lead to a spike in corporate insolvencies and loan defaults eating away at capital buffers, squeezing inter-bank lending and driving major banks into insolvency. Under the banking union, a single resolution mechanism was set up to deal with such a situation and prevent contagion and a full-blown financial crisis. Yet it is only equipped with a fund of €60 billion, backstopped by a further €60 billion from the European Stability Mechanism (ESM). That might not be enough to protect financial stability in the face of even one failing systemic bank. Limited EU-level resolution capacities could necessitate bailouts by member states, threatening a replay of the euro crisis. The lack of a common European deposit insurance is equally worrying, as banking resolutions under new EU legislation must be partially based on defaults (bail-ins), which could lead to bank runs, threatening the entire financial system. To prevent the current crisis from turning into a full-blown financial crisis, policymakers should make the completion of the banking union a top priority, including the establishment of stronger resolution capacities and the foundation of a European Deposit Insurance Scheme (EDIS).

How to prevent another sovereign debt crisis?

With mounting public debt prices, experts have warned of a renewed sovereign debt crisis, especially in highly indebted southern eurozone countries. Lending rates are, so far, nowhere near the excessive levels of 2010-2012, when the spread between German and Greek bonds reached over 17% compared to the current 2.75. Nevertheless, the rise of ECB interest rates and increased political risk with the victory of the far-right in Italy could make it increasingly difficult for indebted states to access finance, especially in light of large-scale deficit spending to alleviate the energy and cost-of-living crises. European governments have already spent more than half a trillion euro on support and relief – and they will likely spend more as the weather turns colder.

The presence of a sufficiently large fiscal backstop is crucial to prevent the outbreak of another sovereign debt crisis. During the euro crisis, the ESM proved too small and ineffective to play a decisive role. But the Recovery and Resilience Facility (RRF), designed in response to the COVID-19 crisis, was a game changer. Raised through common EU debt, it is composed of preferential loans and grants, and provides funding for investment in strategic growth projects. So far, only around €100 billion of the €750 billion in the RRF have been disbursed to member states, leaving a significant amount of firepower for propping up states’ finances during the current crisis. Ideally, a permanent version of the RFF would be established to provide a credible backstop to sovereign finances, which could help the EU to not only weather the current storm, but also prevent future crises by increasing trust in the eurozone’s resilience.

Solidarity and responsibility

Relying on cash injections alone is not enough, though. Effective and credible fiscal rules could go a long way towards guaranteeing less volatile sovereign bond markets and preventing problems of debt sustainability and macroeconomic imbalances in the long run.

Commission President Ursula von der Leyen’s call for an overhaul of the Stability and Growth Pact (SGP) based on more transparency, simplicity and accountability is a step in the right direction. A reformed SGP should make it more enforceable and balance budget consolidation with more investment, particularly in the twin green and digital transition.

A return to the 1970s?

The most striking difference between the current and previous economic downturns is the complete reversal of monetary conditions. Inflation was very low during the sovereign debt crisis and the pandemic, enabling the ECB to intervene decisively with bond buying programs and the promise to do whatever it takes to save the euro.

The current inflation rate does not allow for the same leeway in monetary policy. Rather than resembling the euro crisis, the current situation bears a striking resemblance to the stagflation of the 1970s. Just like then, commodity markets have been disrupted by a war after a long period of expansionary monetary policy, resulting in high inflation and low growth.

Yet, institutions are now very different. Unlike the expansionary central banks of the 1970s, the ECB is mandated to ensure price stability. It has already raised interest rates, while labour unions are nowhere near as strong as in the 1970s. Wage adjustments have, so far, been meagre at best. The price-wage spiral, which was the main dynamic behind sustained inflation in the 1970s, is, therefore, unlikely to return.

Rising interest rates, however, bear the danger of causing a recession and social hardship due to lower real wages and rising unemployment. Such a deflationary approach would entail tackling the crisis on the back of low-income households, like in the 1980s. It would also lay a disproportionate burden on more highly indebted countries in the eurozone periphery and put pressure on the sustainability of their sovereign debt. National relief packages largely varying in size would further fuel disintegration in terms of real interest rates like during the euro crisis. The ECB’s new Transmission Protection Instrument (TPI), allowing for secondary market purchases of securities in member states experiencing deteriorating financing conditions, is, therefore, a positive development – as is the ECB’s relatively cautious approach of increasing interest rates to 1.25%, compared to 3.5% in the US.

This strategy is not without risk, however, as it encourages investors to swap their euros for dollars in search of higher yields, further devaluing the euro against the dollar. A weaker European currency puts additional pressure on prices for imports, which are mostly denominated in dollars. This, in turn, would further stoke inflation, necessitating additional ECB interest rate hikes. The result would be a tightening of lending conditions, which could increase the risk of banking and sovereign debt crises.

The most promising way out of the crisis: Fighting high energy prices

The best way out of this dilemma is to directly confront high energy and commodity prices, which are to blame for more than 60% of inflation. The EPC has proposed a number of measures to reduce prices for the coming winter. In the long run, it will be crucial to diversify supply away from politically unreliable trade partners and fossil fuel providers – objectives that both align with the EU’s ambitions for the green transition and greater strategic independence. The large-scale development of renewable energy inside the EU is the most sustainable approach in the long haul, while in the short to medium term, nuclear energy and preferential gas contracts with close allies like Norway could fill the gap left by Russian gas.

History holds a valuable lesson. In the wake of the OPEC oil embargo in 1973, European countries invested in nuclear power and renewable energy to guarantee greater energy security. But with oil prices falling in the 1980s, most of Europe threw caution to the wind and got hooked again on hydrocarbons from Russia and the Middle East. For the sake of Europe’s economic and political stability, we should be wiser this time.

Philipp Lausberg is a Policy Analyst in the Europe’s Political Economy programme at the European Policy Centre.

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