Opinion – Martin Wolf: Eurozone economies have no choice but to face supply shock together

The economic challenges facing the eurozone are not the same as those facing the US. In comparison, however, they are even more difficult.

The eurozone economy is not suffering from overheating domestic demand to the same extent as the United States. This should make the task of monetary policy easier for the ECB (European Central Bank) than for the Fed (Federal Reserve). But the supply shock hitting the eurozone is much bigger, with a huge rise in the price of energy, especially gas, following Russia’s invasion of Ukraine. This shock is at the same time inflationary and contractionary: inflationary, as it strongly raised the price level; and contractionary, insofar as it reduced the real income of families and the terms of trade of countries.

Crucially, the eurozone is more fragile than the US. Their national economies are diversified and cross-border insurance mechanisms relatively undeveloped. Above all, the policy remains national. As a result, fragmentation is always a risk. However, the eurozone has advantages in dealing with Covid and energy shocks compared to the financial crises of a decade ago. Recent shocks have affected members quite similarly, while the global financial crisis has split the eurozone between domineering creditors and humiliated debtors. This time it’s really different.

So what might the future hold? And what, above all, needs to be done?

Start with monetary policy. In the year to August 2022, consumer price inflation was 9.1% in the eurozone and 8.3% in the US. But core inflation (excluding food and energy prices) was just 4.3% in the eurozone, against 6.3% in the US. Thus, 4.8 percentage points of inflation in the Eurozone were due to increases in energy and food prices, against 2 percentage points in the US. Labor market data similarly indicate substantially less overheating in Europe than in the US.

This explains why the ECB tightened later and less than the Fed — a 1.25 percentage point increase in the intervention rate, down 0.5% in the former, versus a 3 percentage point increase of 0.25 %, in the second. However, the ECB was right to also start to normalize monetary policy, partly because policy had been so aggressive and partly because it needed to prevent the effects of price shocks from being incorporated into expectations. Its actions were not premature either: The IMF’s Global Financial Stability Report reveals that inflation expectations of many market participants have already risen to around 4%.

However, the ECB needs to be cautious about how quickly and how far it will move. One reason for this is that the energy shock will give the economy a powerful recessionary boost. Indeed, recessions are highly likely in the eurozone.

Another reason for caution is the complexity of transmission mechanisms, as presented in a recent speech by Philip Lane, chief economist at the ECB. A particular concern is uncertainty about gaps. It is quite possible that global inflation will soon decrease rapidly because gas prices are falling. In that case, the main impact of today’s monetary tightening could occur long after inflation expectations have already adjusted downwards. Indeed, it is possible that “normal” monetary policy for the eurozone will remain too loose, as it was before Covid.

Of particular concern are the widening spreads on government bonds, which would then be passed on to borrowers in the most vulnerable economies. So far, these spreads are much smaller than they were during the eurozone crisis. In addition, the ECB has several instruments – on its own or in cooperation with other institutions, including the European Stability Mechanism – to deal with fragmentation. This includes asset reinvestment, a new “transmission protection instrument” and, if all else fails, the “outright currency transactions” developed in 2012 after Mario Draghi’s “whatever it takes” rant.

The implementation of these programs, however, will create conceptual, practical and political difficulties, especially regarding the distinction between illiquidity and insolvency. Ultimately, though, it’s simple: throughout these crises, the eurozone has to treat all members as if they were equally fit, even though they’re not.

Will this work? The best answer is that you have to. The survival of the European Union, and therefore of the eurozone, its economic core, is in the national and collective interest of its members. They face a brutal enemy of their most fundamental principles in the east and the unpredictable US in the west. The EU must not just survive, but thrive, if Europe itself is to do so. As has been shown repeatedly since the arrival of Covid, member countries understand this, especially the most important ones. No matter how disorganized and incomplete the structures of the EU and the eurozone are, members must stick together in good times and bad. Now it will be one of the last.

This means much more than ensuring that the monetary regime works for everyone. It also means defining a common energy policy, namely one that accelerates the transition to renewable energies; helping member states protect their citizens from the worst of the energy shock, agreeing on a common policy for Vladimir Putin’s Russia in conjunction with NATO, shaping a trade and economic policy that manages relations with China, and even moving forward for more stable relations with the UK.

The compromises needed to face the energy shock and the Ukraine War will be painful. But they must be done. Without the EU, member countries would be lost. They know this and I am sure they will act on that knowledge. A stronger EU must emerge from these crises, because there is no alternative.

Translated by Luiz Roberto M. Gonçalves