Europe’s economic woes threaten finances around the world
The problems came to the eurozone economy not as isolated spies, but in battalions.
First is the COVID pandemic, which has hit major eurozone economies like those of Italy and Spain particularly hard. Then came a spike in inflation in the Eurozone to record highs, which will soon force the European Central Bank to tighten the brakes on monetary policy and thus increase the risk of a European economic recession. Today, it is the Ukrainian invasion of Russia that has sent energy prices skyrocketing, severely undermining countries like Germany and Italy that are overly dependent on Russian imports of natural gas.
All of this could have serious consequences for the global economy.
Not just because a slowdown in the Eurozone economy could mean less favorable export markets for the rest of the world. The need to tighten the brakes and raise rates at a time when some eurozone countries have very fragile public finances could precipitate a new sovereign debt crisis. This in turn could raise new questions about whether the euro can survive in its current form.
As we learned during the 2010 debt crisis, the Eurozone is not well placed to deal with economic shocks that hit some member countries harder than others. Indeed, in 1999, all the members of the euro zone gave up their individual currencies for the euro. As a result, they no longer have their own independent monetary or exchange rate policies to use as a cushion to promote exports and thus cushion the blow of their economic shocks.
The lack of its own currency to deal with such shocks is particularly problematic for countries on the periphery of the eurozone such as Italy, which has a large budget deficit and the highest public debt-to-GDP ratio of the 150 years of history of this country. If Italy wants to avoid a new debt crisis, there is no doubt that it must clean up its public finances.
Italy, however, could once again learn that tightening its fiscal belt in a euro straitjacket is counterproductive. No longer able to devalue its currency to promote exports to offset the economic effect of reduced fiscal spending, Italy could find itself in another deep economic downturn that would reduce its ability to collect tax revenue.
Over the past two years, the ECB’s bond-buying programs have kept peripheral eurozone countries, notably Italy, afloat. In particular, under its €1.85 trillion ($2 trillion) Pandemic Emergency Purchase Program, the ECB bought most of these countries’ government debt issues. This saved them from having to face the test of the markets.
With eurozone inflation hitting an all-time high of 7.5%, it will only be a matter of time before the ECB is forced to tighten the brakes on monetary policy. The troubled economic periphery of the Eurozone should know that such tightening would include a halt to the ECB’s bond-buying programs. The bank has already ended its pandemic emergency purchase program and hints that it will end its other purchase programs this fall.
An end to bond purchases by the ECB would seem to pave the way for another Eurozone debt crisis, especially if the Eurozone succumbs to another economic downturn. This must be of deep concern to the rest of the global economy.
In 2010, the Greek sovereign debt crisis rocked global equity markets and raised fears of financial market contagion that could have derailed the fragile US economic recovery. What additional shock would cause a new cycle of the eurozone crisis today if it were centered on Italy, whose economy is about 10 times larger than that of Greece?
The last thing the global economy needs is another Eurozone debt crisis. This is especially the case at a time when the Federal Reserve’s efforts to contain inflation could precipitate an economic recession in the United States and China’s zero-tolerance policy could lead to a sharp slowdown in the world’s second-largest economy. Yet, we may well have to prepare for such a crisis as the ECB is forced to scale back its bond-buying activities to deal with its own inflation problem.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was Deputy Director of the Policy Development and Review Department at the International Monetary Fund and Chief Emerging Markets Economic Strategist at Salomon Smith Barney.