Iis Germany’s turn to host the annual G7 leaders’ summit this year and, although the war in Ukraine tops the agenda at the Bavarian gathering, the economic damage wrought by the invasion Russian will come right after.
No one saw what was coming when the G7 last met in Cornwall a year ago. At the time, we were talking about a global post-pandemic recovery; now the fear is of an impending recession as central banks turn hawkish and Vladimir Putin plays the energy card.
The Kremlin has cut gas supplies through the NordStream pipeline by 60% in the past two weeks and alarm bells are ringing in Berlin as the downside of being so dependent on Russian energy becomes apparent. Olaf Scholz, Germany’s new chancellor, is in the unfortunate position of having to clean up a mess caused by his predecessor, Angela Merkel, a politician whose reputation is unlikely to improve over time.
Last week, the German government triggered the second stage of a gas emergency plan. There is no rationing yet, but such an approach is possible, as is the reopening of coal-fired power stations. One of Germany’s goals for the G7 is “strong alliances for a sustainable planet”, which oddly goes along with German energy companies being told to prepare to burn more coal this winter.
When it comes to the G7, the wheel has come full circle. The first meeting of the group (which then included only six countries) was held in France in 1975 as major Western economies struggled to find a response to the oil shock that had ended the long post-war boom. Today, everyone is once again faced with the prospect of a recession.
The US Federal Reserve raised interest rates by 0.75 points earlier this month and signaled that further such hikes are on the way. Its chairman, Jerome Powell, said recession was a possibility when he testified before Congress last week. It’s a confession. The outlook must be pretty bleak before a central banker uses the R-word, but Powell made it clear that when faced with the choice between recession and embedded inflation, he would choose the former.
The Bank of England is also tightening its policy. Relative to the Fed, the Threadneedle Street Monetary Policy Committee is making small strides, so far raising interest rates in 0.25 percentage point increments. It does so against the backdrop of an economy that, despite continued strength in the labor market, appears to be slowing rapidly. The Bank is trying to engineer a soft landing for the economy in which inflation – currently at 9.1% – falls back towards its government target of 2% without triggering a recession. Good luck with that.
The European Central Bank has yet to join other Western central banks in raising rates, despite signaling higher borrowing costs next month. His cautious approach is not surprising as the stakes for the Eurozone are particularly high. If the Federal Reserve or the Bank of England try to meet the highest inflation in 40 years, the consequence will be unnecessary economic pain. If the ECB is wrong, the future of the single currency will again be in doubt.
Europe is vulnerable to a protracted war in Ukraine. It was growing less steeply than the United States before the invasion, in part because the fiscal program—tax cuts and increased spending—in America was larger. Unemployment is higher and, unlike the United States, the EU is not self-sufficient in energy. Europe is closer to the fighting and has suffered more of a supply shock as a result of the conflict.
This is a reason for the ECB to be cautious. Another is the impact of tougher monetary policy – higher interest rates and a reversal of the money creation program known as quantitative easing – that will have on the zone’s weaker members. euro.
Monetary union is an unfinished project. Member States share the same currency but manage their own fiscal and expenditure policies (subject to certain common rules) and issue their own bonds when they borrow on financial markets. The interest rate – or yield – on Italian bonds is higher than on German bonds because investors view Italy as riskier than Germany.
Since the ECB announced that it would join other central banks in raising interest rates, the gap (or spread) has widened between German bond yields and those of Italy, from Spain, Portugal and Greece. Investors worry about how these countries will cope with higher borrowing costs and slower growth.
Ten years ago, Italian and Spanish bond yields reached levels that challenged the breakup of the euro zone into a hard core based around Germany and a softer outer ring. On this occasion, the head of the ECB at the time, Mario Draghi, pledged to do “whatever it takes” to safeguard the single currency. He did the trick.
Today, Christine Lagarde, Draghi’s successor, faces the same problem of fragmentation. At 8.1%, the eurozone inflation rate is far too high for the ECB’s comfort. The question is how to raise borrowing costs without causing such damage to weaker members of the euro zone that their bond yields soar.
The ECB pledged to offer an anti-fragmentation scheme under which the central bank would ensure that bond yields in heavily indebted countries, such as Italy, did not rise excessively. This, however, is not going to be easy. Scholz will struggle to sell a bond-buying program to a skeptical German public, especially since it could result in losses as interest rates rise. Time is not on Lagarde’s side and if she is wrong, the next unwanted shock to the global economy will be a Eurozone crisis.