The next euro crisis has just started

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Lax monetary policy and rising inflation risk post-Covid headache of unseen pain for Europe, writes Dr Oliver Hartwich

As European economies emerge from the Covid-19 recession, the next great European crisis is already visible on the horizon. It is just not clear what kind of crisis it will be: another debt crisis, an inflation crisis, or a combination of the two.

For more than a decade, the European Central Bank (ECB) has been in crisis-fighting mode. He first dealt with the global financial crisis, the sovereign debt crisis and the banking crisis. Last year, he added the Covid-19 recession to this list.

As different as these crises were, the ECB’s response has always been the same. He created more central bank money, bought back public debt, and in so doing reduced interest rates. And really, that’s all central banks can do with their tools.


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This ultra-accommodating monetary policy saved time and was politically sustainable. At least as long as consumer prices don’t go up.

The most obvious immediate losers in ECB policy were savers. If you don’t earn any interest (or have to pay your bank penalties), even low inflation rates consume a good chunk of your capital within a few years.

But savers are too dispersed, and losing a few percent of your savings per year is too small a sacrifice to lead to immediate revolt. Plus, savers could still save their money by investing it in other asset classes (which many have done, just look at the real estate and stock markets).

The ECB could have continued to justify its ultra-accommodating monetary policy as long as European economic growth remained sluggish and price inflation under control. However, this period is now drawing to a close – and it creates multiple dilemmas for European central bankers.

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The latest OECD growth projection showed strong annual economic growth rates between 3 and 6 percent for the next two years across euro area members. This would allow these countries to recover the economic activity they lost during the pandemic.

At the same time, a surge in inflation is being felt in Europe. Just last week, the Bundesbank warned that German inflation could reach 4% by the end of this year.

The combination of these two developments creates a political nightmare for the ECB. It is difficult to justify negative interest rates and further quantitative easing as European economies experience strong growth again (at least by European standards). And it becomes more difficult to explain to savers why they should now accept to lose 4% of their capital due to inflation every year.

To complicate matters, the evolution of emerging price inflation is not uniform in the euro area. While consumer prices have already risen by more than 2.5% in Spain and Germany, France and Italy, consumer price inflation is more than a percentage point lower.

This is proof, once again, that Europe is far from the “optimal currency area” (ACO) necessary to have a viable monetary union. As the late economist Robert Mundell once explained, a COA requires a high degree of economic integration and synchronized business cycles. None of these characteristics have ever been present in Europe. And that makes getting out of the current stimulating environment so much more difficult.

There are also political complications. The ultra-low interest rates of the past decade have allowed European governments to live with large amounts of public debt. This is not only true for heavily indebted southern European governments. The same story goes for the supposedly more stable Central European countries.

Take Germany, for example. Last year, the federal government paid only 6.4 billion euros in interest, the lowest level since the late 1970s. Before the GFC, interest rates were positive and these payments annual amounts were generally around 40 billion euros. A return to such levels would be painful for the German finance minister.

For other countries, a return to past interest rates would not only be painful but potentially fatal. Greece’s debt level now stands at more than double its annual economic output (210% of GDP). For Spain and France, this number is around 115%. For Italy, it is 155%.

The only reason these heavily indebted countries were able to afford these debt levels throughout the pandemic was the continued support of the ECB. If the ECB had not generously bought back the government bonds of these countries, the costs of refinancing would have already pushed them into a sovereign debt crisis.

The level of support should not be underestimated. In 2020, euro area governments issued a total of 991 billion euros in new public debt, 95.5% of which ended up on the books of the ECB and its national subsidiaries. For Italy, the ECB bought 117% of the new debt issued by Italy last year, which means it also absorbed pre-Covid debt.

No wonder, given these interventions, that Italian 10-year government bonds are only yielding around 0.75%. There is no real market for Italian bonds – only a political market in which the ECB determines the interest rates it deems acceptable for Italian public debt.

But with the return of economic growth and inflation, the preconditions for these continued clandestine government bailouts have disappeared. The ECB can, of course, continue to support Italy, Greece and other countries. But this will come at the expense of accelerating inflationary trends – and with it a further expropriation of private savings, income and wealth.

There is no positive outcome from entrenched budget deficits, artificially fueled by desperate central bank measures. There isn’t even a positive choice.

The ECB may not want to risk a repeat of the European debt crisis of the 2010s, which would occur if markets (instead of central banks) determined government debt yields. But neither can it tolerate a sustained rise in inflation.

European central bankers are probably hoping that inflationary pressures will only be temporary and will go away on their own.

But with such wishful thinking, they might only make a bad situation worse.

If inflation doesn’t magically subside, the ECB’s continued ultra-low rates will push it even higher. This, in turn, will also make the eventual rise in interest rates larger than it would otherwise be. Which, of course, would create an even more serious sovereign debt crisis in the future.

The next two years in which the European economy recovers from Covid-19 could ironically result in the worst currency crisis Europe has ever seen.

The next euro crisis has just started.

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