meIt is Germany’s turn to host the annual summit of G7 leaders this year, and while the war in Ukraine will be high on the agenda at the Bavarian meeting, the economic damage caused by Russia’s invasion will take second place.
Nobody saw what was coming when the G7 last met in Cornwall a year ago. At that time, there was talk of global post-pandemic recovery; now the fear is of an impending recession as central banks turn aggressive 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 downsides of relying so heavily on Russian energy become apparent. Olaf Scholz, Germany’s new chancellor, finds himself in the unfortunate position of having to clean up a mess caused by his predecessor, Angela Merkel, a politician whose reputation will certainly not improve with time.
Last week, the German government activated the second stage of an emergency gas plan. There is no rationing yet, but such a step is possible, as is the reopening of coal-fired power plants. one from germany goals for the G7 it’s “strong partnerships for a sustainable planet,” which doesn’t fit with German energy companies being told to prepare to burn more coal this winter.
As far as the G7 is concerned, the wheel has come full circle. The first meeting of the group (then including just six countries) was held in France in 1975, as the big Western economies struggled to find an answer to the oil crisis that had ended the long post-World War II boom. Now all of them once again face the prospect of recession.
The US Federal Reserve raised interest rates by 0.75 points earlier this month and has signaled more such hikes are on the way. Its president, Jerome Powell, said recession was a possibility when he testified before Congress last week. That’s some admission. The outlook has to 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 policy. Compared to the Fed, the Threadneedle Street monetary policy committee is moving in baby steps, so far raising interest rates in 0.25 percentage point increments. It is doing so in the context 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%, recedes 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, though it has signaled higher borrowing costs next month. His cautious approach is not surprising because the stakes for the eurozone are especially high. If the Federal Reserve or the Bank of England struggle to respond to 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 once again be in doubt.
Europe is vulnerable to a protracted war in Ukraine. It was growing less strongly than the US before the invasion, in part because the fiscal package (tax cuts and spending increases) in the US was larger. Unemployment is higher and, unlike the US, the EU is not self-sufficient in energy. Europe is closer to the fighting and has suffered a bigger supply shock as a result of the conflict.
That is one reason for the ECB to be careful. Another is the impact that tighter monetary policy (higher interest rates and a reversal of the money creation program known as quantitative easing) will have on the weaker members of the eurozone.
Monetary union is an unfinished project. Member states share the same currency, but run their own fiscal and spending policies (subject to certain common rules) and issue their own bonds when they borrow from 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 signaled it would join other central banks in raising interest rates, the gap (or spread) has widened between German bond yields and those of Italy, Spain, Portugal and Greece. Investors are concerned about how these countries will deal with higher borrowing costs and slower growth.
A decade ago, Italian and Spanish bond yields reached levels that questioned whether the eurozone would split into a German-based hard core and a softer outer ring. On that occasion, the then president of the ECB, Mario Draghi, promised that he would do “whatever is necessary” to safeguard the single currency. He did the trick.
Now Christine Lagarde, Draghi’s successor, faces the same fragmentation problem. With 8.1%, the eurozone inflation rate it is too high for the comfort of the ECB. The question is how to raise borrowing costs without doing such damage to the eurozone’s weakest members that their bond yields soar.
The ECB has promised to devise an anti-fragmentation device under which the central bank would ensure that bond yields in heavily indebted countries such as Italy do not rise excessively. This, however, will not be easy. Scholz will have trouble selling a bond-buying scheme to a skeptical German public, especially as it could result in losses as interest rates rise. Time is not on Lagarde’s side and if she is wrong, the next unintended shock to the world economy will be a eurozone crisis.