Every day someone asks the question: “Will there be a recession or not?” But this is not a question that can be answered with a simple yes or no. And it’s not that a recession is bad, and if it doesn’t happen, you can take any risk you want.
In particular, we expect much lower growth than many expected in 2023, whether a recession technically occurs or not. Recently, all statistics show a significant slowdown in growth. At the same time, the eurozone is clearly in a worse position than the US or China.
Eurozone politicians, especially the dovish majority in the Board of Governors of the European Central Bank (ECB), have long disagreed that inflation is not as transient as they first thought.
I recall a short but instructive discussion I had in October 2021 with the central bank governor of a “small” eurozone country. By that time, we had been warning customers for months that we would have to get used to high inflation. This sage was of the same opinion.
It was also becoming increasingly clear, he said, that inflation would not just go away and that the ECB’s scenario was too optimistic. However, he belongs to a minority in the Council and has little to no ability to convince others. I think that today, after a few months, there is already a general opinion that inflation will bother us for many years to come.
Inflation as a structural phenomenon
The main problem is supply-side inflation. We are talking about increasing prices for productive resources (labor, fuel, goods, whether it be agricultural products or electricity), operation and transport.
During operation, shock and resuscitation can occur very quickly. We experienced this in Europe during the pandemic. In logistics, a strike, blockade or lack of containers (which is a big problem today) can also cause a shock. But even that can be resolved with time.
We expect that from 2023, new containers will help reduce congestion in the delivery system. All this can be considered temporary.
But the supply shock affecting inputs is certainly much more permanent. Let’s look at the goods. Despite all the talk of a green transition, Europe is still heavily dependent on fossil fuels (oil, coal and natural gas).
The war in Ukraine surprised Russia in terms of fossil fuel supplies, the fuel we still use today. Demand is rising and there has been a shock on the supply side, so prices are rising. These are the foundations of economics.
It is logical to assume that investments will begin, and prices will fall lower. But two factors hinder this. Firstly, we do not use oil as such, but the products of its processing. Europe has built a whole infrastructure for processing Russian oil, but it can no longer be used.
New infrastructure needs to be built, but it will take years to build. Meanwhile, prices will continue to rise.
Secondly, the European Union is introducing rules and regulations for the transition from fossil fuels to green energy. Europe has always controlled everything. But in guiding the transition to a greener economy, he has redirected the investment needed to renovate fossil-fuel infrastructure into renewable energy.
However, Europeans are not guaranteed a continuous supply of green energy. Ultimately, this will lead to an increase in energy prices in the coming years. Thus, inflation is a structural phenomenon.
However, there is another factor that supports inflation to some extent – fiscal policy.
European governments have introduced anti-crisis measures to fight inflation, such as lowering the value-added tax (VAT) on energy, introducing a “social tariff” on electricity and natural gas for the poorest households in Belgium, or raising the minimum wage to 12 euros in October per hour and another contribution of 100 euros for the poorest households in Germany.
Given that the EU countries have a much higher fiscal capacity than other countries, it can be expected that initially ad hoc measures will become more permanent measures and soon more subsidies will come.
When risk becomes reality
We know from history that the only way to bring down inflation is to raise interest rates. Many central banks have done so since the end of the last global lockdown in the spring of 2021.
The ECB also finally decided to join them after much hesitation. At its July meeting, it will raise interest rates by 25 basis points for the first time since 2011 (the so-called gradual tightening). But if the ECB could normalize its monetary policy by simply focusing on inflation and economic growth, that would be too easy. There is another issue that needs to be addressed, as important as high inflation, and that is financial fragmentation.
Bond market volatility is rising across the board due to the massive inflation shock hitting the world, but conditions are deteriorating faster in the eurozone. In a world without quantitative easing (QE), risk overestimation is painful. The ECB Systemic Risk Indicator (created in 2012 from 15 financial stress indicators) has returned to levels last seen at the start of the pandemic in March 2020.
For some countries, the reassessment is more painful than for others. Italy can be an example. After the end of quantitative easing, the cost of servicing government debt has increased, and the yield on ten-year government bonds is now almost three times higher than at the beginning of February.
The gap with Germany also widened and thus reached a risky level again. However, the biggest concern is not the size of the bond yields, but the process of their growth. Volatility is rising too fast and liquidity conditions are rapidly deteriorating. And so foreigners prefer to quickly flee the Italian bond market.
New ECB instrument?
There is no doubt that soon the ECB, possibly already at the July meeting, will present a new tool for managing the spread of government bonds. At the moment we have few details. However, based on recent remarks by Isabela Schnabel, we can assume that this will be some version of direct cash transactions (OMT) with more lenient conditions, a transition period and a shorter maturity than PEPP (Pandemic Emergency Purchase Program). ), possibly two to five years.
This should prevent a repeat of the 2012 crisis, but is far from certain. The European Central Bank cannot but raise interest rates. And the more he increases them, the more the situation will worsen and the more government bonds the eurozone countries will have to buy.
But let’s be optimistic, even a repeat of the eurozone crisis is not negative in all respects. The previous crisis helped put into practice key institutional reforms that have strengthened the structure of the eurozone since 2012. In the event of another crisis, the same thing may happen. But in the long run, the situation in the eurozone government bond market raises a serious question: can this continue indefinitely?
At some point, the southern eurozone countries should be able to resist the markets without the ECB bailing them out again by renewing its mandate. Otherwise, it may happen that in the end the European Central Bank will become the exclusive creditor of the Italian government …