When two do the same thing, it is not the same thing. The well-known saying also applies to the American and European central banks. Both institutions with enormous power and influence face a problem that ideally should not occur under their watch – high inflation. It was 8.1 percent in the eurozone in May, and 8.6 percent in America. Despite the very similar numbers, the two banks, which are supposed to oversee monetary and price stability, choose opposite strategies in the fight against inflation.
While the American (FED) has already raised interest rates several times and shows that it will not just stop, the European (ECB) is currently preparing for the first increase, it should come in July. The ECB thus remains the last important bank that has not raised interest rates (let’s leave aside examples such as Turkey, where the central bank there operates under political pressure). And in connection with this, after several years, the attention of politicians and experts is once again turning to the chronic weakness of the eurozone, which ties the ECB’s hands in the fight against inflation – the large differences in indebtedness and the ability to repay the debt that exist between the individual members of the eurozone.
Numbers and causes
According to economists, there are differences between the causes of American and European inflation, which contribute to the fact that the FED chooses a more aggressive strategy than the ECB. Put simply, US inflation is driven by massive domestic demand spurred by generous pandemic stimulus, while Eurozone inflation is driven largely by rising energy prices. On the contrary, they affect the USA less – also because the country is practically self-sufficient in terms of energy. “The numbers look similar, but the causes are different,” says Jaroslav Borovička, an economist working at New York University.
A special case is Czech inflation: although the country is outside the eurozone, according to Borovička, it is so high because both factors are reflected in the domestic situation at the same time. “Czech inflation is influenced both by the energy prices that prevail in Europe and by the expansionary fiscal policy, when the Czech government, through a combination of financial transfers and tax cuts, created a demand situation similar to that in America,” describes Borovička.
In any case, the Eurozone is facing a problem that has accompanied it from the very beginning and appears more than usual in crisis situations. Nineteen economically different countries, such as Germany, Portugal, Italy or Estonia, have a common central bank, and thus a monetary policy, especially interest rates – which suit some countries more than others. The current, low ones mainly play into the hands of states that have a large debt and have to borrow to pay it off, because higher interest rates are reflected, among other things, in rising debt service costs.
That the impact of higher interest rates will have to be carefully considered by the ECB became clear immediately after the bank announced in early June that it planned to raise interest rates for the first time in eleven years. Already a week later, she had to call an unplanned extraordinary meeting to respond to the rapidly increasing differences in borrowing costs between Italian and German bonds (so-called spreads) that came in response to her announcement. The comparison with German bonds, which are considered the most stable, is considered by experts to be one of the indicators of tension in the eurozone. And the widening gap between how much Italy borrows today compared to Germany was one of the main reasons why many experts and foreign media began to use the term “a new Eurozone crisis”. “Is the Eurozone Heading for a New Debt Crisis?” he asks in the latest edition of the British magazine The Economist and reminds that Italy, which today is the most watched country due to its debt exceeding 150 percent of GDP, currently buys money 1.9 percent more expensive than Germany.
“Unfortunately, I think the situation can escalate,” says Borovička when asked how serious the fears are about a “new eurozone crisis.” And economist Helena Horská also speaks similarly: “The situation is serious precisely because of the great diversity of economies in the eurozone,” she says. The above-mentioned extraordinary meeting also showed that no one wants to risk a scenario in which Italy, the third largest economy in the Eurozone, would cease to be able to repay its debt – which would be a situation many times more critical than when Greece collapsed ten years ago. Although the ECB did not discount the plan to raise interest rates, it nevertheless announced that it is urgently starting to work on measures that should help countries with repayment problems.
More than Greece
If you get into the financial jargon that the ECB speaks, you will find that there is a lot at stake. The bank talks about using “anti-fragmentation tools”, which means nothing more than that it wants to keep the differences in the borrowing costs of individual countries at a relatively similar level – otherwise there is a risk of the eurozone breaking up. According to experts, it is not possible to say exactly what the tolerable difference between Italy and Germany, for example, is, but the downside is that it is not worth testing. “It would become borderline if Italy could no longer service its debt, but no one wants to go that far. During the last crisis, spreads were almost zero for a long time, then suddenly within a few months it jumped and Greece was on the verge of bankruptcy,” says Tomáš Havránek, economist and former adviser to Mojmír Hampl, former vice-governor of the Czech National Bank.
And it is precisely the fear that if the cost of borrowing money rises that Italy will cease to be able to repay the debt, the ECB’s hands are fundamentally tied in its fight against inflation. “I think it’s no secret that the ECB thought that inflation helps to dilute the debts of some countries, which is why it proceeded slowly,” says Borovička in reference to the European Central Bank. However, the ECB cannot postpone the fight against inflation indefinitely, after all, overseeing “price stability” should be the main goal of its activity according to the mandate it is supposed to follow. However, as some economists point out, at a moment when the disintegration of the eurozone is at stake, the effort to keep the euro logically prevails over the efforts to keep inflation down. “According to the law, the ECB is supposed to take care of price stability, but the law does not say – and it doesn’t have to – that if there is no euro, price stability makes no sense. The bank must prioritize keeping the currency together,” says Havránek.
The announcement of the “anti-fragmentation mechanism” is nevertheless an attempt by the ECB not to give up on the plan to raise interest rates at least a little, and at the same time not to let the most indebted members of the eurozone fall. The bank is to announce the details of what exactly such a program should look like in June during the next meeting. According to experts, a situation will probably arise where the bank will slowly raise interest rates, but at the same time will buy bonds of the weakest members of the eurozone in order to dampen the impact of interest rate increases. “The basic interest rate is valid for everyone, but through the purchases of bonds and the supply of financial liquidity, the bank would limit how higher interest rates will affect more fragile countries,” explains Horská.
Such a situation naturally brings with it a number of problems and political controversies. On the one hand, the ECB would further shift the way it perceives its mandate and what all falls under the activities it performs. “Originally, the ECB did not intervene in the bond markets at all. Then she started buying bonds, but proportionally according to the size of the countries, now she would start favoring directly selected countries,” says Jaroslav Borovička. At the same time, it would actually happen that the most indebted countries of the eurozone could borrow more cheaply than those that are not threatened by the pressure of the financial markets – and in whose interest the ECB would not intervene in any way.
“In fact, it would mean that the northern states would subsidize the southern ones. The transfers of money would probably be even larger than, for example, during aid to Greece,” says Havránek. And as the economist Horská reminds, the money would not go from national budgets, but through the channels of the ECB and the individual central banks of the eurozone member states. Unlike the eurozone crisis, when aid to Greece became a controversial political issue in a number of countries, transfers under the banner of the central bank referred to as the “anti-fragmentation mechanism” would probably escape the public eye. Of course, the question remains whether countries such as Germany, which traditionally oppose financial transfers across the eurozone, would agree to this procedure. “It will depend on the position of the Nordic countries, whether they want to meet certain conditions, such as budget rules,” predicts Borovička.
Politicians, not the bank
Last but not least, the scenario described above would increase the already high demands placed on the ECB. The gradual increase in the influence of the ECB and other central banks in how their activities affect economies is a trend of recent years (we wrote about it in detail, for example here), which also carries a number of risks. One of them consists in the fact that institutions have to solve issues that should be solved more by politicians. For example, the increasing indebtedness of some states is a problem that the EU has been dealing with since the 1980s, and so far unsuccessfully.
“Each crisis deepens the problem, but at the same time, the solution keeps getting delayed. It is possible and easily imaginable that the central bank will no longer be able to manage a situation on its own, and then it will have to be resolved at the level of individual governments. Budgetary policy and indebtedness should be solved by politicians, not the central bank. For now, however, we are in a situation where governments do not want to do this, and their reluctance then pushes the ECB to act,” adds Borovička.
But as the diary reminds Financial Times, the alternative in which Italy may get into debt trouble is no more attractive from the point of view of the stability of the eurozone. It is an irony of history that it was Italian Prime Minister Mario Draghi who, ten years ago, from the position of head of the European Central Bank during the eurozone crisis, declared that he would “do whatever it takes” to keep the euro. Today, it may be Draghi as Prime Minister who will need the ECB to do whatever it can.
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