The writer is group chief economist at Société Générale
The economic geography of the euro area is often framed in terms of a “core” and a “periphery”, with sovereign bond yields capturing the hierarchy of public debt sustainability.
While some consider this financial market differentiation desirable to motivate the periphery to undertake reforms and reduce public debt levels, the need to tame the highly procyclical nature of bond markets was a hard lesson learned during the debt crisis. Europe in the early 2010s.
The current energy crisis in Europe has opened up new gaps, characterized by the respective participation of member states in energy-intensive industries and by their degree of dependence on fossil fuels.
On these energy metrics, Germany and Italy fall into a similar grouping, but the similarities end there. Italian households spend a larger share of their income on energy than their German counterparts. And arguably the high proportion of very small companies in Italy can also be a disadvantage. Furthermore, Germany and Italy are still at opposite ends of the bond yield hierarchy.
Ensuring that Europe’s energy geography does not further fragment the region has already prompted several joint initiatives to fill gas tanks, save energy, secure supply and limit price volatility.
However, while EU initiatives include some financial solidarity, most measures to protect households and businesses have been financed at the national level and with significant disparity in design. Germany tops the list in terms of euros available, while France ranks high in price regulation measures. This last factor is particularly visible in inflation, with headline consumer inflation in November at 7.1 percent in France, compared with 11.3 percent in Germany and 12.6 percent in Italy.
With the European energy crisis unlikely to be resolved quickly, there are concerns that such a stark difference in fiscal measures could become a source of further fragmentation. And this would be through various channels.
First on the list is the risk that fiscal support measures will further stoke inflationary pressures, prompting the ECB to further tighten monetary policy. Not in vain, the president of the ECB, Christine Lagarde, has reiterated warned that fiscal support measures must meet a test of the three Ts: “temporary, targeted and tailored to preserve incentives to consume less energy”.
According to the European Commission’s tally in its autumn forecast, 70 percent of the measures taken in the EU to mitigate the impact of high energy prices by 2022 fell into the “non-targeted” category. Significant further tightening of monetary policy could unduly tighten financial conditions in some Member States. Last week, Italian bond yields widened as the ECB stepped up its hawkish stance.
The ECB certainly took these risks into account when designing its new Transmission Protection Instrument. Arguably, however, this as-yet-untested anti-crisis bond-buying instrument would only be used if significant market dislocations occur. The slow-grinding costs of “moderately too tight” financial conditions would likely go unchecked.
TPI eligibility also includes a look at compliance with EU tax rules, which are due to come back into force in 2024, albeit in a revised form. Keep in mind, too, that the tax windfall many governments initially enjoyed thanks to pandemic-related economic restarts and higher inflation will likely be short-lived. Member states with high levels of public debt may well find that fiscal space will be greatly reduced in 2024.
Another concern relates to competitiveness. The national government’s motivation to support domestic companies is understandable, both in terms of protecting competitiveness and preventing relocation to countries like the US.
Commission President Ursula von der Leyen recently called on the EU to adapt its state aid rules in response to the US green energy subsidy package. Several member states, including France, Italy and Spain, have called for more joint funding from the EU. The specific and conditional model of the Next Generation EU fund for the recovery from the pandemic offers a good model.
One last point relates to the great uncertainty surrounding Europe’s energy markets in a crisis that seems unlikely to find a quick solution. For companies, such uncertainty is bound to slow down investment plans. Monetary policy tightening may well be the right choice in the face of high inflation, but this is the first time the ECB has raised rates so aggressively.
The ECB will also reduce its balance sheet at a much faster rate than the US Federal Reserve, mainly due to the repayment of targeted long-term refinancing operations (TLTROs) over the course of 2023. The latest round of TLTRO data of the 2023. pandemic and sought to stimulate bank loans to the real economy.
With Europe likely facing a protracted energy crisis, the ECB’s three Ts are not just a mantra, but a condition for avoiding a new euro crisis.