It is Germany’s turn to host this year’s annual G7 summit, and while the war in Ukraine will top the agenda of the Bavarian summit, the economic damage caused by Russia’s invasion will come second. .
No one saw what was coming when the G7 last met in Cornwall a year ago. Then there is talk of global recovery after a pandemic; now the fear is of an imminent recession as central banks become hawks and Vladimir Putin plays the energy card.
The Kremlin has cut gas supplies through the Nord Stream pipeline by 60 percent in the past two weeks, and alarms are ringing in Berlin as the downside of being so dependent on Russian energy becomes apparent. Olaf Scholz, Germany’s new chancellor, is in a dire position to clear up the mess caused by his predecessor, Angela Merkel, a politician whose reputation will certainly not improve over time.
Last week, the German government launched the second phase of a gas emergency plan. There is still no regulation, but such a step is possible, as well as the reopening of coal-fired power plants. One of Germany’s goals for the G7 is “strong alliances for a sustainable planet,” which is strange, as German energy companies are being told to prepare to burn more coal this winter.
As for the G7, the wheel is spinning full circle. The group’s first meeting (which then included only six countries) took place in France in 1975, when major Western economies struggled to find an answer to the oil shock that ended the long post-World War II boom. Now they are all facing the prospect of a recession again.
The US Federal Reserve raised interest rates by 0.75 points earlier this month and signaled that such increases are on the way. Its president, Jerome Powell, said the recession was possible when he testified before Congress last week. This is a kind of recognition. The outlook should be pretty bleak before the central banker can use the word R, but Powell has made it clear that when faced with a choice between recession and built-in inflation, he will choose first.
The Bank of England is also tightening policy. Compared to the Fed, the monetary policy committee on Threadneedle Street is moving in small steps, raising interest rates by 0.25 percentage points so far. It is doing so against a backdrop of an economy that, despite the continuing strength of the labor market, seems to be slowing down rapidly. The bank is trying to create a soft landing for an economy in which inflation – currently 9.1% – has fallen back to its 2% government target without causing a recession. Good luck with that.
The European Central Bank has not yet joined other Western central banks in raising interest rates, although it is signaling higher borrowing costs next month. His cautious approach is not surprising, because the stakes for the eurozone are particularly high. If the Federal Reserve or the Bank of England make a hash in response to the highest inflation in 40 years, the result will be unnecessary economic pain. If the ECB makes a mistake, the future of the single currency will again be called into question.
Europe is vulnerable to a protracted war in Ukraine. It grew smaller than the United States before the invasion, in part because the fiscal package – tax cuts and spending increases – was larger in America. Unemployment is higher and, unlike the United States, the EU is not self-sufficient in energy. Europe is closer to fighting and has suffered a major supply shock as a result of the conflict.
This is one of the reasons why the ECB is careful. Another is the impact that tighter monetary policy – higher interest rates and a reversal of the money-making program known as quantitative easing – will have on weaker eurozone members.
Monetary union is an unfinished project. Member States share the same currency, but pursue their own tax and expenditure policies (subject to certain common rules) and issue their own bonds when borrowing from the financial markets. The interest rate – or yield – on Italian bonds is higher than that on German bonds because investors see Italy as more risky than Germany.
Since the ECB signaled that it will 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 worried about how these countries will cope with higher borrowing costs and slower growth.
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A decade ago, Italian and Spanish bond yields reached levels that called into question whether the eurozone would split into a hard core based around Germany and a softer outer ring. On this occasion, the then head of the ECB Mario Draghi promised to do “what is necessary” to protect the single currency. That worked.
Now Christine Lagarde, Draghi’s heiress, faces the same problem of fragmentation. At 8.1%, inflation in the euro area is too high for the comfort of the ECB. The question is how to increase borrowing costs without causing such damage to weaker eurozone members that their bond yields are rising.
The ECB has promised to devise an anti-fragmentation device in which the central bank will ensure that bond yields in heavily indebted countries, such as Italy, do not increase excessively. However, this will not be easy. Scholz will have trouble selling a bond-buying scheme to a skeptical German public, especially since it could lead to losses in rising interest rates. Time is not on Lagarde’s side, and if she makes a mistake, the next unwanted shock to the world economy will be a crisis in the eurozone.
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