Inflation, Unemployment and Public Debt – the Dilemma Facing the European Central Bank

In a previous post, we discussed the US Federal Reserve’s almost certain decision to raise key interest rates and the reason why we think this strategy is not one the ECB will pursue – at least not yet. Here’s why:

The Economies in the Euro Area are Wildly Diverse

In the euro area, a key interest rate increase is currently less likely than in the U.S., not only because of the lower economic dynamics on average of all euro area member states but because the euro area economy is also much more heterogeneous.

Looking at selected macroeconomic data in four southern European and three western European member states, it is clear that the decision to raise rates in the euro area is more nuanced.

• The economic slump in 2020 was noticeably larger in the four southern European economies of Greece, Italy, Portugal, and Spain than in Germany, Austria, and the Netherlands. Growth in 2021 and 2022 will not be sufficient in the southern European states to compensate for this disadvantage.
• Unemployment is also noticeably higher in the four southern European countries than in the other three.
• Weaker economic development means that the growth of aggregate demand is smaller. Thus inflationary pressure is lower in Southern Europe, at least in Portugal and Italy.
• Government debt in the four southern European countries is significantly higher than in the three western states.

An Interest Rate Hike Now Would Come Too Early For Those Countries with Weak Economic Development

The need for an interest rate hike and its impact are very different for different countries in the EU.

In southern European economies, inflationary pressure is currently not as great as in the faster-growing western European economies. With unemployment higher in the southern economies, the risk of a wage-price spiral is relatively low.

In addition, lower economic growth means southern European economies are less able to cope with a rise in interest rates and its growth-dampening effects.

Particularly serious is the significantly higher government debt ratios in Southern Europe. For them, a rise in interest rates means increased interest expenditures. A higher interest rate reinforces the increase in government debt. This worsens the long-term sustainability of public finances in the southern European states. Hence, a rise in risk premiums threatens to exacerbate the debt problem.

The ECB has  a Dilemma

If the ECB includes the effects of a key interest rate increase on the long-term sustainability of public finances in its decision-making, it must  consider the government debt of all 19 states.

If one of these states loses its credit rating, there is a threat of state bankruptcy, which could cause domino effects in the real economy like after the Lehman bankruptcy. At the same time, the bankruptcy of one euro area state could lead to fears that other euro area countries could also become insolvent.

So while the Fed can base its monetary policy on the average development of all U.S. states, the ECB must orient itself on the weaker euro area countries. Only if economic growth is strong enough in all 19 countries can an increase in the key interest rate occur can the ECB raise rates. However, by then, inflation rates in fast growing countries of the euro area may already be too high. This is a conflict of goals which can be difficult to resolve.

Economic Policy Options for the Euro Area

Even though the ECB is not expected to raise key interest rates until the end of 2022 to stabilize growth and government debt  (though likely, at the earliest in Q3 and only by a small amount) – those responsible for monetary and fiscal policy as well as all other market participants should prepare for a period of higher interest rates in the euro area.

However, the transition to a phase with higher interest rates must be accompanied by economic policy. The measures currently being discussed – include the following:

• The ECB should communicate as clearly as possible the timetable of the envisaged monetary policy measures so that all market players can prepare for higher interest rates.
• Government spending should be used to strengthen economic growth in order to increase future government revenues.
• Governments should restructure their debt by replacing short-term loans with long-term loans securing low interest rates for the longer term.
• Economic policy needs close coordination between monetary and fiscal policy so that government spending can compensate for the decline in demand in the economy resulting from falling investment.
• Temporary Corona Eurobonds are another instrument under discussion. This would make the entire euro area liable for individual countries’ debts and thus prevent the rise in risk premiums for countries that are currently particularly highly indebted.
• In the long term, the euro area should try to establish the euro as a global reserve currency alongside the U.S. dollar to benefit from low risk premiums.

The Optimal Set of Political Measures -has Yet  to be Found

Which measures under discussion constitute an optimal bundle of measures can only be determined after weighing all the advantages and disadvantages as well as the interactions and side effects. (Such an analysis is beyond the scope of this article.)

Nevertheless, at least one recommendation can be made: When looking for a suitable package of monetary and fiscal policy measures, several macroeconomic target variables should be kept in mind: inflation rate, employment, GDP level, as well as government debt.

To avoid social tensions, distributional effects of the economic policy instruments must also be taken into account.