The European Union faces a tough time as high energy prices bite and debt problems return. The combination of crises, caused by President Vladimir Putin’s invasion of Ukraine and heavy borrowing when interest rates were artificially low, will test the bloc.
In some respects, the current difficulties are more difficult for the EU to manage than the euro crisis of ten years ago. Then the European Central Bank was able to keep interest rates low and buy government debt. It’s not an option now. Indeed, the ECB has just doubled rates to 1.5% and there is more to come.
Moreover, the EU faces a structural shock linked to high energy prices. Highly industrialized countries like Germany will have to restructure their economic models. Tensions between governments are growing. For example, earlier this month, France canceled a joint cabinet meeting with Germany.
But fits also have silver linings for block. It could have the cheapest and cleanest energy in the world by the mid-2030s and it will likely emerge geopolitically stronger.
EU leaders welcomed each other earlier this year when they came together to condemn Putin’s invasion, impose sanctions on Russia and back Ukraine. But they have not fully considered the economic consequences of Russia cutting off gas exports to the bloc.
Governments have been too indiscriminate in the support programs they have given to consumers and businesses to cushion the blow of soaring gas prices. As a result, gas demand did not drop as quickly as it could have. The cost of these support programs also increases public debt. Meanwhile, governments have not done enough to prepare their populations for the difficult times ahead. This increases the risk of populist reactions in the years to come.
Solidarity is fraying. France has blocked a gas pipeline crossing the Pyrenees from Spain. And Germany is spending 200 billion euros to bail out its consumers and businesses, prompting other countries to complain that Berlin is distorting the EU single market by giving its companies an unfair advantage.
Despite this, EU leaders made progress in resolving their differences at a summit earlier this month. An impressive push to get more gas from non-Russian sources, along with unusually mild weather, has helped push gas prices down to a third of eye-popping levels at the end of August, though they’re still five times higher. than two years ago.
At the same time, the EU has accelerated its transition away from fossil fuels. As a result, it will have cheap and clean energy from the mid-2030s. Although many companies will have to relocate their energy activities over the next decade, the bloc should be well placed for the green industrial revolution that will will follow.
Cheap money has allowed governments to rack up debt over the past decade without thinking too much about how it would be repaid. The latest energy subsidies follow shortly after massive support programs during the Covid-19 pandemic.
European leaders are already complaining about high interest rates, with Giorgia Meloni, Italy’s new prime minister, criticizing the ECB last week. But the central bank cannot avoid raising interest rates even if it wanted to. Inflation in the eurozone was 9.9% in September.
High inflation had the side benefit of reducing public debt as a proportion of GDP. But if inflation expectations are confirmed, investors will demand higher yields to hold government bonds, which will further increase the cost of borrowing.
The shock bond vigilantes inflicted on the UK after its short-lived Prime Minister Liz Truss attempted to pursue loose fiscal policy is a useful cautionary tale for EU countries. But it will always be difficult for governments to rein in spending or cut taxes. They fear an electoral backlash if they do not help their populations to cope with the rising cost of living. And they have major investment needs ahead – for example, to fund the green transition, build military defenses and help pay for Ukraine’s reconstruction.
The EU institutions will work hard to prevent the debt problems from turning into a real crisis. The ECB has promised to prevent the interest rates paid by different governments in the euro zone from diverging too much, provided that their debts are sustainable.
The EU again suspended fiscal rules, which would have required countries to reduce their debt to 60% of GDP. In the meantime, the European Commission will soon propose new rules that will give governments even more time to reduce their debt provided they invest in priority projects such as green transition and security.
Highly indebted countries like Italy fear that borrowing more will make their debt problems worse. That’s why they want the EU to issue debt collectively like it did during the pandemic. But Germany and some less indebted countries are resisting.
Currently, the spread between Italian 10-year government bond yields and their German equivalent is contained at around 2%. But if the bond vigilantes turn on Italy and other Southern countries, it’s easy to imagine a repeat of the euro crisis blame game. Northern European countries might accuse their southern counterparts of prodigality, while southern nations might criticize northern ones for selfishness.
The EU will suffer in the years to come because it decided to defend its interests and values after Putin’s invasion. Despite the bickering and mistakes, he has every chance of profiting from this historic decision.
Putin’s peak of power is probably over. If the conflict in Ukraine does not lead to nuclear Armageddon, the EU will emerge stronger and safer.
The EU’s relationship with the US will also change once the Ukraine crisis is over. America will increasingly need EU help to contain China. The EU will need less protection and will become more of an equal partner.
It is difficult to assign an economic value to these geopolitical advantages. But as Europe heads into a tough winter, it’s worth remembering the big picture.
Source: Reuters (edited by Peter Thal Larsen and Oliver Taslic)