Eurozone Caught in the Inflation Trap – Federal Solution Is the Only Way Out in the Long Run.

Perhaps the danger posed by Russia will convince the people.

Soaring prices, faltering growth, rising interest rates, and a war at its border ...

It is a rising tide of peril that the eurozone is facing. It has entered a new zone of turbulence. It is reasonable to hope that it will pass this hurdle since it is first and foremost a political project. But no one wants, or has any interest in, it exploding.

The government that puts an end to the European currency will go down in the history books, a bit like the Serbian nationalists with the assassination of the heir to the Habsburg throne in June 1914 in Sarajevo, the event that triggered the First World War. Not to mention that Vladimir Putin's war in Ukraine and the Russian leader's aggressiveness towards the West now pose a threat that no member state wants to face alone.

Will the eurozone experience the same psychodrama as in 2012?

Nevertheless, the question is whether 2022 will be a repeat of the psychodrama of 2012, the year of the sovereign debt crisis. The European Central Bank (ECB) fears this and has taken the lead in announcing that it is working on a tool to stabilize interest rate differentials between different public debts. As we saw with Mario Draghi, the former president of the ECB, and his now famous “whatever it takes” of July 2012, a central bank can do a lot. A simple sentence was enough to calm all speculations.

Ten years later, it is not Greece but Italy that is seen as the weak link in the eurozone. The ECB's announcement of an instrument that will reduce the interest rate differentials between the public debts of member states has eased the pressure. The Italian 10-year rate, which had risen to 4.20% in mid-June 2022, has come down. The country now has a 10-year debt of 3.10%, while Germany borrows at 1.12% and France at 1.64%.

The third largest economy in the eurozone, Italy is now the weakest link

Interest rates on sovereign bonds depend on the ability of the issuing country to repay its debt, i.e. its ratio of public debt to GDP, its budget deficit, or its long-term growth. Italy is vulnerable in these respects. Its debt has increased over the past decade, particularly during the Covid.

So much so that the country is now carrying a debt load equivalent to 150% of its annual GDP. As its stock of public debt was issued at an average rate of 2.40%, Italian debt maturing is renewed at a higher rate. With Italy's growth barely 0.5% per year and inflation at 2% in the long term, the country's cost of debt is very close to the growth of its tax revenues.

In the event of a new market fever, the Italian government will not last very long.

Why would rates rise again? Because of inflation. It reached 8.6% in June 2022 over one year in the eurozone. This will cause the ECB to react on July 21, 2022, at its next meeting. Christine Lagarde, its president, has already announced a rate hike on that occasion.

However, there is a manufacturing defect in the eurozone.

The ECB is the guarantor of price stability in the eurozone and must stabilize inflation in the medium term at 2%, as specified in its mandate. But this objection presupposes that the eurozone exists. And any rise in interest rates could potentially jeopardize the solvency of indebted countries, such as Italy, and thus the existence of the eurozone.

In short, in the eurozone, as it exists today, it is almost impossible to have both 9% inflation in Germany and 10-year rates close to 3.5% in Italy. On the other side of the Rhine, the political and economic problems are becoming glaring. On the other side of the Alps, bankruptcy is looming.

The ECB must choose between two evils. Monetary policy must now ensure the solvency of states rather than control inflation. For in the absence of any other political and economic power in the eurozone, the ECB is the institution that guarantees the existence of a single currency.

The federal solution is the only viable long-term solution

The so-called “anti-fragmentation” instrument to be presented this summer by the ECB aims to get out of this dilemma by allowing the Italian state to finance itself at low rates. The central bank may well succeed in its operation. But it will not be without political tensions.

Joachim Nagel, the head of the Bundesbank, is pushing for a strong and rapid rate hike to combat inflation and the weakness of the euro. He will not give up without a fight. Especially since without a rate hike in Italy, the country will not be encouraged to manage its public accounts with rigor, according to him.

But Germany cannot take the risk of state bankruptcy, which would lead to the explosion of the eurozone, while European solidarity will be undermined this winter with the gas rationing that is looming. The question will be asked again in five or ten years.

The only solution to close the debate is given by the German economist Isabelle Schnabel, member of the ECB's Executive Board, in her speech at the Sorbonne in mid-June 2022:

“The risk of fragmentation will only disappear with the evolution of the institutional architecture of the eurozone.”

To put it plainly, only a mutualization of public debt and the creation of a true transnational budgetary policy will allow us to escape from the dilemma. A federal advance that the people do not necessarily want, however. Perhaps the danger posed by Russia will convince them.

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