The big eurozone gamble

Dr Oliver Hartwich
11 June, 2024

The European Central Bank’s decision to cut interest rates for the first time since 2019 is a significant turning point in the Eurozone’s monetary policy. After months of grappling with stubbornly high inflation, the ECB has finally blinked, betting that the worst of the post-pandemic price pressures are behind us.

On the surface, the move seems justified. Eurozone inflation, which peaked at a staggering 10.6% in October 2022, has steadily declined to 2.6% in May 2024. The supply chain disruptions and energy shocks that sparked the inflationary surge are gradually easing. The ECB’s commitment to return inflation to its 2% target could help anchor expectations.

However, scratch beneath the surface and doubts begin to emerge. Core inflation, which excludes volatile energy and food prices, remains elevated. Wage pressures, driven by tight labour markets and the desire to recoup pandemic-era losses, continue to simmer. By cutting rates now, the ECB risks reigniting the inflationary embers it has worked so hard to extinguish.

Moreover, and as always, the ECB faces the unenviable task of setting monetary policy for a highly heterogeneous economic bloc. The Eurozone is a patchwork of economies with vastly different structures, competitive positions and growth trajectories. What works for Germany may not work for Greece; what benefits Spain may hinder Italy. In a currency union as diverse as the Eurozone, one size rarely fits all.

The inherent economic flaws in the Eurozone’s design have been apparent since the currency’s inception. Yet, driven by a mix of cold-hearted realpolitik and lofty idealism, Europe’s leaders pressed ahead, brushing aside economic logic in favour of pure politics.

The result has been a monetary union constantly plagued by crisis and instability. From the sovereign debt crisis that nearly tore the Eurozone apart between 2009 and 2012 to the deflationary pressures that followed, the ECB has consistently found itself fighting fires of its own making. Its toolkit, designed for a homogeneous optimal currency area, has proven woefully inadequate for the diverse realities of the Eurozone.

Now, in cutting rates, the ECB is once again betting that it can navigate this minefield. It is a risky gamble. If inflation proves more stubborn than anticipated, or if external shocks like a widening of the Ukraine conflict or the Chinese slowdown hit the Eurozone, the ECB may find itself with little ammunition left to fight the next crisis.

But the ECB’s woes are not just economic. They are also deeply political. The Eurozone, for all its talk of unity and solidarity, remains a collection of sovereign states with divergent interests. The Euro has always been an elite project, with measures often pushed through against the wishes of sceptical publics. This democratic deficit, combined with the Euro’s mixed economic record, has fuelled the rise of populist anti-EU sentiment across the continent.

In this context, the ECB’s latest move is a political gamble as well as an economic one. If it backfires – if inflation resurges or growth falters – it could further erode trust in the European project and fuel the populist forces that threaten to tear the EU apart.

The political ramifications are already evident. In Italy, the Eurozone’s third-largest economy, Giorgia Meloni’s government has been openly hostile to the EU’s fiscal rules, seeing them as a constraint on its ability to stimulate growth.

In France, the Yellow Vest protests that erupted in 2018 were in part a reaction to the perceived economic hardship imposed by the Euro.

And in Germany, the Eurozone’s former economic powerhouse, support for the single currency was never overwhelming to start with.

These tensions are not new, but they have been exacerbated by the pandemic and the uneven recovery that has followed. The ECB, in its role as the Eurozone’s central banker, finds itself at the heart of this quagmire. Its every move is scrutinised not just for its economic impact, but also for its political implications.

The ECB’s rate cut must be understood in this context. It is not just a technical adjustment to monetary policy, but a political move. The ECB is betting that by easing monetary conditions, it can support the Eurozone’s weak and fragile recovery, boost growth and thereby ease the political pressures that threaten the long-term survival of the currency union.

But it is a bet that could backfire. If the ECB’s actions are seen as too little, too late, or if they fail to deliver the hoped-for economic benefits, it could further undermine confidence in the institution and the currency it manages. And if the political fallout is severe enough, it could even spell the beginning of the end for the Euro itself.

From a New Zealand perspective, the ECB’s rate cut is a stark reminder of the challenges facing monetary policy in an increasingly turbulent global environment.

Like the Eurozone, New Zealand is grappling with the aftermath of an unprecedented economic shock. Like the ECB, the Reserve Bank of New Zealand (RBNZ) has had to navigate a tricky balance between supporting growth and containing inflation.

But unlike the ECB, the RBNZ has so far resisted the temptation to ease monetary policy. Despite some of the highest interest rates in the developed world, our central bank has maintained a hawkish stance to bring inflation back to its 1-3% target band.

This reflects some challenges specific to the New Zealand economy. New Zealand’s inflation problem, exacerbated by supply chain disruptions, an overheated housing market, and strong domestic demand, has proven more stubborn than most. At its core however, New Zealand’s inflation hangover has its roots in the RBNZ’s aggressive pandemic-era stimulus, combined with substantial fiscal stimulus.

As a result, while much of the developed world is now moving towards monetary easing, starting with the ECB, New Zealand is likely to remain an outlier for some time. For Kiwi borrowers, particularly those with large mortgages, this means a longer period of pain.

In both Frankfurt and Wellington, the stakes could hardly be higher. The decisions our central banks make today will shape our economic realities for years to come.

To read the article on the Newsroom website, click here.

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