It is Germany’s turn to host this year’s annual G7 leaders ’summit, and while the Ukrainian war will be the first part of the meeting’s agenda in Bavaria, the economic damage caused by the invasion of Russia will pass second.
No one saw what was coming when the G7 last met in Cornwall a year ago. There was talk then of post-pandemic global recovery; now fear is an impending recession, as central banks become hawks and Vladimir Putin plays the energy card.
The Kremlin has cut gas supplies through the NordStream pipeline by 60% in the past two weeks and alarms are sounding in Berlin as the inconvenience of being so dependent on Russian energy becomes apparent. Olaf Scholz, Germany’s new chancellor, is in the unfortunate position of having to clear up a mess caused by his predecessor, Angela Merkel, a policy whose reputation will certainly not improve over time.
Last week, the German government triggered the second stage of an emergency gas plan. There is no rationing yet, but this step is possible, as is the reopening of coal-fired power plants. One of Germany’s goals for the G7 is “solid alliances for a sustainable planet,” which fits strangely with German energy companies being asked to prepare to burn more coal this winter.
As for the G7, the wheel has turned a full circle. The first meeting of the group (which at the time included only six countries) was held in France in 1975, as major Western economies struggled to find an answer to the oil shock that had ended the long post-World War II boom. Now they are all facing the prospect of recession again.
The US Federal Reserve raised interest rates by 0.75 points earlier this month and has indicated that these increases are underway. Its president, Jerome Powell, said the recession was a possibility when he testified in Congress last week. This is an admission. The outlook must be quite unpleasant before a central banker uses the word R, but Powell made it clear when faced with the choice between recession and integrated inflation that he would choose first.
The Bank of England is also tightening policy. Compared to the Fed, the Threadneedle Street monetary policy committee is moving in a few steps, so far raising interest rates in 0.25 percentage point increments. It does so against the backdrop of an economy that, despite the continued strength of the labor market, seems to be slowing rapidly. The Bank is trying to design a soft landing for the economy in which inflation, currently at 9.1%, is reduced towards the government’s target of 2% without causing a recession. Good luck with that.
The European Central Bank has yet to join other Western central banks in raising rates, although it has indicated that borrowing costs will rise next month. His prudent approach is not surprising because the stakes for the eurozone are especially high. If the Federal Reserve or the Bank of England has a hash to respond to the highest inflation in 40 years, the consequence will be unnecessary economic pain. If the ECB is wrong, the future of the single currency will once again be called into question.
Europe is vulnerable to a protracted war in Ukraine. It was growing less strongly than the U.S. before the invasion, in part because the fiscal package (tax cuts and increased spending) in America was larger. Unemployment is higher and, unlike the US, the EU is not self-sufficient in energy. Europe is closer to fighting and has suffered more from a supply shock as a result of the conflict.
This is one of the reasons why the ECB must be careful. Another is the impact that a tougher monetary policy – higher interest rates and an investment in the money creation program known as quantitative easing – will have on the weaker members of the eurozone.
Monetary union is an unfinished project. Member States share the same currency, but implement their own fiscal and spending policies (subject to certain common rules) and issue their own bonds when taking out loans in the financial markets. The interest rate (or yield) of Italian bonds is higher than that of German bonds because investors see Italy as riskier than Germany.
Since the ECB indicated that it would join other central banks to raise interest rates, the gap (or spread) has widened between yields on German bonds and those in Italy, Spain, Portugal and Greece. Investors are concerned about how these countries will cope with higher loan costs and slower growth.
Sign up for the Daily Business Today email or follow Guardian Business on Twitter at @BusinessDesk
A decade ago, yields on Italian and Spanish bonds reached levels that cast doubt on whether the eurozone would split into a hard core based around Germany and a softer outer ring. On that occasion, the then head of the ECB, Mario Draghi, promised that he would do “whatever it takes” to safeguard the single currency. He did the trick.
Now Christine Lagarde, Draghi’s successor, faces the same problem of fragmentation. At 8.1%, the euro area inflation rate is too high for the comfort of the ECB. The question is how to raise borrowing costs without causing so much damage to the weaker members of the eurozone that the yield on their bonds skyrockets.
The ECB is committed to creating an anti-fragmentation device under which the central bank will ensure that bond yields in heavily indebted countries, such as Italy, do not rise excessively. This, however, will not be easy. Scholz will have trouble selling a bond purchase scheme to a skeptical German public, mostly because it could cause losses as interest rates rise. The weather is not on Lagarde’s side and if he is wrong, the next unwanted shock to the global economy will be a eurozone crisis.