Inflation: What Risks for the Euro Zone?

Michel Dévoluy 
Professor emeritus in economics, holder of the Jean Monnet Chair at the University of Strasbourg

With a rate of 10% in 2022, inflation is making a strong comeback and confronting the euro zone with the limits of its peculiarity. The Economic and Monetary Union (EMU) is characterized by two major features. The participating economies are still too heterogeneous and the States resist giving up their sovereignties, with the exception of monetary power. Indeed, a single monetary policy requires a consensus. This is enshrined in the heart of the EMU treaty signed in Maastricht in 1992. The independent European Central Bank (ECB) has been created and given the mandate to maintain price stability. This objective has been so well respected since the advent of the euro in 1999 that inflation seemed to be a thing of the past. Then it took off with the war in Ukraine.

The fight against inflation is necessary for several reasons: the decline in purchasing power of monetary incomes; the loss in export competitiveness; the reduction of the burden of non-indexed debt; the increased information asymmetries between agents; an increased uncertainty. Clearly, inflation clouds the perception of the economy and reduces its growth potential.

Inflation also creates inequality. Incomes and assets depend directly on the degree of exposure of economic actors to price increases. Some suffer from inflation, others can better protect themselves against it. Not to mention the windfall effects resulting from unjustified increases.

Another source of inequality is that not all prices move at the same rate. Theoretical inflation is an average calculated from a standard consumption basket. In practice, the spending patterns of the various subjects differ. The hardest hit are those whose forced purchases relate to goods most affected by the increases, such as gas and electricity at present.

Mobilizing the right remedies against inflation involves understanding its causes. So-called “monetary” inflation occurs when the creation of money exceeds the needs of the real economy. The price-wage loop refers to the “inflationary spiral” mechanism: wage increases lead to an increase in prices, which causes a new wage surge. “Exogenous” shocks suffered by an economy also trigger inflationary processes. This is the case during shortages or surges of imported goods.

The evolution of inflation also depends on the expectations of actors on the future behavior of the economy and prices. Another cause, less studied, the instantaneous dissemination of information at the global level, the opacity of market powers and the complexity of financial instruments facilitate erratic price increases. Excessiveness was already observed with regard to properties and income. It is now present in the waltzing of some prices.

Inflation-fighting strategies run throughout economic history. We will mention them for the record before coming to the thorny issue of the fight against inflation in the euro zone.

The indexation of wage incomes is attractive at first sight. But it poses the risk of triggering a price-wage loop. The wisest thing would then be to reserve this device for maintaining the purchasing power of low incomes, with the obstacle of the threshold effects inherent in this type of measure.

Curbing inflation by restricting public spending only makes sense if the economy is proven to be overheating with the presence of a low unemployment rate.

The administrative control of all prices is an authoritarian procedure which conflicts with the practices of market economies. Less brutal, “tariff shields” set ceilings on already regulated prices, while income compensation and “tariff checks” aim to alleviate the loss of purchasing power linked to price increases. These policies weigh down public finances. They should therefore focus on supporting the less wealthy.

Remains the main weapon. Restrictive monetary policies. They take the form of an increase in interest rates intended to weigh on the cost of borrowing and of a tightening of the conditions for obtaining credit. However, these policies are counterproductive if they break the dynamics of growth and employment. They should therefore be used with caution.

With inflation in the euro zone maintained at around 2%, the ECB has become exemplary and has built up a good credibility. But what to do with an average rate of 10%? This surge is not due to the laxity of the ECB, but to the war in Ukraine. Moreover, a recession is looming. Faced with such a situation, resorting to a brutal monetary rigor would be inappropriate.

In regard to the magnitude of the shock, let us acknowledge that the ECB has acted with restraint so far. It raised its main key rate to “only” 2% in November 2022, knowing that it was still at 0% in June. The ECB's strategy thus avoids fueling the economic slowdown while providing signals intended to curb inflationary expectations. We might still be surprised at so much wisdom when inflation is at 10%. But this restraint in unleashing heavy artillery stems from arguments willingly left in the background. High inflation erodes the public-debts repayment burden. But these have become colossal in recent years. In addition, moderate interest rates ease the cost of new government borrowing, that is essential to balance budgets.

Even if the ECB wanted to react forcefully to inflation, could it really? Here the question of the disparities between the States arises head-on. Heterogeneity within the euro zone is revealed, in hollow, in the distribution of national inflation rates. In September 2022, they ranged from 24.2% for Estonia to 6.2% for France; with 17.1% for the Netherlands, 12% in Belgium, 10.9% in Germany and 9.5% for Italy. It must be emphasized that the single monetary policy conducted by the ECB must imperatively reconcile very different national situations. Huge dilemma. If a crisis occurs, it becomes practically impossible for the ECB to choose a policy which would be optimal for each of the Member States. It's unfortunate. But inevitable as long as the economic, social and political structures of the States are significantly different. The ECB's mission would be simplified and more effective if the euro zone were more homogeneous. To do this, it should be more integrated. Hence more political.

The lack of political union does not only hamper monetary policy. It weighs directly, or indirectly, on all the major economic decisions of the Member States, particularly in budgetary matters. Sharing the same currency while preserving national sovereignties requires both coordination procedures and collective control of national policies. Coordination spurs the convergence of economies, promotes coherence between national policies and promotes unique responses to common challenges. This last point is illustrated by the search for a common European strategy to contain the surge in gas prices. Coordinating mobilizes the European authorities, with the Commission in the lead. The procedures are long and involve a lot of regulations, meetings and reports. Already complex on paper, these mechanisms can be difficult in terms of relations between States and with Europe. When they fail, it is always the fault of “somebody else”, which feeds resentment and serves as a pretext to blame Europe - cheaply.

A control mechanism lays down standards to be followed. Then it monitors and, if necessary, sanctions the non-complying states. The heaviest control mechanism concerns public deficits and debts. The challenge is to prevent the fiscal laxity of a Member State, leading, through contagion and spillover effects, to weakening the euro, a common good for all the countries concerned.

These coercive budgetary rules are enshrined in the Stability and Growth Pact (SGP) resulting from the provisions of the Maastricht Treaty and the Treaty on Stability, Coordination and Economic Governance (TSCG) signed in 2012. In short, to defend their sovereignties, the States of the euro zone agree to live under the tutelage of rules which monitor national decisions. A strange procedure of tying one's hands to remain free.

The examination of the inflationary shock suffered by the euro zone is a stark reminder of the unique, complex and unstable nature of the EMU. Basically, everything stems from the refusal to accept a significant transfer of sovereignty from the Member States to Europe. However, the solution exists: to go resolutely towards a federal construction. The ball is in the States' court, and time is running out. The history of European construction will not go back to the same recipes forever.