paul taylor, a contributing editor at POLITICO, writes the “Europe At Large” column.
PARIS – The continent faces the specter of stagflation, with inflation in the European Union reaching 9.6 percent in June and lowering growth forecasts for both this year and 2023 due to the war in Ukraine, ongoing COVID-19 pandemic, drought and global supply bottlenecks.
The prospect calls for comparisons to the 1970s, when Europe was in turmoil after an oil price shock. And there are fears that, unless handled skillfully, stagflation could create political instability, fuel populism and spark labor unrest in the coming months, with the current transport strikes in Germany and the UK highlighting this potential for social struggle.
In this environment, the challenge for governments and central banks is to avoid the policy missteps made five decades ago, which allowed the toxic combination of roaring inflation, near-zero economic growth and soaring unemployment to continue for nearly a decade. Wwhether they will succeed depends on the lessons learned.
The first major political test will come in heavily indebted Italy, where far-right populists could gain power in quick elections in September following the fall of the coalition government of centrist Prime Minister Mario Draghi.
Elsewhere, governments have a longer breather before having to confront voters. Preventing a wage-price spiral while trying to protect low- and middle-income families from rising fuel and food prices should be their top priority.
The core task of the European Central Bank (ECB), meanwhile, is to show determination to curb inflation and ensure that Europe does not fall into recession by restricting the flow of affordable credit to companies.
The bad news is that our current reliance on fossil fuels may be harder to stop than the European Commission thinks. It seems unlikely that EU countries will achieve the 15% reduction in gas consumption approved by energy ministers last month. And there may be even bigger shocks to the economy and markets, such as a total shutdown of Russian gas.
The good news, however, is that European economies are more robust and flexible than they were in the 1970s. As a result, they are better able to cope with the double shock of limited oil and gas supplies and a global shortage of grain and fertilizers caused by the Russian invasion of Ukraine.
The existence of the euro also means that, unlike in the 1970s, there can be no competitive currency devaluation race within the EU. Central banks are more independent and credible than they were tand the banking sector — supervised by the ECB — has much stronger capital buffers than before.
The likely decline in economic growth due to the supply shock is currently estimated at 2 to 3 percentage points of the EU’s gross domestic product, as opposed to the 8 percent decline between 1973 and 1975 after an Arab oil embargo hit the oil price. quadrupled. That’s not on a comparable scale – or not yet.
Meanwhile, unemployment in most EU countries and the UK is at its lowest level in 20 years, while the employment rate on this side of the Atlantic has held up during the COVID-19 crisis. In addition, many households are still sitting on savings from lockdowns and state leave arrangements, which will help them absorb the shock of a 42 percent annual increase in energy prices and an 11.2 percent increase in the cost of fresh food.
A lesson from the 1970s is to avoid rigid management of wages and prices. Few EU countries now automatically index wages and pensions to inflation — Belgium and Luxembourg are the exceptions, and several others have a partial inflation linkage for public sector wages and state pensions, but most wage formation is left to collective bargaining and market forces.
It is crucial for the ECB to keep inflation expectations close to its medium-term target of 2 percent. So far the signs are that nominal wage inflation remains subdued at about 3 percent, and that unions in key countries such as Germany and France are not making inflationary wage demands. That partly reflects the expectation that this inflation spike will be temporary and will subside next year.
“Nominal wages in the euro area have understandably increased somewhat recently, but clearly less than in the United States, and we cannot yet speak of a wage-price spiral in the euro area, at least so far,” said Olli Rehn. , a member of the ECB’s Governing Council, which this month raised interest rates for the first time in more than a decade.
German Chancellor Olaf Scholz has shown the way forward by reviving roundtable discussions with unions, employers, ministers and the central bank to weigh the trade-off between wage moderation and government support measures for the lower-paid and the poor. Deferred wage increases, possibly linked to certain thresholds, are a traditional German way of softening the blow to living standards.
These kinds of social pacts, common in Northern Europe but considered corporatist by neoliberals since the Reagan-Thatcher era, are well placed to minimize labor unrest and build wider support for a fair distribution of the burden of inflation.
“When an economic shock comes from outside, as it is now and in the 1970s, conventional policy instruments can do very little to prevent it from causing unrest,” said Iain Begg, a professor of European institutions at the London School of Economics. “The best hope is to prevent inflation from propelling itself and for governments to focus on worst-case relief packages, to avoid falling into poverty and food banks, and to work on supply-side responses.”
In this case, the best solution would be to accelerate the transition to renewable energy sources while achieving energy savings and increasing energy efficiency. “There’s still a lot of low-hanging fruit,” Begg says.
The 1970s also show that governments and central banks must avoid “stop-go” policies for national demand management, which alternate sharply between overheating and freezing economies. It will also be important for the leaders of larger economies to coordinate policy actions.
The report is mixed in that regard. The US Federal Reserve has been much more aggressive in raising interest rates than the ECB, fueling a large swing in the dollar-euro exchange rate.
Inevitable political turbulence looms on the horizon, and the best antidote to populist political exploitation of the cost of living crisis and stagflation is to convince voters that we are all in this together. Reacting collectively and blaming Russian President Vladimir Putin’s war offers the best hope for European leaders to contain the coming storm.
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