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Comment: You have to fight inflation, but you can’t. The Eurozone is being crushed by debt

After the vigorous Czech central bank and the slightly belated American one, the European Central Bank is also finally dealing with the question of how to deal with high and resistant inflation. After years of slumber, however, the debt problems of some countries from the group called the infamous PIGS (Portugal, Italy, Greece and Spain) are reawakening because of this. And the time is approaching when their unsustainable indebtedness will finally need to be resolved.

The ECB’s attitude towards inflation belatedly copies the gradual transformation of the Polish or American central bank, which we could observe in the last months of last year and the first months of this year. Over the first rise in inflation during 2021, the European central bankers in Frankfurt – as before those in Warsaw or Washington – just waved their hands, saying that it was only “transitional”. And that inflation will disappear as quickly as it appeared.

As unbelievable as it may seem today, it was really promised back then that no one would take monetary opium in the form of zero or even negative interest rates to the financial markets. Back in September 2021, the Governor of the Polish Central Bank was intoxicated by the transitory nature of inflation and announced that in 2022 everything would be fine from the point of view of price developments. At the same time, none of the members of the US central bank expected more than a double increase in rates in 2022. And they kept repeating in Frankfurt that rates will remain negative in 2022.

But inflation did not want to fall at all. Exactly opposite. In the eurozone, for example, German consumer inflation was the highest in 40 years in May. What’s even worse, demand-side inflation is also on the rise, reaching a historic high in May (3.8 percent). With the historically lowest unemployment rate (6.8 percent), the eurozone is thus starting to play with the stability of inflation expectations. This includes the fact that the index of negotiated wages increased significantly in the first quarter of this year.

In recent weeks, it has become completely unsustainable for the ECB to continue feeding the illusion of the transitory nature of inflation. Already in October of last year, the Polish central bank suddenly trumpeted its retreat. In June of this year, the Fed raised rates in a panic at a rate not seen since 1994. And now, perhaps, the retreat from stubbornly defended dovish positions is finally beginning in Frankfurt as well.

The head of the ECB, Christine Lagarde, who as recently as last December spoke of a tightening of monetary policy during 2022 as “extremely unlikely”, today says that the ECB will raise rates by a quarter in July and by another half a percentage point in September.

Yes, in light of eight percent inflation in the Eurozone or double-digit inflation in the Baltics, it looks more like a joke. But the ECB cannot do otherwise, because it is in a very difficult situation. On the one hand, the Eurozone has its north, which needs much higher rates to cool its overheating economies. On the other hand, however, are the southern states of the monetary union, for which – due to their huge indebtedness – even a hint of a slight increase in rates can be liquidating.

Let the recent developments in Italy be an illustration. Its 10-year bond yields rose to 4 percent in response to the ECB’s announced rate hike, sparking panic in Frankfurt itself. Central bankers there therefore immediately sat down at the drawing boards of monetary policy in an attempt to find a mechanism that would tame inflation in the North without ruining the South.

But that is a monetary-political effort to square the circle, which has no solution. There are always winners and losers in monetary policy. Some can handle the higher rates and some can’t. But it always applies within the economy of one state. In the case of the ECB, however, we are talking about entire states whose possible debt collapse is, in all respects, many times more serious than the collapse of anything within a single national economy.

The Eurozone has never been homogeneous, today it is even more heterogeneous than ever. The dispersion of national inflations is miles away from the Maastricht criteria’s intended unity of inflationary developments. Inflation rates in countries paying with the euro range from 20 percent in Estonia to 6 percent in France. The situation in individual labor markets varies just as dramatically – from non-existent unemployment in Germany to 13 percent in Spain. In such a situation, the Frankfurt bankers are clearly trying to do the impossible by setting a uniform interest rate.

How to get out of it? First perhaps a bit of history.

The Eurozone was not created as an optimal currency area, as we know it from textbooks, but as a political project. It lacks too many factors to become an optimal currency area – such as sufficient labor mobility. Above all, however, the eurozone lacks – or lacked – fiscal federalism in this regard, i.e. budgetary authority, which could cushion regional differences in the given currency area with financial transfers.

Until the post-2009 debt crisis, benevolent bond markets replaced the defunct fiscal federation. They did exactly what the fiscal authority would otherwise do – they equalized the differences. That is why large sums of money flowed from German banks to Greek pensioners or public employees, to finance infrastructure in southern countries and the like. Yes, the price was increasing indebtedness of the beneficiaries. But the markets correctly guessed that if the scythe fell on the stone and southern indebtedness became a major problem, the Eurozone governments, together with the ECB, would do “whatever it takes” to avert the bankruptcy of the south (and the problems of the creditors from the north). Bond traders also bet (successfully again) on the fact that “anything” could easily lead to the collapse of a key element of the eurozone’s financial architecture. That is, the Maastricht criteria dictating in particular the permissible level of the state deficit (3 percent of GDP) and total debt (60 percent of GDP).

The birth of many endless asset purchase programs under different acronyms (APP, OMT or most recently in the PEPP pandemic) was the logical result of the European Central Bank’s avoidance of the reality of the non-existence of a fiscal federation.

However, it was quite easy for a long time and it seemed that Maastricht, which was already hanging on the gutter by the tips of its fingers before its final fall, was really not needed. And that the adherents of modern monetary theory are right: regardless of the amount of bonds bought, inflation remained low.

The ECB therefore carelessly took over from the bond markets their role from the first decade of the eurozone’s existence and became the new leveling authority. But in the pandemic, the campfire with which the ECB played for ten years burst into flames. Governments’ total loss of restraint on spending and the central bank’s unbridled willingness to indulge their fiscal appetites have created an explosive mix of high inflation and extreme debt.

Today, the ECB feels an increasing need to tighten monetary policy, but at the same time realizes that this is not possible due to the indebtedness of the south. In other words, the ECB, with its frivolous, condescending monetary policy of the last decade, has maneuvered into the treacherous waters between the Scylla of a potentially collapsing South and the Charybdis of an inflationary angry North. It has played a massive game of moral hazard in which it has always helped countries through artificially low interest rates and monetary financing of their debt. And she didn’t demand anything except cautious words about the need for structural reforms.

The only solution now is to play the fire game to its logical conclusion. This is a partial cancellation of the debts of the member states of the eurozone. Yes, it sounds scary. But it is necessary. Mainly because if the ECB is to return to standard monetary policy life, it has to untie its hands. With the handcuffs of the high debt of the South on the wrists, an independent monetary policy is simply impossible.

Of course, an objection may be raised as to whether to resort to such a step in times of rampant inflation. But debt cancellation alone is not pro-inflationary. The money that got into economies through debt has been there for a long time. The existence of indebtedness, on the other hand, hangs like a sword of Damocles over the ability to carry out an independent monetary policy and do what is now needed, which is to raise rates significantly.

The ECB has 1.7 trillion euros worth of bonds on its balance sheet bought under the pandemic PEPP program. Only the Italian and Spanish papers from this program lie in Frankfurt for a total of 470 billion euros. There are also bonds for 2.6 trillion euros from the PSPP program – Italian and Spanish bonds are worth 750 billion. The ECB therefore already owns more than a third of the combined Spanish and Italian debt and more than a third of the entire eurozone debt. At the same time, the debt of the eurozone exceeded one full annual gross domestic product in 2021.

All this does not mean, however, that the ECB should approach the necessary debt reduction in the same way as it has approached aid until now, i.e. for free. On the contrary – in exchange for a completely unprecedented step, Frankfurt must receive rock-solid guarantees that this is a one-time aid and that the moral hazard that willy-nilly seals this aid will not become an integral part of the budget and monetary policy architecture of the Eurozone.

The ECB should therefore demand the birth of Maastricht 2.0 with a clear objective, and that cannot be anything other than a common budgetary policy. This is a necessity not only due to the lessons from the development of the first two decades of the eurozone, in which it became clear that a common monetary policy cannot work without a fiscal union. It is also essential to recognize that the budgetary policies of individual states are not enough to meet the biggest challenges of the future – security, climate and others.

Much will be required (and the ECB must uncompromisingly demand) on the way to a common eurozone fiscal policy. For example, constitutional amendments in countries that use debt forgiveness, establishing fixed and unexceeded debt ceilings. The right to veto national state budgets for the newly established fiscal supervision of the Eurozone – this will be a kind of prelude to a common fiscal policy. Determining the procedure for the exclusion of unteachable fiscal sinners, because the euro must not be a one-way street. And much more.

It is indeed high time that the ECB put an offer on the table for the eurozone countries that cannot be refused. The only alternative is permanent inflation or the collapse of indebted states.

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