Klas Eklund, Senior Economist, Mannheimer Swartling : A crucial year for Europe

War, inflation, recession. Europe is facing difficult challenges at home. At the same time, global geopolitical tensions are forcing Europe to take on a new, more active role.

 External shocks have rocked the world – and Europe – in recent years. While Brexit exacerbated both short-term and long-term ailments in the British economy, the pandemic caused supply shocks and recession all over the continent. Energy shortages pushed up costs. Inflation took off. The Russian invasion of Ukraine destroyed lives and livelihoods for millions.

Inflation for the Euro Zone as a whole is now 10 per cent – the highest since the introduction of the common currency. Headline inflation is probably about to peak. Many of the bottlenecks caused by the pandemic are widening, some have vanished. The cost-push inflation is gradually receding. But all forecasts are uncertain. If energy costs rise during a cold winter with supply of Russian gas shut off, prices may shoot up again.

Core inflation, albeit lower, is still trending up, much higher than the inflation target. Inflation has spread to most sectors, and in some countries there is a risk that rising wage costs will prolong the inflation.

The ECB is facing a difficult situation.

  • On the one hand, monetary policy needs to be tightened in order to bring inflation down towards the target. Inflation expectations need to be kept in check – necessary after years of easy money.
  • On the other hand, tightening will probably deepen and prolong the recession. Higher interest rates increase the cost of living and have negative effects on asset prices. The result is lower consumption and investments.

As of now, most forecasters see a rather mild decrease of GDP for the union as a whole. Maybe some 1.5-2.0 percentage points – clearly less than the pandemic-induced recession of 2020, and smaller than the dip expected in the UK. Labour markets are strong, and the banking sector is less fragile than in previous crises. But once again, forecasts are uncertain. It is not difficult to paint a bleaker picture where a more brutal and longer war depresses the European economy and vicious feedback loops emerge in financial markets.

This has not prevented the leaders of the European Central Bank to issue stern warnings that policy needs to be tightened even in the face of dire real consequences. They see no alternative, given the shockingly high inflation levels

Here we need to note that the ECB is the central bank not for just one country. It is the central bank of the entire Euro Zone, i.e 20 countries when Croatia joins. Since inflation and economic growth differ between member states, some countries may find the European key rate out of sync with their national economy. Today there is a huge divergence between national inflation rates in the Euro zone. The Baltic states all show inflation above 20 per cent, while Spain and France are at 7. One interest rate might not fit all.

The monetary union has great economic benefits, increasing trade between members and reducing currency volatility. But the common monetary policy means that structural developments in member states need move in the same direction and that national fiscal policy should complement monetary policy. However, there have been few powerful tools to drive structural convergence. There is no common fiscal policy and mobility of resources across national borders is low.

This imbalance goes back to the Maastricht treaty of 1993. It laid the foundation of the monetary union, but did not address the need for co-ordination with fiscal policies. Neither did the treaty furnish the EU with the tools of a common foreign policy. The union is in this respect still half-baked.

The European Commission is trying to build a more complete union. Ambitious plans for infrastructure, energy and climate investments have been presented. These will help in the long term; but in the short term the looming recession may increase tensions and dissatisfaction with the union.

Thus, Europe’s economic policy-making is facing a crucial test in 2023, not only meeting the recession but also laying the ground for more ambitious structural developments.

This does not mean that Croatia has made a mistake in adopting the euro. The timing may not be optimal, given all the challenges at the moment. But Croatia’s inflation rate is close to the European average, which means that the ECB’s refi rate should be broadly in line with Croatia’s needs. Furthermore, the entry of a new member state shows the strength and attractiveness of the European idea, even in this turbulent world. Or rather: especially in this turbulent word.

Looking beyond Europe, we see in 2023 an environment fraught with strife, lacking effective governance. China is an authoritarian state, plagued by Covid, but still mounting a challenge for global leadership. The US is haunted by polarization, an increasingly dysfunctional political system, and its share of the global economy is steadily shrinking. Russia nurses dangerous dreams about rebuilding its tsarist borders. And there is no global organisation capable of enforcing any global code of conduct, neither for how states should behave towards each other, nor for how to co-operate for common purpose, like mitigating climate change.

Instead, trade wars and decoupling threaten the open global market which has been crucial for the rise and wealth of Europe. Therefore, in this epoch of crises and challenges it is necessary for the European nations to co-operate in order to build a resilient political economy, and to mount a credible alternative to great-power domination.