Peter BOFINGER

Professor of Economics, Julius-Maximilians-Universität Würzburg

Even before the Covid pandemic has subsided, Europe is now facing another major shock in the form of the Ukraine war. It is threatening economic growth and jobs, and the accompanying soaring inflation is hitting low-income households especially hard. In all this, it is unclear how long the war will last and how drastic the restrictions on energy supply will be.

In this uncertain situation, it might first be helpful to look back. When the pandemic broke out in early 2020, hardly anyone would have imagined how long it would last or how severe the restrictions on private and public life would be. Nevertheless, despite all the problems that many people have faced, economically Europe has been relatively successful in overcoming the challenge posed by this pandemic. The best evidence of this is the fact that, regardless of all the challenges, the unemployment rate in the EU reached a historic low of 6.3 per cent in March 2022. 

This positive development is due to the well-coordinated cooperation of monetary and fiscal policy. By suspending the Stability and Growth Pact, national fiscal policies were able to do all that was needed to stabilise the economy during the Covid lockdowns. Through extensive purchases of government bonds, the European Central Bank (ECB) was able to ensure that there were no financial bottlenecks in the process. This is a clear contrast with what happened in the euro crisis, when the ECB acted with complete passiveness. In addition, NextGenerationEU has been a paradigm shift that enables member states particularly affected by the crisis to provide additional stimuli for the reconstruction and resilience of their economies. 

We should build on this experience when it comes to overcoming the shock of the Ukraine war. Economic policy faces the difficult balancing act of importing as little energy as possible from Russia in order not to support its war, but of making sure at the same time that the economic consequences of an embargo remain bearable for the people in Europe. Estimates by the International Energy Agency show that an ambitious 10-point package could reduce gas imports from Russia by a third within a year. If the EU was willing to slow down the path of CO2 reductions by gas-to-coal switching, a reduction by half would be possible. These estimates make clear that an abrupt halt to gas imports would have extreme consequences. 

Furthermore, the EU is heavily dependent on Russia not only for gas and oil, but also for a variety of other raw materials, especially metals. Thus, a consequent embargo would have to go beyond an oil and gas with additional negative implications for the EU economy. 

Source: Gemeinschaftsdiagnose, April 2022

The consequences of the war are now directly reflected in the acceleration of inflation. In the euro area, the inflation rate reached a record high of 7.5 per cent in April 2022. The strong contribution of energy prices to this development can be seen from the fact that the core inflation rate (the inflation rate adjusted for energy prices and unprocessed food) is 3.9 per cent. The energy price explosion is thus increasingly feeding through to the general price trend – indeed, in October 2021 the core inflation rate was still 2.1 per cent.

The ECB is therefore facing a difficult balancing act. While higher interest rates are needed to curb inflation, a restrictive monetary policy would weaken the recovery of the European economy. Yet the euro area economy is not in particularly good shape anyway due to the consequences of Covid and the war in Ukraine, which have resulted in general uncertainty, a lack of inputs, an increase in energy prices, and a loss of sales opportunities in Russia. 

A pragmatic approach by the ECB would be to end the negative interest rate policy immediately. This was introduced by Mario Draghi in the summer of 2014 to avert the danger of deflation.  

For the effects of monetary policy, it is not the nominal interest rates that matter, but the real interest rates (nominal interest rates minus inflation expectations). With rising inflation expectations, an increase in the nominal interest rate by half a percentage point would thus mean that a decline in real interest rates could be avoided and the orientation of monetary policy would remain more or less constant.

The greatest danger in an interest rate turnaround would be an excessive increase in long-term interest rates. This would primarily burden the highly indebted member states and could put them under additional pressure through rising risk premiums. Although the ECB will end its regular bond purchases, it should nevertheless take action on the capital market at any time if there are undesirable developments there. ECB director Isabel Schnabel recently announced in an interview that she is prepared to do this: “We will decisively counter any sudden jumps in yields that have no fundamental justification”.

In terms of fiscal policy, a macroeconomic strategy against the consequences of the Ukraine war should include a renewed suspension of the Stability and Growth Pact in 2023. This would then give sufficient time to create a fiscal policy framework for the euro area that would develop tailor-made solutions for the individual member states that enable both fiscal stability and growth through investment.

If energy policy autonomy vis-à-vis Russia is to be achieved as quickly as possible, extensive investment will be needed in the field of renewable energies, energy grids, and building renovation. Europe, and especially Germany, has relied on Russian energy for far too long, failing to design a European energy strategy – for example, there is a lack of connection between the Spanish gas grid and the rest of Europe. Analysis should be carried out as to which are the best locations for renewable energies. Given the current obstacles to solar and wind energy in Germany, their expansion could be accelerated significantly with a European approach. All this would create many new jobs but would also require considerable public funding. Since such energy-infrastructure networks have significant positive externalities, it makes sense to finance them jointly – ie, via a NextGenerationEU 2.0. 

 While the war in Ukraine has created much suffering and many problems, it is at the same time a wake-up call for Europe finally to take its future into its own hands decisively and consistently. An accelerated shift away from Russian energy imports also opens up the potential for more jobs and an even more ambitious climate policy. The crisis therefore also offers a huge opportunity to accelerate European integration. 

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