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Given the circumstances, the European Union’s economy is doing reasonably well. However, this success currently relies on the EU circumventing its own rules, putting into question how sensible they are in the first place.
The French Greens have received a lot of flack for joining a coalition with left-wing firebrand Jean-Luc Mélenchon for the upcoming French legislative elections in June because Mélenchon’s party is ready to ignore EU rules if they stand in the way of the party pogramme.
“We could almost put ‘Europe’ in brackets in the party’s name,” Sabine Thillaye, a lawmaker of President Emmanuel Macron’s La République En Marche party said about the French Greens, whose official name is “Europe, Ecologie, les Verts”.
Pro-Europeans are right to be afraid of countries unilaterally ignoring EU rules, since the level playing field created by the common rules is the basis of a functioning internal market.
Fiscal rules and state aid
Nevertheless, it should be remembered that the EU as a whole is currently not applying many of its most basic rules, and is arguably all the better for it.
The fiscal rules mandating low budget deficits and low debt levels have been suspended for the third year in a row now, and, looking at the insecure economic outlook, it is not at all clear that they will be reimposed next year.
Likewise, the rules on state aid, normally a centerpiece of EU law to prevent unequal treatment of companies, have been temporarily and partially suspended. First, it was to help companies get over the effects of the pandemic, and now, it is to help them weather the economic consequences of the Russian invasion of Ukraine.
And it seems to work.
In March, unemployment in the euro area reached 6.8%, the lowest unemployment rate since the creation of the single currency. Ignoring the old rules allowed the EU and its member states to react quickly to the crises it faced and keep the economy working.
Adherents of the rules would argue that the rules were not ignored but that they had merely proven their flexibility.
It’s true that the general escape clause that allowed for the suspension of the fiscal rules, for example, is, strictly speaking, part of the fiscal rules. But if the main selling point of a rule becomes the fact that it can be ignored, one should probably start to wonder about how sensible the rule is in the first place.
Another EU principle that was interpreted very widely, if not ignored, is the mandate of the European Central Bank (ECB), which should, in theory, be primarily focused on ensuring price stability, i.e. keeping inflation (or deflation) under control.
How sustainable is this?
However, in the last decade, the ECB did much more than that, ensuring favourable financing conditions for highly endebted EU countries, and propping up the feeble economic development in the euro area at large.
When, at the outset of the pandemic, ECB President Christine Lagarde said the ECB was “not here to close the spreads” between the borrowing costs of EU countries, markets reacted in panic and Lagarde had to backtrack. It turns out that the ECB was very much in the business of closing spreads.
The EU currently seems to be in a limbo. It is mostly aware that the old rules are not fit for purpose anymore, but it cannot yet muster the political will to create new ones. The result is that it collectively circumvents its own rules.
This currently seems to work, but if it goes on for too long, the purpose of the European rules might reasonably be questioned, opening the gates to the Mélenchon way of national disobedience.
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Chart of the Week
Speaking of spreads, let’s take a look at the most closely watched of them all: The difference between the bond yield of an Italian 10-year government bond and the yield of a German 10-year government bond.
The yield is the return that an investor can expect from a bond and it is mostly determined by how confident investors are that they will get their money back.
As the German government bonds, the Bundesbonds, are expected to be among the most secure ones in the market, the yields on it are very low, meaning that the German government has very low financing costs.
The spread between the Italian yield and the German yield shows how much more the Italian government has to pay to investors in order to get financing compared to the German government.
The graph below shows that this markup that the Italian government has to pay, has increased in the past weeks, in line with the increasing uncertainty about the further economic development. The vertical axis shows basis points (100 basis points = 1%) and starts at 80 basis points (0.8 percentage points) to show the development more clearly.
Graph by Esther Snippe
The spread has not yet jumped to the heights it attained after ECB President Lagarde made her ominous “not here to close spreads” remark, and is still far off the levels it reached during the euro crisis. How large the ECB lets this spread grow before it steps in is anyone’s guess.
The problem for the Italian government is that influencing the spread in its favour, at least in the short term, is out of its hands. Much of the price difference is driven by the perception of financial markets, which can easily turn into a self-fulfilling prophecy.
The problem is especially prevalent in Italy, as Italian banks have a lot of government bonds on their balance sheets.
In extreme cases, this exposure can trigger a vicious cycle of deteriorating government finances and bank insolvencies. To prevent this kind of vicious cycle, the EU started a new push towards completing a banking union, which you can read more about here.
The Ministry for the Future: You may have read about the disastrous heatwave that is currently hitting India. Well, this eerily realistic sci-fi novel by Kim Stanley Robinson starts with a similar kind of heatwave that hits India in 2024, which then leads to global political turmoil. It is a highly recommended read because it not only paints a picture of the turmoil that might come with the climate crisis, but it also shows how humankind might innovate under the pressure of this turmoil.
The Whole Field: Also in the realm of political reactions to the climate crisis, this analysis by Max Krahé looks at different possible policy reactions to the climate crisis, namely local solutions, market-based solutions, and state planning. He argues that local solutions are too limited and that market-based solutions can confuse markets and make companies invest less rather than going all in on new sustainable industries. According to him, state planning will be needed if industry is to make the leap towards an ecologically sustainable economy.
Can Europe Weather Looming Gas Shortages? Isabella Weber and Karsten Neuhoff argue that Europe should start preparing for the scenario in which Russia stops delivering gas of its own accord.
How the War in Ukraine May Reshape Globalisation: In this blogpost, World Bank economist Michele Ruta argues that firms will reassess risks in their supply chain, as a response to the war. However, he argues that the structural changes to supply chains will be gradual rather than sudden.
[Edited by Zoran Radosavljevic]