Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 461

Three reasons high inflation may trigger a European crisis

Italy’s 66th post-war government collapsed in January 2021 when a coalition led by Prime Minister, Giuseppe Conte, crumbled. President Sergio Mattarella encouraged the parties to revive the alliance so he could avoid calling a snap general election during a pandemic.

But the talks failed. As concerns grew that any election might usher right-wing populists into power, Mattarella pulled off a masterstroke. He unexpectedly contacted Mario Draghi; yes, ‘Super Mario’ who saved the euro in 2012 with his ‘whatever it takes’ comment. Mattarella asked the Chief of the European Central Bank to form a ‘national unity’ government. Within days, Draghi become Italy’s 29th prime minister since 1946.

The bellwether of European risks

Investors were pleased. On 13 February, when Draghi became Italy’s fourth unelected premier since 1993, the ‘lo spread’ – the yield at which Italian 10-year government bonds trade over their German equivalents, a number that is judged the bellwether of EU economic and political risks – had narrowed to a five-year low of just under 1% (100 basis points).

Draghi’s government retains the confidence of investors yet the lo spread has widened to 200 basis points. What malfunction occurred that widened the gap towards the 300 basis-point level that is seen by many as the tripwire for a crisis?

The culprit, like elsewhere in the world, is inflation. Eurozone consumer prices surged a record 7.4% in the 12 months to April 2022 due to promiscuous monetary and fiscal policies, rising energy prices, pandemic-related supply blockages and Ukraine-war related disruptions.

The ECB has one objective; to maintain price stability, which is interpreted as keeping inflation below 2%. The central bank has little choice but to tighten monetary policy by raising rates and ending its asset buying.

Rising rates bring more worries

Many central banks are doing likewise to tame inflation. For most countries, the main threat is the resultant slowing in economic growth boosts the jobless rate to worrying levels if economies slump into recession.

For the eurozone, the ramifications of tighter monetary policy are more concerning for three reasons.

The first is the ECB is poised to stop acting as the buyer of last resort for its almost-bankrupt ‘Club Med’ members such as Italy, where gross government debt stood at 151% of GDP at the end of 2021. That cessation could trigger a bond sell-off that puts the finances of debt-heavy governments on an unsustainable footing. National government and commercial lenders holding their government’s debt might become entwined in a downward spiral. The ECB would be exposed as lacking any credible way to quell such a government-bank suicide bind.

The second problem with tighter monetary policy is the resultant downturn will remind indebted euro-users that they have no independent monetary policy to help their economies, nor a bespoke currency they can endlessly print to meet debt repayments or devalue to export their way out of trouble. The only macro tool domestic policymakers possess is fiscal policy but that is maxed out. Populist Italian politicians are bound to talk of readopting the lira.

The third means by which higher inflation is poisonous is it creates a fissure between the area’s creditor and debtor nations that would make it harder to find durable solutions for the euro. Inflation-phobic but inflation-ridden Germany and other creditor countries will battle with debt-heavy France (government debt at 113% of GDP), Greece (193%), Italy, Portugal (127%) and Spain (118%) over how far the ECB should go to rein in inflation and how it might help the strugglers.

To maintain its inflation-fighting credentials, the ECB must tame inflation even if that stance crushes economic growth. The core concern of such tight monetary policy is that it would expose how the euro’s flawed structure – that it is a currency union without the necessary political, fiscal or banking unions – has become explosive due to the large debts of southern eurozone governments.

Whither Europe?

To be sure, policymakers are likely to once again thrash out some last-minute fudge that defers a denouement on the euro’s fate. But temporary solutions are only, well, temporary and the euro needs a durable resolution. The indebted south could win the political tussle such that the ECB never makes a serious attempt to tame inflation. But that path might only delay tighter monetary policy and subsequent detonations. The cost of servicing public debt, while rising, is still historically low, which reduces the likelihood of missed debt payments and a crisis.

Eurozone governments are restarting efforts to create a proper banking union but success is not assured. The lo spread is well short of the post-euro record 556 basis points it reached in 2011 during the eurozone crisis that was triggered by the current-account imbalances among members. But Rome’s debt was only 120% of GDP then, and that gap narrowed only due to ECB support that is now waning because the problem today is inflation.

Germany’s economic slump and dislike of inflation will ensure Berlin pressures the ECB to prioritise inflation. The lo spread could widen enough to threaten a flawed currency union, especially if member countries are squabbling over solutions. While Draghi ‘the central banker’ could bluff investors, Draghi ‘the politician’ has no similar obvious masterstroke. To all the world’s problems, be prepared to add elevated doubt about the euro’s long-term future.

 

Michael Collins is an Investment Specialist at Magellan Asset Management, a sponsor of Firstlinks. This article is for general information purposes only, not investment advice. For the full version of this article and to view sources, go to: https://www.magellangroup.com.au/insights/.

For more articles and papers from Magellan, please click here.

 

RELATED ARTICLES

Globalisation is morphing into something less promising

Can quantitative tightening help the Fed fight inflation?

Trusting the process in a high-rate environment

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Latest Updates

Planning

Will young Australians be better off than their parents?

For much of Australia’s history, each new generation has been better off than the last: better jobs and incomes as well as improved living standards. A new report assesses whether this time may be different.

Superannuation

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Investment strategies

A steady road to getting rich

The latest lists of Australia’s wealthiest individuals show that while overall wealth has continued to rise, gains by individuals haven't been uniform. Many might have been better off adopting a simpler investment strategy.

Economy

Would a corporate tax cut boost productivity in Australia?

As inflation eases, the Albanese government is switching its focus to lifting Australia’s sluggish productivity. Can corporate tax cuts reboot growth - or are we chasing a theory that doesn’t quite work here?

Are V-shaped market recoveries becoming more frequent?

April’s sharp rebound may feel familiar, but are V-shaped recoveries really more common in the post-COVID world? A look at market history suggests otherwise and hints that a common bias might be skewing perceptions.

Investment strategies

Asset allocation in a world of riskier developed markets

Old distinctions between developed and emerging market bonds no longer hold true. At a time where true diversification matters more than ever, this has big ramifications for the way that portfolios should be constructed.

Investment strategies

Top 5 investment reads

As the July school holiday break nears, here are some investment classics to put onto your reading list. The books offer lessons in investment strategy, financial disasters, and mergers and acquisitions.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.