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

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

The catalyst for a LICs rebound

The discounts on listed investment vehicles are at historically wide levels. There are lots of reasons given, including size and liquidity, yet there's a better explanation for the discounts, and why a rebound may be near.

How not to run out of money in retirement

The life expectancy tables used throughout the financial advice and retirement industry have issues and you need to prepare for the possibility of living a lot longer than you might have thought. Plan accordingly.

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

Latest Updates

Investment strategies

Have value investors been hindered by this quirk of accounting?

Investments in intangible assets are as crucial to many companies as investments in capital equipment. The different accounting treatment of these investments, however, weighs on reported earnings and could render ratios like P/E less useful for investors.

Investment strategies

Investors are threading the eye of the needle

As investors cram into ever narrower areas of the market with increasingly high valuations, Martin Conlon from Schroders says that sensible investing has rarely been such an uncrowded trade.

Economy

New research shows diverging economic impacts of climate change

There is universal consensus that the Earth is experiencing climate change. Yet there is far more debate about how this will impact different economies across the globe. New research sheds more light on the winners and losers.

SMSF strategies

How super members can avoid missing out on tax deductions

Claiming a tax deduction for personal super contributions can end in disappointment if it isn't done correctly. Julie Steed looks at common pitfalls and what is required for a successful claim.

Investment strategies

AI is not an over-hyped fad – but a killer app might be years away

The AI investment trend looks set to continue for years but there is only room for a handful of long-term winners. Dr Kevin Hebner also warns regulators against strangling innovation in the sector before society reaps the benefits.

Retirement

Why certainty is so important in retirement

Retirement is a time of great excitement but it is also one of uncertainty. This is hardly surprising given the daunting move from receiving a steady outcome to relying on savings and investments.

Economy

This vital yet "forgotten" indicator of inflation holds good news

Financial commentators seem to have forgotten the leading cause of inflation: growth in the supply of money. Warren Bird explains the link and explores where it suggests inflation is headed.

Sponsors

Alliances

© 2024 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.