Stagflation stalks the Eurozone

The European Union’s high dependence on Russian oil and gas has created a major economic shock – and resulted in significant changes in its attitudes to individual country debt.

| 8 min read

The European Union (EU) has been forced by events to change its approach to economic management and to swerve on the road to net zero. The violent invasion of Ukraine by Russia is part of the reason. Its own policy of printing large numbers of euro and relaxing its budget disciplines is another part. It has triggered worrying inflation, as it seeks to recover from the Covid-19 lockdowns and wishes to avoid harsh austerity policies in the more heavily-indebted countries. Stagflation now stalks the Euro area.

Pre-Covid, the course of the EU for the new decade as it sailed under a new seven-year budget framework seemed clear. There would be the usual debt and deficit disciplines providing some restraint on member states which might otherwise wish to borrow too much in the common currency at low rates. Most member states would remain way above the limit of 60% for debt to GDP but would be under some pressure to start cutting their debt levels. Their budget deficits would be constrained to below the 3% ceiling. The EU would borrow money itself to boost member states' spending.

The driving ambition would be to cut carbon dioxide emissions by 55% on 1990 levels by 2030. This would require substantial investment in renewables, new vehicles, improved industrial processes and better-insulated buildings. The EU budget would be “greened” and member states would be required or advised to ensure their domestic policies were driven by the need to cut CO2. One-third of total budgets over the seven-year period would be to pay for the net-zero strategy.

This year, the brutal intrusion of war into a state closely related to the EU through a comprehensive Association Agreement has disrupted supply chains and pushed up world energy and food prices, given the importance of Russia and Ukraine to world energy and food supply. It has persuaded the EU to want to move to life without plentiful supplies of Russian coal, oil and gas. This has led to a lack of enthusiasm to enforce the old debt and deficit rules as before Covid and a substantial rethink of the green growth strategy. It looks as if the EU will be tolerant of continuing high debt levels and understand some countries will need to run higher budget deficits for longer as they combat both rapid inflation and stalling growth.

Money-creation continues

The stagflation that is feared elsewhere is now the everyday reality. Germany’s economy contracted in the fourth quarter of 2021, whilst inflation has hit 7.5%. In the second quarter of 2022, several countries will struggle to grow whilst having price rises several times of target. The European Central Bank (ECB), for this month, is not joining the many advanced country central banks that are hiking interest rates, as they belatedly tackle inflation. Indeed, the ECB is pressing on with yet another quarter of creating more euros and buying more state bonds to keep longer-term rates down a bit when markets want them higher. Counter-inflation policy has been put on hold until July, when the ECB may announce an end to more money printing.

The EU set out extensive green plans to cut CO2 output. Its “Fit-for-55” policy was underpinned by the European Taxonomy for a Green Future, a codification of what qualifies as permitted investment to contribute to decarbonisation. The plans centred around shifting from fossil-fuel electricity generation to renewables, from diesel and petrol vehicles to electric, from a building stock with fossil-fuel boilers and plenty of heat loss to well-insulated properties heated from non-fossil fuels and improved industrial processes that cut the gas or oil inputs.

Recently, the EU seems to have bowed somewhat to Russian pressure over payment methods to keep the Russian gas flowing.

More recently, the EU has decided to rethink the feasibility and pace of this transition. It has proposed changes to its Taxonomy, with natural gas and nuclear power to qualify as transitional fuels that help on the way to less carbon. The argument goes that natural gas is a better alternative to coal, and can be gradually changed from natural gas, which does produce CO2 when used, to a substitute such as hydrogen which burns without that effect.

Nuclear, it points out, is low carbon anyway. It has studied whether there are other “significant environmental harms” and have concluded nuclear with debated “acceptable” methods of waste disposal qualifies as a reasonable transitional investment in electricity-generating capacity. These are important changes, reflecting the reality on the ground that the EU depends mainly on fossil-fuel energy today for its needs. These will be incorporated as amendments through the catchily titled “EU Taxonomy Complementary Climate Delegated Act”.

Meanwhile, the EU has been firefighting, given the dislocation of supplies of energy it is experiencing. Recently, the EU seems to have bowed somewhat to Russian pressure over payment methods to keep the Russian gas flowing. The EU says companies and states can pay for Russian gas under existing contracts without breaking sanctions, in the currency of the contract. This is usually euro, but Russia insists on a double account system to convert the euros paid into rubles at the permitted Russian receiving bank. Mario Draghi, Italy’s Prime Minister, has been quoted as saying EU buyers are paying in rubles through the double-account system.

A rapid change in energy policy

The EU has always accepted that it will take some time to wean its economy off Russian oil and gas. On 16th May, the Trans-European Networks for Energy Regulation completed its passage. First introduced in 2020, it is now a dated instrument, seeking to speed renewables, develop a cross border carbon dioxide network and ending support for new gas and oil projects. Smart grids and more interconnections are crucial to the policy.

Post-invasion, the EU has increased its power over energy policy by proposing EU-level negotiations of energy contracts for imports and a new requirement that, by the beginning of November, gas storage facilities should this year be 80% full to increase resilience. On 18th May, the EU announced its wish to advance the phase-out of Russian gas. It seeks to increase the target for renewables to reach 45% of electricity by 2030, up from 40% and wants to increase the energy efficiency target from 9% to 13% by 2030. This will mean more solar panels, more heat pumps and more insulation.

The EU has relaxed some of its controls on state aid and subsidies to allow member states more flexibility in responding to the energy shock. They are given some latitude to make grants, loans and guarantees to companies and people to combat high prices, even though the European Commission warns that price controls and subsidies can distort and do damage.

The Ukraine crisis, coming on top of the inflation problem, is difficult for the EU member states, with many facing stagflation. The EU will take more power and control over energy and investment approaches as a result of the crisis. It is flexing considerably to keep Russian gas flowing into Europe for the time being, to allow member states to offer fiscal responses to the cost-of-living pressures and growth slowdown they face and to avoid difficult choices in Italy in the long run-up to a general election where more Eurosceptic parties are still polling well.

The general investment background remains difficult for EU shares and bonds, though there are some good global European companies that will have brand strength and good business models for these testing times. The EU will double up on its wish to invest more in renewables and energy conservation. It is also now encouraging rearmament by seeking a role in joint military procurement and an increase in the defence manufacturing base of the EU.

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Stagflation stalks the Eurozone

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