Cyprus borrowed heavily with low-cost bond issues to finance their excessive current expenditures
Economic and financial crises in the euro area are fast developing. With supply-side problems most strikingly reflected in an acute energy crisis, wholesale and retail prices are soaring and production is stagnating or being contracted. Furthermore, the sharp deterioration in the external terms of trade of euro area members is reducing real incomes and threatening a balance of payments crisis. While supply-side difficulties have resulted to a large extent from actions to contain the pandemic and the effects of the Russian-Ukraine war and related sanctions, supply problems have been seriously aggravated by past and ongoing policies of the European Central Banks (ECB) and the fiscal actions of euro area governments.
Misguided policies
Over the last decade the ECB has stubbornly kept interest rates at extremely low levels through among other things massive purchases of government bonds in order to raise the rate of increase of consumer prices to its annual target of 2 per cent. However, ultra-low interest rates had mainly the effect of promoting investments and speculation in equities, government bonds and real estate at the expense of longer-term investments in infrastructure and in raising energy supplies. In consequence, governments in countries such as Italy and Cyprus instead of undertaking reforms and growth-enhancing investments borrowed heavily with low-cost bond issues to finance their excessive current expenditures.
And more recently with the ECB belatedly raising its interest rates to try to reduce inflationary pressures and bond yields rising, policy makers have been focused on preventing another sovereign debt crisis through policies including the introduction the Transmission Protection Instrument (TPI) to mitigate the spread of government bond yields, particularly that on Italian bonds relative to German Bunds.
With these misguided monetary and fiscal policies causing under-investment in energy infrastructure and renewables together with reliance on the import of cheap fossil fuels from Russia, the euro area economy became less resilient to the latest energy shock. In fact, as a result of Russia manipulating and curtailing energy supplies to EU countries and problems and delays in diversifying to alternative energy sources as well as the rush to boost energy stocks ahead of the winter, the import prices for crude oil and natural gas have been driven up to extremely high levels, the price of the latter being currently around ten times that of a year ago. And with import prices rising steeply relative to export prices there has been a massive deterioration in the terms of trade of euro area members. This “terms of trade crisis” and large differentials between US and euro area interest rates have in turn caused the euro to depreciate substantially and add significantly to inflationary pressures. And with the large loss in the terms of trade lowering real incomes and supply bottlenecks hampering production the euro area could experience a deep recession.
Balance of payments problems loom
Data for the euro area indicate that largely owing to the recent huge increases in fuel and other commodity prices, euro area countries are incurring mounting trade deficits with countries outside the euro area. Reflecting soaring prices, particularly of energy imports from Russia and Norway, the trade deficit of the euro area with the rest of the world has skyrocketed over the last year with the deficit for the January-June period of 2022 amounting to 140 billion euros compared with a surplus of 101 billion euros in the same months of 2021.
More detailed information on extra-EU trade shows that the trade balances of most euro area members with countries outside the EU deteriorated sharply in the first six months of 2022. For example, the trade deficit of Greece with non-EU countries nearly trebled to over 12 billion euros in the first six months of 2022 as its imports from non-EU countries rose by 84 per cent.
Export receipts for Southern European countries during 2022 are being boosted by substantial increases in tourist revenues. While higher services exports should help to contain increases in the current account deficits of vulnerable euro area countries a key issue will be the extent to which trade deficits with non-EU members continue to rise and cause financing problems. In this connection with prices of energy and energy-intensive products spiraling to very high levels in July and most of August it is likely that the trade balances of euro area countries will deteriorate further.
Thus, there could be pressure on euro area countries in financing their deficits with non-EU countries? In the years prior to their financial crisis countries such as Spain, Ireland and Cyprus recorded very large current account deficits in the balance of payments well in excess of the size of their government deficits. However, with a considerable part of these deficits being with other euro countries the current account imbalances could be largely covered by financing under the Target2 arrangements of the Eurosystem used for settling payments of transactions in euro. Also, huge short-term external capital inflows into domestic banks enabled external deficits to be more than funded. However, as pointed out in articles by myself and Savvakis Savvides it was the reckless and wasteful use of these funds by banks that was the main cause of financial crises in Spain, Ireland and Cyprus rather than insufficient funding to cover current account deficits.
But this time it could be different. Mounting current account deficits are resulting from huge trade deficits of a number of euro area countries with non-EU countries meaning that there could be limits on the use of the Target2 system for the financing of current account deficits. Surely, new arrangements for cross border payments in certain non-euro currencies such as for the financing of energy imports from Russia will have to be made. Furthermore, large foreign capital inflows into countries such as Spain, Ireland and Cyprus to take advantage of low taxes and perceived attractive property deals as happened prior to previous crises are hardly likely to be repeated.
Hence, policy-makers in the euro area apart from making efforts to tame inflation from the demand side and preventing a sovereign debt crisis will need to be very vigilant in monitoring developments in the balances of the external current accounts of euro area countries and assessing whether deficits are being supported by sufficient funding and the productive use of such funds.
Supply-side problems and policies
It is possible that supply-side problems highlighted by the ongoing energy crisis will be prolonged and cause rapid inflation and losses in the terms of trade to persist. Remedying such a grim situation of recession and possible financial crises in the euro area, let alone rampant inflation, will require policies that substantially raise productive investments.
But the undertaking of investments to improve the supply situation through among other things constructing energy infrastructure, such as port facilities to enable the import of energy from new sources into the EU, will take time. However, in the period before investment projects are completed, elevated energy and other key prices such as for fertilisers will cause many households to suffer miserably from steeply rising living costs and businesses from the higher cost of operations including the payment of increased wages to help protect workers from inflation. To help alleviate this suffering governments will need to give handouts targeted to lower and middle-income households to cover at least a significant part of increases in their energy bills. And certain vulnerable businesses should be assisted as well. For instance, the need to subsidise the cost of fertilisers for agricultural crop producers would seem compelling.
Increased government revenues resulting from the impact of higher prices on receipts from VAT, excises and carbon emissions taxes should help finance higher government expenditures for assistance to households and businesses. In addition, entities that have profited from the pandemic and the energy crisis such as health clinics and pharmaceutical importers and producers and distributors of fuel products should be taxed more heavily so as to contribute significantly to stretched government finances.
In concluding it is the view here that supply-side problems and inefficiencies can only be fixed fundamentally if there is a substantial improvement in relations between the “West” and Russia and China, that would entail, among other things, the West retreating from the imposition of sanctions against Russia.
