How to fight — and how not to fight — stagflation
Paul Taylor, a contributing editor at POLITICO, writes the “Europe At Large” column.
PARIS — The Continent is facing the specter of stagflation, with European Union inflation hitting 9.6 percent in June and growth forecasts slashed for both this year and 2023 due to the war in Ukraine, the lingering COVID-19 pandemic, drought and global supply bottlenecks.
The prospect is prompting comparisons to the 1970s, when Europe was roiled after an oil price shock. And there are fears that, unless handled skillfully, stagflation could spell political instability, fuel populism and spark labor unrest in the coming months, with current transportation strikes in Germany and the United Kingdom highlighting this potential for social strife.
In this climate, the challenge for governments and central banks is to avoid the policy missteps made five decades ago, which prolonged the toxic combination of roaring inflation, near-zero economic growth and rising unemployment for almost a decade. Whether they will succeed will depend on lessons learned.
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The first big political test will come in heavily indebted Italy, where hard-right populists could win power in a snap election this September, following the fall of centrist Prime Minister Mario Draghi’s coalition government.
Elsewhere, governments have a longer respite before having to face voters. Preventing a wage-price spiral while trying to cushion low- and middle-income families from soaring fuel and food prices should be their top priority.
The core task of the European Central Bank (ECB), meanwhile, will be displaying determination to curb inflation, while taking care not to topple Europe into recession by throttling the flow of affordable credit to businesses.
The bad news is that our current dependence on fossil fuels may well be harder to quit than the European Commission thinks. EU countries seem unlikely to achieve the 15 percent gas consumption savings endorsed by energy ministers last month. And there may well be more severe shocks to come for the economy and markets, such as a total shut-off of Russian gas.
The good news, however, is that European economies are more robust and flexible than they were in the 1970s. Hence, they are better placed to cope with the double shock of constricted oil and gas supplies and a global shortage of grain and fertilizer caused by Russia’s invasion of Ukraine.
The euro’s existence also means that, unlike the 1970s, there can be no competitive currency devaluation race within the EU. Central banks are more independent and credible than they were then, and the banking sector — supervised by the ECB — has far stronger capital buffers than before.
The likely fall in economic growth from the supply shock is currently estimated at 2 to 3 percentage points of EU gross domestic product, as opposed to the 8 percent drop between 1973 and 1975, after an Arab oil embargo quadrupled the price of oil. That isn’t of comparable magnitude — or not yet, anyway.
Meanwhile, unemployment is at its lowest levels in 20 years in most EU countries and the U.K., while the labor market participation rate has held up on this side of the Atlantic throughout the COVID-19 crisis. Moreover, many households are still sitting on savings from lockdowns and state furlough schemes, which will help them absorb the shock of a 42 percent year-on-year rise in energy prices and an 11.2 percent hike in fresh food costs.
One lesson from the 1970s here is avoiding trying to rigidly administer wages and prices. Few EU countries still automatically index wages and pensions to inflation — Belgium and Luxembourg are exceptions, and several others have partial inflation linkage for public sector pay and state pensions, but most wage-setting is left to collective bargaining and market forces.
For the ECB, keeping inflation expectations close to its 2 percent medium-term target is crucial. So far, the signs are that nominal wage inflation remains moderate at about 3 percent, and that trade unions in key countries such as Germany and France aren’t pressing inflationary wage demands. That partly reflects expectations that this inflation spike will be temporary and will subside next year.
“Nominal wages in the euro area have understandably risen somewhat in recent times, but clearly less so than in the United States, and we cannot yet speak of a wage-price spiral in the euro area, at least thus far,” said Olli Rehn, a member of the ECB’s policymaking Governing Council, which raised interest rates this month for the first time in over a decade.
German Chancellor Olaf Scholz has shown the way forward by reviving “concerted action” roundtables with unions, employers, ministers and the central bank to discuss trade-offs between wage restraint and government support measures for the lower-paid and poor. Deferred pay rises, possibly linked to certain thresholds, are a traditional German way of softening the blow to living standards.
This kind of social pact, common in Northern Europe but decried by neoliberals as corporatist since the Reagan-Thatcher era, is well placed to minimize labor unrest and build wider support for the fair sharing of the burden of inflation.
“When an economic shock comes from outside, as now and in the 1970s, there’s very little that conventional policy instruments can do to prevent it causing distress,” says Iain Begg, professor of European institutions at the London School of Economics. “The best hope is to avoid inflation becoming self-propelled and for governments to target support packages at the worst-off, to prevent them descending into poverty and food banks, and to work on supply-side responses.”
In this case, hastening the transition toward renewable energy sources while making energy savings and boosting energy efficiency would be the best response. “There’s still a lot of low-hanging fruit,” Begg said.
The 1970s also shows governments and central banks should avoid “stop-go” national demand management policies, which alternate sharply between over-heating and freezing economies. It will also be important for the leaders of larger economies to coordinate policy action.
On that front, the report card is mixed. The U.S. Federal Reserve has been far more aggressive in raising interest rates than the ECB, fueling a big swing in the dollar-euro exchange rate.
Inevitable political turbulence is on the horizon, and the best antidote to populist political exploitation of the cost-of-living crisis and stagflation is to persuade voters that we’re all in the same boat. Responding collectively and blaming Russian President Vladimir Putin’s war offer the best hope for Europe’s leaders to ride out the upcoming storm.