Eurasia Press & News
The EU Has Deftly Managed Inflation and the War in Ukraine
More than three decades ago, U.S. President George H. W. Bush expressed a wish for a Europe both “whole and free.” Russian President Vladimir Putin’s unprovoked invasion of Ukraine in February 2022 made that unrealized vision more elusive. Russia’s Hobbesian war of choice in Ukraine was a direct challenge to the Kantian idea of universal peace on which the project of European integration was founded. The conflict has reminded the European Union that it remains dependent on the United States for its security. Long-simmering tensions between eastern and western Europe on how to deal with Moscow have been laid bare. At the same time, the return of high inflation in 2022 has brought back familiar fault lines between northern and southern Europe.
But 2022 also demonstrated that the EU is remarkably resilient. Member countries weaned themselves off their Russian energy dependence with remarkable speed and resolve. Even when it was economically costly, European leaders remained united in their support for Ukraine. The European Central Bank (ECB) successfully managed to fight inflation by ending its bond-buying programs and raising interest rates without triggering a large market selloff of sovereign debt. European autocrats such as Hungarian Prime Minister Viktor Orban found themselves more isolated and on the defensive. The economic consequences of Brexit were a serious problem for the United Kingdom and only a relatively minor headache for the EU.
WON’T GET FOOLED AGAIN
These positive developments confirm that EU leaders have learned from past mistakes. Consider how, in early 2010, the EU dithered before coming to terms with the sovereign debt crisis: for almost three years, leaders responded with temporary fixes and blame games. It wasn’t until the summer of 2012 that Mario Draghi, then the president of the ECB, finally quieted the financial markets’ fears when he promised to do “whatever it takes” to preserve the euro. Only in January 2015 did recovery begin in earnest, when the ECB started all-out quantitative easing, its program of buying sovereign bonds from its member states on a large scale.
In comparison, when COVID-19 hit Europe in 2020, it took the EU only a few weeks to come up with a comprehensive response. In March 2020, the ECB launched the Pandemic Emergency Purchase Programme (PEPP), a 750 billion euro (about $811 billion) effort that temporarily bought public and private assets to safeguard the monetary transmission mechanism. This stabilized European banks’ lending and deposit rates and staved off any immediate financial collapse. A few weeks later, France and Germany threw their weight behind a European pandemic recovery fund, which would become known as “Next Generation EU” and grow to 750 billion euros. Managed by the European Commission and financed through jointly guaranteed bonds, the recovery fund unified Europe by providing large grants to those member states who needed it most and safeguarded the continent’s economic recovery.
When Russia invaded Ukraine on February 24, 2022, the EU quickly swung into action. In close coordination with the United States, the EU imposed a range of sanctions, banning Russian elites from traveling to member countries, freezing the assets of Putin’s inner circle, and crippling Russian trade by imposing import and export taxes. Perhaps most important, member states weaned themselves off Russian coal, oil, and gas. Orban protested some of these measures but almost always ended up acceding to them. And although Russia’s economy has not yet collapsed, the EU’s actions are chipping away at the Russian government’s revenue.
A few days after the Russian invasion, German Chancellor Olaf Scholz proclaimed a Zeitenwende (turning point) in German foreign policy, and he has generally followed through on leading his country in a new direction. Before the war in Ukraine, Germany had plans to start operating Nord Stream 2, a pipeline set to carry natural gas directly from Russia to Germany. Now, Berlin has not only abandoned the controversial project but also cut its dependence on Nord Stream 1, an earlier pipeline that had been operational since 2011. In addition, Scholz promised to dramatically beef up German defense spending by creating a new 100 billion euro (about $108 billion) fund for modernizing the German military. Germany also broke with previous taboos by sending lethal weapons directly to Kyiv and becoming one of the EU’s most generous funders of humanitarian efforts in Ukraine. Germany’s response to the war in 2022 would have been unthinkable in late 2021, when “change through trade”—or a belief that the best way to effect change was through economic ties—still informed Germany’s foreign policy toward Russia.
FOLLOW THE MONEY
In addition to contending with the war in Ukraine, last year the EU also needed to come up with a combination of fiscal and monetary policy to combat rising prices. When inflation was low and easy money prevailed in the market, it was straightforward for eurozone governments to spend money in response to the pandemic and to combat climate change. Government deficits widened, but fast growth and low interest rates meant that the ratio of sovereign debt to GDP remained manageable. That allowed eurozone finance ministers to paper over their national and structural differences on sovereign debt and competitiveness.
But pandemic-induced supply constraints, higher than expected demand in the aftermath of Europe’s recovery from COVID-19, and rising energy prices forced the ECB to follow the U.S. Federal Reserve and wind down its bond-buying programs in March 2022. In July 2022, the ECB started raising interest rates. That created friction between the eurozone’s northern and southern members. Countries such as Greece and Italy hold much more sovereign debt as a percentage of their national incomes than Germany and the Netherlands. As in the euro crisis of 2010–12, rising interest rates risked prompting investors to once again ask for much higher risk premiums for holding southern European debt, increasing the differences between sovereign bond yields. Such a dynamic could call into question the sustainability of Italian debt and risk a messy sovereign default.
The north-south divide appeared poised to grow in September 2022, when Italy elected Giorgia Meloni, the leader of the far-right party Fratelli d’Italia (Brothers of Italy), as prime minister. Meloni formed an outspoken right-wing coalition with Matteo Salvini’s far-right Lega Party and former Prime Minister Silvio Berlusconi’s center-right Forza Italia. The risk of Meloni’s Euroskeptic government colliding with the EU initially frightened financial markets. Those fears, however, were put to rest when Meloni committed to a fiscally austere budget in close coordination with Brussels.
To its credit, the ECB anticipated a return of higher risk premiums for southern member states in 2022 and launched a “transmission protection instrument,” a new bond-buying program meant to prevent a disparity in borrowing costs among eurozone governments. The details of the TPI were kept deliberately vague, and thus far investors have refrained from testing it. According to the Financial Times, a majority of economists now expect that the ECB may never even need to use the instrument. By unveiling TPI, Christine Lagarde, the president of the ECB, promised not to allow another sovereign debt crisis, which reassured financial markets, just as Draghi’s pledge to do “whatever it takes” similarly worked in 2012.
OUT IN THE COLD
In addition to its skillful handling of the inflation crisis, the EU finally started to rein in Europe’s budding autocrats—Orban of Hungary and Poland’s de facto leader Jaroslaw Kaczynski. Orban was reelected to a fourth consecutive term as prime minister in the spring but found his close alliance with Kaczynski strained by disagreements over how to deal with Putin. Poland—together with Estonia, Latvia, and Lithuania—led the charge for tougher sanctions on Russia. Orban found himself torn between wanting cheap Russian gas and close ties with Putin on the one hand and the need for EU funds on the other. As long as Orban and Kaczynski were on the same side, it was difficult for Brussels to discipline them on issues such as the rule of law and democracy. But Putin’s war in Ukraine has driven a wedge between Hungary and Poland, leaving Orban cornered.
Hungary and Poland are not members of the eurozone, and the ECB has no jurisdiction over their economies. Without the protection of a single currency, high inflation has hit their currencies—the Hungarian forint and the Polish zloty—particularly hard, leading their respective central banks to raise rates much more aggressively than the ECB. This has resulted in considerably higher sovereign bond yields, making it harder for both countries to finance their future deficits and rendering them reliant on the Next Generation EU funds. But the money comes with conditions: in particular, recipients must respect the rule of law and democracy. The EU has appropriately frozen some of the money allocated for Hungary. In response, Orban has vowed to address corruption allegations and reform the judiciary. Many observers remain rightly skeptical. Orban may not deliver on those promises, but he is undoubtedly starting 2023 in a much weaker position than he started 2022.
Notably, the United Kingdom is also beginning 2023 on the back foot, and that is due in no small part to its decision to leave the EU. When it came to recovering from the effects of the pandemic, the British economy lagged far behind the economies of its continental peers. Brexit has also stoked a major crisis of unity in the country. Because the British pulled out of the EU single market against the wishes of a large majority of Scots, Brexit has reawakened enthusiasm for Scottish independence. Furthermore, by creating a new customs border in the Irish Sea between Northern Ireland and the rest of the United Kingdom, Brexit has rekindled Irish Republican dreams of reunification. In the meantime, both Moldova and Ukraine are knocking on Brussels’s door, as both countries still see EU membership as a beacon of freedom and democracy. Brexit has hurt the United Kingdom much more than the EU—and that will leave a lasting impression on EU member states, aiding the union’s cohesiveness.
IN A BETTER PLACE
To be sure, this does not mean 2023 will be an easy year for the continent. Most EU officials were confident in the summer of 2022 that they could make it through the winter of 2022 as gas storages were full and alternative energy sources had been secured. But they are much less sanguine about the next two winters. Financial markets took Meloni’s budgetary restraint and conversion to EU orthodoxy at face value in 2022. But they may yet test her government’s mettle in 2023. Democratic backsliding continues to be a problem in a handful of member states. And there is no guarantee that the EU’s unity over defending Ukraine will hold, especially as Europeans will be asked to make more sacrifices over time.
But for now, the EU deserves high marks for its handling of the crises of 2022. Support for Ukraine—both at the elite and the popular level—remains remarkably resilient. The euro is stronger as a currency in political terms than it was before the COVID-19 pandemic. And the euro is once again strengthening compared with the dollar, underlining its attractiveness in financial markets. The EU’s aspiring autocrats are weaker because of their non-euro membership and growing dependence on EU financial largesse. And although the United Kingdom continues to tear itself apart over the consequences of leaving the EU, the remaining 27 member states have emerged stronger as a whole. When historians consider the recent past, they may well decide that 2022 was the year the EU got its mojo back.
