Luke
Hello, and welcome to Macro Bytes, the economics and politics podcast series from abrdn. My name is Luke Bartholomew, and I'm joined today by my co-host Paul Diggle to talk about the various different challenges facing Europe at the moment. And there is an awful lot going on between inflation, stalling economy, concerns about energy supplies, political crisis, monetary policy changes. So, there will be a lot to talk about. And we will try and draw some connections and some of the interactions between these themes as we go. But Paul, perhaps the best place to start is just with you laying out what the economic situation is looking like at the moment.
Paul
Well, the short story is that it's not looking particularly great in the European economy. Just looking at the economic data flow, survey data, so measures of consumer confidence are extremely weak at the moment. They're actually at all-time lows - lower than they were in the trough of the financial crisis and Covid. I think we know why they're so weak. It's because people are watching the news. They see headlines of war, high inflation, they experience high inflation constantly at the petrol pump, at the supermarket in very high touch areas. If you look at other sources of economic data, things like PMI surveys, which we monitor quite closely as economists, industrial production, retail sales, GDP, they're not quite as bad. They're not at all-time lows, but they've certainly been worsening recently as well. So, we've had PMI prints below 50, which means they're actually consistent with a contraction in the European economy. So, I would say the macro outlook is pretty poor at the moment, the data flow is weak. And recession is a very real possibility in the European economy.
Luke
So that's a pretty poor picture right now. But I guess the big concern for Europe is, what things are going to look like in a few months when winter rolls around. And there are big concerns about what the state of the energy outlook is going to be - given talk of Russia using energy supply to Europe as a political tool, perhaps even going so far as cutting off entirely its exports of gas to Europe, which obviously have huge consequences for the European economy in terms of the need for energy rationing hurting businesses and households. So, Paul, can you talk us through what some of those impacts would be in more detail and how big a risk that kind of scenario is?
Paul
Yeah, I think the first thing to say is the immediate risk of the Nord Stream 1 pipeline. This gas pipeline from Russia into Germany, which carries an awful lot of Europe's natural gas, which had been closed for about a week or so of scheduled routine annual maintenance. The immediate risk was that actually that wouldn't get turned back on and you would be immediately into the gas shortages, gas rationing scenario. And that didn't happen. The pipeline has just been turned back on. There was an important turbine piece that was being repaired, which was shipped from Canada actually, which was held up in international sanctions against Russia, which in the end was able to make its way back onto the pipeline, and allow gas to flow again. So that immediate risk has been cleared. But as you say Luke there are some big hurdles ahead. There are probably three alternative realistic scenarios. There's a best case, which is that with Nord Stream 1 turned back on, flowing at about 40% of pre-Ukraine invasion norms, that that situation basically continues. Europe has a certain amount of shortage and it has certainly weighed on the economy somewhat. But we continue at about these levels of supply. And Europe is able to slowly build up its gas reserves into the winter, follow through on its plan of transitioning away from gas and fossil fuels more generally, towards more renewables, more nuclear. That's not helpful. But it's not kind of instant recession. That's the best case, then there's kind of a worst case, which is actually there is a full shut off of Russian gas at some point. Perhaps because with the expansion of Russia's military aims in Ukraine, there's a revival or a deepening of the economic conflict with Europe and you get a shut off. And there's various modelling out there, which tries to think about what this would do to the economy. It's about 1% to 4% of GDP. I mean, that's a very big range, given the uncertainties. It's particularly bad for Germany, Italy, Austria, Slovakia. These are all countries with quite high Russian gas dependencies. It's particularly bad for industries, which are very gas intensive, certain areas of manufacturing, cement, glass production, but it's bad for the economy as a whole. And it would basically mean, I think, instant recession. And then there's a middle scenario in which it's some kind of mixture of the two intermittent on and offs. Which I think you would also want to think of as being a drag on the economy.
Luke
Now we can get to Italy in a moment, which you talked of as being one of the worst hit economies but another economy, country, that you mentioned, being particularly exposed is Germany. And I guess that constitutes a bit of a change in the way that we tended to think about Germany in the post financial crisis period, that it's this powerhouse economy in Europe, it's the one that drives growth in economies all over the continent. So, I guess I'm wondering, as we talked a little bit with Helen Thompson in a previous episode, how Germany got itself in that position. But what does Europe look like when Germany is struggling as an economy?
Paul
Well, it's an interesting reversal, as you say, of the normal situation, or at least the one we had over the past decade or so. And it will actually require European solidarity that was helping or pointing at Germany, you can imagine, say the redirecting gas supplies around Europe into Germany to support a manufacturing sector that had to face rationing in this worst plausible, worst case scenario of a shut off. So, it's solidarity that needs to help Germany. And while that is not the situation we were used to over the past decade, remember, if you go back to the 90s or the early 2000s, Germany was the sick man of Europe, after reunification with a quite a rigid labour market, but float before the Hartz reforms. So, it would almost be harking back to that situation of a much weaker German economy, but it's the largest economy in Europe in the eurozone. A German economy in recession is almost certainly a European- wide economy in recession. So, it's not like this would be some kind of idiosyncratic contained shock. When it happens in your biggest economy. It happens everywhere else as well.
Luke
So, turning then to Italy, and one of our recurring themes on this podcast is the important interaction between politics and economics. And we've talked about the likely impact of high inflation and poor economic growth in hitting the political system and putting various political systems under pressure and Italy seems to be one of the first places that that story is playing out. So, Paul, can you talk us through what's been going on in Italy recently and the state of the government there.
Paul
Yeah, let me try. It's a complicated situation so, Draghi, the former ECB President, had been the prime minister for the past year and a half or so. And he led a quite a broad coalition of parties. And he is the unelected or was the unelected technocratic Prime Minister, which Italy has a tradition of in moments of crisis, but supported by a large spectrum of the parties within the parliament. So that's how he derived his political legitimacy. And then coming into a crucial piece of budgetary legislation, which was passing a package of fiscal measures, which were meant to partly tackle the cost of living crisis, one of the coalition partners, the Five Star Movement, actually withdrew its support from the coalition and from the budget measure, because it saw it actually as insufficiently supportive. So, it was exactly as you say, Luke, the politics of inflation playing out, calls for more fiscal support played into one of the parties in the coalition then withdrawing from it. And because budgetary measures occur under the confidence rule, they're kind of, they're simultaneously confidence votes in the government. That was a vote of no confidence in a way. Now, in the end, actually Draghi was able to pass the legislation and the bill because his coalition was so broad, that withdrawal of one party didn't affect his ability to pass the bill. But I think he personally saw the removal of support from one party as an existential risk to his prime ministership. Because he's unelected, because he's technocratic, I think he wanted a very broad base of support. And then, so he tendered his resignation to the President – Mattarella. Mattarella actually rejected the resignation initially and said, go back and stitch back together the coalition. Draghi tried to do that, but in the process, actually, it frayed further and other coalition partners also increased their demands. And Draghi then resigned a second time, and this time Mattarella had no choice but to accept it because by that point, actually, a lot of the parties of the coalition were splintering off. And Italy is now heading to snap elections in September this year.
Luke
And what should we expect from those elections Paul given what polling looks like at the moment?
Paul
Yeah, so the polling reveals no single obvious coalition that is guaranteed to win those elections, but the most likely coalition that could emerge in the lead looks like a right-wing coalition, made up of three parties Fratelli d'Italia (brothers of Italy), Liga, and Forza Italia - Berlusconi's party. And two of those actually, Liga and Forza were partners in the Draghi coalition as well. They've actually lost support in the polls somewhat. So Fratelli d'Italia is likely to be the senior party in that coalition. So, it's a coalition of the right, and parties that had a Eurosceptic past, which they will have perhaps played down a little bit more recently.
Luke
So, given that Eurosceptic past that's been played down recently, I mean, how much should we think that the leopard has changed their spots there? Or was that a matter of political positioning to be part of the Draghi government? And the reason I ask is that previously, one of the things that markets have been worried about is this idea of Italy leaving the eurozone Italy exit or an ad-EU as I quite like to call it or other names it goes by, And that concern has diminished I think it's fair to say a little bit over the last few years. But you know, should that be something that markets start worrying about, again, given the likely composition of the government?
Paul
Yeah, ‘Italexit’ was definitely the traditional worry that investors have when they see the rise of populists in Italy. That EU exit has actually really dampened down in the Italian political debate post, the Recovery Fund, the big pan-EU fiscal package that was done during the pandemic, of which Italy was the biggest beneficiary. So, those parties more broadly have kind of moderated their
Euroscepticism, just as they have in France and with Le Pen’s, because that just turned out to be a bit less of a vote winner and they pivoted to focus on cost of living questions. And that became the dominant part of the political narrative instead. So, I don't think a Liga /Fratelli Italia /Forza government imposes immediate EU, eurozone existential risks in the way it might have done in earlier periods, post the financial crisis and the European sovereign debt crisis. But it certainly poses risks that need to be taken account of by financial markets. In particular, those parties adherence to EU fiscal rules, to fiscal sustainability and to the reform agenda, which would continue to unlock Recovery Fund monies would definitely be in question if they have agendas that look quite fiscally profligate. And that would start to run counter to what the Recovery Fund is asking of countries in return for money. So, I think that's where the risk would probably lie. One could also imagine further down the road into a European recession, or a period of macro weakness, that questions of EU or eurozone membership could in time resurface - especially given that, as I said, Eurosceptic is a kind of tradition within those parties - even if it's not front and centre right now. But more broadly, the risk distribution, the panoply of potential outcomes, has certainly shifted a bit more negative at the margin, relative to when there was this known technocrat in the prime minister's office - Draghi.
Luke
So, one of the ways in which that increased risk manifests itself in markets is an increase in the borrowing cost of Italian government debt over other eurozone countries. And that's a dynamic we've been seeing a lot of recently. And into that fray, has recently stepped the European Central Bank, just announcing a new tool, which it thinks will try and help cap some of that increase in Italian and other government borrowing costs. So, Paul, do you want to talk a little bit about what that tool involves? And is it the kind of thing that we should think takes away some of that risk that you were just describing?
Paul
Yeah, so the ECB announced this anti fragmentation tool that they called the Transmission Protection Instrument, the TPI, (by the way, yet another three-letter abbreviation of the ECB that we're going to have to remember and use). And what that tool basically does is that it allows the ECB to make potentially unlimited purchases of sovereign debt of a country where, it sees an unwarranted volatile situation in that country's sovereign debt market. So, one could imagine a very big widening of the cost of Italian over German sovereign debt, and the funding cost, which the ECB saw as impairing the transmission mechanism of its monetary policy into the whole eurozone. And it would use this tool to push back against it. By the way, it's not QE, because these purchases are intended to be sterilised. So, at the same time as buying one country's sovereign debt, it might be selling another's or in some other way, draining liquidity out of the financial system. So, it's not actually monetary policy loosening as such. It's not QE. But it is a way I think, to get the right constellation of financial conditions that the ECB wants to see during its tightening cycle. Now, is it the sort of thing that can help tackle the increased borrowing costs in Italy that have occurred around this political crisis and the resignation of Draghi? I'm not sure it's perfectly designed for that. And nor am I sure if the ECB would actually want to use it in a situation like that. Remember, the language of the tool is that it is used to tackle ‘unwarranted’ widenings in the cost of debt of eurozone members. It's not clear if a volatile political situation, the resignation of a prime minister, and the likelihood of a more populist government that would spend more and adhere slightly less to Europe’s fiscal rules is actually ‘unwarranted’ as such, and the sort of thing that that the ECB would step in and push back against. The other thing to say is that there's reasonably strict conditionality attached to the tool as well. So, the ECB wants to make sure that countries are fully compliant with Europe's fiscal framework in order to be eligible for the Transmission Protection Instrument. Markets seemed to initially say that that conditionality was too strong, and a country like Italy might fail to adhere to that conditionality. What I would say in response to that is that, in the end, it's actually the ECB’s decision, whether they're going to use the Transmission Protection Instrument with a particular country or not. They're not going to be completely bound by these conditionality rules.
Luke
So, the other big decision that the ECB has just made is to increase its policy rate by half a percentage point, the first interest rate increase since 2011, indeed, an interest rate increase, which I think history probably hasn't judged, especially kindly. So, given what we've discussed in terms of the inflation outlook, the economic outlook for Europe, what do you think the likely path of interest rates is from here from the European Central Bank now that this era of negative interest rates has ended, at least for now? And how likely is it that the European Central Bank is walking into another policy mistake, like it was in 2011.
Paul
The 50 basis point hike that the ECB has now done, took the policy rate only back to zero, but they did, I think, suggest that further hikes were coming. So, although the ECB, in its monetary policy statement pulled back from forward guidance and sort of explicitly saying ‘we'll hike this amount on this date’. The overall tone and tenor of the meeting was that more interest rate hikes are coming, precisely as you say Luke to tackle this high inflation situation, high gas prices, a reasonably tight labour market and emerging wage pressures as well. And importantly, there's an interaction here between the Transmission Protection Instrument and the path of interest rate hikes, because the more the Transmission Protection Instrument is used, the stronger it is, the more of a backstop it is for funding costs in more vulnerable peripheral eurozone economies, the more the ECB can actually do to hike the risk free rate, because in the process of hiking that risk free rate, it will be somewhat less worried about causing a huge kind of volatile period in peripheral sovereign debt markets as well. So these interact, and actually, the TPI allows interest rates to go higher. So I actually think that there's more 50 basis point hikes to come from the ECB. Perhaps they could do another one in September, and then perhaps another in October as well. But, crucially, the activity outlook, the economic activity outlook, is worsening as we've said, at the start of the podcast, and recession is probably coming in in the eurozone, partly because interest rates are going to go higher and funding costs are going up. But also, because of this panoply of other headwinds that the economy is facing. So, I think eventually, that rate hiking cycle will probably be brought to an end, it'll be truncated early by a weakening in the economy. And I'm not sure that history will then go back and judge it in the way that it judges the 2011 Trichet rate hike as having been a policy error and mistake. I mean, Trichet then was perhaps, kind of jumping at ghosts of inflation worries. Whereas this time around, it is very clear that inflation is well beyond and above the target. So, some tightening to bring inflation under control, I think is quite straightforwardly justified. It's just this time around it’s negative supply side shocks, which mean inflation higher but are also pretty bad for economic activity. That's the invidious position that the ECB finds itself in, and why we think that this rate hiking cycle probably gets shortened. And you could actually be back in a situation of rate cuts in a full-blown recession further down the road.
Luke
An invidious position indeed Paul. And I guess what this conversation has brought out is how that complex interaction between politics and economics is combining at the moment to create a particularly difficult situation for policymakers. And of course, we bill ourselves as a politics and economics podcast so of course, this is grist to our mill. And it's no doubt a theme that we will be returning to in September when we come back from our summer break. So, thank you very much for listening to the podcast. Please do subscribe, like us on your podcast platform of choice and we look forward to speaking to you again in September when we return. So, thanks very much.
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