It is Germany’s turn to host the annual summit of G7 leaders this year and while the war in Ukraine will be top of the agenda at the gathering in Bavaria the economic damage caused by Russia’s invasion will come a close second.
Nobody saw what was coming when the G7 last met in Cornwall a year ago. Back then the talk was of global post-pandemic recovery; now the fear is of imminent recession as central banks turn hawkish and Vladimir Putin plays the energy card.
The Kremlin has cut supplies of gas through the NordStream pipeline by 60% in the past two weeks and alarm bells are ringing in Berlin as the downside of being so dependent on Russian energy becomes apparent. Olaf Scholz, Germany’s new chancellor, is in the unfortunate position of having to clear up a mess caused by his predecessor, Angela Merkel, a politician whose reputation will certainly not improve with time.
Last week, the German government triggered the second stage of an emergency gas plan. There is no rationing as yet but such a step is possible, as is the re-opening of coal-fired power stations. One of Germany’s goals for the G7 is “strong alliances for a sustainable planet”, which sits oddly with German energy companies being told to get ready to burn more coal this winter.
As far as the G7 is concerned, the wheel has turned full circle. The first meeting of the group (which then included only six countries) was held in France in 1975 as the big western economies struggled to find a response to the oil shock that had put an end to the long post second world war boom. Now all of them once again face the prospect of recession.
The US Federal Reserve raised interest rates by 0.75 points earlier this month and has signalled further such increases are on the way. Its chairman, Jerome Powell, said recession was a possibility when he gave testimony to Congress last week. That’s some admission. The outlook has to be pretty grim before a central banker uses the R word, but Powell made it clear when faced with the choice between recession and embedded inflation he would choose the former.
The Bank of England is also tightening policy. Compared with the Fed, Threadneedle Street’s monetary policy committee is moving in baby steps, so far raising interest rates in 0.25 percentage point increments. It is doing so against the backdrop of an economy which, despite the continued strength of the labour market, appears to be slowing rapidly. The Bank is trying to engineer a soft landing for the economy in which inflation – currently 9.1% – falls back towards its 2% government target without triggering a recession. Good luck with that.
The European Central Bank has not yet joined other western central banks in raising rates, although it has signalled higher borrowing costs are coming next month. Its cautious approach is unsurprising because the stakes for the eurozone are especially high. If the Federal Reserve or the Bank of England make a hash of responding to the highest inflation in 40 years the consequence will be needless economic pain. If the ECB gets it wrong, the future of the single currency will once again be put in doubt.
Europe is vulnerable to a prolonged war in Ukraine. It was growing less strongly than the US before the invasion, in part because the fiscal package – tax cuts and spending increases – in America was greater. Unemployment is higher, and unlike the US the EU is not self-sufficient in energy. Europe is closer to the fighting and has suffered more of a supply shock as a result of the conflict.
That’s one reason for the ECB to be careful. Another is the impact tougher monetary policy – higher interest rates and a reversal of the money creation programme known as quantitative easing – will have on the eurozone’s weaker members.
Monetary union is an unfinished project. Member states share the same currency but run their own tax and spending policies (subject to certain common rules), and issue their own bonds when they borrow from the financial markets. The interest rate – or yield – on Italian bonds is higher than that on German bonds because investors see Italy as riskier than Germany.
Since the ECB signalled it would join other central banks in raising interest rates the gap (or spread) has widened between German bond yields and those of Italy, Spain, Portugal and Greece. Investors are worried about how these countries will cope with higher borrowing costs and slower growth.
A decade ago Italian and Spanish bond yields reached levels that called into question whether the eurozone would splinter into a hard core based around Germany and a softer outer ring. On that occasion, the then head of the ECB, Mario Draghi, pledged he would do “whatever it takes” to safeguard the single currency. It did the trick.
Now Christine Lagarde, Draghi’s successor, faces the same fragmentation problem. At 8.1%, the eurozone’s inflation rate is much too high for the ECB’s comfort. The question is how to raise borrowing costs without causing such damage to the weaker members of the eurozone that their bond yields rocket.
The ECB has pledged to come up with an anti-fragmentation device under which the central bank would ensure bond yields in heavily indebted countries, such as Italy, don’t rise excessively. This, though, is not going to be easy. Scholz will have trouble selling a bond-buying scheme to a sceptical German public, especially since it could lead to losses as interest rates rise. Time is not on Lagarde’s side and if she gets it wrong the next unwelcome shock to the global economy will be a eurozone crisis.