As recently as 2018, Italy, the EU’s third largest economy, threatened to leave the eurozone.
Unlike northern European economies, its GDP was still below pre-crisis levels, unemployment remained at staggeringly high levels and the success of Eurosceptic parties in the elections that year meant that an exit seemed like a possibility. realistic perspective. If that had happened, it would have dealt a severe blow to the cohesion of the euro zone and to the future of the “European project”.
The threat of renewed pressure for a “Grexit” and a “Quitaly” has reappeared with the turn in the ECB’s monetary policies.
The surge in inflation in Europe and the response it dictates to the ECB highlight and exacerbate the flaws in the European project.
While southern European economies and banks are in much better shape than they were in 2008 after major banking reforms across the eurozone, Greece and Italy remain heavily indebted and their economies that are relatively weak and therefore sensitive to a sudden spike in interest rates.
Italy’s debt-to-GDP ratio is trending towards 150%, Greece’s towards 200%, even as rates rise and economic growth slows in the euro zone. Stagflation – a recession in Europe even though inflation and therefore interest rates remain high – seems likely.
Yields on Italian and Greek government bonds in debt markets are already rising rapidly. Yields on Italian 10-year bonds were around 1.2% at the start of this year, but are now above 4%. Greek government bonds had yields of around 1.3 percent at the start of the year, but are now yielding 4.7 percent.
As these debts mature, they will need to be refinanced at much higher rates, in weaker economies and, once the ECB’s asset purchases are completed on July 1, without the support of purchases. of ECB bonds.
The intensification of pressure on the two weakest economies in southern Europe – Spain and Portugal are in much stronger forms than a decade ago – has resurfaced the threat to the euro area itself.
At this stage, this threat is not acute, but the resumption of the debate on the potential for “fragmentation” of the euro zone signals that the pressures are building.
The much-watched relationship between Greek and Italian bond yields and Germany’s is moving in the wrong direction.
At the start of the year, when German bonds were trading at negative yields, the spread between German and Italian 10-year bond yields was just under 1.4 percentage points and, for bonds Greeks, by 1.5 percentage points. This week, those spreads have exploded to over 2.4 percentage points and 2.9 percentage points respectively.
Although they are far from the five percentage points recorded during the worst of the eurozone debt crises (which Mario Draghi cooled with his “everything that’s necessary” promise mid-2012) they are the largest since the start of the pandemic and are growing rapidly.
Lagarde is aware of the threat even as she has pledged the ECB to end QE and raise eurozone interest rates at each of the next two meetings. She indicated that there will be a 25 basis point increase next month and potentially a larger increase in September.
She promised to tackle the “unwarranted” fragmentation of the euro zone and said the ECB would deploy its existing tools and new tools if necessary to avoid a serious divergence in financial conditions within the euro zone, although no one Seems at all sure what these “new tools” might be.
In past episodes, the strongest economies in Northern Europe have resisted efforts to mutualize the debts of Southern economies.
Structural vulnerabilities in the Eurozone – members share a common currency and a free trade and travel area but retain economic and political sovereignty – which were exposed during and after the financial crisis have not been resolved and therefore the divergent nature of their economies threatens the stability of the zone in times of stress.
Soaring inflation in Europe and the response it dictates from the ECB highlight and exacerbate these flaws in the European project. The ECB will probably manage, as before, but there may be difficult and tense moments before the threat of fragmentation dissipates.
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