There’s more to the EU than the common cold. She is so sick that she is afraid with every trembling step. This could choke the economy and push the Union into recession. Especially in the case of Italy.
On Thursday, the European Central Bank (ECB) raised interest rates for the first time in eleven years. This is significantly slower than the US or Switzerland. The reason: Many EU member states are in massive debt. This severely limits the ECB’s room for manoeuvre. Because high interest rates can bring indebted countries to the brink of national bankruptcy. It is now becoming more expensive for them to take out new loans. Those who are already heavily indebted have to pay additional risk premiums for new loans.
Italy poses a threat to the entire Eurozone
Greece still leads the euro countries with a debt ratio of over 202 percent. Italy also leads the way with a debt of over 154 percent. The situation there has worsened due to the government crisis. If the government in Rome were to borrow new money from the market, it would be more expensive due to risk premiums than if the government in Berlin were to do so with less national debt.
So the ECB was forced to create a “Transmission Protection Instrument” or TPI for short, while simultaneously raising rates. He wants to use this tool to keep interest rates on government bonds as uniform as possible within the euro zone.
“If Italy can no longer pay its national debt, the EU has a problem. An Italian government bankruptcy will tear the eurozone apart,” says Reto Folmi (46), professor of economics at the University of St. Gallen. “The EU cannot take on the debt of the third largest economy among its members.”
Interest rates will rise significantly
A new interest rate of 0.5 percent hasn’t pushed Italy into the abyss yet. But the ECB has already announced further rate hikes. Because in the fight against inflation, the first step is unlikely to be enough. Countries such as Germany, Italy and Spain were already between 8.2 and 10 percent at the end of June. In the Baltic states of Latvia, Lithuania and Estonia it is even between 19.2 and 22 percent. By comparison: Inflation in Switzerland is 3.4 percent.
The question is how much the ECB will tighten interest rates. “It’s hard to predict,” Folmi says. “However, as long as interest rates remain below core inflation, the EU will not bring inflation under control.” Core inflation currently stands at 3.7 percent. It accounts for highly volatile materials such as energy or food.
Instead, the ECB would need to raise the key interest rate by several percentage points from the current 0.5 percent to bring inflation under control. Such a high interest rate would severely affect indebted states, after all they would have to pay more for their loans in the market.
Italy needs reforms
“If interest rates for Italy rise to 5 percent, the country would have to spend 7.5 percent of GDP on its current debt alone to pay interest,” says the economics professor. If interest rates eat up 10 percent of GDP, this is no longer manageable.
Urgent structural reforms are needed in debt-ridden states. The growth of the Italian economy has stagnated for decades. “Wages are practically at the same level as they were 20 years ago, so the tax force is not growing,” says Falmi.
He mentions two starting points: Italy needs to make its labor laws more flexible and its education system more practical so that workers can more easily access the labor market. However, TPI’s weak point can take its revenge here. If the ECB adjusts interest rates in highly indebted countries, the pressure for necessary reforms eases.
The end of the war may still prevent a recession
Along with corresponding interest rate hikes, the EU is threatened by recession, which will further hamper particularly vulnerable member states. “It is impossible to say at the moment whether there will actually be a recession and how long it will last,” Falmi insists.
An early end to the Ukraine war could prevent a eurozone recession or another debt crisis. Energy prices should return to normal and inflation should drop significantly. But Föllmi says: “Unfortunately, this scenario is currently not possible.”
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