Even before Omicron threw a wrench into European governments’ plans for a gradual return to normalcy, 2022 was going to be a challenge for the old continent. The most urgent question concerned the extraordinary monetary and fiscal measures deployed by the public authorities to combat the socio-economic impact of the pandemic. Any decision to maintain, eliminate or change the policy mix had to be taken in the context of a continent that is still trying to fully recover. Omicron could make things darker.
For policymakers, it will be crucial to understand whether the impact of the new variant on the economy will increase or decrease inflationary pressures. The OECD warns that disruptions in the global supply chain could become more entrenched because of Omicron. The variant could delay the recovery, fueling concerns that even some of Europe’s largest economies may well enter a phase of stagflation.
The inflation bug
The European Commission has adjusted its inflation forecast for 2022 upwards from less than 2% to 2.2%. These are not yet levels that would make the ECB lose sleep. However, the fact that some countries, like Germany, experience much higher inflation, complicates the picture. The presence of higher inflation in some countries simply makes the central bank’s efforts to communicate its intentions less obvious.
This is also caused by another concern. By the end of 2022, EU member states will have to decide what to do with the Stability and Growth Pact, the fiscal rules framework that has been suspended due to COVID until 2023.
Budget support, both from the EU through its Stimulus Fund, as well as from national governments, has been essential to avoid more serious consequences for European economies. In the euro zone alone, the public deficit / GDP ratio fell from -0.5% in 2019 to -6.9% in 2020.
In Italy, the budget deficit in 2021 is still expected to be around 10%. In 2022, the government of Rome expects a deficit of 5.6%. However, these projections depend on growth that remains strong. Even so, Italy’s GDP is only expected to reach pre-COVID levels in the second quarter of 2022. More importantly, the debt-to-GDP ratio is only expected to reach its already very high pre-COVID levels by now. 2030.
Is the Stability and Growth Pact Dead?
It is clear that any mechanical return to strict application of the rules of the Stability and Growth Pact would quickly come up against the realities on the ground, not just in Italy. This is why many Member States and a large part of the European Commission regard the pact as dead. If so, the EU has a year to decide what to do about it. Shortly, although the European Commission, as many expect, were to make a proposal on how to change the rules in the first quarter of 2022.
The development of the debate will also have consequences for monetary policy. First, because the ECB has absorbed much of the debt issued by national governments in the euro area to finance the response to COVID. Part of this debt will have to be refinanced in the not too distant future, despite efforts to issue securities with longer maturities.
Any tightening of financing conditions would increase debt service costs. It is important to note that it would be much more difficult to sustain the recovery if both fiscal and monetary support were drastically reduced and especially if it happened in a synchronized fashion. Something will have to give.
Despite recent progress on the economic front, for Europe in 2022, the risks still seem to be on the downside. Managing the recovery to make it sustained and sustainable will prove difficult under any circumstances, regardless of Omicron.
The new German government
This is where politics plays a crucial role. How the new German government positions itself will be decisive in determining how ambitious any possible changes to the pact might be. In its coalition contract, the Social Democrats, Greens and Free Democrats decided not to touch the brake on the national debt. It will be reintroduced as initially planned in 2023. At the same time, they are trying to give themselves room for maneuver for the public financing needs resulting from green and digital transitions with off-balance sheet spending, for example, via the State. owned development bank, KfW.
At the same time, all three parties insist that the EU stimulus fund should continue to be seen as a one-off measure, not the start of a permanent EU tax facility. Despite a few nuances, there isn’t much in this yet to suggest an immediate break with the cautious European fiscal policies of the government of former Chancellor Angela Merkel.
The result of an overly cautious approach could be bad news for the ECB, as the central bank should make up for governments’ lack of ambition. The French and Italian governments will no doubt try to convince Berlin to be more courageous.
However, French President Emmanuel Macron has only two or three months next year to make progress on the European front before his re-election campaign kicks off in full and diverts him from his other duties.
France also holds the rotating presidency of the European Council in the first half of 2022. Usually, this role is interpreted as that of an honest intermediary, which somewhat constrains the country’s room for maneuver. More importantly, it is unclear whether President Macron will be re-elected in the spring.
What happens next for Prime Minister Draghi?
Italy has different constraints. Since Mario Draghi became Prime Minister, the government in Rome has aligned itself closely with Paris, especially on tax issues. The two countries even signed a bilateral friendship pact that echoes the most famous Franco-German Elysee treaty of 1963. Prime Minister Draghi could try to push where President Macron needs to show more restraint, at least in the first half of next year.
However, it is not known whether Prime Minister Draghi’s government still has a lot of gasoline in the tank. Sustaining the positive results of 2021 will be more difficult in 2022, as it will become clear whether Italy’s growth will continue and Prime Minister Draghi’s continued efforts to reform the country will still receive the necessary support from the political parties which currently form the majority. . Prime Minister Draghi may choose or soon be forced to accept a less operational role, that of President of Italy. This would make him a guarantor rather than a maker of policies. However, it would also mark the end of the truce and the start of an open political war between the parties that have supported Prime Minister Draghi so far.
All this to say that despite recent economic progress, for Europe in 2022, the risks still seem to be on the downside. Managing the recovery to make it sustained and sustainable will prove difficult under any circumstances, regardless of Omicron.