The Eurozone’s moment of truth

European Central Bank President Christine Lagarde is drawing inspiration from the French poet Paul Valéry. “The trouble with our times is that the future is not what it used to be,” she said at the annual conference in Frankfurt for the ECB and its watchers.

The “exceptionally high” uncertainty unleashed by US President Donald Trump would prevent the central bank achieving its 2 per cent inflation mandate in the short term, she said. But it would set monetary policy to ensure inflation was “always converging back towards 2 per cent over the medium term”. Agility and clarity were her watchwords.

What she and others did last Wednesday, however, was a Swot analysis of Eurozone economic management, identifying strengths, weakness, opportunities and threats.

Most agreed on the Eurozone’s strengths. It is a large economy with sensible economic management and broadly succeeded in returning inflation to target after the 2021-22 shocks. Unlike the US Federal Reserve, the ECB faces no threats to its independence and does not have to deal with what Professor Klaus Adam of University College London described as “lunatic” domestic policy ideas, such as creating a strategic reserve of cryptocurrencies when the dollar is already a reserve currency.

The Eurozone’s weaknesses are also well known. There is still a tendency to think of the bloc as a loose amalgamation of 20 individual economies with their own structural economic deficiencies undermining growth and prosperity. There is also an open question as to what extent the ECB failed to address the inflation issue promptly in 2021-22. ECB chief economist Philip Lane was pessimistic that the dismal science would be able to answer this question in 100 years.

This left the opportunities and threats to be the main focus of attention both in the main hall and in the corridors of the conference. Three dominated discussions.

Trade barriers

With 25 per cent steel and aluminium tariffs having been imposed by the US on the day of the conference, no one thought the EU would escape further trade restrictions coming from the Trump administration. April 2 is the next date to watch, when the US promises to impose “reciprocal” tariffs. If truly reciprocal, these would include a reduction in US tariffs on SUVs from the EU from 25 per cent to 10 per cent. No, I am not holding my breath.

In the US, the tariff announcements have spooked households, as shown in the latest inflation expectations published by the University of Michigan last Friday. There is not much comfort yet to be had from the New York Fed’s less timely data and this will worry Federal Reserve officials when they meet this week.

Compared with the US, where tariffs will create at least a one-off rise in US prices, the European picture is more ambiguous. Inflationary effects will stem from EU retaliation and the supply shock of trade fragmentation. Disinflationary pressures will be fostered by lower US demand for EU exports, a large rise in uncertainty and lower Chinese import prices if it redirects goods to Europe.

François Villeroy de Galhau, governor of the Banque de France, said the new world was one of uncertainty, unpredictability and irrationality. “We are aware [the] environment can change tweet by tweet from one day to the next.”

The implication for the ECB is unpleasant. Because it cannot act ahead of Trump’s latest wheeze, however agile the central bank is, it will be behind the curve.

European security and public spending

Germany’s Green party has now joined the Christian Democrats and Social Democrats in a bid to revolutionise the country’s fiscal straitjacket, with the nation’s Federal Constitutional Court rejecting initial attempts to block the move.

If successful, the country’s fiscal policy will shift from limiting public investment and defence spending through the debt brake to providing a huge boost, although the scale and timing of the additional spending is still uncertain.

The market reaction has been clear. As the chart shows, German government borrowing costs in nominal and real terms have jumped, with inflation expectations rising too, providing the ECB with a clear incentive to persuade financial markets it has a grip on inflation.

Once the money flows, the most important public policy question is how much additional security is bought per euro spent.

For the ECB, the questions are simpler. It needs to assess the inflationary consequences of additional public spending, which depend on the levels of slack in the economy, the speed of purchases and whether they are directed to foreign or domestic suppliers.

That is for the future. So far, the results have created a disinflationary problem for the ECB. It is now dealing with tighter financial conditions without any fiscal spending and companies cannot be expected to invest in production lines until they are sure government contracts will flow.

The upshot is that the monetary policy should wait until the new defence strategy emerges. This will also force the ECB behind the curve.

With the inflationary consequences again uncertain, Professor Refet Gürkaynak of Bilkent University said the ECB should examine what was the worst possible way Europe’s new security strategy could evolve. I wasn’t going to let him say that without specifying his view. So I asked him. His answer was good and depressingly plausible.

Fiscal policy in Europe turns into tariff policy in the US. There is continuous talking about it. ‘We’re going to do this; we’re going to do that; we are going to do it tomorrow; we decided not to do it today but the month after.’ Whatever. But nothing actually is being done, so that you get all of the uncertainty of fiscal policy and none of the defence benefits or the spending benefits.

The euro as the world’s reserve currency

Academics and policymakers alike said the best opportunity for Europe was the possibility that the euro could become the world’s most important international reserve currency.

While Wall Street fantasists imagine a Mar-a-Lago Accord, depreciating the dollar, funding the US government for nothing and other countries accepting some vague promises on security, the reality is that Europe is more interested in promoting itself as a safe haven, distantly removed from crazy Americans.

On hearing talk of the euro as a reserve currency, French central bank governor Villeroy de Galhau said the ECB needed to accelerate plans for its central bank digital currency at both retail and wholesale levels to make the offer more concrete. “I really believe that they are much more relevant after the executive order of January 23,” he said.

Before we got carried away heading to the airport singing “Ode to Joy”, the limits of European integration and harmony were on display at a later session of the conference. Professor Athanasios Orphanides, of MIT and a former Bank of Cyprus governor, highlighted the “crazy framework” of the ECB which undermines investor confidence that it stands as a backstop to Eurozone governments.

This results in France, Italy and Spain, for example, paying much higher premiums to cover default and liquidity risks than the US, Japan, the UK and Canada even though their fiscal positions are no worse. Orphanides’ chart below is compelling.

This chart should be sufficient to temper any enthusiasm you might have been feeling about the euro becoming the international reserve currency. Its case for Europe was not helped when Joachim Nagel, the Bundesbank president, shot Orphanides down, saying these were political questions and the ECB was not operating in a fiscal or political union.

This left me thinking that the US might well trash the dollar’s reserve currency status without the euro necessarily benefiting.

What I’ve been reading and watching

• The FT’s guide to Trump’s economic team is a must-read. Something useful to bookmark

• How inflation is changing Japan in many ways from vegetable boycotts to thrifty consumers

• As the Fed examines the US economy, it cannot have failed to notice the sour mood of US consumers. It is notable, however, that this is nearly all coming from Democrats

• As far as the UK is concerned, this week’s Bank of England Monetary Policy Committee meeting is likely to be significant. More important are the big issues facing the government, concisely laid out by Martin Wolf

A chart that matters

If there is one thing that Donald Trump has managed to achieve, it is to make people nervous. This might impede the long-term performance of the US economy, requiring higher interest rates.

Financial markets have taken the view over the past month, however, that it will just make households and companies spend less, raising the likelihood of Fed rate cuts to give them a nudge. The Fed’s summary of economic projections on Wednesday will allow us to see to what extent officials concur.