The euro has lost a good 15 percent of its purchasing power since January 2021. By New Year’s Eve 2023, the loss is likely to increase to more than a fifth of its value. According to the Bundesbank, Germans are expecting inflation of five percent in each of the next five years. Many worry about the future of the common currency. Right? In any case, the euro almost plummeted against the US dollar in 2022 – the exchange rate reached its low point in September, a dollar cost 1.04 euros. The international press was already speculating about the “collapse” of the euro.
Since then, the common currency has been able to recoup some of the losses, and the dollar currently costs “only” around 92 cents. However, that is still a good ten cents more than two years ago. The relative strengthening of the euro is probably due not least to the interest rate hikes by the European Central Bank (ECB). Before the ECB belatedly initiated the turnaround on interest rates, the growing interest rate differential compared to the USA was a driving factor for the depreciation of the euro. In the meantime, the central bank has narrowed the interest rate differential – and ECB President Christine Lagarde is signaling further significant interest rate hikes.
In addition, the inflation expectations of the financial markets are significantly more optimistic than those of private individuals. So is it time to sound the all clear? Can one promise the citizens that the stability of the euro is secured for the future because the external value of the common currency has recovered and the ECB will continue to raise interest rates?
The political pressure on the ECB is growing
Unfortunately no: On the one hand, the dollar, like many other currencies, has lost a massive amount of purchasing power, so a stable exchange rate would only mean a comparable drop in purchasing power for the euro. On the other hand, it is not enough that the ECB wants to fulfill its mandate to ensure price stability. In order to achieve this goal, fiscal policy would have to ensure that public finances remain sustainable in the long term even if interest rates are significantly higher. Here, however, definite doubts are appropriate.
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In the euro zone, unlike in the US, for example, fiscal policy is primarily made at the level of the sovereign member states. Each of the 20 governments must ensure that future government debt can be financed through higher tax revenues or lower spending growth. This is primarily guaranteed by the Maastricht criteria, according to which total government debt may generally not exceed 60 percent and annual new debt may not exceed three percent of gross domestic product.
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Indeed, if euro area countries worked towards meeting these limits, the ECB would be free to do whatever it takes to bring inflation down to 2 percent a year. But that is not the case. As early as last autumn, French President Emmanuel Macron and Italy’s Prime Minister Giorgia Meloni opposed excessive interest rate hikes by the ECB. While the political pressure on the ECB is growing, the Maastricht criteria have been suspended since 2020 due to the crisis.
The reform of the fiscal rules
The fiscal rules are to be fundamentally reformed by 2024. This makes sense, if only because the previous rules have not prevented excessive deficits and rising debt ratios, which is mainly due to the considerable discretionary powers of the European Commission. Instead of strictly sanctioning violations of the rules, it has interpreted the rules very broadly in favor of the states. Above all, a reform would have to ensure better compliance with the rules and a more effective limitation of public debt.
In fact, the opposite threatens. Leading politicians like Macron are pushing for a further relaxation of the Maastricht criteria to give them more leeway for their spending policies. The European Commission presented a proposal in November, and the international community must now find a consensus as soon as possible. The proposal provides for country-specific fiscal and structural plans to be negotiated with the Commission as the cornerstone of the new set of rules. It wants to give the member states more leeway for their fiscal adjustment path and promises to limit deviations from it more strictly.
>> Read here: ECB Director Fabio Panetta against committing to rate hikes beyond February
In the light of past experience, it is foreseeable that the new negotiation approach will have even less success in putting heavily indebted member states on an austerity course. That is why the federal government urgently needs to intervene in a robust manner in the negotiations. The aim is to ensure the stability of the euro and the currency union, without making large transfers at the expense of the low-indebted countries. This requires a stronger binding effect of simpler and more transparent rules – with less rather than more influence from the European Commission.
The author: Volker Wieland is Managing Director of the Institute for Monetary and Financial Stability at the Goethe University in Frankfurt.
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