The euro could break Europe yet

The single currency hinders member countries from tackling the spiral towards an inflationary crisis

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This week the European Central Bank (ECB) released its monthly estimate for inflation showing that, for the second month in a row, inflation in the eurozone is at or below the ECB’s target of 2pc.
This has been hailed as a victory by the central bank after a few gruelling years of inflation, the effects of which can still be felt across the Continent as a general cost of living crisis to this day.
The ECB can pride itself on the fact that it is faring better than the US Federal Reserve in this respect. In the United States, inflation remains slightly above target at anywhere between 2.4pc and 2.6pc over the past few months. Britain falls in line with the eurozone, with inflation at or below the target rate.
But the European authorities should not celebrate too soon. While inflation across the eurozone may have come down, it appears that inflation divergence within the bloc may have come back.
Unlike the United States and Britain, the eurozone is not one economy but rather 20 separate economies and if the inflation rates start to diverge between these economies, it can cause problems.
Looking at the October inflation data in detail we see some cause for concern. Belgium, Bulgaria and Croatia have very high rates of inflation: 4.5pc, 4.5pc and 3.6pc respectively. Meanwhile, Ireland, Lithuania and Slovenia appear to be tipping into deflation with rates of 0.1pc, 0.1pc, and 0pc respectively.
The problem with inflation divergence is that it can chip away at the stability of the single currency. A single currency requires a single rate of interest – the rate set by the ECB. Interest rates are, of course, set with reference to a country’s inflation rate.
But if we have wildly different inflation rates in different countries, then it is very hard to set the correct rate of interest.
The corollary to this monetary problem in the real economy is competitiveness. When inflation rises faster in one economy than in another, the competitiveness of the economy with higher inflation falls relative to the economy with lower inflation because prices and wages rise faster in the more inflationary economy.
Normally, currencies move relative to one another to offset this change in competitiveness. So the country with higher inflation will see its currency fall in value relative to the country with lower inflation. But of course, in the eurozone there are no separate currencies and so there is no mechanism for countries to seamlessly adjust their competitiveness.
This is what happened in the run-up to the eurozone debt crisis of 2011. Countries with higher inflation rates became uncompetitive relative to those with lower inflation rates.
This led them to suck in huge amounts of imports without increasing their exports in lockstep and this meant that they fell deeper and deeper into debt. When a financial crisis hit the whole thing unwound and the uncompetitive countries were forced into harsh austerity programmes.
How is inflation divergence looking today relative to history?
To look at this we will take the highest rate of inflation in the eurozone and subtract it from the lowest rate. This gives us the “inflation divergence spread”. Between 2005 and 2013, during the period when imbalances were growing, the inflation divergence spread was 7.7pc on average. Between 2014 and 2021, when the economies were forced into adjustment, the spread was 4.1pc on average.
Fast-forward to the inflationary period of the last few years and we see that between 2022 and today the spread has been 12.5pc on average. As of October, it stands at 5pc.
So we can say that the last two years have been far worse than the period when the imbalances built up prior to the last crisis and today, even with overall inflation defeated, the spread is substantially higher than the stable period of 2014-2021.
What does this mean? It means that we are already seeing imbalances start to build up in the eurozone. If we see another bout of inflation, these imbalances are almost certain to become unsustainable.
But even if inflation does not build up, inflation divergence is still worse today than it was in the period of stability. If this remains the case, imbalances could continue to quietly build.
If this occurs, it seems likely that at some point the eurozone could face another crisis. What that would look like in practice is anyone’s guess, but the economies that were overly inflationary would have to suffer a punishing adjustment in living standards.
From the recent statistics it looks like the victims would not be the PIIGS (Portugal, Ireland, Italy, Greece and Spain) of yesteryear but rather countries like Croatia, Bulgaria and even, somewhat surprisingly, Belgium.
It looks as though there may be a bumpy ride ahead.
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