About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
For Europe, the war in Iran brings some seriously bad news.
Disruption in traffic through the Strait of Hormuz is “significantly affecting” the eurozone’s economy, European Commission President Ursula von der Leyen said this week. A prolonged crisis could trigger a government bond market crisis in three of Europe’s four largest economies: France, Italy, and the United Kingdom.
The three countries were on unsustainable debt paths even before the war. According to the International Monetary Fund, they have public debt to gross domestic product ratios in excess of 100%. France and the U.K. have budget deficits in excess of 5% of GDP. In this respect, their public finances are just as troubling as those of the U.S., which has a deficit of 6% of GDP. Unlike the U.S., however, these European countries are highly dependent on imports to meet their energy needs.
The European bloc has spent roughly $32 billion more on oil and gas than they would have without the war as the closure of the strait spikes global energy and fertilizer prices. The European Central Bank has increased its food inflation expectations from 2.3% to 2.9% through 2027, a top U.K. minister said this week that fuel and food prices might stay elevated for up to eight months after the war ends.
Higher prices will foreclose the chances of the over-indebted European countries’ growing their way out of their debt problem. Higher inflation might instead force the ECB to raise interest rates, boosting the cost of carrying such debt. At the same time, falling business activity and the effective energy and food price tax on households will further slow an already sclerotic European economy, if not trigger a full-scale economic recession.
After the war, new pressures for additional public spending will complicate the task of getting the public finances under control. There will be strong political pressure to enact energy and food price subsidies, especially for lower income households. The temporary rollback of energy taxes in nearly two dozen European countries will put a dent in government revenue. Meanwhile, President Donald Trump’s repeated threats to pull out of the North Atlantic Treaty Organization will add urgency to Europe’s need to substantially increase its military spending.
For France and Italy, putting their public finances on a more sustainable path won’t be an easy task. Stuck within the eurozone straitjacket, they lack an independent monetary and exchange rate policy to offset the contractionary impact on aggregate demand of budget belt-tightening. Indeed, they might have to attempt budget austerity in the context of the ECB raising interest rates and the euro strengthening. Fiscal constraint in those circumstances might heighten the risk of a recession.
In the run-up to France’s presidential election next year, that prospect is likely to strengthen political resistance to unpopular budget austerity.
The U.K. is more fortunate. It has its own central bank and its own currency. Unlike France and Italy, it has the option of using its interest rate and exchange rate policy to boost demand as an offset to fiscal austerity. This increases the chances that the U.K. can put its public finances in order without a recession.
Another small—but important—piece of good news is that the ECB is better equipped today to handle a eurozone debt crisis than it was in the 2010s, when Greece’s debt crisis led to contagion to the rest of the bloc.
In the middle of that crisis, then-ECB President Mario Draghi famously declared “the ECB will do whatever it takes” to avoid the collapse of the euro. The ECB has since created the Transmission Protection Instrument—a tool designed to protect against unwarranted spikes in borrowing costs across euro-area countries. It allows the central bank to intervene by buying unlimited amounts of bonds in the secondary bond markets of any of its member countries with deteriorating financing conditions. (In order to benefit from the TPI, a country must comply with the eurozone’s fiscal framework and can’t have major macroeconomic imbalances.)
This isn’t to say there is room for complacency in Europe. Since the start of the Iran war, French and U.K. government bond yields have increased by 0.5 and 0.7 percentage points, respectively, to their highest levels since 2008. It is to say, however, that it is unlikely we will have a systemic European bond crisis, despite the headwinds caused by the war.
That’s good news for the rest of the world, too.