History teaches that it is always a costly economic mistake to allow the inflation genie to escape from the bottle. Christine Lagarde, the President of the European Central Bank (ECB) will soon find out that it is a particularly costly mistake to have allowed high inflation to occur in the Eurozone. Such inflation now once again risks exposing the Euro’s structural weaknesses and bringing on another round of the Eurozone sovereign debt crisis. 

The essence of Ms. Lagarde’s present economic policy predicament is that she is faced with two fundamental economic challenges but has only one monetary policy to deal with those two challenges. This is highly problematic when those two challenges each require different monetary policies.

The first challenge is that, both as a result of a Russian-induced energy shock and too loose a monetary policy, inflation is now well above the ECB’s 2 percent inflation target. Headline inflation reached an all-time high of over 10 percent last summer before moderating to its present still uncomfortably high 8.5 percent. Meanwhile core inflation, which strips out volatile food and energy prices, is now running at close to 6 percent.

Unlike the Federal Reserve, which has a dual inflation and employment policy mandate, the ECB has a single inflation policy mandate. This leaves the ECB with little option but to forcefully address its inflation problem. This explains why the ECB is now raising interest rates at the fastest rate on record. It also explains why the ECB has terminated its aggressive round of government bond buying and is now engaging in quantitative tightening at the pace of EUR15 billion a month.

The ECB’s second major policy challenge is to maintain market confidence in the ability of its highly indebted member countries, like Italy and Spain, to finance themselves on reasonable terms. As we learned in the 2010 Greek debt crisis, when markets lose confidence in a Euro member country’s ability to deal with its public finances, the ECB quickly finds itself confronted with a Eurozone sovereign debt crisis.

Since the 2010 sovereign debt crisis, Italy and Spain’s already high public debt levels have surged. They have done so largely as a result of their governments’ aggressive budget policy response to the 2020 COVID-19-induced economic recession. Whereas in 2010 Italy had a public debt to GDP ratio of 120 percent, today that ratio is close to 150 percent. This ratio is an all-time high for Italy and exceeds that which prevailed in in the immediate aftermath of both world wars.

Until recently, the ECB maintained negative policy interest rates and engaged in massive government bond buying. It did so as part of its effort to promote a Eurozone economic recovery from the ravages of the COVID-19 pandemic. This policy combination was a godsend to the highly indebted Eurozone economic periphery. Low interest rates eased those countries’ ability to service their public debt mountains. Meanwhile, the ECB’s large purchases of their government bonds reduced the economic periphery’s need to tap the international bond market.

All of this now puts the ECB in an impossible position. To fight inflation, it will need to keep raising interest rates and continue with its policy of quantitative tightening. However, the ECB’s pursuit of such policies will be anathema to Italy and Spain. Those countries require ultra-low interest rates to keep their debt servicing costs low. That in turn would require that the ECB return to its low interest rate policy and its large-scale bond purchases to prevent those countries’ borrowing costs from rising markedly.

With Eurozone inflation remaining stubbornly high, the ECB has little real alternative but to stick to its hawkish monetary policy stance. This must make it only a matter of time before markets begin to seriously test the Italian and Spanish government’s ability to finance themselves. As if to underline this point, the Italian government’s borrowing costs have already risen to their highest level in the past decade.

In 2012, Mario Draghi managed to defuse the Eurozone debt crisis with his “whatever it takes” speech. We have to hope that Christine Lagarde has another rabbit to pull out of the hat to spare us from a repeat of the Eurozone debt crisis. However, I would not suggest betting the farm on that happening.

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