Committee on Economic and Monetary Affairs
Written by: Laura Simón (ES)
Relevance of the Topic
From doing your groceries to applying for a mortgage, the cost of living is on the rise. European citizens are struggling to reach the end of the month as their wages are becoming too low to cover basic costs. The EU economy is experiencing inflation at unprecedented rates. In this situation, the market experiences a rise in prices as the currency loses its value. The European Central Bank’s (ECB) response to the crisis has been to raise interest rates, making the cost of borrowing money higher. This measure is designed to slow down spending and decrease demand leading to lower prices. However, this slowdown in economic activity could lead to a recession, meaning that European economies could start to lose value. Paired with inflation, this phenomenon is what economists refer to as ‘stagflation’.
Every day regular Europeans are seeing their savings dwindle as the purchasing power of the Euro falls to a historic low. Moreover, decreased economic returns can lead to increased unemployment and poverty, threatening the livelihoods of millions of European citizens.
For the nineteen members of the Eurozone, interest rate hikes and inflation affects each member directly. Moreover, many other EU Member States’ currencies are either directly or indirectly tied to the Euro. Because we share an economy, the act of one is an act for all. Therefore, the EU must coordinate its policies if it wants to get out of this cost of living crisis in one piece.
Key Terms & Definitions
- Inflation: Is a general increase in the prices of goods and services in an economy due to the devaluation of the currency.
- Interest rates: tell you how high the cost of borrowing is. So, if you’re a borrower, the interest rate is the amount you are charged for borrowing money, shown as a percentage of the total amount of the loan. The higher the percentage, the more you have to pay back for a loan of any given size.
- Wage-price spiral: is a phenomenon in which workers demand higher wages so that their purchasing power1 keeps up with the increased cost of living, causing prices of goods to rise due to increased demand and higher cost of labour incurred in production, causing an increased cost of living which then leads to workers to demand higher wages and so on.
- Purchasing Managers’ Index: is a measure of the prevailing direction of economic trends in manufacturing. Production costs have a huge impact on final prices and the lack of materials used by the manufacturing sector appears to be the main cause of this crisis.
- Eurozone: Consists of nineteen Member States of the European Union that have adopted the euro as their currency. These countries all use the Euro as their currency.
- Stagflation: This phenomenon takes place when inflation rises while economic activity slows down. It can cause quite a dilemma for economists as actions meant to regulate inflation can lead to further recession and vice-versa.
- The European Commission: has the power to propose legislation. The European Commission recently proposed an energy price cap to help European citizens deal with rising energy prices. Furthermore, The Commission plays a crucial role in coordinating economic policy between the Member States when dealing with the current cost of living crisis.
- The European Central Bank (ECB): is responsible for keeping prices stable in the Eurozone. The ECB is also responsible for the monetary and exchange rate policy in the Eurozone and supports EU economic policies. The ECB acts as the central bank of all those countries that adopt the Euro and it has the sole authority to produce Eros.
- Policymakers from Member States: Governments and private institutions from Member States play an important role. As they come up with their own laws and measures, based sometimes on individual interests, international organs struggle to create a balance. Moreover, during a crisis, financial assistance for Member States may be required as they are currently suffering from interest rate peaks and a debt rise.
- The International Monetary Fund (IMF): The IMF is a United Nations institution with the aim of creating economic growth, stability and equality around the world. They act through the evaluation of their members, analysing rates and demanding particular policies in exchange for financial aid. They have control over international transactions, granting loans to countries encountering crises and boosting nations experiencing growth. IMF funds come from member quotas.
- The European Stability Mechanism (ESM): is an organisation whose action is based on the ESM intergovernmental treaty. Their role is to assist Eurozone Member States undergoing economic difficulties through different types of financial programmes and instruments. The ESM raises money for these programmes through the sale of bonds and bills to investors rather than through taxation of Eurozone citizens.
- Workers and consumers: are the most affected by the current cost-of-living crisis due to the value of wages depreciating due to inflation and products becoming more expensive. Workers and consumers produce a lot of value through working and purchasing, hence they stand at the core of the European economy.
Rising interest rates
Now that we understand what interest rates are, we can start to understand what role they play in the current crisis. The ECB regulates interest rates by lending money to European banks at certain rates. The ECB considers an inflation rate of 2% ideal. With a current inflation of 9.9%2, the Governing Council of the ECB has tried to bring down inflation by raising interest rates, recently increasing interest rates by 75 points with further increases expected. Essentially, by making money more expensive, they expect to reduce consumer spending and encourage consumer austerity. The purpose of interest rate hikes is to lower demand so that prices can stabilise. However, on the other hand, raising interest rates has a major impact on economic activity. Because raising interest rates lowers the demand for goods, they indirectly decrease the number of jobs. Furthermore, raising interest rates also leads to a lower cost of housing, as higher mortgage rates lead to less available spending power. Moreover, the results of raising interest rates are not immediately apparent, forcing banks to guess their best next move based on models. However, these models cannot take into account major crises, geopolitical or otherwise, as we’ve seen with the pandemic and war in Ukraine.
The rise in manufacturing costs
The pandemic and the Ukraine War have had a massive impact on the market. Due to higher gas and energy prices, the cost of producing and transporting products has skyrocketed. This has led producers to raise prices so that they are able to afford the additional costs. Energy and farming industries are struggling, which is translated into the suffering of the rest of the market sectors as they represent the base of the pyramid, as energy and agricultural products are goods which are often necessary to produce other goods or are goods which are used by every consumer.
With the escalation of the Russo-Ukrainian war, gas has become a scarce commodity in Europe. This has caused gas prices, and therefore energy prices, to spike upwards. European states have been trying to cut off their dependence on Russian gas. However, due to a big reliance on natural gas for, among other things, energy production, turning to other sources for natural gas, such as the United States, has been an expensive endeavour. Due to decreased supply, high demand and price gouging, the gas being sold to Europe is far more expensive than before. Having few production capabilities within the EU, relying on other countries’ gas may not be the best idea. Therefore, Europe perhaps may need to look elsewhere for solutions to its gas and energy demands.
Why can’t we just print more money? A common government strategy to tackle recession consists of investing large sums of money into the economy through subsidies or economic aid to citizens. This measure is meant to stimulate the economy by ensuring money keeps circulating, therefore keeping the economy running. However, such large-scale investments can be hard to finance. An easy solution for governments is to borrow significant sums of money in times of crisis leading to growing debt. With many European countries still having very high debt-to-GDP ratios, the EU needs to devise a way to alleviate Member States from the burden of debt while also ensuring they have the means to tackle a recession.
Measures in place
Besides the rise of interest rates and aiming for more economic independence, the EU counts on several plans and strategies, some of which go back to its first actions.
- Capital Markets Union (CMU): is a plan to create a single market for capital. Regarding the aim to develop a recovery plan, they have adopted several measures, the latest being The Capital Markets Recovery Package. The objective is to boost investments by reducing bureaucratic processes and barriers. The recovery prospectus will be available for capital increases of up to 150% of outstanding capital within a period of 12 months.
- The Stability and Growth Pact (SGP): Agreed at the Amsterdam summit in 1997, is known as the Eurozone’s fiscal rule book. It is a set of fiscal rules designed to prevent EU countries from spending beyond their means. However, given the absence of relevant elements of economic policy coordination, the stability and growth pact also started to assume that role, something that eventually led to its failure as it had not been sized up to perform that function. Nonetheless, the stability pact is important and should continue to pursue its role of ensuring fiscal discipline.
- The Banking Union: their basic aim is to ensure that European banks are strong and supervised. It was created by the European Commission in response to the 2008 financial crisis. All 27 EU Member States are a part of the Banking Union.
- Various stimulus packages: Member States all over the Union have been sending out stimulus checks to consumers to compensate for the rising cost of living. Ranging from energy subsidies for low-income families and energy-intensive businesses to the slashing of Value Added Tax and subsidising public transport tickets, Member States have been attempting all sorts of measures to compensate for the rising cost of living for those who need it most.
- Decoupling energy prices and energy price ceiling: In order to combat rising energy prices, Member States have agreed to decouple energy and gas prices. This measure is meant to lower the price of energy generated by non-gas-powered power plants. Furthermore, the European Commission has proposed a cap on energy prices in order to ensure a fair price for consumers and limit exorbitant profits for energy producers. Although some Member States have introduced their own energy price cap, a European-wide cap is yet to be implemented.
Food for thought
At this point, you might find yourself wondering “should the EU encourage saving over money flow?” The truth is that the current crisis is not the EU’s first economic challenge and won’t be the last. What can we learn from the past, which errors just can’t be repeated? Are we going to let differences break us, leaving behind unity? Which measures have gotten us out of a crisis in the past? Are they applicable now? The European Union is facing a Union-wide crisis that is having a major impact on its economy and its citizens. How can the EU get out of this crisis while protecting its most vulnerable citizens and fragile economies? Everyone knows time equals money. How can the EU respond to this crisis on time without leaving anyone behind?
- “Explained: Why Europe faces soaring energy bills and a cost of living crisis” Euronews (2022) – Article explaining how we got into the current cost of living crisis and how long it may yet last.
- “Russia’s energy influence over Europe ‘is nearly over’ as bloc races to shore up winter gas supplies” CNBC (2022) – Article which explains what strategies are currently being used to safeguard Europe’s gas supply without relying on Russia.
- “Why combating inflation will not be easy in Europe” GIS (2022) – An in-depth look at the current inflation rates, analysing the core problems while looking at possible solutions.
- “How does raising interest rates control inflation?” The Economist (2022) – A video excellently explaining the many effects raising interest rates has on the economy.
- “Can Europe’s industry survive without Russia?” Into Europe (2022) – A video explaining the effects of Europe’s move away from Russian gas and the alternatives Europe has.
- “What is the EU’s Stability and Growth Pact and why is it important?” Euronews (2022) – A news article explaining the functioning and the importance of the EU’s Stability and Growth Pact.