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Citation suggestion: Velimir Šonje, VS (2023). Behind the Veil of Inflation: Eurozone After This Crisis. Future Europe, 3(1), 27–36.


High inflation, which emerged in the second half of 2021 and accelerated in early 2022, seemed to be a consequence of monetary policy during the pandemic. However, at a scrutiny, high inflation was not a domestic phenomenon in the Eurozone. It emerged in the global economy and was driven by the consequences of lockdown and consequent economic policy reactions. Inflation was mainly a consequence of the macroeconomic stabilisation policies in the United States. The European Central Bank (ECB) could do very little, as if it were a central bank in a small open economy. Therefore, recent institutional changes and monetary policies in the Eurozone did not lead to loss of control over money supply and prices within it. Instead, they should be primarily understood as a balancing act within the architecture of the Eurozone, which is characterised by weak common fiscal instruments and long-term decline in the relative size of the European economy vis-a-vis the United States and China. Hence the relative importance of external shocks is increasing in the Eurozone. Within this setup, events during the pandemic and its aftermath confirmed the possibility of a monetary union without a developed fiscal union.  

However, high inflation poses a threat to the credibility of the Eurosystem. The correlation between a more flexible inflation target, which was introduced in July 2021, and the emergence of high inflation, although not a causation, is a reason to worry with regard to the long-term ability of the ECB to manage credible currency. The ECB can rebuild the credibility of its monetary policy in the new institutional setup if the call of central bankers for a more uniform monetary transmission across Eurozone, as reflected in the new transmission protection instrument (TPI), remains clearly separate from fiscal policy making. 


The Great Recession of 2008/09 led to an unprecedented change in the monetary and fiscal institutions and instruments in the Eurozone. The pandemic recession in 2020 and its aftermath were accompanied by further institutional inventions. The Pandemic Emergency Purchase Programme (PEPP) was a nonstandard monetary intervention of previously unimaginable proportions (€ 1.850 billion, which accounts for 15% of GDP in the Eurozone for 2021). Another example is the old definition of the inflation target of the European Central Bank (ECB; up to 2% per annum), which was replaced by a more flexible symmetric target of 2% in the medium term.1 Lastly, in July 2022, the ECB Governing Council introduced a transmission protection instrument (TPI), which enables purchase of government bonds irrespective of national capital keys. This scheme is applicable only if economic and fiscal fundamentals are sound, but bond markets temporarily suffer from unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area (ECB’s official wording). The fiscal rules of the Stability and Growth Pact (SGP) were suspended to enable a sufficiently strong fiscal stimulus to counter the recession due to the pandemic.2 Next Generation EU (approximately € 800 billion or 6% of the GDP of the EU) demonstrated the capacity of the EU to devise a one-off common fiscal instrument financed by the issuance of a common EU bond (signed by the European Commission; however, paying it off remains to be determined). 

High inflation in the second half of 2021 and 2022 seemed to be a consequence of the monetary policy of the ECB and fiscal expansion. This article depicts a relatively different picture, that is, higher inflation emerged in the global economy, which was driven by lockdowns and economic policy reactions to the pandemic that primarily occurred in the United States. The initial inflation impulse was imported into the EU and the Eurozone. Moreover, the consequences of the Russian aggression only added fuel to the fire. 

The implied absence of the direct link between money supply and prices in the Eurozone does not indicate that the Eurosystem is free of problems related to monetary policy credibility. On the contrary, the correlation among the revised definition of the inflation target of the ECB, the unprecedented monetary expansion and the emergence of high inflation, could be easily confused with causation. Therefore, the Eurosystem must rebuild its reputation and protect the credibility of the euro during this episode of high inflation and its aftermath. These actions can be achieved only if monetary and fiscal operations remain strictly distinct. In this respect, having a monetary union with a decentralised fiscal policy can be helpful but requires carefully crafted monetary instruments and fiscal rules. 

The first section of the paper, which is entitled The Roots of High Inflation, illustrates that the Eurozone should be understood as a small open economy in the context of the global economy. An important sequel to this story is elaborated in the second section: Flexible Inflation Targeting Makes Sense. Notwithstanding new policy instruments, such as the TPI, monetary transmission and inflation rates are not uniform in the Eurozone in a manner that is comparable with the relative uniformity of the monetary transmission and inflation rates across US federal states. This notion leads to the third section entitled Monetary union Without Fiscal union: A Reinterpretation. Decentralised fiscal policies may present advantages over premature fiscal centralisation, which eurofederalists frequently call. The advantage of fiscal decentralisation is reflected in the easier rebuilding and maintenance of monetary policy credibility during episodes of high inflation and in their aftermath. 

The Roots of High Inflation 

The Eurozone/EU nominal GDP of € 12.3/14.5 trillion (2021) represents approximately 13%/15% of the global GDP. In terms of nominal GDP, the US economy is approximately 60% and 87% larger than those of the EU and the Eurozone, respectively. China is approximately of equal size. The GDP of Japan reached approximately 41% of that of the Eurozone and the GDP of the United Kingdom came close to one quarter of the nominal GDP of the Eurozone in 2021. 

Eurozone/EU is relatively open to international trade. The sums of exports and imports are approximately 42% and 23% in the EU and the United States, respectively.3 The EU imported approximately 58% of consumed energy products in an annual amount of approximately € 350 billion or 2.4% of the GDP in 2020.4 In terms of the import of agricultural and food products, the figures for 2021 amounted to € 150 billion or 1.2% of GDP. With a relatively large share of imported goods and their prices determined by the markets for global commodities, Eurozone is a price-taker similar to any other small and open economy in that it imports part of inflation. 

Despite of importance of imported inflation, refraining from overestimating the external shocks to the prices of food and energy related to the increased geopolitical tension and the outbreak of the Russian aggression on Ukraine in early 2022 is important. The reason is that the current cycle of high inflation began much earlier. 

The Eurozone rate of inflation reached 4.1% in October 2021, which is five months prior to the Russian invasion. It was equal to the previous historical maximum recorded in July 2008. The inflation rates for November and December 2021 continued to grow, which reached 4.9% and 5.0%, respectively. 

The inflation in 2021 was related to the pandemic and its global consequences. The world price of crude oil was normalising in 2021 after a dip during lockdown in the spring of 2020. China and the United States were rapidly recovering from the lockdown-induced short recession in 2020 and, until September 2021, the situation was seemingly returning to normal. The price level in the Eurozone 5 as of August 2021 was 2.71% higher compared with that in March 2020, such that the implied average monthly rate of change for 17 months (February 2020 to August 2021) was 0.16%, which is 1.9% per annum and perfectly in line even with the old definition of the ECB inflation target of up to 2% per annum. For this reason, the initial months of high inflation in 2021 did not provoke inflation anxiety among policy makers. As such, they retained the rhetoric of transitory inflation.6 

The fact that the ECB’s definition of inflation target changed to 2% over the medium term in July 2021 was less important compared with other factors that had led to inflation rate which exceeded the target in the months following September 2021. In October and November 2021, the global price of crude oil spiked over its long-term average. The commodity markets in general were booming and supply chain disruptions contributed to cost-push factors, which lifted inflation in the Eurozone. The stop-and-go (close-and-open) pandemic measures worldwide created global supply problems, including an upsurge in the cost of international transportation.7 However, the key to understanding inflation does not lie on the supply side. The root causes were on the side of the global aggregate demand dynamics. The global aggregate supply was unable to cope with the pace of recovery of aggregate demand in 2021. It was a mix of monetary and fiscal policies implemented in 2020 and 2021, primarily in the United States, which created a strong global demand pressure. 

The fiscal expansion of the United States was the strongest after WWII. Biden’s fiscal deficit of 12.1% in GDP (2021) followed Trump’s 15% of GDP deficit figure in 2020.8 These figures are more than twice as large compared with that of the Eurozone, where the fiscal deficits for 2020 and 2021 reached 7.1% and 5.1% of GDP, respectively, although its economic activity contracted more than that of the United States.9 

The US Federal Reserve (FED) acted as an innocent bystander. The monetary policy was accommodating fiscal expansion. The United States reached the previous historical maximum rate of inflation of the Eurozone of 4.1% (reached in October 2021) six months earlier, that is, April 2021. By the end of 2021, the consumer price index in the United States was running at 7% per annum, which was approximately 2 percentage points above the inflation in the Eurozone. Coupled with the equally astounding recovery of China in the second half of 2020 and 2021, the economic stabilisation policies of the United States created an unprecedented increase in global aggregate demand. They affected the prices of global assets and commodities and paved the way for disruptions in supply chains, because the global supply lacks elasticity. In terms of distinction between the cost-push (supply side) and demand-pull factors of inflation, the aggregate demand of the United States (recall that the United States composes nearly a quarter of the global GDP) as measured by domestic absorption10 increased by 10.9% in nominal terms in 2021 compared with that prior to the pandemic in 2019. The comparable rate of growth in the Eurozone was 1.8%. In the Eurozone, a significant contribution came from government consumption only. The consumption of the household sector was still depressed in 2021 compared with that in 2019 (−1.7% in nominal terms).11 Demand-pull factors of inflation were absent in the Eurozone. 

The major differences in the aggregate demand dynamics between the United States and the Eurozone explain why the ECB did not consider policy tightening in 2021 and why the transitory inflation narrative prevailed. The US Federal Reserve (FED) began to consider tightening in the spring of 2021, when tapering talk began about phasing out nonstandard monetary instruments. However, tapering talk is akin to treating cancer with a headache pill when the demand is booming, and inflation is running high. Nevertheless, foreign exchange markets, which tend to anticipate policy changes, immediately reacted. The United States dollar was at its short-term low versus EUR in May 2021 (approximately 1.22 USD per euro), and then began to appreciate. At the moment of writing this article (September 2022), the overall rate of USD appreciation recorded since May 2021 is approximately 20%. The stronger dollar also contributed to inflation in the Eurozone because many imported commodities are dollar-denominated.  

Therefore, the Eurozone behaves like a small open economy. It is importing exogenous inflationary shocks, which is partially induced by foreign and primarily US monetary and fiscal policies. At the same time, the Eurozone is facing constraints to domestic demand management. In addition, it faces the problem of neglecting the implications of the floating exchange rate of the euro vis-a-vis the US dollar, because a weak euro implies more expensive imports, whose world prices act as adverse shocks on the supply side. The recovery of domestic demand and the subsequent war in Ukraine added a further impulse to inflation in 2022; however, the genesis of the present inflation cycle is rooted in events that occurred much earlier. 

Flexible Inflation Targeting Makes Sense: The Role of Relative Price Variability 

As a large € 12 trillion economy, the Eurozone is intuitively perceived as a global economic giant; effectively, however, it functions similar to a small open economy within the global economy. As a consequence, after living with the German-inspired rigid inflation target (up to 2% per annum) for more than two decades, the Eurozone shifted to a flexible inflation target in July 2021. This change occurred at the beginning of the recent period of high inflation. However, assuming that change of the inflation target in 2021 had anything to do with inflation in 2021 and 2022 would be erroneous. We explain this by using the standard Phillips curve conceptual framework. 

The Phillips curve (1958) represents a negative relationship between inflation (or nominal wage growth) and rate of unemployment. If an economy is large and closed, then inflation and wages are driven by internal demand and the structural features of the labour market, respectively. The structure of the labour market determines the long-term natural rate of unemployment or the so called non-accelerating inflation rate of unemployment (NAIRU). Money supply management cannot influence NAIRU, but it is critical for short-term changes in aggregate demand, prices and inflationary expectations. Therefore, the central bank can set the inflation target at a rate, where the short-term Phillips curve crosses the NAIRU. Such a credible inflation target helps control inflationary expectations and minimises the cyclical fluctuations of economic activity. This story is applicable to an economy that is large and closed.  

Alternatively, if an economy is small and open, then prices are subject to external shocks. Indeed, external shocks have dominated the Eurozone since 2020. Even William Phillips was aware of this fact: in the original formulation in 1958, he emphasised that the curve is identifiable in the absence of exogenous inflationary shocks.12 

The major problem with exogenous inflationary shocks is that they are hardly predictable. In addition, when they are strong, policy makers are left with no other option but to explain to stakeholders and the public that inflation features a significant part that the central bank cannot control. However, explanatory honesty is risky because it may be extremely complicated for the public to understand. Explanatory honesty can also undermine the confidence of policy makers in instruments that they manage and public confidence in the central bank and currency. Thus, a credibility crisis may emerge. 

In this regard, considering the two types of small open economies in the context of monetary policy credibility is beneficial. In very small open economies, flexible inflation targets lead to loss of credibility, especially when such economies are poorly managed. In addition, the exchange rate is crucial for domestic prices and inflation expectations. In this case, credibility can be restored only by importing stability from abroad. Fixed exchange rate regimes, currency boards or entries to a monetary union are apparent crutches.  

In regular small and open economies, such as the Eurozone, striking a balance between a flexible inflation target, which is required due to structural openness and monetary policy credibility, is possible. However, doing so is walking on the edge. Personalities, narratives, central bank communications, even cultural factors, institutions, and history, are important for resolving the trade-off between a flexible inflation target and credibility.  

In the context of the Eurozone, such soft factors are related to its internal strucutral heterogeneity. Three factors of structural heterogeneity within the Eurozone exist, which further complicate the resolution of the credibility trade-off. Namely, the Eurozone is not a fiscal union; national labour markets exhibit extremely diverse structural characteristics (at the time of writing, the rate of unemployment widely ranges around the EU-27 average of 6.6%, from 2.9% in Malta and Germany to 11.4% in Greece and 12.6% in Spain).13 Lastly, various policy traditions and policy design capacities are employed to address exogenous inflationary shocks, which are reflected in extremely different instruments for national fiscal interventions.14 

Interestingly, the level of economic development does not belong to the heterogeneity factors of the Eurozone. Real GDP per capita ranges from 65% of the EU-27 average in Greece to 277% in Luxembourg. The measurement of income per capita is sensitive to peculiar factors in Luxembourg and Ireland,15 such that the true representative range is approximately 1:2 (65% in Greece vs. 132% of the EU-27 average in the Netherlands). In the United States, the District of Columbia is an outlier, similar to Luxembourg and Ireland, such that its true range lies between 35,000 USD per capita at purchasing power parity in Mississippi and 75,000 in Massachusetts and New York.16 Therefore, putting aside differences in the level of economic development, the fundamental heterogeneity in the Eurozone is related to specific features of the national labour markets, decentralised fiscal policies and differences in other economic policy traditions, institutions and practices of the member states. 

The internal heterogeneity of the Eurozone is reflected in very large variations of national inflation rates compared with differences in the rates of inflation across federal states in the United States.17 In July 2022, the Eurozone’s inflation of 8.9% was significantly below the unweighted average of 19 national rates of inflation (11.6%) and its median value (10.4%). The Baltic states significantly influenced the distribution of the inflation rates of member states, as the maximum value was recorded in Estonia (23.2%), whereas Malta and France exhibited the lowest inflation of 6.8%. Nonetheless, even without the Baltic states, the range of inflation rates in the Eurozone is large compared with that observed in the United States.18 

The variation in inflation rates may be compatible with the convergence of price levels if converging countries record higher rates of inflation. However, convergence does not explain the majority of variations in national inflation rates during the recent period of high inflation. This is additional argument on why the flexible inflation target in the Eurozone makes sense: the idiosyncratic factors that influence national markets make the concept and measurement of the inflation of the Eurozone subject to large price variations around the mean.19 This scenario makes up the nightmares of monetary policy makers. The TPI of the ECB was born out of these considerations in July 2022. However, TPI (purchase of government bonds irrespective of national capital key) may have quasi-fical implications. 

Monetary Union Without Fiscal Union: A Reinterpretation 

Central bankers in Europe are facing the following tough questions: (i) how can high inflation be addressed without hurting economic activity, which is facing adverse real external shocks and the consequences of the war in Ukraine, including Russia’s decoupling from the west; (ii) how should the current and targeted inflation (and their difference) be interpreted in a manner that would calm inflationary expectations while national rates of inflation are so different; (iii) finally, how should national heterogeneities within the Eurozone be overcome to render the transmission of monetary policy more effective (TPI related issue)? 

The relationship between fiscal and monetary policy is crucial for providing answers to these questions. If the public believes that economic policy making is devised in the regime of fiscal dominance with mainly accommodative monetary policy, then inflation expectations may become rooted. Consequently, the amplitude of economic cycles and interest rates may widen, the natural rate of unemployment (and interest) may become barely identifiable and distinguishing cyclical changes in unemployment from structural ones may become difficult.20 The variability of relative prices and the likelihood of policy errors increase, whereas long-term economic growth may decelerate, because allocating the factors of production towards their most productive uses in a described environment is more difficult. 

The economy of the United States in 2020–2021 is an example of fiscal dominance regime (recall FED acting as a passive bystander in 2021).21 In general, the stronger the central political power, the more likely that a monetary union will be under the fiscal dominance regime. This scenario is not always bad: extreme shocks, disasters, wars, and catastrophes indeed require extreme interventions. In such cases, possessing ability for fiscal accommodation and credible monetary authority at the same time may be advantageous. However, if monetary policy accommodation lasts for too long (as in the case of the Federal Reserve in 2021), or if fiscal intervention is employed as if it were a catastrophe or war, while society is facing a much more benign threat, then the long-term consequences of fiscal dominance regime may be disastrous in all cases. Society may end up with monetary authority that has lost its credibility and cannot implement accommodative monetary policy when accommodation is truly needed. 

Many political and economic models disregard this danger. A monetary union without fiscal union is often presented as a structural weakness of the Eurozone. This argument has three origins. The first is political: it involves the call of eurofederalists for the homogeneity of the union. The second is intuitive and is for technocrats who prefer strong tools of intervention: for example, the imitation of powers and the determination of macroeconomic stabilisation policies in the United States is an attractive motive to follow despite policy errors that may lead to global implications, as explained in The Roots of High Inflation section. The third argument in favour of fiscal unification is related to the fiscal interpretation of the economic theory of optimum currency area (OCA), which is popular among macroeconomists. 

In the original formulation of OCA theory by Robert Mundell in 1961, the synchronisation of business cycles and the mobility of capital and labour are sufficient conditions for the OCA. Later additions to the original formulation point out that perfect synchronisation and perfect factor mobility are rarely observed in the real world. Fiscal transfers within monetary union are required for compensation. The late Mundell did not prefer this fiscal add-on to his theoretical base. Instead, he believed that cyclical coordination within the Eurozone will increase with time, irrespective of fiscal policy (endogenous maturation of the currency union). 

The fiscal interpretation of OCA theory disregards the history and politics that underlie the real world of fiscal redistribution. In the real world, peculiar events occur such as excessive political centralisation, bureaucracies awash with the money of taxpayers, technocrats who are not subject to accountability and democratic control standards, and public resentment due to the feeling of high power distance. In such a world, fiscal decentralisation with decision-making at the lower organisational level, which can be overseen by the public, may be advantageous per se. Among other advantages, fiscal decentralisation can prevent the emergence of fiscal dominance regime in a large monetary union without fiscal union. 

Thus, we are faced with a fundamental Eurozone dilemma. On the one hand, two arguments are in favour of the fiscal interpretation of OCA. Firstly, without sufficient fiscal transfers, government bond yields (national interest rates) will wildly fluctuate and undermine the effectiveness of a common monetary policy (transmission), and secondly, without sufficient common monetary policy instruments, macroeconomic interventions will be weak for addressing major swings in business cycles (the big bazooka problem). Both failures may create incentives for exits and lead to the breakup of the monetary union. On the other hand, the sufficiency of fiscal transfers cannot be viewed without reference to their efficiency and effectiveness, which are dependent on democratic and market control over fiscal policy. Missing this reference may also create incentives for exits and lead to the breakup of the monetary union if member states, that is, national democracies, begin to perceive that the costs of the union are greater than its benefits. 

As such, institutional innovations in the Eurozone evolve as balancing acts between the two poles. Institutional inventions after 2008, including the most recent ones, partially compensate for the lack of common fiscal policy.22 They are primarily motivated by reactions to (or prevention of) overly wide fluctuations in the government bond yields and spreads of member states. 

The variability of government bond spreads is a good test of the effectiveness of a monetary union without fiscal union. The extremely low variability of bond spreads is viewed as negative because it may reflect overoptimism and the loss of the preference of government creditors for fiscal discipline and sustainability. This error occured in the 1999–2007 period. On the other hand, an extremely high variability may also be negatively considered, because it may reflect financial panic, that is, markets occasionally lose their role of reflecting fundamental information (TPI clearly reflects an endeavour to prevent this type of market failure).23 This tendency was evident in the 2009–2014 period. Therefore, government bond markets are not always pricing risk properly.24 Nevertheless, information feedback from government bond markets is indispensable, because it is reasonably accurate for most of the time.  

Figure 1 depicts 283 (January 1999 – July 2022) monthly variations of 10-year government bond spreads versus the German Bund yield for the 11 original member states of the Eurozone. The data demonstrate that market sensitivity to risk was clearly paralysed before the Great Recession. During the Great Recession, the risk-off mode was then deactivated, and risk perception exploded in a type of compensatory sobering, as illustrated by the escalating sovereign risk in the Eurozone. However, after the introduction of Eurozone reforms in the 2011–2014 period, the volatility of spreads moderated. Thus, assuming that markets were pricing risk correctly after 2015 is reasonable. 

Figure 1. Standard deviation of 10y government bond spreads vs. Bund for 11 original members of the Eurozone 

Source: Eurostat, author’s calculations. 

The key question is as follows: Who receives information feedback from government bond markets and what incentives does it create?  

If market information acts as an input to the democratic decision-making of member states, then an opportunity exists for (i) corrective fiscal actions at the national level, which may lead to the sustainable convergence of interest rates across member states and (ii) the avoidance of fiscal dominance regime in the Eurozone. In this case, the ECB can appropriately balance flexible inflation targeting and monetary policy credibility. 

What if this signal or incentive were to be lost, for example, due to premature fiscal unification? Firstly, a more technocratic mindset would prevail in the ECB Governing Council due to the smoother functioning of the monetary transmission mechanism. It would strengthen the illusion that the Eurozone is a large, closed economy similar to the United States, which can increase the likelihood of policy errors, such as the ones recently observed in the United States. Secondly, even if government bond markets would retain certain degrees of elasticity to fundamental fiscal information (which is very unlikely in the case of fiscal unification), then the question is, Who would receive this information and act upon it? Given the history, size and political structure of the Eurozone, a highly likely scenario is that the major information recipient would be weakly overseen central bureaucracies with limited democratic accountability. Long-term consequences in terms of public resentment (reaction to the feeling of high power distance) and the future of EU integration are beyond the consideration of this article; however, this vision remains bleak. Hence, fiscal decentralisation is key to the prevention of fiscal dominance in the Eurozone and bureaucratic dominance in the EU. Cleverly designed institutions, which aim to ensure the smooth functioning of government bond markets can oil the channels of monetary transmission and ensure the effective responses of countercyclical monetary and fiscal policies in a fiscally decentralised monetary union. 

Conclusion: On the Transmission Protection Instrument and Stability and Growth Pact Reform 

In this respect, the functioning of government bonds and financial markets in general is critical. The infrastructural integration of government bond markets within the existing fiscally decentralised political model can improve bond price discovery and the disciplinary role of the government bond market.25 This aspect can provide a fertile ground for the long-term convergence of government bond yields and increased effectiveness of monetary policy transmission. For this reason, the new TPI of the ECB is an important step in this direction. 

TPI is the latest addition to the common instruments intended to strike a balance between monetary and fiscal rules and interventions. This balance reflects a tendency to use effective monetary tools only if their redistributive potential is limited by prior fiscal instruments, which resolve big distributional questions with democratic legitimacy. For example, the European stability mechanism (ESM) is a fiscal intervention tool, which can be supported by the outright monetary transactions (OMTs) of the ECB only if a prior political decision exists on ESM lending by the ministers of finance in the Eurozone. Similarly, instruments of monetary policy, such as quantitative easing, PEPP and Asset Purchase Program (APP), follow politically legitimate national capital keys which reflect the ECB’s shareholdings in proportion to national populations and gross national products. Hence departures from capital keys in search for the effectiveness of monetary transmission is similar to opening Pandora’s box. National capital keys provide relatively stringent guidelines, which eliminate the danger of the excessive redistributive effects of monetary instruments without political legitimacy.  

In the same spirit, the new TPI is aiming at the government bonds of member states, given that they do not exhibit an excessive deficit or macroeconomic imbalance procedure, which legitimizes departure from national capital keys. This situation renders TPI as a mechanism for the correction of bond market failures, not for the correction of government bond spreads when they reflect reality of sovereign credit risk. TPI design rules out objections about the lack of prudential concerns associated with the ease of access of member states to financial markets and institutions.26 This institutional invention is a clever one, which will make a positive contribution to the financial stability of the Eurozone, if the doors for burdening the TPI with large redistributive effects without prior democratic political proof remain closed. 

The strength of barriers between fiscal and monetary interventions is rooted in the general principles of the EU Treaty. However, translating the general principles to practical delineations is difficult. In fact, the fiscal-monetary barrier may shift over time. For example, being in the Excessive Deficit Procedure (EDP) rules out TPI (it makes a member state a candidate for ESM/OMT if a country cannot correct short-term fiscal imbalances). However, EDP activation is dependent on SGP fiscal rules, which are currently suspended and under revision. In other words, fiscal rules may change. So, the ECB Governing Council may find that it is not on automatic pilot. Acting in such circumstances is difficult when the Governing Council needs to decide on the applications of member states for TPI.  

In response, the ECB Governing Council will need to develop transparent financial criteria for delineation between the volatility of bond yields which correctly reflect fiscal fundamentals and volatility, from volatility which is qualified as unwarranted, disorderly market dynamics that poses a serious threat to the transmission of monetary policy across the euro area. The results of this analysis will face political criticism because political elites in member states, which will eventually face the rejection of their applications, will raise their voices against the ECB in particular and European institutions in general. Therefore, remaining independent and driven by considerations about financial markets and conditions is of critical importance for the Governing Council instead of transforming into a logrolling forum for the negotiation of silent fiscal support for the governments of member states. 

The forthcoming SGP reform may further complicate this situation. Many voices call for a more decentralised implementation of fiscal rules.27 This is a reasonable proposal in a fiscally decentralised monetary union. It is affirmative for the disciplinary role of markets and national democracies. It may alleviate incentives for the re-direction of national political conflicts and anger towards EU institutions. In addition, it considers the reality of various countries, such as Greece, Italy and, perhaps, a few others, which find that calibrating the long-term paths of public debt to GDP towards 60% is impossible. Although 3%/60% fiscal rules may no longer be relevant for many member states, seriously considering long-term bond yields and spreads in national decisions on midterm fiscal policies is critical. For this mechanism to work properly, an important aspect is that government bond markets should work as smoothly as possible and do not fail. An even more important notion is that the ECB remains truly independent from national fiscal woes. 


  1. New definition of inflation target was implementedin July 2021.
  2. Suspension is still active and the debate about the SGP reform is ongoing.
  3. The World Bank, World Development Indicators Database.
  4. Eurostat (2022), EU Imports of Energy Products, Eurostat, 23 September, https://ec.europa.eu/eurostat/statistics-explained/index.php?title=EU_imports_of_energy_products_-recentdevelopments#Overview
  5. Measured by HICP (source: Eurostat).
  6. After registering deflation in the second half of 2020, higher inflation rates in 2021 carried over the effect of the low base; hence, normalisation.
  7. Baltic Dry Index, which measures the cost of international maritime transportation, surpassed the pre-pandemic historical high by an astounding 120% in early October 2021. It remained above this rate from April 2021 to June 2022.
  8. Source: The Balance.
  9. Source: Eurostat.
  10. Sum of household consumption, gross investment and government consumption (C+I+G).
  11. Source: FRED for US, Eurostat for Eurozone.
  12. A. W. Phillips (1958), The Relation Betweeen Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957. Economica, November, p. 283-299. https://doi.org/10.1111/j.1468-0335.1958.tb00003.x
  13. Eurostat, data for July 2022. The comparable range for US federal states is from 1.8% in Minnesota and 2% in Nebraska, New Hampshire and Utah, to 4.5% in Alaska and New Mexico and 5.2% in the District of Columbia.
  14. For example, countries with low real GDP per capita and Denmark tend to pass large shares of exogenous energy price shocks onto corporations, while the household sector is subsidized. In more developed countries, the relative strength of inflation passthrough is sectorally inverse. Another interesting case is Malta, which has long-term fixed energy prices due to its special agreement with supplier SOKAR from Azerbaijan.
  15. The valuation of R&D is an issue in measurement of Irish GDP. The economy of Luxembourg is heavily dependent on financial services. It is much more informative to view the actual individual consumption, which stands at 45% above the EU average in Luxembourg and 10% below the average in Ireland.
  16. Source: Statista.
  17. Source: United States Congress Joint Economic Committe.
  18. Highest rate of inflation in July 2022 among 11 original members of the Eurozone was in Belgium (10.5%).
  19. Additional factors are in favour of flexible inflation targets, which are beyond consideration in this article, such as demographic change (ageing), deglobalization, changes in long-term productivity growth and structural shifts in preferences for risk-free liquid assets, which may lower the natural rate of interest and render estimation more difficult at the same time (P. Andrade, et. al. 2019), The Optimal Inflation Target and the Natural Rate of Interest, Brookings Papers on Economic Activity, Fall, 173-255. https://www.brookings.edu/wp-content/uploads/2020/10/Andrade-et-al-final-draft.pdf
  20. The structural origins of unemployment variations may have become increasingly more important over the last decade or so, which involves factors such as population ageing, immigration, technological change and, most recently, the restructuring of global supply chains (onshoring instead of offshoring, which was prevalent during the earlier stage of globalisation).
  21. Fiscal dominance should not be confused with the strength of fiscal stimulus. Fiscal dominance is a political feature that reflects histories, institutions, widespread beliefs, preferences of voters, even the beliefs, personalities and political careers of key policy makers. In this respect, notably, the public debt-to-GDP ratio of the United States took 26 years (1981–2007) to double from 31.5% to 63% and only 14 years for the next doubling from 63% to 126% in 2021. The long-term path of the public debt of the United States is not necessarily a reflection of fiscal dominance in its entirety: long-term economic growth, private savings-to-GDP ratio and the structural features of the global demand for government bonds also play important roles in shaping the historical path of public debt. However, it does indicate the political submisiveness of monetary policy decision-making at least during certain historical periods that call for increased intervention.
  22. The European stabilility mechanism (ESM), outright monetary transactions (OMTs) and transmission protection instrument are clear examples of such instruments. OMTs are the bond purchase instrument of the Eurosystem for member states that use ESM money. This instrument was never used, although it has been in place since 2012. Member states can apply to the ECB Governing Council for activation of the TPI if it they are not subject to excessive deficit or macroeconomic imbalance procedure.
  23. 29 Bond markets misprice long-term fiscal solvency, which lies beyond the investment horizon of bondholders (e.g. due to the absence of very long-term perspectives on the sustainability of public pension systems in an era of ageing population).
  24. 30 Government bond markets are typically organized as segmented OTC markets with predominant roles of specialists or market makers and a small role of retail investors. Infrastructural integration, low transaction costs and openness to a large number of investors would contribute to price discovery within the efficient and integrated market. Government bonds will largely remain bonds of member states for decades to come, but no reason exists for not having an integrated bond market, which technically functions as if it were a market for one government bond based on the principles of low cost, rapid settlement and transparent accessible auction.
  25. In line with Art. 124 of the Treaty.
  26. R. Beetsma et. al. (2022), Making the EU and national budgetary frameworks work together, Vox EU, 13 September, https://cepr.org/voxeu/ columns/making-eu-and-national-budgetary-frameworks-work-together


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