From Past Shocks to Future Uncertainties: Navigating 25 Years of Euro Area Challenges

A IEP@BU-CEPS report to the European Parliament's Committee on Economic and Monetary Affairs
Number: 64
Year: 2024
Author(s): Daniel Gros, farzaneh shamsfakhr

The euro area has been subject to a series of very different shocks, some of which, such as the COVID-19 pandemic, were unprecedented. While the ECB’s reaction to these deflationary shocks was vigorous, it persisted too long with its expansionary measures and failed to see their inflationary impact when energy prices shot up. The future is likely to bring new challenges, but climate change might not be the most important threat to price and financial stability.

This document was provided by the Economic Governance and EMU Scrutiny Unit at the request of the Committee on Economic and Monetary Affairs (ECON) ahead of the Monetary Dialogue with the ECB President on 15 February 2024.

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Executive Summary

• The main lesson from the first quarter century of the euro is that the past is a poor guide for the future. The dominant source of shocks affecting the euro area has changed several times over this period. 

• Financial markets represented the main source of tension in the first 15 years. A global credit boom, coupled with a profound asymmetry within the euro area when German unification happened, created first inflationary pressures and then deflationary when the crisis set in. 

• Only a few years after the financial crisis had been overcome, the COVID-19 pandemic created another unprecedented challenge, followed shortly by the sharp spike of energy prices triggered by the Russian invasion of Ukraine. 

• The ECB was slow to recognise the challenge to price stability from the reopening of the economy after COVID-related lockdowns and the spike in energy prices. That delay was compounded by maintaining an overly expansionary policy stance even after the recovery from the pandemic recession had taken hold. 

• The recent bout of inflation has confirmed the observation that the inflation process is asymmetric, with high rates of inflation much more likely than very low rates of inflation or deflation. 

• Climate change will most likely remain as a pressing policy issue in the EU and at global level, with great uncertainty around the magnitude and timing of its potentially substantial economic cost. 

• While climate-related physical risks are growing even in Europe, they should not necessarily lead to a systemic financial risk. Physical risks are of a more long-run nature, likely to be localised and do not involve sectors with high leverage. 

• Similar reasoning applies to transition risk related to sudden increases in mitigation efforts. The recent fourfold increase in the ETS emission certificate cost provided a useful stress test that did not reveal vulnerabilities. 

• The green transition and its interplay with digital transformation involves both synergies and challenges that go beyond the brown sectors. Policies that target these sectors as a potential risk to financial stability might miss other challenges. 

IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.

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