Of all the places in history, Mexico in 1982 could give us a hint about the future of European monetary policy.
It may sound strange, but a Mexican scenario may be in the works after the ECB changed course last week.
After more than a decade of loose and ultra-loose monetary policy, Europe’s central bankers announced two consecutive interest rate hikes for July and September. The ECB will also cease its large asset purchases at the same time.
The ECB’s measures aim to bring inflation under control, which is running above 8 percent in the eurozone. The first question is whether a cumulative 50 basis point hike will significantly dent that rate.
But another, and more important, question is whether parts of Europe will suffer the same fate as Mexico 40 years ago.
It is important to remember what happened to Mexico and other Latin American countries back then. Today’s Southern Europe has remarkable parallels to Mexico and Latin America of the 1980s.
During the 1970s, stagflation and inflation spiralled out of control in many parts of the world. Particularly acute were the problems in the US, where inflation and the expectation of further inflation had become entrenched.
To quell the US inflation storm, the chair of the Federal Reserve, Paul Volcker, brutally increased interest rates. At their peak, central bank interest rates reached 20 percent.
It was shock therapy for the US economy, which brought about a painful domestic recession, but it worked: US inflation dropped back to a tolerable level.
Yet the story was not over – at least not for the rest of the world.
Volcker’s monetary policies did more than just raise interest rates. They also boosted the value of the US dollar in foreign exchange markets.
It came as a double shock to foreign countries that had previously borrowed heavily in US dollars. Not only did they now have to increase interest payments on their borrowings but to afford those more expensive US dollars, they also needed more of their local currencies.
The result was the Mexican debt crisis of 1982 – and it was the first of many Latin American debt crises in the 1980s.
Mexico had borrowed too much, and borrowing in US dollar-denominated bonds had made that even riskier.
Mexico’s ensuing debt crisis was not solely its own fault. Yes, Mexico had borrowed too much. But the brutal rise in US interest rates had triggered it. Those interest rates, again, were the response to high inflation – which in turn was caused by loose monetary policy and supply shocks. As always, economics is complicated.
Still, there is one important lesson we can learn from what happened back then: once inflation spirals out of control, efforts to curb it will be brutal and have many nasty side effects.
Which brings us straight back to the ECB.
The announced moderate increases in the ECB’s rates are far from being brutal. Even after the ECB’s now-announced hikes, the ECB will remain well below what a neutral monetary policy would look like according to the Taylor Rule.
However, the writing is now on the wall that Europe’s monetary party is about to end (finally). The ECB’s leaders are unlikely to be happy about that, but rapidly rising inflation leaves them with no choice but to reverse course.
We can see proof of this ECB reversal in the yields of 10-year Italian government bonds. They are trading at about 3.8 percent, which is the highest level in almost a decade.
That, on its own, would already be reason to be concerned. Italy is heavily indebted, so such an increase in the Italian government’s borrowing costs will be costly to their minister of finance.
But what conjures up thoughts of Mexico 1982 is the simultaneous increase in the yield spreads between Italian and German bonds. That spread has doubled from last year and now stands at more than 2 percent. It means that markets are once again separating Eurozone members by their perceived risks.
This is something that we saw during the eurozone crisis of 2009 to 2012, and it may indeed remind us of the Mexico debt crisis of 1982.
The parallel here is that we see a major central bank act to bring inflation under control. But in doing so, it is pushing highly indebted countries to their limits – and potentially beyond.
There are two differences between Mexico 1982 and Italy 2022. The first is the most obvious. Where Paul Volcker increased interest rates to eye-watering levels, the ECB’s President, Christine Lagarde, has barely started that process. So far, the ECB’s rate hikes happen in homeopathic doses.
The second difference is a more speculative one: when Volcker raised interest rates, he triggered crises in countries that borrowed in a foreign currency – the US dollar. This is why Mexico was hit so much.
When the ECB hikes interest rates (or rather when the ECB will eventually hike interest rates properly), the countries most affected would have borrowed in euros. But the question will be whether an Italian euro will be the same as a Dutch or a German euro.
In other words, we will at some stage get back to the fundamental issue of the euro, namely whether it has a future as a common currency.
The more inflation takes hold in Europe, and the more this inflation drives European government bonds’ yields apart, the more dangerous the game becomes for the ECB. And then it will no longer be about whether the ECB can fight inflation, but whether it can keep the euro alive.
Having contributed to Mexico’s debt crisis with his monetary policy, Volcker ultimately had to arrange a big and unprecedented loan to save Mexico in 1982.
Christine Lagarde may find herself in the same situation with Italy in the future. And yet she will have no choice but to fight inflation now.