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Industrial Policy

EU governments spend big against inflation, adding fuel to fire

PRAGUE — Fearful of high prices sparking social unrest, European governments are ladling out support, but their strategy may backfire.

On the one hand, cash-strapped voters are taking to the streets demanding an end to historically high prices; on the other hand, copious handouts and sweeping tax cuts risk doing more harm than good.

“The ‘whatever it costs’ approach would not be the right response against inflation,” French Finance Minister Bruno Le Maire told reporters on the sidelines of a meeting of EU finance ministers in Prague this week. “You run the risk of feeding inflation instead of fighting inflation.”

Inflation keeps accelerating, averaging 9.1 percent in August across the currency zone and reaching above 20 percent in the Baltics. The European Central Bank on Thursday raised interest rates by an unprecedented 75 basis points, and warned more hikes might be needed.

The rise in prices is largely the effect of an energy supply crisis triggered by the war in Ukraine, and Russia’s decision to shut off gas supplies to Europe in retaliation for sanctions.

As a result, electricity prices — which under EU rules are linked to the price of gas — are now several times higher than a year ago, sending bills soaring and hurting businesses’ and households’ bottom lines. In Germany, Europe’s largest customer of Russian gas, power prices reached a staggering record of €1,000 per megawatt/hour in August before subsiding. 

So far, the pressure to appease angry voters has had the upper hand. Governments have rushed to spend hundreds of billions of euros — in some cases amounting to several percentage points of GDP — through policies including cutting fuel excise duties and VAT rates, handouts to households, and bailouts to energy companies. On average, the EU spent 0.9 percent of its GDP in efforts to cushion the impact of inflation in the first eight months of 2022, a figure that’s likely to double by year’s end, Economy Commissioner Paolo Gentiloni said.

But this is largely helicopter money that doesn’t target those most in need, and runs the risk of incentivising demand and countering central bankers’ efforts to rein in inflation.

“When you introduce a measure, the tendency to leave it there is inevitable; and when you have a difficult situation it’s very difficult to limit your intervention to certain groups,” Gentiloni said, urging governments to make support “temporary and targeted.”

But targeting low-income groups is challenging, Irish Finance Minister and Eurogroup President Paschal Donohoe acknowledged. “Responding to help societies in a targeted way from a policy point of view is complex,” he said, adding that “scale and design” were key.

Finance ministers on Friday agreed to prioritize targeted cash transfers instead of broad-based measures.

“We clearly err on the side of income transfers to be more efficient,” said ECB President Christine Lagarde, noting a slight improvement in the design of aid measures, 15 percent of which are now targeted, compared to 10 percent previously.

But while public opinion has been overwhelmingly in support of Ukraine and the EU’s response to Russia’s invasion, politicians are wary that the public may turn against them and they see big spending as a means to prevent backlash and social unrest.

“There is a strong political wind blowing, and we’re doing our best to lean against it and to prevent excesses from taking place,” said an EU official.

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