ECB squeeze leaves room for fiscal war response

European countries have to shoulder the burden of the economic response to the war in Ukraine. That will add to the debt loads accumulated during the pandemic, at a time when the European Central Bank is pushing up borrowing costs. But governments can afford to be bold.

In normal times, the classic policy response to a jump in energy prices would be to let households and businesses absorb the shock. Governments would not cushion the blow with price controls, and central banks would not worry too much about temporary inflation.

This time, however, neglecting the inflation threat could force the ECB to take tougher measures later. Prices were already rising by an annual 5 per cent in January, and the Organisation for Economic Co-operation and Development sees the energy shock adding a further 2 percentage points to inflation this year. That's why the ECB has scheduled the end of its bond purchases, and may even raise interest rates this year.

The tighter policy comes at a bad time for governments, who still have to help their economies absorb higher energy prices and an influx of refugees, and boost defence spending. Bruegel estimates that the fiscal cost could reach 4 per cent of GDP. Gross debt in the euro zone had already risen to a little under 100 per cent of GDP, with Italy's at 150 per cent.