"The Three Highs" Scorch Europe's Economy

Liu Ying (Research Fellow, Chongyang Institute for Financial Studies, Renmin University of China) Since this summer, Europe’s economy has been scorched by extreme heat. Against the backdrop of the ongoing Israel–Iran–U.S. conflict, oil prices continue to fluctuate, further heightening inflationary risks in Europe. At the same time, persistently high public debt burdens are weighing heavily on the continent. These seemingly disparate "three highs"—high temperatures, high inflation, and high debt—are interwoven across production, consumption, fiscal policy, and financial markets, threatening an already fragile European economy. What Europe must now guard against is a new trap: the convergence of climate and energy shocks with fiscal constraints, resulting in a vicious cycle of low growth, high inflation, and high debt. Photo Source: Xinhua News Agency Most notably, abnormal extreme heat is tangibly disrupting Europe’s economic trajectory. Extreme heat not only reduces outdoor labor productivity and causes agricultural output losses, but also forces tourism to restructure. Moreover, Europe’s economic “lifelines”—rivers such as the Rhine and Danube—have suffered from critically low water levels, undermining inland shipping efficiency and sharply raising transportation costs for industrial goods and energy. Some nuclear power facilities have also seen their operations affected by high temperatures and insufficient cooling water. Extreme heat may cost the EU approximately 1% of GDP this year—roughly €180 billion. High temperatures are not only causing crop failures and economic losses; they are also giving rise to a new form of “climate-driven inflation”: falling agricultural output pushes up food prices; geopolitical conflict drives up energy prices; surging electricity demand strains energy systems; reduced labor productivity raises finished-goods costs; and infrastructure rebuilding demands greater fiscal outlays. Thus, extreme heat is emerging as a macroeconomic variable affecting Europe’s inflation, fiscal stability, and financial system. The problem is that Europe has barely emerged from its highest inflation in over four decades—only to confront renewed price pressures. Eurozone inflation rose to 2.9% in July, up from 2.8% in June, significantly exceeding the ECB’s 2% medium-term target. Faced with this complex inflation and economic landscape, the ECB chose to hold its key interest rates steady in July. Yet amid the evolving and intricate dynamics of the Israel–Iran–U.S. conflict, European energy prices remain highly uncertain, and the full impact of the inflationary shock has yet to fully materialize. The ECB thus faces a dilemma: continuing to cut rates to stimulate growth would exacerbate inflation expectations; tightening monetary policy again would further raise financing costs for businesses, households, and governments—thereby intensifying debt risks. Markets have already begun repricing Europe’s interest-rate path, with widespread expectations that the ECB will hike rates again, potentially forcing European monetary policy back into an “inflation-fighting first” phase. What truly constrains Europe’s policy space, however, is likely its increasingly heavy debt burden. One of Europe’s most pressing macroeconomic contradictions today is this: “spending needs keep rising, while available fiscal resources keep shrinking.” The European Commission forecasts that the EU’s debt-to-GDP ratio will climb from 82.8% at the end of 2025 to 85.3% by 2027. Italy’s government debt ratio exceeds 135%, and many European countries’ budget deficits and debt ratios have already breached warning thresholds. Europe is entering a new “debt-constrained era.” In the past, under low-interest-rate conditions, high debt did not necessarily trigger an immediate crisis, since governments could roll over debt at relatively low cost.

The European Central Bank Holds Steady—What Is It Afraid Of?

When markets repeatedly script "rate cuts are imminent" into their trading narratives, the European Central Bank chooses to keep its hands in its pockets—refusing to reveal its cards just yet. On the surface, this reflects caution; more deeply, it signals a defensive posture—not unwillingness to act, but reluctance to move before the situation becomes clearer. Many interpret "holding rates unchanged" simply as one word: hawkish. But the real issue is far less linear. Europe today faces not just inflation or just sluggish growth—but a far more complex hybrid challenge: economic recovery remains incomplete, inflation has not decisively retreated to safe levels, and external geopolitical risks continue to stoke energy prices. Premature policy shifts would carry a far greater cost than merely missing one rate cut: they risk reigniting inflation that has only just begun to ease. Ultimately, what the ECB fears most is not market disappointment—but market misperception. Its first fear is that inflation is only "pretending to recede." The greatest headache for major central banks globally is not high inflation per se, but its “stickiness.” A decline in prices from peak levels does not automatically signal that risks have dissipated. In Europe especially, the transmission chains linking energy, transport, manufacturing, and food are long and complex. Once oil prices rebound, the impact rarely stops at gas station price tags—it ripples through corporate costs and household expenditures. This is where monetary policy hits its most awkward impasse: it can suppress demand, but cannot directly eliminate supply-side shocks. Rate hikes can slow consumption and investment, but they cannot control Middle Eastern geopolitics—or oil tanker routes. If geopolitical tensions push up crude oil and natural gas prices, Europe’s disinflation trajectory could be derailed. Should the central bank have already signaled easing, markets would instantly repricing: bond yields would rise, inflation expectations would rebound, and wage negotiations could become markedly more aggressive. That is precisely the scenario the ECB desperately wants to avoid: having painstakingly pulled inflation down from elevated levels, only to see it reignited by a premature, “front-running” rate cut—and thereby rekindle collective market expectations of rising prices. Central banks have never feared poor data today as much as they fear losing tomorrow’s credibility—the belief that they can safeguard price stability. Its second fear is that an energy shock drags Europe back into “slow growth + high costs.” For the U.S., rising oil prices are primarily an inflation event; for Europe, they often double as a growth event. Because Europe’s economy is more sensitive to external energy shocks, higher energy costs not only lift headline inflation but also erode corporate profits, undermine manufacturing confidence, and reduce household disposable income. Put simply, if oil prices surge too rapidly, Europe suffers two simultaneous pains: rising costs on one side, weakening demand on the other. This is not the traditional case of “an overheated economy needing cooling,” but a far more intractable combination—insufficient growth strength paired with insufficiently low prices. Once this state takes hold, monetary policy space shrinks dramatically. Cutting rates too quickly may fuel inflation expectations; maintaining high rates may further hamper economic recovery. The ECB’s current reluctance to commit to a clear rate-cutting path stems fundamentally from its uncertainty about whether the current energy risks are merely a passing gust—or whether they will become the dominant theme of Europe’s next economic phase. In other words, it is not competing with markets—it is wrestling with “uncertainty.”

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