On June 18th, Eurostat released the latest inflation numbers for the EU and its 27 member states:
The euro area annual inflation rate was 1.9% in May 2025, down from 2.2% in April. A year earlier, the rate was 2.6%. European Union annual inflation was 2.2% in May 2025, down from 2.4% in April. A year earlier, the rate was 2.7%.
These are good numbers, continuing the trend of slowly declining inflation rates after the 10+% that plagued the euro zone three years ago. However, by historical comparison the inflation rate is still on the high side. Figure 1 reports the inflation of the current 20 euro states all the way back to December 2000. The dashed light-blue line represents the 1.9% inflation rate in May this year.
Figure 1
We have to go back to the first decade of the euro’s existence, 2000-2009, to find an inflation rate consistently higher than what it is today. Economic activity was generally higher across the EU, including the current 20 euro zone members; with higher GDP growth rates and lower unemployment, Europe’s economies had a natural inclination toward higher inflation.
However, for precisely this reason, inflation back then was less problematic: it was the kind economists refer to as demand-pull inflation. When a high rate of economic activity causes inflation, the root cause of that inflation is excess demand for labor and for the goods and services that consumers and businesses buy. When excess demand causes an increase in inflation, that increase in itself has a cooling-off effect on economic activity: excess demand recedes until demand aligns with supply.
With excess demand gone, inflation falls back again. In short: demand-pull inflation is a problem that solves itself.
The type of inflation that the euro zone is currently dealing with is not of the demand-pull kind. Current inflation is a lingering tail end of the monetary inflation that began at a fragmented level in 2021 and hit Europe with full force in 2022. The origin of this monetary inflation was an excessive expansion of the money supply, which in turn was used primarily to buy up government debt.
There is no more dangerous way to cause inflation than to monetize government budget deficits. The rise in inflation is rapid and unstable—exactly as we saw in 2021 and 2022—but its decline is agonizingly slow. The reason is simple: during the surge phase of the monetary inflation episode, businesses and households rapidly build in higher inflation rates in their contracts. They adjust prices more frequently, negotiate wages more often, and are reluctant to ‘believe their own eyes’ when inflation reaches its peak.
Although money supply is no longer being used to buy up government debt, inflation lingers on in price contracts and pricing habits among businesses.
A closer look at Eurostat’s inflation numbers shows this lingering effect at the national level, but it also shows that it varies significantly between the member states. Figure 2 reports a significant spread of inflation rates across the EU, from 5.4% in Romania, 4.6% in Estonia, and 4.5% in Hungary to 1.4% in Ireland, 0.6% in France and 0.4% in Cyprus:
Figure 2
The inflation spread has an upward bias, just as one would expect on the tail end of a major inflation episode. Every month in 2025 so far, at least five EU members have had an inflation rate higher than 4%.
For comparison, in 2018 only two countries exceeded 4% inflation: Romania for eight months, and Estonia for one month.
Although persistent inflation is a problem, it is not a permanent one. The root cause of inflation is gone, and all that remains is a market-driven process where worries about inflation are slowly ground down by reality.
With that said, there are worrying clouds on the inflationary horizon. I see a risk that the EU will inflict upon itself another dose of the same type of destructive inflation as in 2022. The reason is in the determined and highly coordinated effort to increase Europe’s defense spending. There are only three ways to pay for this expansion:
- Redistribution of current government spending. If lawmakers cut spending on social benefits, they can free up money for a larger military. I fail to see how this could be done on a scale broad enough to finance a pan-European surge in military spending to the 5% of GDP that is sometimes mentioned as the new goal. The required cuts to welfare state benefits would cause unmanageable social unrest.
- Higher taxes. Although politically tempting, this would be destructive to the European economy. If there is one thing the EU’s member states cannot afford right now, it is higher taxes. While I see no hints of higher taxes to fund more military spending, it cannot be ruled out that Europe’s left-leaning legislatures would try to do it anyway.
- Deficit monetization. This is the one option that we should fear. Given the significant political difficulties associated with redistributed spending and higher taxes, it cannot be ruled out that the European Central Bank once again is roped into funding budget deficits. If that happens, Europe’s economy is in big trouble: it would be hurled into another serious episode of monetary inflation—right on the heels of the last one.
Let us not get lost in pessimism: Europe may find a way to expand military spending without solving impossibly difficult ideological deadlocks, and without causing another outbreak of inflation. Hopefully, by being made aware of the hard realities that come with various funding options, they can steer clear of those that will send Europe back into 2022.
