Category: Economical and financial crisis

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Conjoncture Economical and financial crisis Economical policy

Trump: Consistent Concerns, Inconsistent Actions?

Published by Les Échos on April 7, modified and completed on April 10

Trump has a few central economic ideas that seem to guide his words and actions. And while he appears to many to be disorderly, incoherent, and contradictory, his worries are not devoid of both a sense of reality and coherence. But he seems to have only one weapon to achieve his goals, wielded in a brutal and crude manner: tariffs. Doubtless, along with a weakening of the dollar. But the wielding of these weapons is contradictory and dangerous.

The difficulties of the American economy are not due to its growth rate or productivity gains, which have been significantly higher than those of the Eurozone, particularly for the past fifteen years. On the other hand, between 2000 and 2024, the share of industry in GDP fell from 23% to 17%, with the resulting adverse effects on American workers and middle class.

Furthermore, the twin deficits, public and current, have led, over the last twenty-five years, the United States to see its public debt soar from 54% to 122% of GDP and its net external debt multiplied by a factor of 4 (approximately from 20% to 80% of GDP).

Monetary Dilemma

This explosion of both debts will sooner or later pose a problem regarding the dollar’s status as an international currency. However, the United States has a structural need to finance its debts, and therefore a need to attract capital from the rest of the world.
And owning the international currency (approximately 90% of foreign exchange transactions, 45% of international transaction payments, 60% of official central bank reserves) greatly facilitates this financing, since countries with a current account surplus, most often in dollars, almost systematically reinvest this liquidity in the American financial market. Especially since the United States has outperforming equity returns, and by far the deepest capital market.

This status as an international currency also requires the country with this considerable advantage to accumulate a current account deficit over the years so that the rest of the world can hold the amount of international currency it needs, quasi automatically financing this deficit.

But, as in all things, balance is essential, and in this matter, it is difficult to maintain. The United States does not regulate the size of its deficits and debts according to the needs of the rest of the world, but according to its own needs. This, moreover, gives the international monetary system an intrinsically unstable character, as the global currency is merely the debt of one of the system’s players imposed on the others, and not that of an ad hoc institution, not being one of the players themselves.

Robert Triffin, as early as the 1960s, stated that if the United States did not run a sufficient current account deficit, the system would perish from asphyxia. And if this deficit (and therefore the external debt) became too large, the system would die from a lack of confidence.

Faced with the dangerous dynamics of external debt in particular, today Trump must therefore protect confidence in the dollar to perpetuate its financing by the rest of the world without (too much) pain, that is to say at non-prohibitive rates, and, at the same time, try to reduce excess imports compared to exports so that the trajectory of this debt can be sustainable. With a coherent objective of reindustrialisation, thus making it possible to reduce this gap, by limiting imports of industrial products, while making his voters happy.

So Trump is right to be concerned about the unsustainable trajectory of U.S. external debt. The dollar’s role as an international currency goes hand in hand with current account deficits for the country issuing such a currency. However, if these deficits become too large and external debt grows excessively relative to GDP, U.S. creditors might lose confidence in the dollar, potentially causing its value to drop significantly and/or increasing refinancing rates due to higher risk premiums demanded by the global market. This concern is justified.

Fragile Confidence in the Dollar

Yet, Trump seems to have only one weapon in his arsenal to achieve this: tariffs. And the apparent aim of weakening the dollar. At first glance, indeed, both an increase in tariffs and a weakening of the dollar can simultaneously lead to a decline in US imports, an increase in domestic production and in exports, and a need for non-Americans to develop their industries within the United States to maintain their commercial presence.

However, this strategy, while seemingly coherent, clashes with the contradictory need for a stable dollar if we wish to maintain the confidence of the rest of the world, which buys US debt.

Furthermore, the weaponisation of the dollar by previous administrations to enforce financial sanctions imposed by the United States, has already seriously damaged the confidence and desire of the rest of the world to hold unlimited amounts of dollars. Those of the “Global South” countries in particular, which are simultaneously challenging the American double standard.

In addition, the abrupt and seemingly erratic announcements regarding huge tariffs increases are also not fostering confidence in the American economic and financial system, to say the least. This is without even considering their very dangerously regressive potential for the global economy.

Let us also incidentally note that Biden’s IRA had effects similar to tariffs – though much less abruptly and violently- by heavily subsidizing industries producing exclusively in the U.S., which violates WTO rules.

Additionally, the Trump’s idea that the imbalance between U.S. imports and exports is primarily due to unfavorable and unfair conditions imposed by surplus countries is incorrect. While China has built its growth on exports while restricting access to its market, the significant U.S. current account deficit mainly stems from an insufficient domestic competitiveness and from a strong lack of savings compared to investment, that is to say from demand being much greater than domestic supply, leading to huge current deficits and consequently to a evergrowing reliance on external financing.

Instead, structural measures to enhance U.S. industrial competitiveness and public deficit reduction are essential.
In summary, while concerns about maintaining a sustainable trajectory for U.S. external debt are justified, balancing individual current accounts with each country based on perceived abuses by surplus nations is totally misguiding. Furthermore, aggressive use of tariffs or dollar manipulation reflects a crude and dangerous approach to economic policy that is risky, even as a negotiation tool. And lacks theoretical as well as empirical legitimacy.

Protecting Financial Stability

Trump is therefore right about his “obsessions,” but undoubtedly wrong in the nature of his response.

He also brandishes threats against countries that are considering creating alternative payment systems to the dollar, and perhaps soon against those that channel less of their excess savings into American financial markets.

And perhaps he also dreams of transforming their debt obligations to the United States into very long-term, low-interest debt (see Stephen Miran, Chairman of Trump’s Council of Economic Advisers). This would, of course, definitely precipitate the rest of the world’s loss of confidence in the dollar.

It is also possible, with the same objective, that he is considering facilitating the development of stablecoins, cryptocurrencies backed by the dollar, in the hope that they will spread worldwide, thus de facto dollarizing the planet. To the detriment of the monetary sovereignty of other regions of the world. We can therefore bet that, in countries around the world, authorities would prevent this by regulating payments within their borders, thus protecting their sovereignty and global monetary and financial stability.

The economic and financial challenges facing the United States are significant. But the solutions to address them are certainly more diverse and more structural than simply imposing tarifs. And, much worse still, very high tariffs, with inevitable retaliatory measures, would lead to a huge global recession combined with a major financial crash.

Olivier Klein is a professor of economics at HEC

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Economical and financial crisis Euro zone

Europe: The Threat of Erasure

L’Opinion, March 11, 2025

When a pure and simple balance of power prevails around you, to be heard and, better still, respected, you must be strong and united when you want to defend the values ​​of the rule of law, multilateralism, international law, and the idea of economic and social regulation. Europe upholds these values, but currently has little capacity to enforce them. And yet, it has the potential.

Lagging behind

But Europe has significantly fallen behind the United States economically. From 2000 to 2024, the Eurozone experienced half the growth rate of the United States, averaging around 1% annually compared to 2% across the Atlantic. With productivity gains of 0.7% per year compared to 2%. These gaps have widened further since 2019. China dominates global production of solar panels (84% of market share) and wind turbines (55%).

Europe also has a very limited presence in other future industries (electric batteries, semiconductors, data industries, etc.). Due to a lack of investment in new technologies and a deficiency in productivity gains, Europe has not given itself the means to achieve economic power.

Despite the laudable nature of its intentions, Europe has adopted a highly normative and often insufficiently realistic approach, to the detriment of its economy and competitiveness. It manufactures at high cost and has become obsessed with creating all kinds of meticulous standards. Moreover, regulations are often disparate among the different members of the European Union, which is also a significant obstacle to economic growth.

Hyperpowers

However, the lack of balance between ethics and efficiency cannot sustainably uphold the stated ethical principles, due to the lack of a dynamic and sufficiently competitive economy. And so, Europe, as it has operated in recent years, has focused on appearing righteous. But far from this essential balance, it is ultimately often viewed as a hindrance. With its complex and insufficiently effective governance, it is seen as having great difficulty to assert itself in the face of the rise of Chinese and American hyperpowers.

But even if Europe, among developed countries, does not have exclusivity in this regard, many countries on the continent are weakened by the growing distrust in their populations’ ability to live together, as well as in institutions and democracy itself. We in Europe must not shy away from carefully analysing the reasons for this loss of confidence. At stake are the detrimental effects of ignoring popular (and not populist per se) demand for public authority, security and better regulation and integration of immigration.

In some European countries, it is also important to carefully assess the disempowering and distrust-inducing effects of excessive administration. This also includes the negative effects, both socially and economically, of public overspending and compulsory contributions, overregulation, the serious excesses of the rise of individual rights in the face of weakening obligations, and hardline egalitarian tendencies.

Whilst populist movements are growing significantly, including in France, Germany, Austria, and the Netherlands, for example, it is not enough to simply criticise them. Only a fair and urgent awareness and appropriate responses from governing parties can prevent the advent of a brutal, populist backlash.

Causalities

Let’s not reverse the causalities; populism is the symptom and consequence of a disaffection with democracy and institutions, much more than its cause. European credibility will then only be stronger, both within Europe itself and vis-à-vis the United States or the “Global South,” and its criticism less easy.

The decline is not inexorable if Europe and its constituent countries are still capable of a strong multidimensional resurgence, of an essential impetus.

These two combined phenomena—economic decline and rising distrust of institutions—could lead to the “slow death” (cf. Mario Draghi) of our old continent, assailed by doubt. An existential question, if ever there was one. Civilisations, even the most magnificent ones like ours, can end up slowly fading away. But this decline is not inevitable if Europe and its constituent countries are still capable of a strong multidimensional resurgence, an essential impetus.

By pooling many of our strengths and seeking greater unity, in the diplomatic and military spheres. But also in the economic and industrial spheres, through greater integration, the ability to create European champions, and a drastic reduction in our internal regulatory barriers.

Governance

And this will only be possible by significantly improving the governance of the European Union. Ultimately, by rediscovering the right balance between the necessary regulation of market forces versus the buoyancy of the economy, and social environmental protection versus efficiency, rules versus freedom, tradition versus modernity, respect for the individual versus that of society… Without these balances, our model could disappear in a moral bankruptcy with a financial bankruptcy in tow.

A European scale is the only way possible, given the dominance of the American and Chinese superpowers. Europe can and must react vigorously and not allow our model, our way of life, and our economic, social, and value system to disintegrate. The challenge is to ensure a future for our European civilisation.

By not allowing Europe to slip out of history through an inexorable weakening. By not allowing the rise of authoritarian and brutal regimes, more indifferent to the rule of law, in this very country. By making Europe’s voice heard in the concert hall of great powers. To conclude, let us quote Cioran: “A civilisation begins with myth and ends with doubt.”

We can still muster the resources and strength to resist doubt. Three minimum conditions are essential for this: first, lucidity in analysing our weaknesses as well as our strengths. Second, the essential sense of urgency. And finally, the courage to regain the governance and balance essential to our vitality.

Olivier Klein is a professor of Economics at HEC and Managing Director of Lazard Frères Banque.

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Bank Conjoncture Economical and financial crisis

Europe : high time to wake up

Les Échos , the 18th of February 2025

We are at a real turning point in the history of Europe. In this changing world, which has turned its back on multilateralism and today faces the pure and simple return to the balance of power between nations, one of two things will happen: either Europe pulls itself together economically, politically, diplomatically and militarily, or Europe that is half-asleep continues its decline and gradually disappears from history. 

But getting its act together will not be easy. If Europe has clean hands today, it is heading towards having no hands at all. Let us put an end to our inability to be bold and innovative on our aging continent, due to the constant desire to regulate and standardise before inventing, creating and developing. Furthermore, to force the rest of the world to follow our standards is naive; we have neither the economic nor the diplomatic power to impose them on others.

Let us stop thinking of ourselves in Europe as the camp of the self-righteous, by developing for ourselves at every turn finicky regulations where the letter ends up prevailing over the spirit. They end up hindering our companies, with endless bureaucracy. These are worthwhile goals, but the never-ending red tape needlessly damages our competitiveness.

Let us do away with our naivety in wanting to be continuously top of the class on climate, when this leads directly to the detriment of our industries and de facto favours populism which has a strong climate skepticism. Let us instead seek to best combine the health of the planet and growth, by investing massively in the industries of the future – where we have no presence – including in the climate transition industries – where we are so weak.

Let us also leave behind our naivety when it comes to energy, where yesterday we were subjugated to Russia, and tomorrow to the United States. It is essential for our global competitiveness. Currently we are on average paying at least five times more than the Americans for the price of natural gas.

Let us think that the single financial market would be highly desirable, but that it would not produce the expected effect on its own. The surplus of European savings will spontaneously finance more investments in Europe – only if we establish an explicit framework of financial solidarity within the euro zone. For this, the public finances of France, among other countries, must finally be credible. Risk sharing versus market discipline, right? We also need a European capacity to facilitate the development of our newly created companies to make them global giants. And thus provide attractive returns.

The multiple non-financial barriers to doing so are crippling.

Europe no longer knows how to correctly combine the principle of ethics and that of efficiency. Ethics alone, constructed as an absolute end, to the detriment of efficiency, is only a short lived illusion that we create for ourselves. The reverse is also true. But today, multifaceted, quasi-dogmatic formal ethics has ideologically taken too much precedence over its indispensable partner and unduly hinders it. It is the right balance between regulation and free play of the market that we must aim for. One that enables the dynamics of the economy while seeking the necessary protection against its potential excesses.

Europe has been, and can once again become, the place on earth that best combines these two principles. This has made our social market economy model so strong. It is up to pro-European democratic forces to vigorously regain the vitality and balance they need. Before others impose a brutal paradigm shift on us.

 It is only through this renewed vitality that Europe will be able to continue to chart its course and control its destiny. This is an urgent matter.

Categories
Economical and financial crisis Economical policy

Can the French public debt rate be stabilised?

When the interest rate is equal to the growth rate, as it is today, stabilising the debt rate requires a zero primary public deficit (before interest charges on the debt). And a primary surplus is needed to reduce this debt rate. Otherwise, the public debt
continues to increase and, the higher the debt rate, the greater the risk of a snowball effect.

France is far from enjoying a stabilised debt situation. With a very high public debt to GDP ratio of over 110%, and a very marked upward trend in this rate (the rate was around 20% in 1980), France is experiencing a primary deficit of between 3 and 4% of GDP, with an interest rate on the debt approximately equal to the nominal growth rate. This, without correction, will sooner or later lead to a refinancing crisis.

If the interest rate on the debt were to be higher than the nominal growth rate, due to a generalised rise in interest rates or in the spreads paid by France or because of a fall in the growth rate of the French economy, the snowball effect of the public
debt would become even more significant.

It would therefore be necessary to reduce public spending by around 100 billion euros. Doing it too quickly would lead to too sharp a slowdown in growth and would be difficult to accept. Doing it too slowly would lead to a new dangerous increase in public debt, which would put the country’s solvency at risk, would very probably also slow down growth due to the fear of savers and investors thus generated, and finally would risk a financial crisis which would force adjustments to be made urgently and brutally, as in the case of Spain and Portugal, for example, during the Eurozone crisis.

Let us add that given the comparatively very high level of French public spending and compulsory contributions on GDP, it is much more economically efficient to reduce the former and not increase the latter. Reducing public spending indeed contains much less risk of slowdown, and could even promote growth, compared to increasing taxes. Also, while it seems elegant to say that the choice between reducing spending and increasing taxes is a political choice, it is certainly not relevant in terms of economic efficiency in France’s current situation.

Moreover, income inequalities after redistribution are among the lowest in Europe in France and the level of redistribution on GDP is already one of the highest. Reducing income inequalities in France is therefore not a reasonable objective, because it would go against the pursued goal by further reducing competitiveness which is already too low and an incentive to work that could be improved, and therefore an employment rate that is already insufficient. Which would go contrary to the direction of the announced objectives.

Stabilising and then reducing the French public debt rate is a sine qua non condition for the sustainability of our social protection and our standard of living. Risking hitting the debt wall by refusing structural reforms or going back on those that have been carried out would risk forcing us to implement austerity policies that socially are very costly.

Let us recall that if the United States, which has a very high public debt rate and a large primary deficit, does not have the same burning obligation to date, it is because it has benefited until now from a much higher economic dynamic than ours, from a stock market yield and interest rates higher than ours, which attracts capital from all over the world. Thus, they have, until now, had no trouble refinancing their external debt as well as their public debt. However, this will not absolve them ad vitam aeternam from having to correct their public finance trajectory as well.

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Conjoncture Economical and financial crisis Global economy Uncategorized

Inflation, Endgame?

After having surprised us with its vigour, inflation, due to a demand shock – which rebounded very strongly once the lockdowns ended – and to a supply shock – dramatically reduced during the pandemic -, seems to be gradually returning to acceptable levels. The causes of this decline can be attributed to a gradual increase in global production capacities and the fall in excess demand through the deflation of excess savings generated by the lockdowns. But disinflation was also caused by a very reactive and internationally coordinated monetary policy as well as the strong credibility of central banks who showed great determination in wanting to bring inflation back on target. This has ensured that the inflation expectations of the various economic actors – businesses and households – do not become dislodged. Let us add that until now, contrary to a number of forecasts based on historical data, we have witnessed a soft landing of the economy, that is to say without recession and without any systemic financial shock. So is the game won? Quite possibly. However, several points should make us cautious about this diagnosis.

Salaries have recently increased at a rate that remains high (between 4 and 5% per year). However, in the euro zone, almost zero productivity gains make it impossible to compensate for this increase. Corporate margins are therefore at stake. Continuing in the euro zone, it is the fall in import prices which has provided a large portion of the disinflation. But can they continue to fall further? And prices for services continue to rise rapidly. Furthermore, until now, the sharp increase in interest rates in a context of historically very high public and private debts has not produced the financial impact that was feared. And yet hadn’t we talked about a possible “perfect storm” on this topic? Some reasons for this non-event: increased savings and inflation protection policies have fuelled growth which helps overcome rising costs of debt. Banking regulations, significantly tightened since the last major financial crisis (2007-2009), have generally succeeded in safeguarding the banks.

Companies, taking advantage of the very low rates preceding the return of inflation, had extended their loans and had taken them out at a fixed rate instead. However, let’s keep in mind a few elements that also encourage caution. The professional real estate sector, during the real estate bubble preceding the pandemic, may have experienced excess debt here and there, resulting in insolvencies beginning to appear. Many companies in all sectors, sometimes with high leverage, will have to refinance their loans over the next few years. States themselves, which are highly indebted, will gradually have to bear sharply increasing interest charges which will disrupt their solvency trajectories. The sensitivity of financial markets to this type of situation could thus increase significantly. In addition, central banks will certainly be keen not to reproduce periods of interest rates that are too low for too long, periods which weaken financial stability. And they will want to maintain room for manoeuvre to deal with future systemic crises. Inflation, moreover, for structural reasons, will no longer be as low as during the last 30 years.

We should therefore have changed our interest rate regime a long time ago, returning to more normal rates, that is to say closer to nominal growth rates. Also, if the situation so far has proven to be a successful landing of inflation without major damage to the economy, to avoid a large-scale upheaval that is still possible, it is therefore up to private and public economic actors, supported by macro-prudential rules well established by the concerned authorities, to adapt vigorously to ensure the sustainability of their solvency and their growth.

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Economical and financial crisis Economical policy Global economy

Monetary policy challenges put into perspective

Monetary policies, in practice as in theory, necessarily adapt to changes in the way the economy is regulated and, by construction, to successive changes in inflation regimes.

The appearance of high inflation during the 1970s led to a change in the use and theory of monetary policy at the end of the decade and in the first half of the 1980s. The literature of the time endorsed the idea that the monetary weapon must be dedicated to the fight against inflation, creating a consensus on the fact that there could be no effective arbitrage between the fight against unemployment and the fight against inflation. In the medium-to long-term, accepting more inflation to strengthen growth only caused an increase in structural inflation, without an increase in the pace of growth. From 1979, Volcker heavily restricted the expansion of the monetary base (the quantity of central bank money), which raised interest rates to record highs and, in doing so, caused a strong recession.

The resulting cyclical drop in inflation gradually led to a structural regime of low inflation. Monetary policy was not the only reason here, or even the major reason. The 1980s were in fact, on the one hand, a time of financial liberalisation (deregulation and globalisation) and, on the other hand, in the real sphere, the very beginning of globalisation, which was greatly accentuated during the following two decades.

The effects of technological developments

Financial globalisation has put increased pressure on long-term interest rates in countries experiencing comparatively high inflation. And globalisation has led to the emergence of a competitive workforce cheaper than that of developed countries, implying necessary wage moderation in advanced countries. But also symmetrically a massive exit from poverty in emerging countries.

The 1990s and 2000s also brought a new technological revolution. The digital and robotics revolution, while statistically it has not shown clear evidence of an increase in productivity gains, has nevertheless slowed the growth of wages, in particular for the least qualified workforce, via the possibilities of substituting work by automation which it facilitates for certain categories of tasks.

Thus, once again, as at the end of the 19th century and the beginning of the 20th, low inflation was established for the long term, made possible by the return of the globalisation of the capital and commodity markets as well as investments and by the development of a new technological revolution. As a result, the 1990s and 2000s meant that monetary policy could be used not only to combat inflation but also to further promote regular growth at a good level.

From money supply to interest rates

Hence a new evolution of economic theory, in support of this new practice. On the one hand, it justified abandoning the money supply as an instrument of monetary regulation, to highlight the essential role of interest rate rules, i.e. the setting of key (short term) interest rates by central banks. In practice as in theory, exit LM from theoretical and econometric models (see Jean-Paul Pollin, Une macro-économie sans LM, Revue d’économie politique, March 2003). And on the other hand, the new theory of monetary policy argued that there were optimal interest rate rules that simultaneously kept inflation at the desired target level (2% increasingly became the benchmark) and ensure regular and balanced growth. This gave central banks the new ability to institute a period of great moderation, during which real cycles were greatly attenuated and inflation was almost, if not completely, under control.

The reappearance of financial cycles

However, parallel to this apparent great temperance, another phenomenon has gradually gained momentum and has not been taken into consideration by most theoreticians as well as practitioners of monetary policy. This is the reappearance of financial cycles, interacting with real cycles but with a significant degree of autonomy due to their own dynamics. These financial cycles had, however, been concomitant, at the end of the 19th century and the beginning of the 20th century, with financial globalisation and globalisation. But their ability to cause severe financial instability, with profound economic consequences, was largely ignored until the new major financial crisis of 2007-2009. In the theory forged in the 1990s and prevailing until the great crisis, financial stability was in fact considered to be a given as long as regular growth and stable inflation were both established.

However, without much attention and therefore without much monitoring, financial cycles have once again developed, longer than real cycles, made up of several phases.

With long enough real growth, a phase of rising debt rates (in the private and/or public sector depending on the period) and the development of bubbles in property assets (mainly stocks and real estate) gradually begins. This leads to a phase of euphoria where we end up collectively thinking that growth will continue forever and that the prices of heritage assets will rise constantly, giving valid reasons for this each time. The financial cycle, in its paroxysmal phase, ends with a violent reversal, due to a sudden change of opinion, a rupture of previous conventions which until then legitimised the level of debt ratios, leverage, multiples of valuation, etc., although historically very high.

Ensure multidimensional stability

These reversals of phases are partly due to the fact that it becomes more and more difficult to rationally justify these phenomena, but also because euphoric anticipations always end up being disappointed sooner or later. Finally, let us note the role of chance in these sudden changes of opinion, in these mass stampedes. De facto, certain events, however significant, do not cause any rupture, while others, sometimes seemingly more insignificant, end up doing so. Thus begins the final, catastrophic phase of the cycle, with bursting of bubbles, a sudden rise in the insolvency of a number of economic agents and recession, in a context where borrowers then seek to significantly lower their leverage and where lenders can rationally, out of fear of the future, limit their credits. All of which drive each other into a vicious cycle and contain a high risk of depression and deflation.

Thus, in such a model of regulating the economy, the stability of prices at a low level and the regularity of growth do not automatically lead to financial stability. On the contrary, the low inflation policy that this mode of regulation generates leads to structurally low interest rates, which in turn encourage increasing debt and bubbles. Monetary regulation must therefore in reality, during these periods, ensure multidimensional stability. It must strive to promote monetary stability (inflation as its objective), a regular and an adequate level of growth (effective growth as its potential), but also financial stability (fighting against an unreasonable rise in public and/or private debt rates and against destabilising speculative dynamics).

Financial deregulation and globalisation, as the long history has taught us, thus facilitate financial instability, itself linked to the intrinsic pro-cyclicality of finance. Even if, moreover, they also produce favorable effects of which is not the issue here. In such a context, it is therefore not a question of wanting to re-fragment the financial markets, but, through appropriate regulations and ad hoc policies, of knowing how to limit this pro-cyclicality as much as possible beforehand and of limiting the potentially catastrophic effects when they occur.

Fundamental uncertainty

This intrinsic pro-cyclicality and instability of finance are thus due to this endogenous uncertainty, qualified as fundamental or radical uncertainty, different from risk situations which allow a probabilistic calculation. They are also due to the simultaneous existence of an information asymmetry between the co-contracting economic agents − here for example between the lender and the borrower − which does not allow prices (or interest rates) to always play their role of balancing supply and demand. But they are also due to the presence of cognitive biases which reveal the insufficient realism of pure rationality defined and assumed by canonical models. These concepts, which make it possible to develop a theory closer to reality, more faithful to the world as it is, do not, however, call into question individual rationality. On the one hand, they provide the means to take into account a rationality that is itself more realistic, that is to say a limited rationality (the cognitive power of individuals is not infinite) and a contextual rationality (it depends on the elements of knowledge at our disposal). On the other hand, they make it possible to analyse why the sum of individual rationalities does not systematically give rise to collective rationality. In other words, why the sum of the rationalities of each, in certain circumstances, comes out of a “corridor” in which the spontaneous way actors play leads to a return to balance, but in the opposite way builds cumulative imbalances which induce a generalised vulnerability of the system (See in particular Leijonhufvud, Nature of an Economy, CEPR, February 2011).

Equipped with the prevailing theories at the time, the monetary authorities were thus unable, before the huge financial and economic crisis of 2007-2009 violently erupted, to take into account these financial cycles which see debt and bubbles expand. However, from 1987 (equities), then during 1990, 1991 and the following years (real estate), in 1997 and 1998 (sudden stop crises in emerging countries), in 2000 (equities) and of course in 2007-2009 (debt and real estate), systemic crises have reappeared, consisting of the bursting of successive speculative bubbles and increasingly pronounced credit and overindebtedness crises.

On the other hand, the return of systemic financial crises has provoked, at the international level, a salutary reaction from central banks and regulators. First of all they were able to avoid catastrophic events in these crises and to avoid the return of long periods of depression which historically follow such situations (Reinhart and Rogoff, This time it’s different, eight centuries of financial madness, Pearson, 2013 ), as was the case during the crisis of 1929. And this, thanks to curative actions, with the reaffirmed role of the central bank as lender of last resort, and preventive measures, by limiting the risks taken by banks through imposing an increase, notably in equity capital in proportion to the risks taken, to absorb possible significant losses. Then, after the great financial crisis of 2007-2009, by additionally putting in place, among other things, so-called macro-prudential regulations, in order to limit the pro-cyclicality of credit and financial markets, notably through tightening or easing counter-cyclical prudential rules, and finally by imposing liquidity ratios on banks.

Insufficiently low long-term rates

As a curative action, in order to avoid the devastating effects of systemic crises once they are triggered, including long depression and deflation, central banks have, rightly, lowered their key rates towards zero, or for some even below zero (including the ECB). But they had to face the constraint of the minimum rate being zero (“zero lower bound”), or even the constraint of the minimum rate being a little below zero (“effective lower bound”). These rates have in fact proven to be insufficiently low to avoid the risk of deflation and to bring long-term rates down as much as needed. As a result, they became innovative by launching a policy considered unconventional, that of Quantitative Easing (QE), which consists of purchasing securities directly on the markets, of thus taking virtual control of long rates and risk premiums, particularly bond premiums. Note, however, that the central bank of Japan had implemented such a policy much earlier to deal with the consequences of the violent burst in 1990 and the following years (“the lost decade”) with their major bubbles on the stock market as well as on that of real estate, leading to lasting economic stagnation and deflation.

Central banks dramatically increased their balance sheets in doing so, causing a considerable increase in the quantity of central bank money. Hence the name quantitative easing. These policies thus prevented any self-destructive speculative hype. And, after the peak of the crisis, they facilitated the debt relief of the many players requiring it, by positioning long-term market interest rates below the nominal growth rate.

But, when economic growth became satisfactory again and loan output returned to a pre-crisis pace, the central banks did not end their QE policy (or tried to do so and then quickly abandoned it, as with the Fed). We can analyse the reasons why. In any event, this has caused a problematic asymmetry in the conduct of monetary policy, since, during a severe shock, they have rightly put in place unconventional policies which they have not removed, even carefully, when normal growth returns. By thus maintaining rates that are too low in relation to the growth rate for too long, monetary policies have gradually facilitated, in many countries, both advanced and emerging, a very high valuation of the stock market and an even more visible real estate market bubble, as well as a sharp rise in debt relative to GDP.

Structural inflation below 2%

What were the explicit or unspoken reasons that pushed central banks towards this asymmetry? The answer frequently put forward is the persistence of an inflation rate that is too low compared to the inflation target of 2%. And the existence of an extremely low natural interest rate, which can be an indicator for analysing the accommodative or restrictive nature of monetary policy. This rate, unobservable, but the result of a model, is defined as that which ensures that the effective growth rate is equal to the potential growth rate, with inflation stable and equal to the objective level. However, without going further into the debate (Cf How to avoid the debt trap after the pandemic? Olivier Klein, Revue d’économique financier, May 2021), let it be noted that the underlying model is open to criticism from different points of view and that the inflation policy induced by globalisation and the digital revolution very likely generated structural inflation below the 2% objective. Central banks have fought in vain, as the facts show, against inflation, probably wrongly considered too low, by keeping interest rates too low for too long. Let us add that a protracted policy of very low rates ends up lowering the interest rate itself in the long term (Cf What anchors the natural rate of interest, Claudio Borio, BIS working papers, March 2019).

The tacit reasons were probably, in the United States, to seek to push growth on a long term basis above its potential to increase the employment rate and, in the euro zone, to protect the integrity of the monetary zone, which could have suffered from a rise in interest rates, while the insufficient convergence of the structures and economic conditions of the different member countries was clear. Let us add that the fear of a rise in interest rates creating a strong impact on the valuations of heritage assets and the insolvency of many players, including public ones − even more so when inflation was not an issue − had to play a role in maintaining these unconventional policies.

The turning point of 2022

However, be that as it may, inflation made its comeback after the end of the lockdowns, generated by restricted supply and boosted demand, further fuelled by the impact of the war in Ukraine on energy and agricultural products prices. This brings us to the turning point for monetary policies in 2022 and the ridge path they must now follow. The sudden dramatic rise of inflation necessarily led central banks to sharply increase their key rates. On the one hand because inflation is very unfavourable for businesses and households which cannot easily match the price increases in their own prices or salaries. On the other hand, because high and unstable inflation results in the loss of the benchmarks necessary for an orderly, confident, and therefore uncontested, setting of prices and wages, essential to an efficient economy, and can lead to an inflationary regime of generalised indexation, leading to uncontrolled inflation. Additionally, it was necessary to finally emerge from a period where interest rates were too low for too long, with the consequences described above. All these reasons explain why after having hesitated over the transitory nature or not of inflation, the central banks raised rapidly and strongly their key rates. And at the same time the beginning of quantitative tightening which they proceeded.

But we must also highlight the unique situation that central banks are faced with today and which requires them to proceed very cautiously from now on and to move forward, implementing monetary policy in small steps, paying particular attention to the careful study of data between each decision, in order to identify the effect of their own policy on inflation, real growth, and financial stability.

Underlying inflation has not been defeated and requires higher rates or at least being maintained at current levels over the long term. But, at the same time, a rise that is too rapid or too strong can materialise the accumulated financial vulnerabilities generated by rates that have been too low for too long, on the liabilities side of balance sheets (too much debt) or on the assets side (highly or overly valued assets) of numerous private and public players. Interest rates at the current level, or even higher, have and will tend to put a strain on the financial robustness of many players and the continuation of a very high valuation of heritage assets. Moreover, real estate, in many countries, has started to show significant signs of weakness, even warning signs of a pronounced reversal of the cycle. The central banks have therefore begun a use of monetary policy which will constantly scrutinise the state of overall financial stability and the leading indicators of the economy. They will therefore be cautious. Without losing their essential credibility in their fight against inflation. Central banks must not in fact be dominated by either budgetary policies or financial markets.

Monetary policy cannot do everything

Finally, let us emphasise that we very probably expected too much from monetary policy alone. It can’t do everything. It is crucial that fiscal policy is shaped in a way that is compatible with the phase in which the economy finds itself. Until then, there is no need to support overall demand since the end of the lockdowns, even if it has been desirable to protect the weakest populations in the face of the very sharp increase in food and energy prices. It is no less crucial that the essential structural reforms are carried out. As inflation results in this case from the impact of supply and demand for goods and services, but also for work, it is particularly important to develop production and sustainably increase the number of people available in the the job market. Through structural policies, it is therefore essential to raise the level of potential growth in order to best avoid the detrimental effects of excessively high debt ratios, especially when interest rates return to normal.

Is it still possible to value financial assets objectively?

The propensity for financial instability is due to the fragility of conventions (common opinions), which are not based on the objective foundations of a probabilistic forecast of future financial asset prices. As the various states of the future world are recurrently difficult to predict, the possibility of a rational and objective (not self-referential) valuation of assets at any time, always leading to fundamental or equilibrium prices, is in fact an assumption that can regularly prove to be heroic.

The same applies to the assessment of the solvency of economic agents, which is essentially endogenous to the system, i.e. again self-referential. Solvency stems from the fact that everyone believes that the company or government in question will subsequently be able to refinance its debt under normal conditions. This obviously depends on future trends in economic data and the borrower’s specific financial ratios. But also, by construction, on what the average opinion thinks today will be tomorrow’s average opinion on these subjects. The average expectation of what will be acceptable to everyone in the future is crucial in determining the solvency of an economic agent. This is the hallmark of a self-referential phenomenon that is endogenous to the system.