Category: Economical and financial crisis

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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.

Categories
Economical and financial crisis Economical policy Global economy

Global fragmentation: economic and financial consequences

Growing geopolitical tensions have and will have lasting effects on international trade (including the reorganisation of goods flows) and on the international monetary system. These tensions are generating global fragmentation by heightening commercial and financial polarisation between the increasingly marked zones of influence of the two superpowers, the United States and China, even if many countries would like to keep them at an equal distance. This situation follows several decades of globalisation in terms of trade, investment and finance, having served to significantly reduce world poverty and the gap between advanced and non-advanced countries and resulting in a lasting period of disinflation. But they have also led to profound upheavals in national industrial structures, with necessary and sometimes painful reorientations.

The economic, financial and social risks involved in planetary fragmentation are the subject of increasing debate. And major international bodies are rightly concerned about the fragmentation process under way. Globalisation has significantly reduced inequalities between rich and poor countries. In 1981, 40% of the world’s population lived below the extreme poverty line, compared with just 10% today. In China and India, for example, two billion people have risen above the poverty line. And what is true of income is also true of health, with the difference in life expectancy between advanced and non-advanced countries having narrowed considerably. The effects of highly developed international trade and globalised capital markets are, by these standards, clearly established.

We also know that the optimal functioning of globalisation hinges on mutually accepted and respected rules regulating international trade and on national policies serving to support transformations in production structures and the nature of the resulting jobs. But in the last ten years, the acknowledgement of the indispensable nature of these international rules and regulations has been undermined, particularly by China’s growing thirst for power and the attendant reaction of the United States.

Sino-American tensions are clearly central to these concerns. The rise in US protectionism largely initiated in the policy proposals of Donald Trump has continued under the Biden administration, with security measures restricting technology exports and the recent introduction of the Inflation Reduction Act. In the opposite camp, China persists with its numerous anti-competitive policies, both explicit and implicit.

The consequences of COVID, Brexit and the war in Ukraine have also contributed to the reorganisation of trade routes and capital flows. The risk of fragmentation has been reinforced by the conflict in Ukraine and the resulting increase in sanctions affecting trade, investment and the assets of sanctioned institutions and individuals.

These observations, like the economic and financial implications mentioned here, are not analysed from a moral standpoint, nor from the realistic standpoint of the balance of power between nations with opposing political regimes. Today’s growing global fragmentation has de facto effects beyond the intentions having driven the trend.

Partial de-globalisation, such as the relocation of production plants, could have favourable consequences for the climate and, in all likelihood, for the number and nature of jobs for the middle classes in advanced countries. But the resulting rise in structural inflation will erode their purchasing power. Symmetrically, it will slow down catch-up on the part of less advanced countries, with the corresponding social impact. Lastly, the reduced mobility of capital resulting from fragmentation will create fewer opportunities for financing, especially for development projects in less advanced countries. And it will increase the cost of borrowing.

Increased geopolitical tensions and the resulting sanctions, de facto and de jure, reduce the international mobility of capital in financial markets as well as in cross-border bank lending.

Consequently, financial vulnerabilities are also expected to increase, as capital could become scarcer for some countries, banks less internationally financed and therefore more fragile, and “sudden stop” or currency crises more frequent. This could undermine global financial stability. And overall – trade, investment and finance combined – it is likely to reduce global growth.

This process of fragmentation will also impact the international monetary system, potentially transforming it. What role will the US dollar and Chinese renminbi play in the future? Can and will the dollar lose more and more clout in foreign exchange reserves and international payments? The issue is important both macro-financially and for US power itself.

The dollar’s share of international trade has held steady over the last 20 years, while the relative weight of the US economy in world trade and GDP has declined slightly, measured in purchasing power parity.

In contrast, the share of the US dollar in central bank reserves has fallen by over 10 percentage points. This has not benefited the euro, sterling or yen, which generally stand to gain from the diversification of foreign exchange reserves. Instead it has benefited the renminbi, for one quarter of the decrease, along with other currencies including those of Australia, Canada, South Korea and Singapore, for the remaining three quarters. In addition, gold has once again become a source of reserve diversification, particularly for emerging central banks.

The US fundamentally needs the US dollar as a de facto, if not de jure, international currency. The country’s current account is structurally and significantly in deficit and its net external debt is constantly growing (from 10% of GDP in 2000 to roughly 70% today).

As such, the US dollar’s role as the world’s reserve and transaction is essential to the United States’ maintaining its position as a superpower. It enables the country to refinance its deficits problem-free and reduces its borrowing costs. China perfectly understands this correlation between global power and global currency and is patiently building the basis for the internationalisation of its own currency. China is encouraging countries having entered its zone of influence to gradually break free from the greenback or invoice and trade less in the currency. It is also gradually building the necessary infrastructure by creating future offshore renminbi clearing houses.

In another key factor, the United States, by using the dollar to develop the extraterritoriality of its law, and to impose sanctions (including the freeze on Russian central bank reserves), could run the risk of precipitating the decline in the use of the dollar as both an international transaction currency and a reserve currency. The monetary weapon of power is thus double-edged, as the refinancing of deficits and the vertiginous external debt of the United States would not be able to withstand a gradual de-dollarisation of transactions and reserves.

Symmetrically speaking, as long as Chinese government policy largely dominates the economy, it will be extremely difficult for the renminbi to internationalise. To be successful, a currency needs to inspire trust. Money is a debt, a bank debt relative to non-bank economic agents in a country. And internationally, money stands as a country’s debt. Which is why across-the-board trust in political, military and economic power is essential. But this trust also depends on how the currency is regulated and, hence, on the validity and stability of the institutions that define and supervise the currency. If it were to occur, the de-dollarisation process would therefore be extremely gradual, taking place over the long term.

Today’s fragmentation trend is a clear consequence of ongoing global disorder and polarisation. Political, military, economic and demographic forces, as well as the greater or lesser wisdom of leaders and peoples, will determine the final shape (on a transitional basis at least) of today’s transformations. These developments will impact growth, standards of living, quality of life and financial stability around the world.

Bibliography:

  • Geo-economic fragmentation and the world economy
    Shekhar Aiyar, Anna Ilyina
    27 March 2023 – Vox Eu columns
  • Confronting Fragmentation Where It Matters Most: Trade, Debt, and Climate Action
    Kristalina Georgieva
    16 January 2023 – IMF
  • Geopolitics and Fragmentation Emerge as Serious Financial Stability Threats
    Mario Catalán, Fabio Natalucci, Mahvash S. Qureshi, Tomohiro Tsuruga
    5 April 2023
  • The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Nontraditional Reserve Currencies
    Serkan Arslanalp, Barry J. Eichengreen, Chima Simpson-Bell
    24 March 2022 – IMF
  • Le passage à une situation de multiples monnaies de réserve (The transition to a multiple reserve currency situation)
    Patrick Artus
    5 January 2023, Flash Economie
  • Le système monétaire international et le financement des Etats-Unis (The international monetary system and the financing of the United States)
    Patrick Artus
    30 March 2023, Flash Economie
Categories
Bank Economical and financial crisis Economical policy

Central banks: towards a policy of “small steps”

The global economy is slowing. This will complicate the situation of highly indebted governments and private players. But in principle it should facilitate disinflation, thus slowing the rise in interest rates and possibly facilitating their subsequent decline. However, activity is holding up better than expected and labour markets continue to be tight – high employment rates and low unemployment rates – which is maintaining the level of core inflation. This is consequently accompanied by very low or even zero productivity gains.

Monetary policies are therefore set to continue with their interest rate hikes, albeit with great caution. And at least maintain this level of interest rates, for longer than was expected by the financial markets. There are many reasons for this necessary caution. The new financial conditions have tightened, which in itself results in a slowdown in credit and the economy. Interest rates are therefore higher, risk premiums (“spreads”) larger, lending conditions more stringent, liquidity less abundant, etc. Further monetary policy tightening is therefore not necessarily required. Small steps will now be key, with a study of all the available data between each decision, so as not to do too much or too little.

But above all, the vulnerabilities of the financial system as a whole are obviously what has made central banks very cautious. Of course, the recent signs of this instability had partially idiosyncratic causes. Silicon Valley Bank was poorly managed and under-supervised. The simultaneous increase in the number of cases and the resulting contagion nevertheless show the potentially systemic nature of these events. Long-term rates too low for too long have made many balance sheets highly vulnerable. On the liabilities side, because many companies and governments, and even individuals, both in advanced and emerging countries, were able to take on debt without apparent pain, up to the point of over-indebtedness with a normalisation of interest rates. On the assets side, because in order to seek a little yield in times of zero or even negative interest rates, end investors, either directly or through various asset managers, were encouraged to take more and more risks, whether by extending the maturities of the assets purchased, by a greater dissymmetry between the duration of assets and of liabilities, by accepting higher credit or equity risks, by increasing leverage, etc. The rapid rise in interest rates marked an abrupt break from this long period of rates that were too low (i.e. below the growth rate), during which these weaknesses accumulated. Today, the large global real estate bubbles appear increasingly vulnerable, and the fall of the equity markets will be even greater if they continue to ignore the gradual effects of the general tightening of financial conditions. And the risk of insolvency of many highly indebted players has risen sharply.

Central banks are very aware of this situation, such as the risks generated by a very tense geopolitical situation, leading to, among other things, a costly fragmentation of economic zones. And although on average banks are much stronger than during the big financial crisis, with shadow banking remaining much less regulated, monetary policy authorities will double down on caution, but will preserve their indispensable credibility in their fight against inflation.

Categories
Bank Economical and financial crisis

Economic and financial paradigm shift for the banking industry

A shift in economic and financial paradigm occurred as the pandemic ended. How does this change impact the banking business?

Today, inflation is back and not just temporarily. It implies a rise in interest rates, partly due to the spontaneous movement of financial markets to protect real investment returns – even if the markets seem to be overestimating the speed and intensity of the fall in underlying inflation – and even more so due to the change in monetary policy that has become necessary, with the rise in central bank key rates – which for the same reasons will probably be stronger and longer than that anticipated by the markets – and the slow but steady and programmed exit from ‘’quantitative easing’’.

These strong macro-financial changes deeply affect the environment in which banks operate. By the same token, they deliberately tighten the financial conditions (credit rates, lenders’ risk appetite, risk premiums, etc.) that all economic agents experience. And this, precisely in order to reduce inflation. It should also be noted that the financial markets, especially the stock market, seem to underestimate the effect of this tightening of financial conditions on the economy, which could later lead to a more brutal revision of valuations if this is not taken into account.

Let us therefore analyze the effects of this macro-financial paradigm shift for the banking industry.

First, liquidity.

During the euro crisis, banks lacked liquidity. In fact, American banks practically stopped lending to European banks. Then, when the eurozone crisis ended, thanks to the TLTRO, quantitative easing, etc., liquidity became overabundant and excess bank liquidity became expensive, due to the negative interest rate policy of the European Central Bank (ECB). The deposit facility rate (i.e. the investment rate for central bank money held by banks) reached -0.5%. The aim was for banks to avoid holding too much cash.

But the steady rise in the ECB’s key rates, and the gradual exit from quantitative easing in the euro zone in March of this year – the “quantitative tightening” – as well as the gradual end of the TLTROs, are changing the situation. The FED has started its quantitative tightening since June 2022.

This signals the end of abundant liquidity, but also of free money. And the end of magic money at the same time. As a result, the competition between banks to attract customer deposits to their balance sheets has increased, and the cost of customer resources has risen rapidly, while refinancing on the financial markets has also become much more expensive, especially since the central banks have raised their interest rates.

In addition, the last two-three years have shown strong growth in bank deposits due to government support to businesses and households during the pandemic – which was in turn made possible by the central bank’s financing of the induced public debt overhang – and because of the temporary fall in spending during the lockdowns. This phenomenon has disappeared. Continuing to grow loans, without further resorting to the financial markets, therefore requires each bank to adopt a more active policy of deposit collection. At the level of the banks as a whole, this is already mechanically increasing the cost of access to client resources, in addition to the effect of the ECB’s rate hike.

Second, the evolution of the net interest margin (NIM).

On the surface, this is a paradoxical topic. In the past, banks rightly explained that the interest rate effect on their NIM was negative when long rates approached short rates, which were themselves approaching zero. And indeed, this change in the interest rate structure has been costly for banks. The net interest margin rate has been roughly halved over the last ten years, with loan production rates and deposit collection rates approaching dangerously close to zero. What industry can withstand a halving of its margin rates?

Today, rates are rising and commercial banks have stated that their net interest margin will be temporarily affected again. So, would rate movements, whether up or down, particularly in France, be unfavorable to the banks? No. But, in fact, for about 12 to 18 months, the cost of deposits – particularly regulated passbook savings accounts, whose rates are set by rules that take into account changes in the inflation rate – rises faster than the return on loans. Why is that? Because, in France, for instance, many retail banks have more fixed-rate loans on their balance sheets than variable-rate loans, given the large amount of loans to individuals, professionals and SMEs, which are generally at fixed rates. As for TSEs and large companies, they borrow more at variable rates and manage their interest rate risk themselves.

Thus, the more regulated savings (Livret A, etc.) banks have on their liabilities list and the more mortgages (fixed rate in France with a 20-25 year term) they have on their assets list, the more the rise in interest rates worsens their NIM rate, and for longer.

However, at about 18 months, even for these banks, the return on assets rises faster than the increase in the cost of liabilities, i.e. their resources. Nonetheless, the interest rate effect will only be positive after this transition period if the interest rate structure is normal, i.e. if long rates are higher than short rates. An inverted rate situation, which is generally and fortunately not sustainable, is costly for bank NIMs. The reason is that, in this case, medium- to long-term fixed-rate loans are issued at rates that are lower than the cost of deposits, which are implicitly or explicitly (in the case of regulated passbook accounts) indexed to short-term rates and inflation.

Most retail banks with individual, professional and SME customers have therefore experienced a more difficult last quarter of 2022 and will experience a downturn in 2023. Over the course of 2024, their income statements should improve again, assuming a normal yield curve.

The volume effect on the banking NIM may also be less favorable, as lower growth and the effect of rising interest rates on loan demand may lead to a lower production of loans.

Finally, the cost of risk is making a comeback.

2023 will therefore be a year in which liquidity will be tighter and commercial banks will, on average, experience declines in their NIM rates. It will also most likely be a year of rising credit risk costs. In recent years, the cost of credit risk has been falling.

Long-term rates, which were very low, too low, for too long, have in fact led companies to survive when they would have disappeared if rates had been set at “normal” levels (equal to the nominal growth rate). This is what is known in the economic literature as “zombie companies”.

Moreover, the public authorities rightly supported companies during the pandemic to protect national production capacity and jobs, for example by distributing state-guaranteed loans (PGE) in France. Many of the companies that benefited from these loans would naturally have disappeared without this aid. The beginning of the repayment of these loans will undoubtedly lead some of them not to survive.

In addition, there is no doubt that, with interest rates rising and probably normalizing at around 4% over the cycles, these “zombie companies” will not be able to resist. The same goes for companies with too much leverage. Hence an unstoppable and normal rise in the cost of risk for banks in the future.

The year 2023 will therefore mark a probable decline in results for retail banks. And inflation, which affects the overheads of all companies, will not be reflected in the same way in bank pricing. But if the economy does not go into recession – they seem to be holding up well so far and growth expectations are improving – and if global real estate bubbles do not suddenly deflate, as well as if high stock market valuations do not undergo a sharp and sudden change of opinion, commercial banks will be able to start seeing their results improve again during 2024. They would then be able to continue actively contributing to the financing of economic growth.

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Conjoncture Economical and financial crisis

The lasting end of free money

It’s understood. Inflation needs to be fought, and the central banks’ policy will contribute actively to this battle. But the financial markets anticipate that, when inflation returns to its target, the central banks will cut their interest rates again, and long-term rates will gradually return to low levels in anticipation – they are already doing so in part – thus referring to the last decade. Let’s look at why this will probably not be the case. The years 2010 to 2021 saw very low long-term rates for several combined reasons. We were in an extended phase of globalisation and technological revolution. This pushed prices downwards and did not easily allow for wage increases. Inflation was very low, leading to very low interest rates. And because the central banks rightly feared deflation, then were faced with inflation under their target, they dropped their key rates to zero or even to the negative territory, while initiating a “quantitative easing” policy, thus more or less taking control of long-term rates and risk premiums.

However, starting in 2016-2017, while growth normalised after the very serious crisis of 2007-2009 and loans regained good momentum, long-term rates settled at very (too) low levels, for a very long time (too long), admittedly with very (too) low inflation. Long-term rates notched below the growth rate, excluding periods of crisis or convalescence, triggering an increase in financial instability. This means permanent and unsustainable debt growth in the event of a significant rise in interest rates; public and private debt grew by more than 45 points of GDP in advanced countries and 60 in emerging countries between 2008 and 2021. And the development of bubbles in equities and real estate; residential real estate prices rose by more than 40% in advanced countries between 2008 and 2021 and 35% in emerging countries. In addition, risk premiums are too low.

The current rise in interest rates therefore corresponds to a normalisation as well as a fight against inflation. The inflation component was gradually lowered due to insufficient supply – which was partially dislocated by the impact of measures against contagion – and demand that rebounded sharply after the lockdowns. However, a few structural factors are likely to persist. The effects of a partial deglobalisation movement and the sustainable cost of the energy transition. Such as the partial indexation of wages and probably a better ability of employees in the future to negotiate the sharing of added value, which has become distorted over the last 30 years in favour of profits in the OECD (except in France and Italy in particular). Structural inflation is likely to be between 2% and 3%. Once inflation returns to these levels, and excluding the effects of the business cycle, normalised long-term rates will probably average at the potential growth rate, i.e. in the eurozone between 1% and 1.5%, to which the inflation rate should be added, i.e. 2-3%. Long-term rates at around 4% should become the norm again across cycles. They would not facilitate the development of financial cycles, which are moving from growth phases to euphoria phases, leading to gradual over-indebtedness and the creation of bubbles. This leads to violent financial and economic crises. Short-term rates may, however, rise and bite into inflation, then fall somewhat later.

We are most likely to see a lasting end to free money.

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Economical and financial crisis Global economy

How can we deal with inflation?

The facts are clear. Some economists have claimed in recent years that debt did not matter because they thought that interest rates would remain very low in relation to the growth rate (negative i-g) for a long time. On the one hand, this analysis was based on a bold anticipation of future inflation, and on the other, it did not take into account budgetary constraints, which, even if low when interest rates are below the growth rate, still exist(1). Thus, this assertion led to a recommendation to spend more, undoubtedly to deal with the major challenges we are facing, but without worrying about constantly expanding debt. It was as if central banks had entered an unlimited policy of quantitative easing, both in terms of duration and amount. I explained previously why (2), even assuming that inflation did not return, which was by no means sure, such a situation may not be sustainable, given the financial vulnerabilities it added to. And given the possibility of a major recession. And, finally, as the monetary system is a debt settlement system, given that confidence in money could disappear because debts can never be constantly growing faster than the real economy.

Inflation has now returned(3 & 4) and is no longer merely transitory. Let us analyse the consequences of its return in force for all players.

Central banks: they must combat inflation. This is essential, because an inflationary regime must be avoided, that is, a system in which indexation is triggered between prices and prices, prices and wages, wages and prices. Thus, the inflation rate is neither low nor stable. Such inflation creates inequalities between households, which obviously do not have the same capacity to react to protect their purchasing power. It also leads to inequality between companies that do not all have the same capacity to “set prices”. In addition, as history has shown, once the stability and predictability of the inflation rate is disturbed, confidence wanes among economic players, producers and consumers. Prices can no longer be set easily, and need to be reset several times a year, or even more in the case of hyperinflation. This undermines confidence. Between employees and companies where employee representatives may have to request a second round of negotiations within a year, or more. This undermines the reliability of negotiations between the company’s employees and management, causing tension. Between lenders and borrowers, with lenders no longer knowing how to set lending rates, as interest rates are constantly rising. This widespread uncertainty creates tension and undermines confidence, which is one of the cornerstones of economic efficiency, growth and life in society. This is why rather low and stable inflation, ideally around 2% or 3%, is highly desirable, and why central banks have no choice but to implement a monetary policy that can at best ensure inflation is maintained at this level, and, if necessary, brought back to it.

However indispensable it is, this mission of central banks is difficult under the current circumstances. If interest rates rise too sharply or too much, this can easily trigger a recession, a hard landing. It may indeed be over-calibrated, if it is assumed that the transitory component of current inflation will weaken in the near future. Supply constraints can and should indeed ease over time, excluding the consequences of the unfolding war in Ukraine, which could exacerbate shortages of energy and certain agricultural products.

However, raising interest rates too slowly would not do enough to combat the return of high inflation by allowing indexation to develop. And reacting late, once inflation expectations are no longer anchored at a low level and indexations are put in place, is much more costly in terms of growth, since deep recessions are difficult to avoid.

But there’s more. The mission of central banks is all the more difficult because we have experienced interest rates that were too low for too long. Of course, long-term and short-term rates had to be driven towards zero in order to enable us to emerge from the major crisis of 2007-2009 and the risk of deflation that it entailed. It was also necessary during the pandemic. However, as soon as growth returned (in 2016-2017), maintaining such low interest rates, on the pretext that the natural interest rate was very low, was dangerous. Moreover, the natural interest rate is a concept and not an observable variable. It is neither theoretically indisputable(5) nor easy to use. Similarly, it is possible that the very low inflation rate of the period – which quantitative easing policies did not manage to raise – was due to structural forces (globalisation and the technological revolution), with a Phillips curve made flat as a result, and not to a lack of demand, and therefore to a cyclical phenomenon. Keeping rates too low for too long has led to consequences that the Bank for International Settlements has described very well for years. When the interest rate is too low in relation to the growth rate for too long and there is a growth phase, bubbles develop. Equity bubbles, real estate bubbles and over- indebtedness of governments and private agents. Today, if rates must be raised and quantitative easing policies gradually come to an end in the face of a major risk of a change in the inflation regime. As assets (equities and real estate) are highly valued and the level of global debt is very high, central banks must face the risk of sudden bursting of these bubbles and solvency crises of economic actors with too much debt. With the attendant risks to growth(6).This situation of macro-financial vulnerability is therefore necessarily problematic for central banks, and they must therefore be very determined and very cautious. This is why they have begun to normalise their policy and will go without debate until they reach what they consider to be their neutralisation (i.e. a monetary policy that is neither restrictive nor growth-promoting) towards the end of 2022 or the beginning of 2023. But once this stage is reached, they will act according to the circumstances. If growth slows down sharply, if the markets fall dramatically, they will take action. The state of wage and price indexation, and therefore of the level of underlying inflation, will then be scrutinised to determine whether it is appropriate or dangerous to position interest rates above the rates already reached. If the inflation trajectory does not take a satisfactory downward path, we can bet that the central banks will continue to tighten their monetary policy in order to make it more aggressive, both by a stronger rise in key rates (i.e. short rates) and by sustained quantitative tightening in the United States and by its initiation in the euro zone, thus contributing to a stronger and more rapid rise in long interest rates.

Central banks must remain credible in the face of inflation. They must be clear in their statements, showing an unwavering determination to fight it. Conversely, they must be gradual and prudent in their actions, without however being dominated by governments or financial markets.

Governments, for their part, have no choice but to have a credible medium-term solvency trajectory(7). An excessively strict fiscal policy would destroy growth, but doing nothing when the level of indebtedness is high would considerably undermine their credibility, causing a high risk on the public debt markets in the short term. They therefore need to put in place a policy of managing public finances without austerity, but which in reality provides an exit from any kind of support policy, with a focus on the weakest populations, must therefore be put in place. The pandemic, by its very nature unexpected, brutal and temporary, should clearly be differentiated from a possible change in inflation regime.

In addition, the investments needed to increase potential growth or green growth must be financed. However, this financing must be secured by more rational and efficient management of public spending, particularly current expenditure, as well as by structural reforms(8). These are absolutely necessary for increasing potential growth, for public finances and for increasing supply, which is itself a factor in the fight against inflation. Certain supply-side policies may have positive effects quickly, others more in the medium term, both on inflation and on growth. This includes policies that increase the employment rate, such as pension reform, as well as unemployment benefit reform. The shortage of jobs in recent months is in fact preventing the supply of goods and services from being higher, as well as supporting the phenomenon of (partial) wage indexation.

Companies with too much debt, for example according to the ratios proposed by the ECB itself, must

pursue a reasonable but real deleveraging policy in order to better get through this coming period of rising interest rates and fewer financing facilities.

For households, the question of purchasing power arises(9). It will be difficult to preserve it completely. For companies, it will not be possible to index systematically wages to inflation. Moreover, since 1983, the Delors and Bérégovoy Act has prohibited companies from indexing wages to prices. If they did so, they would precipitate rising inflation and also destroy their competitiveness or profitability, both of which would severely reduce their ability to invest and employ in the future. Companies cannot therefore do everything. And they can only act according to their specific situation. It is also impossible for governments to protect everyone against inflation over the long term, as for many of them, their fiscal room for manoeuvre has already been tested. It should also be noted that such a policy is contrary to that pursued by central banks. This non-cooperation between economic policies could prove dangerous in terms of financial stability. The generalised support of purchasing power, together with insufficient supply, is also precipitating the deterioration of the foreign trade deficit, which has already been affected by the rise in the cost of imported energy. The rise of interest rates will further accentuate the budgetary constraints of the States, for those of them that are more indebted. There is still a possibility of protecting households’ purchasing power as effectively as possible: we are in a special situation in which inflation needs to be reduced, purchasing power protected and a proven labour shortage needs to be addressed. Most companies are short of employees. Increasing wages a little in exchange for a moderate increase in working hours could be part of the solution, as long as it is the choice of companies and employees themselves.

This would be good for growth, good for public finances and good for foreign trade.

CEO of BRED and Professor of Financial Macroeconomics and of Monetary Policy at HEC Paris

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