Category: Economical and financial crisis

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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.

Categories
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.

Categories
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

Bibliography :

Categories
Economical and financial crisis Global economy

Inflation and purchasing power: breaking out of an impossible equation

Inflation has just exceeded 5% in France and growth for the first quarter fell by 0.2%. Companies will not be able to (and should not) compensate for the entire loss of employees’ purchasing power, as this would lead to a drop in their results, which would sooner or later undermine their investment capacity, their competitiveness and therefore employment capacity, especially since they have already been financially weakened by supply difficulties and the rising cost of raw materials and many intermediate products.

This would therefore be very damaging to households themselves in the long term. It would very dangerously strengthen the indexation spiral, with inflation then spiralling out of control. This is why, since 1983, companies have been prohibited from systematically indexing wages to prices.

At the same time, the French government will not be able to protect households over the long term as it has done today by taking on their extra costs. Monetary policy will no longer make it possible to finance the resulting excess public debt, and the markets will probably be less willing to swallow this extra debt at today’s rates… a very worrying snowball effect on debt could ensue.

As such, households will to a certain extent lose purchasing power while inflation remains high, taking their part of the burden, with the resulting economic and social risk. Companies will also be required to contribute. The government will increasingly limit itself to protecting the weakest.

However, this loss of purchasing power is not inevitable. Working households could better protect their purchasing power without leading to a wage-price loop if productivity gains were sufficiently high or if the wage-to-value ratio remained broadly stable following wage increases. This would allow companies not to increase their prices further and protect their competitiveness and their capacity for employment and investment.

The solution would be for employees to work a little harder in exchange for higher pay, in a proportion to be negotiated.

Unfortunately, productivity gains are now zero. The only possibility for the economy to come out of this in the best possible way – for households, companies and the government – is for employees to work a little harder, depending on their type of job, in exchange for an increase in wages, in a proportion to be negotiated. This is possible, as there are bottlenecks due to labour shortages in many sectors.

Thanks to the increase in activity, this would also boost receipts from social security contributions and taxes without raising their rates, so would help maintain our high level of social protection, while promoting better control of the public deficit and debt. Retired households can only maintain their purchasing power if the number of years of contributions of working people is increased (depending on how hard the work is), although pension accounts will continue to deteriorate.

There is a real room for manoeuvre for France. In addition to the efforts companies can make to partially limit the loss of their employees’ purchasing power – a mix of wage increases and PEPA bonuses, for example – it is perfectly possible, without changing the law, to open negotiations at company level before the end of the year on this additional compensation in exchange for additional work. It is also possible and advisable to consider company agreements that allow each employee or team to choose their own balance.

In any case, it a way out of a major problem that could otherwise quickly become an impossible and painful equation.