Category: Economical policy

Should interest rates be lower than the growth rate for the long term, implying that debt is not important? This is not my thesis and I believe that central banks will initiate or continue a gradual increase in their rates. What will be the possible and relevant reactions for any government with a high level of debt?

Before the very recent war in Ukraine, growth was strong, even if it fell slightly in view of the slow return to a more normal growth rate after the 2021 rebound.  Monetary policy was therefore expected to be at least normalised, smoothly due to the high overall debt and highly valued financial and real estate markets, by gradually exiting the quantitative easing policy, as well as by cautiously raising interest rates.  This need for tightening came from the risk of overheating. But also from the risk of monetary policy being exhausted in the event of new (and there are always) future crises. Finally, from the development of bubbles due to interest rates that have been too low for too long compared to growth rates.

Then, several months ago, there was an upsurge in inflation. It was clear that part of this inflation was not transitory and that we were probably changing inflationary regime.  The Fed, then the ECB, were therefore prompted to accelerate their announcement of a gradual end to their net securities purchases on the markets.   They also said they would raise their rates a little faster than expected. For the same reasons as described above, however, the issue was still not to proceed too quickly in exiting their very accommodative policy. Moreover, the ECB had to deal with the more specific and difficult eurozone issue, due to the large imbalances between the countries of the South and the North.

At the same time, governments had, and still have, a need for investment for the development of new technologies, re-industrialisation (even partial) and the energy transition. There was therefore a conflict between, on the one hand, the objective of financial stability undermined by interest rates that have been too low for too long and now the fight against inflation and, on the other hand, the objective of financing the necessary new investments and the solvency of governments, or even private players, whose debt had increased sharply since 2000 for the private sector and since 2007 for the public sector, with in addition a significant increase in public debt due to the pandemic.

Hence, the raising of several voices in the eurozone. The first stating the need to change the common budgetary rules, by excluding investment budgets from the calculation of constraints on public deficits. This proposal is sometimes coupled with the idea that, under current circumstances, the level of public debt was of little importance, and that the central banks would continue to finance future deficits for a long time. Another voice showed a narrower path, but it seems to me much more credible, certainly explaining the need to change the eurozone’s common rules, which are dated and ineffective, but at the same time stressed the importance of the compromises to be found between the countries of the North and the South on these changes in rules so as to select as candidates for exclusion only investments that actually generate potential growth or facilitate the energy transition. All expenses not always resulting in more potential growth. And the improvement in growth potential not always requiring additional spending. It was also crucial, from this point of view, to agree on reasonable budgetary rules, preventing any “free rider” behaviour.

The spectre of stagflation

Today, the war situation has created the spectre of stagflation. Therefore of a slowdown in growth which will be at least 1% and inflation even stronger than expected before the start of the war. This will create an even more intense dilemma for central banks. However, if the very sharp upsurge in inflation were to lead to no reaction or a very weak reaction on their part, a major risk of an inflation spiral could arise. Today, the question of whether there will be a second round of inflation no longer arises. Many industrialists and large retailers are increasing their prices, otherwise they are no longer able to cope with rising costs. And many companies have begun to raise their wages. They cannot act otherwise, in order to retain their skills, as well as to be able to recruit. The upcoming wage negotiations will reinforce this phenomenon.

However, if inflation takes hold through price-to-price, wage-to-price and price-to-wage indexation, with slower growth, we will enter a potentially lasting stagflationary dynamic. When Volcker, then Fed Chairman, tried to exit a long stagflation, in 1979, he had to provoke a deep recession in order to break the indexation phenomena. Ignoring inflation would also be very dangerous in terms of inequality, because no one is equal, neither among employees nor among companies, in the face of the ability to pass on any price increases in their incomes. Moreover, there is a need to fear inflation that could be transformed into a system of hyperinflation, causing economic agents to lose their bearings. Stable and low inflation allows for viable wage agreements; reliable price catalogues between producers, distributors and consumers; loan agreements to set interest rates between borrowers and lenders based on shared inflation expectations. In short, stable and sufficiently low inflation is essential to confidence. However, it is necessary for an efficient economy. Monetary policy must therefore react in a timely manner. If it were not to do so, it would have to act later by taking much more risk. Central banks must remain credible.  By supporting growth, of course, but clearly by combating inflation. Uncontrolled inflation also undermines growth itself.

This path will be very narrow

This path will be very narrow.  The monetary tightening policy must therefore necessarily be very cautious, and therefore very gradual. As a result, this trajectory will also require governments to play their part. On the one hand, governments will have to make the aforementioned necessary investments, generators of potential growth and, on the other hand, reduce unnecessary expenditure or reallocate it usefully. France has had the highest public expenditure as a percentage of GDP in the eurozone for a long time, but in some areas this expenditure has, in recent decades, provided a quality that bears little relation to the level of expenditure incurred. The OECD’s many comparative measures testify to this on a regular basis. Thus, the effort must not be only financial. The essential investments can therefore only be made if the essential reforms are carried out. Such as the reform of retirement – which while reducing the public deficit – supports potential growth because it increases the population available for work, whereas currently France is one of the countries with the significantly lowest employment rate after the age of 60.

All in all, it is imperative that central banks neutralise, at least, but cautiously, their monetary policy, in order to combat too much inflation, as well as to avoid financial instability due to bubbles that would continue to develop. And, at the same time, it is essential that governments increase potential growth through investment and reform and ensure better control of spending. In order to give credible trajectories to their fiscal policy and ensure their solvency in a world where interest rates will be structurally rising.

On 16 March this year, the Fed increased its intervention rate by 25 cents and indicated that there would be numerous hikes in the future. The following day, the ECB, in turn, announced an end to its net securities purchases at the end of June and paved the way to subsequent rate hikes. Furthermore, if the ECB did not perform such a policy change, the euro would continue to depreciate against the dollar in particular, leading to even higher inflation, due to the rise in prices in euros of imported products. The trend therefore seems to be underway.

The idea of a “war economy”, war against climate change, war for re-industrialisation, as well as a military war, as begins to be mentioned here and there among some economists – if it led to the belief that debt was of no importance and that the central banks would be obliged to finance any new deficit thus allowing very sustainable spending without constraints – could lead to a disaster. This concept of war economy, as previously stated, inevitably leads to the idea of a very long period of time.  Unlike a “whatever it costs”, limited to the duration of the pandemic. However, this idea includes an unthinkable: money. Money is the foundation of the debt settlement system. Having confidence in money means having confidence in the effectiveness of the debt settlement system. Therefore, if ever the monetary constraint[1] were suspended for too long, then confidence in money could be called into question. And if we no longer had confidence in money, we could experience, not traditional inflation, but a flight from money. If the central banks were to never stop quantitative easing and endlessly keep rates too low relative to the growth rate, not only would there be regular serious financial explosions, but sooner or later this would also lead to a flight from money that would be dramatic. This would result in the disorganisation and collapse of the economy and society. Because money constitutes the social link. As Michel Aglietta says: “confidence in money is the alpha and omega of society”.

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[1] Either the obligation to pay one’s debts or, more precisely, for governments and companies, to refinance them at maturity with lenders other than central banks.

Monetary union is our common good. The virtues of the euro have proved its usefulness, notably in times of crisis, through the determined action of the European Central Bank. But the ECB cannot indefinitely palliate the inadequacies of structural policies such as the incompletion of the eurozone’s regulatory method.

The sustainability of European monetary union hinges on solidarity. But are the interests of European countries sufficiently aligned to achieve that solidarity? If divergences are too strong, it would be an illusion to believe in the long-term future of a budget such as the Next Generation EU plan or a Community debt, both of which stand as remarkable advances.

One-way solidarity

Since the creation of the eurozone, the Northern countries of the monetary union have further industrialised while the Southern countries have gradually deindustrialised. In correlation, the former have gained market share in global trade while the latter have lost ground. With their current account surpluses, Northern countries have accumulated net assets in the rest of the world; in contrast, with their current account deficits until the eurozone crisis, Southern countries have amassed debts relative to the rest of the world. A major divide also exists regarding initial education levels and occupational skills, and in terms of youth unemployment rates and employment rates. Productivity gains are also divergent, while differences between the North and South are growing in terms of public debt as a percentage of GDP. To safeguard the solidarity forged during the pandemic, trust must be established between Northern and Southern countries by reducing these major divergences. This calls for three vital things.

Firstly, Southern countries are duty bound to implement structural policies, i.e. ad hoc investments and reforms. This does not involve austerity measures, as, on the contrary, these policies serve to increase potential growth by boosting productivity, improving the effectiveness of initial education and occupational training, more effectively mobilising the working-age population (notably through pension reform) and optimising public spending. These reforms are the only way to prevent Northern countries from having to demonstrate one-way solidarity towards Southern countries on an indefinite basis. But while these reforms are necessary, they do not suffice in themselves. Structural policies alone will fail to remedy the industrialisation shortfalls of Southern countries.

Realistic budgetary rules

Hence the second vital need, for an industrial and regional planning policy in the European Union, implemented through targeted investment and aid from Northern countries to Southern countries. The Next Generation EU recovery plan is an answer. The projects involved must be effectively implemented so as to foster competitiveness and industrialisation in the relevant countries.

The third requirement is the reconstruction of shared and realistic budgetary rules, which are no longer such today. These rules must be effective and support these developments, while ensuring that there are no free riders in the Union.

If these three requirements are not fulfilled, populism will continue to rise in Northern countries refusing to indefinitely assist Southern countries, or populism will continue to grow in Southern countries increasingly deindustrialised without aid from the North. Devaluations, far from being a miracle solution, are not possible in a monetary region, making it more difficult for countries to catch up on competitiveness in isolation. This leads to the build-up of local industrial polarisation in countries with the greatest comparative advantages. Avoiding this trap will hinge on the aforementioned efforts at both Community and national level.

 A monetary union is, in principle, very effective when growth is facilitated by the fact that the financing capacities of certain countries in that union allow the financing needs of others to be met, thus pushing the external constraint to the boundaries of the monetary zone and not the borders of each of its constituent countries. This is the case, for example, in the United States of America for the various States that make up the United States of America. Sustained stronger growth in California, for example, would not be hampered by the weaker growth in other States, even if this would lead to an increasing current account deficit of the first State vis-à-vis all the other States, because the only relevant current account balance is that of the United States as a whole and not that of each of the States. It is therefore necessary for capital to flow efficiently within a Monetary Union. And in order for this movement to take place without hindrance, we need a transfer union, i.e. elements of budgetary solidarity between the States.

 The eurozone crisis, which began in 2010, was a “sudden stop” crisis, specific to this area, and not the mere development of the previous great financial crisis. Until then, the financial markets had properly matched the financing capacities of the Northern countries to the financing needs of the Southern countries within the eurozone. However, ever-increasing divergences between the current account balances of the eurozone countries, namely the growing deficits and surpluses of the various parties, had emerged since the creation of the euro. And when the markets realised that there was in reality no solidarity mechanism between the eurozone countries, they suddenly stopped allocating the financing capacities of the Northern countries – i.e. their current account surpluses – to the financing needs due to the current account deficits of the Southern countries. The crisis therefore happened suddenly, as always when the financial markets suddenly discover, and often belatedly, reality as it is. Countries that are structurally more importers than exporters, seeing their external financing cut off by the markets and not benefiting from solidarity from other eurozone countries, were obliged to immediately curb their demand, thus their imports, by reducing investment, wages, social benefits and public spending. As a result of strong austerity policies, the Southern countries quickly brought their current account balances to near-zero levels. Northern countries, with continued high current account surpluses, began to finance the rest of the world, including US current account deficits, but paradoxically not the other countries of the eurozone itself. This, strictly speaking, does not correspond in any way to an efficient allocation of capital within a Monetary Union.

 Therefore, it is now important to ask how we can build an efficient monetary zone through a real solidarity project in the Union. The expected “technical” improvements to both the European capital market and the Banking Union cannot alone achieve it.

 Since the idiosyncratic crisis in the eurozone, the only elements that have helped partially intermediate the financing capacities of one party with the financing needs of other parties have come from the European Central Bank, through its relations with the national central banks in the eurozone (Target 2).  It is therefore the central banks that have actually encouraged capital flow, but independently of the markets. Then, the emergence of the COVID-19 pandemic resulted in the Next Generation EU plan and the Community loan, which now make it possible to enter a new dimension because they create clear elements of solidarity and a better flow of capital. For the first time in the history of the region and in reality of the European Union, Community expenditure, through donations, mobilises amounts that are incomparably higher than previously, while not split according to the relative weight of each country but according to their needs.  On condition, however, that they undertake the necessary reforms. And the financing of these donations is done through a Community loan. These are obvious demonstrations of solidarity.

 Of course, the issue that arises is that of the European Union’s future resources, which are essential to repay these loans. The challenge is then whether European countries will reach an agreement on common taxes, such as on plastic, CO2 or digital technology. And whether this Community budget and loan will be sustainable. Europe’s “Hamiltonian moment” will only be a real one if there is long-term common expenditure of large amounts, a Community debt and resources specific to the European Union, and not only in response to the pandemic. Will solidarity be sustainable or will it, as many Northern countries are already saying, be a one-off, an isolated operation, specific to the pandemic?

 A monetary union can only be sustainable if there are clear elements of a transfer union. Thus, the fundamental question is whether the interests of the various European countries are sufficiently convergent to achieve this and to agree on it over the long term. If they are not, it becomes very difficult to ensure the permanence of a Community budget and debt. However, Northern countries have significantly increased their industrial capacity while Southern countries have gradually de‑industrialised since the creation of the eurozone. Consecutively, Northern countries have gained market share in global trade (increase in their exports as a percentage of global exports), while Southern countries have diminished their share.  Countries with current account surpluses, thus the Northern countries, have accumulated net assets in the rest of the world; whereas Southern countries, with current account deficits, until the eurozone crisis, have conversely built up debts to the rest of the world on an ongoing basis. At the same time, assessments of initial education levels, as well as professional skills, are very different between the countries of the South and the North. Like youth unemployment rates and general employment rates, productivity gains also diverge.

All these factors contribute to the level of growth and the quality/price competitiveness of each country. Finally, the consequences are a growing North-South divergence in the levels of public debt to GDP.

If this situation persists, post-pandemic solidarity is likely to be short-lived. Especially since, in addition, current inflation, if not only transitory, would lead the ECB to gradually increase its rates, at the very least to neutralize its policy, if not more so. That would increase the difficulties of Southern countries that would not have sufficiently engaged in a credible policy of normalizing their fiscal policy. On the other hand, if the ECB, does not push its interest rate up, to protect them, that would significantly increase tensions in Northern countries with regard to a single monetary policy considered too accommodative for too long and would undoubtedly also cause dangerous market reactions.

 Faced with these considerable and numerous divergences, what must we build to achieve greater solidarity? How can we build mutual trust between the countries of the North and the South? Three points can be put forward here.

 Firstly, Southern countries must implement structural policies, i.e. ad hoc investments and reforms aimed at significantly reducing these divergences. These necessary reforms are not austerity policies, since, on the contrary, they increase potential growth, by increasing productivity, improving the efficiency of initial and vocational training, by better labour mobilisation, including through pension reform, as well as by optimising public spending. Only these policies will ensure that Northern countries do not have to send subsidies indefinitely to Southern countries. This will make it possible to activate the necessary elements to achieve at least some elements of a transfer union.

 While these reforms are necessary, they will not be sufficient. Structural policies alone will not make up for the increased differences in industrialisation levels between the countries of the North and the South. Hence the second point: an industrial and regional planning policy in the European Union must also be implemented, through investment and aid from Northern countries to Southern countries, in order to contribute to their re-industrialisation in certain well-chosen sectors. On this point, we can hope that the Next Generation EU plan will be able to provide answers, since this plan presents and includes major projects for the future. They should therefore be set up according to the relative specialisations, existing or desirable, so as to promote industrialisation and competitiveness in countries requiring it.

Finally, the third point is based on the necessary reconstruction of shared and realistic budgetary rules: they are no longer so today. These rules must be effective and make it possible to support these developments, while ensuring that there are no free riders in the countries of the Union.

 Individual (country-by-country) efforts by the members of the Union, and jointly transitory efforts from North to South, are needed, because they will, in a shared interest, allow the North not to finance the South ad infinitum, and the South not to experience continuous de-industrialisation with all that this implies both economically and socially. And there is a need for budgetary rules that make it possible to implement these policies effectively, but also without leaving the possibility for some countries to count indefinitely on the aid of others, by perpetually postponing the necessary reforms. Otherwise, either populism will continue to rise in the Northern countries that will not agree to pay subsidies ad infinitum to the Southern countries, or populism will continue to grow in the Southern countries, if we leave them to continually become de-industrialised without coming to their aid. Especially as this de-industrialisation is encouraged by an incomplete monetary union, i.e. in particular without the coordination of economic policies and without a transfer union. The catch-up of competitiveness differentials cannot be facilitated by devaluations, which are by the way never miracle solutions. That leads to a dynamic of increasing competitiveness divergences, with induced phenomena of industrial polarisation located in countries with the best comparative advantages. Without individual and common efforts, therefore, there will be no permanent elements of solidarity to get out of this trap. We would then suffer from this rise in populism, which would ultimately endanger the Monetary Union, which is an undeniable common good, due to the virtues of the euro, which has demonstrated its usefulness to us, especially during crises, thanks to the determined action of the European Central Bank.  But the ECB definitely cannot be the only player at the table.