Category: Euro zone

Today, inflation has returned for the long term. Central banks must counter it. But an excessive rise in interest rates can trigger a recession, a hard landing. It can be too strongly calibrated, if we think that the transitory component of current inflation will weaken in the near future. Supply constraints have already begun to ease over time, barring the consequences of an escalation in the war. But an excessively slow rise in interest rates would lead to an increase in indexation. Reacting late, once inflation expectations are no longer anchored at a low level, would cost much more. Making deep recessions inevitable.

Interest rates too low for too long have globally led to very high debt ratios and bubbles in both equities and property. Rates must therefore be raised and quantitative easing policies gradually come to an end. But central banks are facing the risk of bursting bubbles, with impacts on growth, and the risk of insolvency for the most indebted companies and governments. This situation is therefore problematic for central banks, which must be very determined and very cautious. As a result, they have begun the normalisation of their policy and will go as far as its neutralisation. Including through a gradual exit from quantitative easing. But once this stage is reached, they will act according to the circumstances. If growth weakens sharply, if markets fall substantially, they will warn. The state of wage and price indexation, and therefore of the level of “structural” inflation, will then be scrutinised, in order to question the opportunity or danger of positioning interest rates above the neutral rate. If the inflationary regime were to strengthen further, they would very likely tighten their policy, both by raising their interest rates above the potential growth rate, and increasing quantitative tightening.

In this context, they will conduct monetary policies that are closely linked to data as they arise. While avoiding being dominated by fiscal issues and financial markets.

Meanwhile, governments have no choice but to have a credible medium-term solvency trajectory. An overly strict fiscal policy would destroy growth, but doing nothing when the level of indebtedness is high would undermine their credibility, which would be a very high risk in the short term.  They therefore need to put in place a policy of managing public finances without austerity, but which in reality is an exit from support policies. The unexpected, brutal and temporary pandemic is indeed to 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, as well as by structural reforms. The latter are necessary to increase potential growth, i.e. sooner or later for a better ratio of public debt to GDP. They are also a means of combating inflation, the origin of which in Europe is more linked to a supply shock. And when the labour supply is very insufficient, job shortages can be alleviated by the reform of the labour market and the unemployment system, as by pension reform. In France, the employment rate of people over sixty is much lower than that of the rest of the eurozone.

The road is narrow. The essential fight against inflation, without too many economic and financial difficulties, requires a good combination of monetary policy and structural policies. Monetary policy can do a lot, but it cannot do everything on its own.

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”.

[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.