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Conjoncture Economical and financial crisis Global economy Uncategorized

Inflation, Endgame?

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

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

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

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

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Conjoncture

Structural reforms are crucial for protecting social welfare

The concept of structural reforms is not well understood. Their purpose is, in fact, to boost a country’s economic growth potential, without necessarily lowering wages or social protection through austerity measures. It is important to clarify this distinction, as confusion can be detrimental to the discussion.

Why is it essential to increase France’s growth potential? Firstly, to lower the structural unemployment rate, which, despite recent progress, is still around 7 percent. The country also faces unacceptably high youth unemployment, at around 18 percent (compared to 5 percent in Germany). Secondly, increasing growth potential would help ensure a better financial position for the state, local authorities, and social security, which would lead to increased sustainability for social protection and pensions. There is no point in dissociating the financial question from the capacity to maintain a high level of social welfare.

Thirdly, France needs to seek competitiveness from above, which can be achieved through two possibilities: lowering the cost of labor and social protection via austerity policies – as was the case in Spain and Portugal during their debt crisis and the financing of their foreign trade deficit, during the euro zone crisis of the 2010s. Or, on the other hand, improving quality-price ratios of national products and services through structural reforms, such as developing added value and the range of production, notably through innovation. Public expenditure must also be managed efficiently to avoid excessively high tax rates, which could reduce competitiveness and employment and jeopardize the sustainability of social welfare. 

Germany has been successful in this regard since 2000, with reforms that have strengthened its competitiveness despite having one of the highest labor costs in Europe, through industrialization based on high added value. This resulted in a high trade surplus, a structurally low unemployment rate, and a relatively low public debt ratio.

France has a similar labor cost to Germany but needs to improve its production range and quality-price ratio, as it currently offers a low quality-price ratio. As a result, the country has a low level of industrialization and a trade deficit that is constantly deteriorating. France’s lack of structural reforms over the past few decades has led to an excessively high unemployment rate, one of the lowest employment rates among comparable countries (68 percent compared to 77 percent in Germany and Sweden or 82 percent in the Netherlands), and a high permanent budget deficit, resulting in an excessive and steadily rising level of public debt.

The potential growth rate of an economy is the sum of the growth rate of the working population and productivity gains. France needs to implement several structural reforms to increase the quantity of work, which is one of the lowest in relation to its population (610 hours of work per year and per inhabitant, compared to more than 700 in Germany or 750 to 900 in the Netherlands, Sweden or Portugal). This would help finance social protection for all and public services, so their level does not fall. A better functioning labor market is essential to achieve this, which would also put an end to the paradox of a still too high unemployment rate coexisting with a high proportion of companies unable to recruit as much as they wish, which constrains supply and growth and facilitates inflation.

Additionally, the employment rate needs to be raised by making it easier for young people to enter the labor market and by increasing the number of years spent at work before retirement, as neighboring countries have done. France has a very different employment rate at both ends of the life cycle, with about 35 percent of 60-64 year-olds employed compared to 62 percent in Germany or 70 percent in Sweden.

Education, both initial and continuing, must also become one of France’s strengths once again. International comparisons show that France’s training and education efficiency is decreasing despite a budget that is similar to or even higher than those of other European countries doing better in this regard (about 1 point of GDP more in France than in Germany). Here again, reforms are essential, even if the rise in the level of training can only be slow. The efficiency of education conditions the number of jobs as well as their qualification, which, in turn, influences the range of production and its quality-price ratio.

Finally, let’s not forget the reforms that enable productivity gains, which are essential for potential growth. France has made great progress in creating “tech” companies, and the Research Tax Credit (CICE) is a valuable example. However, it is important to note that the profit rate is a determinant of the amount of research and development carried out by companies. After being lower than neighboring countries for a long time, it has improved since the introduction of the CICE and the lowering of the corporate tax rate. 

In contrast, public spending efficiency remains far below what is desirable. Despite being on the podium of public spending rates (about 8 points of GDP more than in Germany, 9 than in Sweden or 13 than in the Netherlands), France’s quality of public spending (including social security) is only average compared to OECD countries and is perceived as decreasing. This high level of public spending also results in a tax rate that is almost the highest in the world (more than 6 points of GDP above that of the euro zone excluding France), which is a definite handicap to competitiveness.

On top of that, compulsory levies, although very high, do not cover expenditure, which leads to a permanent public deficit and a permanently increasing public debt relative to GDP. As a result, our growth is obtained at the cost of an ever-increasing debt ratio, which is ultimately unsustainable. Since 2000, public debt in the euro zone has increased by 25 points of GDP, while France’s has increased by 50, twice as much. In the early 2000s, France’s public debt ratio was identical to Germany’s, at around 60%. Today, it is about 110% in France and 70% in Germany. Reforming the State and local authorities, combined with reforming the social systems, would help maintain the high level of social protection for the French and prevent it from declining.

Efficiency and respect for each person’s duty towards the common good of social protection are not a search for the lowest social standards, but rather the only way to preserve what is valuable for all. Ignoring or denying the usefulness of structural reforms would be playing with fire.

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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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Conjoncture Economical policy Euro zone

“Inflation, interest rates and debt”

Updated on 21/10/2022

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Conjoncture Economical and financial crisis Global economy

Post-lockdown: neither austerity nor voodoo economics

The central banks took swift and effective action. States also acted rapidly in an attempt to handle the cost of the unprecedented fall in production as effectively as possible. They did so by enabling the financing of company losses and by taking on the cost of labour, since businesses generating zero revenue cannot continue paying their employees. The aims are to prevent layoffs and bankruptcies, protect production capacity and avoid an appalling rise in poverty.

The set of measures temporarily lifts monetary constraint – vital in normal circumstances to the efficient functioning of the economy – from economic players, businesses and households.

Monetary constraint

But in today’s economic meltdown, the normal exercise of monetary constraint would be catastrophic, leading to bankruptcies and countless irretrievable job losses. For their part, the central banks, while ensuring the liquidity necessary to the financial system, have wisely suspended the monetary constraint of states.

Once the health crisis is over, putting an end to this exceptional suspension will not be an easy task, and it would be dangerous to let people believe that monetary constraint at all levels could be durably lifted simply by central banks buying state and company debt on an ad lib basis.

While monetary constraint should not be abruptly reintroduced, as this could send the economy into a new downward spiral, neither should it be suspended for too long. This is because we must absolutely avoid a flight from currency, the value of which is wholly dependent on the trust placed in the effective exercise of monetary constraint, and hence in banks and central banks, as well as in the quality of debt, including public debt.

Fatal illusion

Central banks should make a part of the additional public debt resulting from the health crisis interest-free on a practically indefinite basis to lighten the load and foster the return of growth. But they must do so in a precise and strictly circumscribed manner. The idea of central banks permanently suspending monetary constraint is a fatal illusion. The major risk involved in acting as if monetary and economic constraints no longer exist is thus not a return of traditional inflation but a loss of confidence in currency. Sooner or later, this would lead to the appearance of a form of hyper-inflation and deep financial instability.

Pressure from public opinion

The reopening could thus entail elevated risks of economic policy mistakes. Under pressure from public opinion, policy may seek to return too swiftly to orthodoxy or assume that we are exempt indefinitely from any and all constraints.

A solid supply policy must be led to rebuild the country’s production capacity and even increase it to reduce its strategic dependence. The process will require all the capacity for work and entrepreneurial spirit of everyone involved. The supply policy must further mobilise labour and include a substantial focus on recapitalising businesses and facilitating investments. Failing this, companies will exit lockdown heavily in debt and may well be unable to invest sufficiently on a lasting basis.

The supply policy must be accompanied by a policy to boost demand, since both have suffered considerably during the crisis. Increasing taxes will not be compatible with either policy. Consequently, we will need to accept budgets with extremely gradual deficit reductions and the fact that monetary policies can only return to their unconventional practices in a cautious fashion. But to salvage trust in state debt and in currency, this should be achieved as part of a highly explicit plan.

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Conjoncture Economical and financial crisis

Post-lockdown: neither austerity nor voodoo economics (complete version)

Read the complete version of my column in the 14 May 2020 issue of Les Echos

The central banks took swift and effective action. States, including France, also acted rapidly and appropriately in an attempt to handle the cost of the unprecedented fall in production as effectively as possible. They did so by enabling, as far as possible, the financing of company losses and by taking on the cost of labour, since businesses generating zero revenue cannot continue paying their employees. The key objectives are to prevent layoffs and bankruptcies, protect production capacities, in some measure, and avoid an appalling rise in poverty.

In essence, the set of measures introduced temporarily lifts the monetary constraint from the various economic players, businesses and households. Monetary constraint applies in normal periods as it is vital to the efficient functioning of the economy.

The sole businesses that are likely to survive in the medium and long term are those that do not bleed money in an uninterrupted fashion. Otherwise, economic efficiency – which French politician Michel Rocard famously said was the only good way to spare human suffering – would not be possible and no Schumpeterian growth permitted. The same applies to households, which cannot spend more than they earn on a lasting basis.

But in today’s economic meltdown, the normal exercise of monetary constraint would be catastrophic, leading to bankruptcies and countless irretrievable job losses.

For their part, the central banks, while ensuring the liquidity necessary to the financial system, have wisely suspended the monetary constraint of states.

Once the health crisis is well and truly over, reactivating monetary constraint will not be a simple matter. But it will be indispensable. And it would be misleading and dangerous to let people believe that monetary constraint at all levels could be durably lifted simply by central banks buying state and company debt on an ad lib basis.

While monetary constraint should not be abruptly reintroduced, as this would send the economy into a new downward spiral, neither should it be suspended for too long. This is because we must absolutely avoid a flight from currency, the value of the latter being wholly dependent on the trust placed in the effective exercise of monetary constraint, and, hence, the trust placed in banks and central banks, as well as in the quality of debt, and public debt in particular.

In this respect, I believe that central banks should make a part of the additional public debt resulting from the health crisis interest-free on a practically indefinite basis to lighten the load and foster the return of growth. But they must do so in a precise and strictly circumscribed manner. The idea of central banks permanently suspending monetary constraint is a fatal illusion.

While there has not been a correlation between the money supply and inflation since the 1980s, the major risk involved in acting as if monetary and economic constraints no longer exist is not a return of traditional inflation (which would be welcome if it were to remain limited) but a loss of confidence in currency through widespread mistrust.

Sooner or later, this would lead to the appearance of a form of hyper-inflation and major financial instability. Economic history, right up to the present day, is littered with examples of interminable ruin and crises with terrible social impacts resulting from the illusion that no constraint exists and that everything is possible without having to produce the requisite wealth.

The reopening could thus entail elevated risks of economic policy mistakes. Under the sway of emotion and the pressure of public opinion, policy may seek to return too swiftly to orthodoxy or believe that we are exempt indefinitely from any and all constraints.

A solid supply policy must be led to rebuild the country’s production capacity and even increase it to reduce its strategic dependence. The process will require all the energy, capacity for work and entrepreneurial spirit of everyone involved. The supply policy must further mobilise labour and include a substantial focus on recapitalising businesses and facilitating investments. Failing this, companies will exit lockdown heavily in debt and unable to invest sufficiently on a lasting basis.

The supply policy must be accompanied by a policy to boost demand, since both have suffered considerably during the crisis. Increasing taxes will not be compatible with either policy. Consequently, we will need to accept budgets with extremely gradual deficit reductions and the fact that monetary policies can only return to their unconventional practices in a cautious fashion. But to salvage trust in state debt and in currency, this should be achieved as part of a highly explicit plan.