Will interest rates stay below the growth rate permanently, as if debt doesn’t matter? In contrast, we can think that the central banks will initiate or continue a gradual increase in their rates. So what are the possible and relevant responses for a highly indebted state?
Before the most recent war in Ukraine, growth was strong, albeit declining slightly given the slow return to a more normal growth rate after the recovery in 2021. Monetary policy should therefore at least be normalized, easing due to high global debt and the highly valued financial and real estate markets, by phasing out the policy of quantitative easing (quantitative easing), as well as by cautiously raising rates. This need for tightening arose from the risk of overheating. But also the risk of monetary policy exhaustion in the event of a new future crisis (and there is always one). Finally, the development of bubbles due to too low rates for too long compared to growth rates.
Then came, a few months ago, a revival in inflation. It was clear that some of this inflation was not transient and that we were probably in the process of changing the inflation regime. The Fed and then the ECB were thus led to accelerate their announcement of a phasing out of their net purchases of securities on the markets. They also said they would raise their rates a little faster than expected. For the same reasons described above, the challenge then was always not to go too fast in the exit from their highly accommodative policies. The ECB also had to deal with the more specific and delicate issue of the eurozone, with its strong imbalances between the countries of the South and the countries of the North.
At the same time, states have had and need investments for the development of new technologies, reindustrialization (even partial) and 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 henceforth the fight against inflation, and, on the other, the financing of the necessary new investments and the solvency of states, or even private players, whose debt burden had been significant since 2000. increased for the private sector and since 2007 for the public sector, with a significant increase in public debt as a result of the pandemic.
Hence the emergence of different voices in the eurozone. Some pointed to the need to change the common fiscal rules by excluding investment budgets from the calculation of the limits imposed on government deficits. This proposal is sometimes accompanied by the idea that in the current circumstances the level of government debt was insignificant and that central banks would continue to fund future deficits for a long time to come. Others showed a narrower, but in my opinion much more credible path, which certainly explains the need to change the common rules of the eurozone, which are dated and not very effective, but at the same time underlined the importance of compromises between the countries of the North and the countries of the South on these rule changes to select only those investments as candidates for exclusion that actually deliver potential growth or facilitate the energy transition. Not every expense always leads to more potential growth. And improving growth potential doesn’t always require additional spending. In this perspective, it was also crucial to agree on reasonable budgetary rules, in order to avoid any “free rider” behavior.
The specter of stagflation
Today, the war situation has created the specter of stagflation. So a slowdown in growth that will be at least one point, as well as an inflation much stronger than expected before the start of the war. So this will create an even more intense dilemma for central banks. However, if the very sharp rebound in inflation leads to no or very weak response on their part, there is a high risk of runaway inflation. Because today the question arises whether there will be a second round of inflation. Many manufacturers and major distributors are raising their prices, unable to contain the rise in their costs any longer. And many companies have started raising their salaries. They cannot act otherwise if they want to maintain or recruit their skills. The next wage negotiations will amplify this phenomenon.
However, if inflation enters through the indexation of prices to prices, wages to prices and prices to wages, with slowing growth, we will indeed enter a potentially persistent stagflationary dynamic. When Paul Volcker, then Fed president, tried to break out of a prolonged stagflation in 1979, he had to drive a deep recession to break the indexation phenomenon. Ignoring inflation would also be very dangerous in terms of inequality, because no one is equal, neither among workers nor between companies, in the ability to pass price increases on to their incomes. We must also fear inflation that could turn into a system leaning towards hyperinflation, causing economic agents to lose their position. Stable and low inflation enables viable wage agreements; reliable price catalogs between producers, distributors and consumers; loan contracts that make it possible to set interest rates between borrowers and lenders based on a shared inflation expectation. In short, stable and sufficiently low inflation is essential for confidence. The latter is necessary for an efficient economy. Monetary policy must therefore react in a timely manner. If she didn’t, she would have to trade later and take a lot more risk. Central banks must remain credible. By supporting growth, of course, but by clearly fighting inflation. Moreover, uncontrolled inflation undermines growth itself.
A narrow path
This path will be very narrow. The monetary tightening policy must therefore necessarily be very cautious, and thus very gradual. This process will therefore absolutely require that governments also play their part properly. On the one hand, it will have to make the necessary investments to generate potential growth, and on the other, reduce unnecessary expenditure or redistribute it usefully. In France, we have had the highest public expenditure-to-GDP ratio in the Eurozone for a long time; in certain areas, however, over decades this expenditure has produced only a quality disproportionate to the level of expenditure incurred. The many comparative measures taken by the OECD regularly testify to this. The effort should therefore not only be financial. The necessary investments can therefore only be made if the necessary reforms are implemented. Such as that of retirement, which while reducing the government deficit, supports potential growth as it increases the population available for work, while France is currently one of the states with the employment rate significantly lowest after 60 years.
All in all, it is imperative that the central banks, at the very least, but cautiously, neutralize their monetary policy in order to fight against too much inflation and to avoid financial instability due to bubbles that would develop further. . At the same time, it is essential that governments increase potential growth through investment and reform and ensure better control over spending. To give their fiscal policies credible trajectories and ensure their solvency in a world where interest rates will rise structurally.
On March 16 of this year, the Fed raised its intervention rate by 25 cents, signaling that the hikes ahead would be numerous. The next day, the ECB, in turn, announced that it would stop its net purchases of securities at the end of June and opened the door to further rate hikes. Moreover, if the ECB did not lead such a policy change, the euro would continue to depreciate, especially against the dollar, leading to even higher inflation due to the rise in the price of imported products in euros. So the movement seems to have been launched.
The Unthinking of the “War Economy”
The idea of a “war economy,” war on climate change, war for reindustrialization, as military war, as it’s beginning to be conjured up by certain economists here and there – if it would lead to debt not mattering and central banks forced to fund each new deficit and thus allow very sustainable spending without restrictions could lead to disaster. This concept of war economy inevitably leads to the idea of a very long duration. Unlike a “whatever it takes”, limited to the duration of the pandemic. But this idea involves an unthought: money. Money is the foundation of the debt settlement system. To have confidence in money is to have confidence in the efficiency of the debt settlement system. Therefore, if ever the monetary constraint has been suspended for too long, confidence in the currency could be called into question. And if we lost faith in money, we could not experience traditional inflation, but an escape from money. If Central Banks Never Stopped Doing” quantitative easing and endlessly maintained rates that were too low in relation to the rate of growth, not only would serious financial explosions regularly occur, but sooner or later, a cash outflow that would be dramatic. The result is the disorganization and collapse of the economy and society. Because money determines the social bond. As Michel Aglietta says, “trust in the currency is the alpha and the omega of society”.
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 Either the obligation to pay its debts, or more precisely, for the states and corporations to have to refinance them in due course with lenders other than the central banks.