The comeback of inflation will change the relationship to debt

Before the most recent war in Ukraine, growth was strong, although slightly declining given the slow return to a more normal growth rate after the rebound in 2021. Monetary policy should therefore be at least normalized, smoothly due to high global indebtedness and highly valued financial and real estate markets, by gradually exiting the quantitative easing policy)as well as by cautiously raising rates.

This need for tightening came from the risk of overheating. But also the risk of exhaustion of monetary policy in the event of a new future crisis (and there always is). Finally, the development of bubbles due to rates that have been too low for too long compared to growth rates.

Rebound and consequences

Then came, several months ago, a resurgence of inflation. It was clear that part of this inflation was not transitory and that we were probably in the process of changing the inflationary regime. The Fed, then the ECB, were thus led to accelerate their announcement of a gradual halt to 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 as those described above, the challenge then was always not to go too fast in the exit from their very accommodating policy. The ECB also had to deal with the more specific and delicate question of the euro zone, with its strong imbalances between countries of the South and countries of the North.

At the same time, States had, and still have, a need for investment 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 were too low for too long and henceforth the fight against inflation and, on the other, that of financing the new investments required and the solvency of States, or even private players, whose indebtedness had increased sharply since 2000 for the private sector and since 2007 for the public sector, with, in addition, a significant increase in public indebtedness due to the pandemic.

If the very sharp upturn in inflation leads to no reaction or a very weak reaction on their part, there could be a major risk of runaway inflation.

Hence the rise of several voices in the euro zone. Some stated the need to change the common budgetary rules, by excluding investment budgets from the calculation of the constraints imposed on public deficits. This proposal is sometimes coupled with the idea that, in the 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.

Others showed a narrower, but I think much more credible path, certainly explaining the need to change the common rules of the euro zone, which are dated and not very effective, but at the same time underlining the importance of compromises to be found between the countries of the North and the countries of the South on these changes of rules in order to select as candidates for exclusion only the investments that actually bring potential growth or facilitate the energy transition.

Not every expense always leads to more potential growth. And improving growth potential does not always require additional spending. It was also crucial, in this context, to agree on reasonable budgetary rules, preventing any “free rider” behaviour.

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 inflation that is still much stronger than expected before the start of the war. This will thus create an even more intense dilemma for central banks. However, if the very sharp upturn in inflation leads to no reaction or a very weak reaction on their part, there could be a major risk of runaway inflation.

Because today, the question of whether there will be a second round of inflation no longer arises. Many manufacturers and large distributors are increasing their prices, unable to contain the increase in their costs any longer. And many companies have started to increase their salaries. They cannot act otherwise if they wish to retain their skills or be able to recruit. The next wage negotiations will reinforce this phenomenon.

Stable and sufficiently low inflation is essential for confidence.

However, if inflation takes hold through the indexation of prices to prices, of wages to prices and of prices to wages, with slowed growth, we will indeed enter into a potentially lasting stagflationary dynamic. When Paul Volcker, then president of the Fed, tried in 1979 to get out of a long stagflation, he had to cause a deep recession to manage to break the phenomena of indexation. Ignoring inflation would also be very dangerous in terms of inequality, because no one is equal, either among employees or among companies, in terms of the ability to pass on price increases to their incomes.

We must also fear inflation that could turn into a system tending towards hyper-inflation, causing economic agents to lose their bearings. Stable and low inflation allows viable wage agreements; reliable price catalogs between producers, distributors and consumers; loan contracts allowing the fixing of interest rates between borrowers and lenders based on a shared inflation expectation.

In short, stable and sufficiently low inflation is essential to confidence. The latter is necessary for an efficient economy. Monetary policy must therefore react in time. If she didn’t, she would have to act 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 therefore very gradual. This trajectory will therefore imperatively require that governments also play their part well. On the one hand, the latter will have to make the necessary investments, generating potential growth, and on the other, reduce unnecessary expenditure or reallocate it usefully.

It is imperative that central banks neutralize, at least, but cautiously, their monetary policy.

In France, we have long had the highest public expenditure relative to GDP in the euro zone; however, in certain areas, these expenditures have for several decades provided only a quality that bears little relation to the level of expenditure incurred. The many comparative measures of the OECD very regularly attest to this. Thus, the effort should not only be financial. The necessary investments can therefore only be made if the necessary reforms are carried out.

Like that 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 States which have the employment rate after the age of 60 significantly weaker.

All in all, it is imperative that the central banks neutralize, at the very least, but cautiously, their monetary policy, to fight against too great an increase in inflation, as well as to avoid financial instability due to bubbles which would develop further. And, at the same time, it is essential that governments increase potential growth through investments and reforms and ensure better control of expenditure. In order to give credible trajectories to their budgetary policy and ensure their solvency in a world where interest rates will be structurally on the rise.

On March 16 of this year, the Fed increased its intervention rate by 25 cents and given to understand that the increases to come would be numerous. The ECB, the next day, in turn announced a end of its net purchases of securities at the end of June and opened the door to further rate hikes. What’s more, if the ECB did not lead such a change in policy, the euro would continue to depreciate, particularly against the dollar, leading to even higher inflation, due to the rise in the price of imported products in euros. The movement therefore seems to have been launched.

The unthought of the “war economy”

The idea of ​​a “war economy”, war against climate change, war for reindustrialisation, as military war, as it is beginning to be evoked here and there by certain economists – if it led to think that the debt did not matter and that the central banks would be led to finance any new deficit thus allowing very sustainable spending without constraint – could lead to a disaster.

Money is constitutive of the social bond.

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 includes an unthought: money. Money is the foundation of the debt settlement system. To have confidence in money is to have confidence in the effectiveness of the debt settlement system. Therefore, if ever the monetary constraint was suspended for too long, then it would be the confidence in the currency that 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 central banks never stopped doing “quantitative easingand endlessly maintained rates that were too low in relation to the rate of growth, not only would serious financial explosions occur regularly, but also sooner or later would be engendered a flight from money which would be dramatic. The result is the disorganization and collapse of the economy and society.

Because money is constitutive of the social bond. As Michel Aglietta says: “Confidence in money is the alpha and omega of society.”

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