Redistributive policy

The main risk of recession comes from the lax policy of the ECB

The reasons for the European Central Bank to raise interest rates now to counter rising inflation are overwhelming. The arguments against prompt action are largely invalid. Raising rates today would have a much weaker restraining effect than doing nothing and letting inflation thrive. The main risk of recession does not come from the rise in rates but from maintaining the current extremely flexible policies.

An oil shock like today brings inevitable dilemmas for monetary policy makers. In 2004, Ben Bernanke (just before taking over from Alan Greenspan as Federal Reserve Chairman) said, “Monetary policy cannot offset the recessionary and inflationary effects of rising oil prices at the same time. He must choose.

We must weigh the disadvantages and relative advantages of each option. Allowing inflation to rise to protect gross domestic product growth should only be considered if growth was falling sharply, unemployment was soaring, and the economy was drifting further and further away from full capacity with weak inflation. This is not the current environment. Unemployment in the United States fell to 3.6% in March, the lowest since the start of the pandemic, and wages are on the rise.

In Europe, the unemployment rate is falling and inflation is soaring. The euro area unemployment rate fell again in February to 6.8% of the labor force, its lowest level since Eurostat began compiling this series in April 1998. Inflation annual growth in the euro zone reached 7.5% in April, compared with 7.4% in March and 5.9% in February.

Inflation has become a serious risk, while eurozone monetary policy has never been so accommodating. Real interest rates are becoming more and more negative, currently around -7%, causing massive distortions. Central banks should tighten their policy in these circumstances. The ECB does the opposite. The Fed is currently raising interest rates and will start shrinking its balance sheet in June. The ECB should follow suit without delay.

Since higher inflation reduces the debt burden, many people wonder, “Isn’t inflation the miracle cure for debt?” This reasoning is flawed. Very high double-digit inflation would be needed to offset the current high debt levels. This would increase social risks and fuel populism, as many people would suffer an unavoidable drop in income.

Moreover, high inflation would blur the investment horizon and discourage entrepreneurs. The ensuing declines in the exchange rate would lead to more imported inflation, with a clearly recessive effect. The sustained rise in prices reduces consumption, reduces the margins of companies subject to strong competition and slows down investment.

What is the ECB’s response? The central bank has been hesitant and ambiguous. He says, “We need to put the brakes on quantitative easing first and only then start raising rates.” The pandemic emergency purchase program ended on March 31 but could be resumed, if necessary, to counter the shocks linked to Covid-19.

Monthly net purchases under the separate (pre-existing) asset purchase program will increase from €40 billion in April to €30 billion in May and €20 billion in June, and are expected to end in third trimester. A rise in interest rates will come “some time” later, but without being automatic and depending on macroeconomic conditions. The Board of Governors intends to reinvest the principal payments of maturing securities purchased under the PEPP until at least the end of 2024.

The ECB’s inflation projections foresee a moderation in inflation from 5.1% in 2022 (7.1% in its “severe” scenario) to 1.9% in 2024. The ECB does not expect stagflation.

However, the ECB’s forecasts appear too optimistic. Commodity prices are skyrocketing due to the Ukrainian war and other developments. Financial markets are banking on oil at $125 a barrel, with the European Union suffering from a collapse in Russian demand. European growth could be below the 2.3% of the ECB’s “severe” scenario. The green energy transition and decarbonization costs will drive prices up even further. the BlackRock Institute Highlights how eliminating Russian gas imports could add 1-1.5% to inflation in Europe and significantly reduce growth.

High inflation imposes a tax on savings. Investment is essential for growth. The “liquidity trap” enunciated by John Maynard Keynes – savings remain liquid since long-term projects yield nothing – leads to a devastating drop in productive investments. It encourages bubbles by diverting savings to real estate and speculative assets. “Zombie companies”, kept alive by subsidized interest rates, reduce global productivity. Real estate bubbles will continue with excessively cheap mortgages. Share buybacks – which put money in shareholders’ pockets but are usually unproductive – continue their ascent: from 267 billion dollars over 12 months at the end of March 2021 to a record of 319 billion dollars at the end of March 2022 in the United States.

An accommodative monetary policy will almost certainly fuel a wage spiral. On the contrary, oil prices tend to rise even more if currencies depreciate: the traditional reaction of oil-exporting countries to depreciations in buyers’ exchange rates.

The increase in interest rates could recreate higher “spreads” on government bonds in the euro zone, to the detriment of the most indebted countries. However, the policy adjustment now creates room to cut rates later, in the event of a recession. The reappearance of spreads in Europe should not take precedence over the decision-making process. The ECB cannot be required to eliminate all traces of interest rate differences in the financial markets. If this were the case, the central bank would have to buy vulnerable securities without limit – which is difficult to reconcile with the Maastricht Treaty.

High and ever-growing debt and negative real interest rates are far from a “magic wand”. Instead, they represent a fatal trap. History has taught us the social and political cost of such a policy. The best way forward is to reduce excessive public deficits, restore the remuneration of productive investment, encourage work more than redistribution and take strong measures to stop the deadly cycle of decline. Europe benefits from a substantial savings surplus. This money should be used inside and not outside the EU. This requires European savings to be remunerated at least as attractively as in the United States.

The ECB must play its part and act now. Further hesitation creates the risk that the central bank will have to take much tougher action later if and when inflation gets completely out of control. This would deal a fatal blow to the credibility not only of the ECB but also of the entire European construction.

Jacques de Larosière is former Managing Director of the International Monetary Fund, Governor of the Banque de France and President of the European Bank for Reconstruction and Development. This is an edited version of his speech to the CDU’s Economic Council in Berlin on April 27. His latest book ‘In end the reign of financial illusion’ is published by Odile Jacob.