by Xavier Ragot, with contributions from Céline Antonin, Elliot Aurissergues, Christophe Blot, Eric Heyer, Paul Malliet, Mathieu Plane, Raoul Sampognaro, Xavier Timbeau, Grégory Verdugo.

The purpose of this analysis is to open up discussion about how the war in Ukraine will affect the French economy. Such an assessment is of course uncertain, as it requires a forecast of diplomatic and military developments and in particular involves critical assumptions about sanctions and economic policy responses.

If consequences that are deemed negative are identified, this should not be read as a criticism of these policy choices, but rather as a contribution to how best to limit their negative impacts.

This document is intended as a summary and refers to relevant work for further consideration. Ongoing study will clarify the analyses and the relevant calculations.

The war in Ukraine will affect the French economy through eleven different channels.

I – The economic shock: Short-term effects

1) The first effect is of course on France’s energy bill

Increases in the price of gas and oil will reduce the purchasing power of French households and raise production costs for business. The gas price is the first unknown. The average daily price in 2019 was €14.6/MWh, before falling to €9.6/MWh in 2020 due to the pandemic. The price per MWh reached €210 on 10 March 2022!  This high level will not last. A level of €100/MWh is a realistic assumption, which would constitute a six-fold increase in price from 2019. Second, the higher gas prices will not be passed on to households immediately, because many contracts have expired (Antonin, 2022) and the government will wind up bearing part of the energy bill through the regulation of gas prices. However, the price increase on imports will be paid by domestic agents.

France imported 632 TWh of gas in 2019 and 533 TWh in 2020, as the pandemic slowed activity. But what counts most are net imports, which are lower. The cost of net gas imports in 2019 was €8.6 billion. Imports in 2022 will be affected by a possible economic slowdown but also by gas storehouses. For 2022, a working hypothesis could start from the level of net imports in 2019. Applying an increase of €85/MWh, this results in an additional cost of around €40 billion if the increase were to last one year. If the higher price were to last longer, then it would generate substitution effects in the medium term, as discussed below.

The price of oil is equally difficult to predict, as it depends on the behaviour of strategic players, such as OPEC. The price of a barrel of Brent crude fluctuated between USD 60 and USD 70 in 2019. It rose to USD 133 on 8 March, before falling back to USD 114 after OPEC announced a boost in production. The price of oil will, much like gas, depend on the sanctions on Russia; Russian crude represented around 10% of France’s purchases in 2020 and in 2019 constituted about 4.8% of the world’s known reserves. We could assume an average price of 110 dollars (or 100 euros, which is consistent with the EIA analysis). In 2019, France’s crude oil bill was €21.8 billion, to which must be added €13.3 billion of refined products. Assuming unchanged demand and using these same amounts, we end up with a total oil bill of 58.5 billion euros, i.e. an extra cost of 24 billion euros. The euro/dollar exchange rate could also fluctuate during the crisis, with a probable depreciation of the euro that is difficult to estimate at present. As a result, a constant exchange rate of 1.1 will be kept.

This increase will necessarily generate moves towards import substitution and reduction. These effects have been studied for the German economy (with references to the measures) by Bachman et al. (2022), who focus only on substitution effects. Using the literature (Ladandeira et al., 2017), they assume an elasticity of -0.2. In the case of a reduction in the quantity of gas and oil, how much residual capacity do firms have to produce? The answer to this question depends on assumptions about the extent energy can be substituted by other factors. Depending on these assumptions, all of which are realistic, the estimate for Germany ranges from 0.7 GDP points to 2.5 GDP points, or even more due to supply effects alone.

For France, a concrete example of substitution would be a reduction in heating: a 1° reduction in heating leads to a 7% reduction in gas consumption, i.e. a reduction of gas consumption by 4.2 billion m3, whereas 14.7 billion m3 of Russian gas is consumed.

The following table summarises estimates of how much price increases will raise costs, using various assumptions.

The table shows the uncertainty of the estimate depending on the duration of the price rise and the assumption of partial short-term substitution. The figure of 64 billion euros is close to three GDP points, which would be a significant shock to the French economy. A duration of six months with substitution behaviour would lead to a shock of one GDP point. Here we see the critical importance of political uncertainty.

2) Macroeconomic effect of rising energy costs

The primary effects of higher energy prices would be a reduction in household purchasing power, an increase in business production costs and higher costs to the state due to regulating prices. The impact on growth would proceed through complex mechanisms. As mentioned above, it occurs through substitution effects but also through the diffusion of energy prices to production prices and wages.

The OFCE has estimated the macroeconomic impact of a rise in energy prices in three different ways. First, by using two macroeconomic models, the emod.fr model, also used in forecasting, and the Threeme model, which breaks down energy consumption by sector (Antonin, Ducoudré, Péleraux, Rifflart, Saussay, 2015). Another strategy has been to use possibly non-linear econometrics (Heyer and Hubert, 2016 and Heyer and Hubert, 2020). Note that the latter work includes substitution possibilities measured by the elasticities mentioned above.

The results are as follows. In the model-based approach, a long-term oil price increase of 10 dollars leads to 0.1% to 0.15% less GDP growth and 0.6% inflation in the first year. With the econometric approach, a 10 dollar oil price increase reduces growth by 0.2% and leads to a 0.4% increase in inflation, with a relatively linear effect and a maximum impact after four quarters.

Because of the size of the shock, it is difficult to know whether to consider the high ranges because of the non-linearities or the low ranges because of a greater substitution effort and a fall in the savings rate. Furthermore, the estimate is made for oil and not for gas. For this reason, we will consider average effects, without seeking to maximise the fall in GDP. Thus, an increase of 40 dollars (compared to the situation in 2019), which is increased proportionally to take account of increases in the price of gas as well, leads to a fall in GDP of about 2.5 GDP points in the upper range and an increase in inflation of 3% to 4%. This amount corresponds to a multiplier for the negative shock on energy expenditure of -1. With unchanged business behaviour and unchanged public policy, this fall in GDP translates into a drop of the same order in market employment, so about 600,000 jobs (change compared with a non-war environment). In the low range (short duration and substitution), we obtain a fall in GDP five times smaller at 0.5 GDP points.

At this stage, this estimate does not take into account the effect of the conflict on other commodities, cereals or precious metals, which are of secondary importance compared to energy prices and are discussed by COFACE.

3) Uncertainty channel

Modelling the effect of the war in Ukraine depends heavily on the reaction of households and businesses to the uncertainty generated by the war. In an environment like this, the savings rate is expected to rise in the medium term (after purchases of basic necessities), which would aggravate the depth of a recession. However, after the Covid-19 crisis, households in France have an excess of savings of 12% of annual income (166 billion euros, OFCE Policy Brief no. 95), which they could dip into to pay the additional energy bill without changing their consumption habits. This attitude depends crucially on the perceived duration of the shock. A shock that is expected to last very long may lead to an additional increase in savings.

Companies’ wait-and-see attitude (before knowing which way markets are going) is leading to a downturn in investment. For business, the period of high uncertainty during the pandemic was marked by a good level of investment, partly due to public support (OFCE Policy Brief no. 95).

The third effect of the uncertainty channel is an increase in precautionary savings and a search for secure savings. As a result, savings are more likely to be directed towards safe assets, including public debt, and the real interest rate on France’s public debt may fall. After the outbreak of the conflict, rates did indeed fall in Germany (0.20 points), the United States (0.15), France (0.20), Italy (0.35) and Spain (0.2). In the longer term, how rates change will depend on how the policy of the European Central Bank (ECB) is perceived, which is discussed below. The search for safe assets will also cause the stock markets to fall and lead to negative effects on financial wealth, which won’t modify consumption in France much.

4) Redistributive effects

Higher energy prices will affect households differently and will disproportionately hit the poorest households with the lowest savings rates (Malliet, 2020).

There is considerable heterogeneity in the structure of spending on energy products. According to data from the 2017 Budget des familles survey conducted by INSEE, 10% of the consumption expenditure of the households in the poorest decile goes on electricity, gas and other fuel for the home and on fuel for transport. At the other end of the scale of living standards, households in the richest decile spend less than 7% on these items. On the other hand, Malliet (2020) shows that there is still considerable heterogeneity in the structure of consumption of these products even within a given decile. There is a significant proportion of the population that is highly exposed to certain energy prices, which requires that targeted measures be adopted that take into account this extraordinary exposure to certain goods for which – unless the household makes a major investment – there are few readily available substitutes.

The anti-redistributive aspect of a rise in energy prices therefore leads to a marked drop in the consumption of households with the lowest savings rate. This effect, in addition to the uncertainty channel, leads to a drop in aggregate demand and activity. Compensation for the loss of purchasing power induced by the rise in the price of oil and gas of 30% thus comes to 20 billion euros in the high range.

5) Destabilising financial effects

In addition to the average effect on interest rates, the sanctions that entail the exclusion of certain Russian banks from the Swift system is leading the banks to default on payments. Freezing the Russian central bank’s assets will generate difficulties that will probably lead to an explicit default on Russia’s public debt (a first since 1998) if the conflict continues for a few more weeks. According to the rating agencies, the risk of a sovereign default is imminent. A decree already allows for the repayment of the public debt to certain countries in roubles. The risk of a default on Russia’s debt is approaching one (measured by the CDS), and evaluations of the impact of sanctions on Russia’s debt point to a fall in GDP of between 7.5% and 10% in 2022 (Coface). The risk on Turkish and South African debt is also mounting.

The exposure of French and European banks and investment funds to Russian risk (public and private) is difficult to estimate because of possible contagion effects. The amount of external public debt is, however, low, estimated at USD 60 billion. The ECB can be trusted to intervene in the event of heightened financial instability, but the risk of a tightening of credit is likely.

The following graph shows the exposure to Russian risk by country, measured by residents’ consolidated position in Russian assets (Bank for International Settlements data).

We see that France’s exposure is high, at 22%, as is Italy’s. However, this exposure doesn’t include the possible contagion effects of financial crises.

II – Fiscal policy response

How the economy fares after such a shock will depend on the fiscal and monetary response.

6) Reception of refugees

First of all, while the primary purpose of taking in refugees obviously is not economic, this will generate expenditures that will probably be financed by debt and so will have an effect on activity. The experience of the last refugee crisis in 2016 leads to a first estimate. As Jean Pisani-Ferry notes, according to UNHCR analyses, Germany’s intake of 750,000 refugees in 2016 called for a budgetary effort of 9 billion euros, i.e. about 10 billion euros per million refugees. For an estimated 4 million refugees (given that currently the number is about 2.5 million), this leads to a temporary cost of 40 billion for Europe, which, on the scale of Europe, is not all that much but which for the countries hosting the most refugees, such as Poland, is huge.

The central question, however, is how to organise support for these millions of refugees. Gregory Verdugo has discussed the challenges for the European asylum system from 2019 and the integration of refugees. Note that the long-term impact of migration is positive, even if today’s refugees are mainly women and children. Of course these economic considerations are not central to how to support the refugees.

7) Support for the most vulnerable households

As noted, the rise in energy and food prices is strongly anti-redistributive and disproportionately affects the poorest households. For this reason, to offset the rise in inflation at the end of 2021, the French state has introduced an inflation allowance and exceptional support in the form of a €100 energy voucher, for a total estimated cost of €4.4 billion (€3.8 billion and €0.6 billion). The government has announced that it will spend €24 billion, or about 1 GDP point, to offset the rise in energy prices. This is the order of magnitude of the increase in the oil bill, without taking into account the increase in the price of gas. The OFCE Policy Brief on purchasing power, published on 17 March, deals with these issues.

This price increase will make the country poorer (negative supply shock) due to domestic dependence on energy imports. Responding to the shock with a wage increase is not a good solution, as it leads to higher prices and induced inflation, as companies in turn would face higher production costs. Support for vulnerable households should therefore be fiscal and not wage-based. The low interest rates on France’s public debt opens up some fiscal space that should be used temporarily.

8) Energy investment

Reducing dependence on Russian oil and gas (which will be compulsory if there is an embargo) will lead to additional investments. The recent IAE report on ending this dependence leads to “sobriety” measures but also to new investments, which are difficult to quantify for France at this time.

9) Military expenditure

Another consequence of the war in Ukraine will be higher military spending. This will lead to medium-term investments, the economic effect of which will depend on how it is financed (by debt or taxes). Germany has announced a package of 100 billion euros to be used in the short term. France, on the other hand, already has a higher level of military spending and at present is sticking with a policy of increasing military spending by 3 billion euros per year.

10) Europe and European fiscal rules

The war in Ukraine will most likely lead to the suspension of European fiscal rules for another year, until 2024. The establishment of a common European debt is under discussion, but the outcome remains uncertain.

III – European Central Bank and monetary policy

11) The ECB is in a difficult situation, as it faces rising energy prices, falling activity and high levels of public debt

One point needs to be clarified: the rise in energy prices will certainly push up the price index and therefore average prices, but this primarily involves domestic impoverishment. In other words, the ECB cannot fight this energy cost-driven price increase (which will also push European entities to find ways to reduce their energy dependence). This price increase will lead to inflation if wages and other prices start to rise continuously after this initial impulse. In other words, it is against possible second-round effects, not first-round effects, that the ECB needs to fight. In contrast to the 1970s shock, it is unlikely that the rise in energy prices will lead to an inflationary spiral, due to the de-indexation of wages. However, the way in which the SMIC, the French minimum wage, is indexed should push it higher. A fiscal effort on behalf of people paid the minimum wage to compensate for higher energy costs does, however, make less relevant the increase in the SMIC induced by higher energy prices.

However, the current difficulty concerns the existence of some second-round effects upon exiting the Covid-19 crisis (irrespective of the price of the war in Ukraine), as core inflation was already at 2.7% in February, above the 2% target. It is therefore important that the absorption of the energy price shock does not lead to self-sustaining price increases.

Second, the ECB will have to deal with a new wave of financial instability, with possible contagion in the financial system and rising interest rates in some countries.

Finally, the most likely outcome is that the ECB will take steps to support public policy. The point is not so much to stimulate demand, which would be inappropriate in this kind of environment, but rather to avoid interest rate hikes in some countries, as is suggested by a reading of its statements in the 10 March ECB press conference. Indeed, the statement of Thursday 10 March and the reduction in the volume of securities repurchases go hand in hand with a vigorous affirmation of the fight against the fragmentation of the euro zone, and therefore against the rise in interest rate spreadswhich could destabilise highly indebted countries such as Italy. Our reading therefore is of an ECB policy of risk reduction without support for demand, which seems justified during the military conflict.

Conclusion

The war in Ukraine is a massive income shock that, without a public response, would lead to a fall in GDP of 2.5% and a rise in inflation of 3% to 4% in the highest estimate of a long-term rise in prices, without behavioural changes, but also without taking into account financial instability. Considering the low range of a short conflict reduces these effects by three-quarters, to a fall of less than 1 GDP point.

• Rising energy prices lead to anti-redistributive effects, which should lead in turn to budgetary efforts on behalf of poorer people.
• As a result, government support of at least 1 GDP point is likely, limiting the fall in GDP but pushing inflation into the high range.
• Financial instability is possible, which would substantially increase these effects, without taking into account of course any extension of the war into Europe outside Ukraine, which would completely change the method of estimation.

by Gregory Verdugo

An unprecedented crisis

Since the war in Ukraine started, unprecedented numbers of refugees have poured across the country’s borders. As of 15 March, the UN High Commissioner for Refugees counted more than three million refugees who have crossed the border since the Russian offensive began on 24 February. In just three weeks, the number of refugees has surpassed the year-long peaks reached during the 2015 and 2016 migration crisis. The number already exceeds the total number of refugees that followed the Bosnia and Herzegovina war in the years 1993-1995.

A specific status

In order to avoid having asylum applications filed in more than one European country, the Dublin III Regulation (2013) requires refugees to apply for asylum only in the first country through which they entered the EU. This regulation aims to encourage border states to better monitor their borders but also both to clarify which country is responsible for examining the asylum application and to prevent attempts at “asylum shopping”.  During the 2015 migration crisis, this system disproportionately placed the burden of receiving refugees on countries with a Mediterranean border that were directly on the route of Syrian and Afghan refugees. Countries such as Greece and Malta were soon overwhelmed by asylum applications, which far exceeded their processing capacities.

Faced with the massive and rapid flow of Ukrainian refugees, the European Union, aware of the inadequacy of the Dublin Regulation, took unprecedented steps. The Temporary Protection Directive, drawn up in 2001, was activated for the first time on 4 March 2022, following its unanimous adoption by the EU Council of Interior Ministers on a proposal from the EU Commission.

Temporary protection offers Ukrainian refugees a right of residence for one year, which can be extended up to three years. Beyond the right of residence, temporary protection also provides access to education, which is crucial given the number of displaced families, and it guarantees access to social and medical assistance and the right to family reunification.

Temporary protection simplifies the reception of Ukrainian refugees by preventing the clogging of asylum systems. In some countries, processing asylum applications can take several years before a final decision is reached. Even if a fast-track procedure had been introduced, it would have been difficult to avoid overloading the asylum system and lengthening the processing time for the large number of Ukrainian refugees. Such long delays penalise the refugees. Uncertainty about the possibility of staying in the host country reduces in particular the incentive to establish links with the country and to learn the language (Hainmueller et al., 2016).

Another advantage of temporary protection is that it allows Ukrainian refugees immediate access to the EU labour market. Only four countries in the EU have previously allowed asylum seekers immediate access to the labour market. All the rest restrict access to employment for periods of between two and 12 months, and sometimes indefinitely. Recent studies have shown that work bans are particularly costly, not only because people do not contribute immediately to the economy, but also because the bans have a persistent negative effect on asylum seekers’ subsequent employment after they have finally been granted refugee status (Fasani et al., 2021).

The challenge of economic integration

The scale of future arrivals and the length of stay of refugees will depend both on what happens with the conflict and on Ukraine’s post-conflict economic prospects. While not all refugees will want to stay in the EU, the large-scale destruction already witnessed suggests that the country’s post-conflict economic difficulties may prompt many refugees to prolong their stay or even to settle down. The return of refugees could also be jeopardised by the lack of security in certain areas or in the country as a whole. It is therefore likely that a proportion of refugees will stay in the EU for a long time, if not permanently, as happened with Yugoslav refugees long after the conflict ended (Bahar et al., 2022).

The economic integration of refugees poses specific challenges (Verdugo, 2019). Most studies suggest that, at least initially, refugees encounter more difficulties than economic immigrants in finding employment and integrating into the host country’s labour market (Dustmann et al., 2017). This is because economic migrants prepare for migration, so those who migrate are positively selected, i.e. it is those who are best prepared and most capable of succeeding within their home population who try their luck abroad. Economic migrants are also more likely than refugees to master the language of the host country and to benefit from solidarity networks that help them to integrate economically (Borjas, 1987). In contrast, the migration of refugees is not economically motivated. They are forced to migrate in order to escape physical insecurity, and they do so in an emergency. Refugees are more often workers whose knowledge is less valuable in their host country (Chiswick, Lee and Miller, 2005).

On the other hand, refugees, unlike economic migrants, face uncertainty about the possibility of returning to their country of origin. Their migration is more likely to take place over a longer time horizon than that of economic migrants, which may encourage them to build long-term relationships with the host country. Cortes (2004) finds that, in the United States, while refugees initially face greater economic hardships, they tend to catch up with economic migrants in the longer term.

How to allocate refugees

The burden of hosting refugees has always been unevenly distributed (Huertas Moraga and Hagen, 2021). The Ukrainian crisis is no exception. Most Ukrainian refugees are currently in the countries bordering Ukraine and, as of 15 March, over 60% were in Poland. As in the 2015 migration crisis, EU countries face the challenge of spreading their reception over a number of countries so that the cost doesn’t fall on a small number of countries and exhaust their good will.

Despite the adoption in 2015 of a European Agenda for Migration, which highlights the benefits of cooperation, progress in this respect has been limited. The Pact on Migration and Asylum proposed by the European Commission in September 2020 has yet to be discussed by the EU Parliament and Council. In this draft, the European Commission proposes to introduce mandatory quotas based on GDP and population size, with some flexibility. A new proposal is that each country can choose either to take in refugees or to contribute to the cost of returning migrants whose asylum applications have been rejected.

Other innovative proposals are also circulating. In an influential article, Fernández-Huertas Moraga and Rapoport (2014) propose the introduction of quotas that are then tradable on a quota market between EU countries. So if a country wants to reduce its quota and take in fewer asylum seekers, it can pay another country to receive more. Fernández-Huertas Moraga and Rapoport (2014) also propose the introduction of a system that could match asylum seekers’ preferences with each state’s preferences. Asylum seekers would thus declare which countries they prefer, and the countries would identify their preferences for different categories of asylum seekers. A centralised allocation algorithm would allocate asylum seekers based on the two groups’ respective preferences. While governments have always been reluctant to offer asylum seekers greater choice, the EU Commission is nevertheless proposing to take into account their preferences and try to receive them in countries where they have “meaningful links”.

Whatever system is put in place to distribute the Ukrainian refugees, they are currently free under temporary protection to move between European countries and thus to choose their preferred destination. If reception quotas are introduced, it is not clear how effective they will be unless refugees’ mobility is restricted. However, it seems difficult to move refugees in an authoritarian manner to countries that they have not chosen and where they have no ties and may have difficulty integrating. In the short term, the most credible solution seems to be to combine compensation for the countries that receive the most refugees with incentives to settle in countries that do not receive so many.

By Christophe Blot

With the return of inflation in 2021, the focus is now
on the central banks and their mandate for price stability. Between 15 and 17
December 2021, the Federal Reserve, the Bank of England (BoE), the European
Central Bank (ECB) and the Bank of Japan (BoJ) all held their final monetary
policy meetings of 2021. What do these meetings tell us about their approaches
to asset purchases and monetary policy in 2022? Is a rapid rise in interest
rates on the cards? Despite remaining uncertainty about the future course of
the pandemic and its consequences for activity in the first half of 2022, the central
banks have gradually revised their assessment of the situation with regard to
rising inflation. They now think that the inflationary shock will continue into
2022. Based on this, the British were the first to act as the BoE announced an increase
in its key rate. The Federal Reserve is likely to follow in 2022, presaging future
normalization. As for the ECB, despite winding down its asset purchase
programme linked to the health crisis, it is not yet envisaging the normalization
of monetary policy. In any event, its latest meeting did not suggest a rate
hike in 2022 in the euro zone.

Central banks raise inflation expectations

The recent surge in prices in all the industrialized
and emerging countries is largely due to the rebound in energy and many other commodity
prices in connection with the effects of the health crisis on the global
economic situation in 2020 and 2021.[1] This follows a long period of low inflation,
which led central banks to set their interest rates at a very low level and to
implement unconventional monetary policies such as asset purchase programmes.
These policies, which resulted in sharp increases in their balance sheets, were
aimed at holding down long-term rates.[2] Yet price stability is a key element of the
central banks’ mandate. It is therefore natural that the recent inflationary
pressures raise the question of how they will react and whether they might tighten
their monetary policy stance, since inflation is well above the 2% target
generally used by central banks to judge price stability.[3] Indeed, in December 2021, the year-on-year change
in the consumer price index rose to 5% in the euro zone and, in November, 5.1%
in the UK (Figure 1). In the United States, the consumer price deflator –
an indicator monitored by the Federal Reserve – rose by 5.7%, the highest level
since the early 1980s.[4] Beyond the impact on energy prices, the underlying
indices also rose. In the euro zone, the year-on-year change climbed from 0.4%
in December 2020 to 2.7% a year later, while in the US the underlying
consumption deflator reached 4.7% in November.[5]

While initially the central banks were not all that
concerned about the phenomenon, considering it temporary, it is clear that they
have gradually revised their view, resulting in upward revisions of their
inflation expectations for 2022 (Figure 2). Thus, the inflation projection
that was communicated by the Federal Open Market Committee
(FOMC) in December 2020 for the end of 2022 was 1.9%. One year later, the
inflation forecast for the fourth quarter of 2022 was 2.6%. The ECB has also
issued a significant revision, with inflation expectations rising from 1.1% in
December 2020 to 3.2% – for the year as a whole – according to the latest
projections of December 2021.[6] Inflationary pressure is still considered temporary,
as all three central banks foresee inflation in 2023 closer to the target.[7] Nevertheless,
in the context of a recovery but also of uncertainty about the effects of the
new Omicron variant, the central banks are facing a dilemma. Should they
counter these inflationary pressures by tightening monetary policy? Even if the
rebound in inflation is temporary, inflation would be well above target for
some months, which could lead to second-round effects. Moreover, the
accumulation of household savings could boost growth in 2022 and keep inflation
high.[8]

Conversely, could tightening prematurely undermine the
recovery and slow the fall in the unemployment rate? In this respect, the
unexpected return of inflation could also provide an opportunity to see how the
ECB and the Federal Reserve might adjust their monetary policy after the
announcement of their inflation target revisions. Indeed, in July 2020, the US
central bank announced that it wished to wait for an inflation target of 2% on average, indicating that after being under target,
as was the case in recent years, it would tolerate inflation above 2%. The
rebound in inflation might have suggested that the Federal Reserve would be
less reactive to rising inflation. However, the acceleration of prices has been
significant in the US, and the recent change in tone suggests that even if the
Fed tolerates inflation above 2%, the current level is probably too high.[9] Paradoxically, the ECB has not announced average
inflation targeting (AIT) but has made it clear that the target is 2%
and that it should be interpreted symmetrically. The ECB
therefore considers that inflation below or above 2% is not compatible with its
objective of price stability. Nevertheless, this is a medium-term target and
takes into account lags in the transmission of monetary policy. So even though
the ECB has not indicated that it will tolerate inflation above 2%, it will not
automatically tighten monetary policy when observed inflation exceeds the
target but it will condition its action on its inflation expectations over a 12
to 24-month horizon. Its expectation for 2023 therefore indicates that current
inflation is temporary and that beyond 2022 inflation should again be below 2%.

The Bank of England and Federal Reserve consider
normalization

The communications from the central banks’ monetary
policy meetings held between 15 and 17 December 2021 were expected to focus on
two points: the continuation of their asset purchase programmes and the level
of the key interest rates.

The BoE was the quickest to react by raising its key
rate by 0.15 percentage points, from 0.1% to 0.25%. As stated in its 16 December
press release: “The MPC’s remit is clear that the inflation
target applies at all times, reflecting the primacy of price stability in the
UK monetary policy framework.” Furthermore, it was decided to
maintain the stock of securities acquired by the BoE. A key element of this
decision is the way in which the BoE has implemented its asset purchase policy.
Unlike the Federal Reserve and the ECB, which announce purchase flows on a
monthly basis, the BoE proceeds in stages, announcing a target for the stock of
assets – revised if necessary – and making purchases quickly in order to reach
the target.[10] Moreover, the BoE has not made its rate decisions
conditional on its asset purchase policy, whereas ECB communiqués have always
stated that it would only consider rate hikes once asset purchases have stopped.

In the United States, a rate hike is to be preceded
by a so-called taperingphase during which the Federal Reserve
gradually reduces monthly purchases. The strategy implemented by the US central
bank therefore consists first of all of communicating this path for asset
purchases. This first step was launched in November. At the meeting of 15
December 2021, the FOMC announced that the pace of tapering down was being
accelerated: from January 2022, monthly purchases will be USD 60 billion (40 bn
for Treasuriesand 20 bn for Mortgage-backed Securities)
compared with USD 120 billion per month before November 2021. There will be
further reductions in the following months. The Federal Reserve is acting in a
sequenced manner, as it did during the previous phase of normalization that
began in January 2014 (Figure 3). Purchases stopped at the end of 2014,
and the policy rate was raised in December 2015. Finally, the reduction in the
size of the balance sheet – in billions of dollars – had been announced in June
2017 and implemented from October 2017.[11] However, the timetable is likely to be
accelerated, as information from the 15 December meeting suggests that there
could be three rate hikes in 2022. The time between the end of asset purchases
and a rate hike would be shortened, and rates would rise more quickly than in
this previous phase of normalization, when there was only one hike in 2015 and
another one a year later. The FOMC members in fact anticipate a target rate for
federal funds of 0.9% at the end of 2022, compared to the current range of
0-0.25%.[12]

It should also be noted that, in accordance with
its mandate, the FOMC is focusing on the situation in the labour market, since
the Federal Reserve must not only ensure price stability but also achieve
maximum employment. In this regard, while the unemployment rate fell to 4.2% in
December, employment remains 1.8% (or 2.8 million jobs) below the December 2019
level, also reflecting withdrawals from the labour force. The prospects of
stabilizing the size of the balance sheet – in value terms – in early 2022 and
of several rate hikes therefore indicate that the Federal Reserve sees labour
market conditions as gradually converging towards the maximum level of
employment.

The ECB takes a more cautious approach

In the euro zone, inflationary pressures have
increased even as the economic recovery remains more fragile. In the third
quarter of 2021, GDP was still 0.3% below its level at the end of 2019, whereas
for the United States it was 1.4% above. There is nevertheless improvement in terms
of the unemployment rate, which in November 2021 stood at 7.3%, lower than the
level observed prior to the outbreak of the pandemic. However, in her press
release at the 16 November press conference, Christine Lagarde considered that
monetary policy must remain accommodating in order to bring inflation down towards
its medium-term target. Thus, beyond the current inflationary pressure, the ECB
still considers that inflation will remain below target in 2023, which
therefore argues for a slower normalization of monetary policy in the euro area.
Nevertheless, the Governing Council announced the end of the Pandemic Emergency Purchase Programme (PEPP) in 2022.
The PEPP had been put in place in March 2020, in the context of the pandemic,
to combat sovereign risk.[13] Note that purchases had already slowed in line
with the announcements made since September 2021 (Figure 4).  However, this reduction in purchases under
the PEPP would be partly offset by an increase in purchases throughthe Public Sector Purchase Programme
(PSPP). In the second quarter of 2022, purchases are to increase from 20
to 40 billion euros per month. They would then adjust to 20 billion euros in
October 2022, after a plateau of 30 billion euros in the third quarter. At this
stage, the ECB is not indicating a complete halt to asset purchases. The size
of its balance sheet would therefore continue to grow, postponing for the time
being the prospect of a rate hike, probably beyond 2022.[14]

Although there has been talk of normalizing monetary
policy, the central banks remain cautious about the recent inflationary surge,
considering it a temporary episode. The same caution seems to prevail in most
other industrialized countries. In Japan, although inflation is rising (to 0.6%
in December 2021), it remains well below the BoJ’s target. The BoJ has
therefore not changed its communications. Quantitative easing continues, and it
is sticking to the goal of keeping the short-term rate at -0.1% and the
government bond rate at 0%. Earlier this month, the Bank of Canada and the
Australian central bank also maintained their rate targets. The target rose,
however, in Norway.

How did the markets react to these policy announcements?

Since 15 December, long-term rates have risen in
the euro zone, the United States and the United Kingdom, approaching the levels
seen before the outbreak of the pandemic (Figure 5). The trend in Japan is
much more modest. The average rate on government bonds issued in the euro zone rose
by 24 basis points, with a slightly larger increase in Italy and Spain than in
Germany and France. In the United States, the increase is comparable: 24 basis
points between 14 December 2021 and 4 January 2022; but the rate is still below
its pre-crisis level. In the UK, it’s risen over 35 basis points. The markets
have therefore incorporated a moderate tightening of monetary policy by 2022.
Should inflation remain at the level observed at the end of 2021, the central
banks could accelerate the pace of monetary policy normalization, either byraising policy rates further or by reducing the
size of their balance sheets, which would probably result in a further rise in
long-term rates.

The year 2022 should therefore be characterized by
a rise in short-term rates and probably also in long-term rates in the UK and
the US. It is clear that the inflationary surge observed since mid-2021 will
lead the central banks, in particular the BoE and the Federal Reserve, to
accelerate the normalization process. Normalization is also important to give
central banks room to manoeuvre in case of new negative shocks. There is,
nevertheless, economic uncertainty due to the arrival of the Omicron variant.
Even if agents have partly adapted to the health restrictions, a slowdown in
growth without a reduction in inflationary pressures would create a more
delicate trade-off for the central banks between their price stability
objective and the need to support the economy.

---

[1] See the OFCE post
of 17 December 2021 [in French] on this point and the more detailed analysis of
Le Bayon and Péléraux (2021).

[2] The policy rate set by the central banks
represents a target for very short-term market rates. Changes in this rate are
then intended to influence bank rates and all market rates along the term
structure.

[3] The Federal Reserve and the ECB have recently reaffirmed
the symmetry of this objective by revising their inflation targets.

[4] Inflation measured by the consumer price index rose
by 7.1% in December.

[5] In December 2021, the consumer price index
adjusted for food and energy prices rose by 5.5%.

[6] The way that inflation expectations are determined
differs between the central banks. In the case of the Federal Reserve,
expectations are formulated by the members of the FOMC, while for the ECB they
are formulated by its own economists.

[7] Respectively, 2.3% and 2.2% at the end of the year
in the US and UK, and 1.8% for the year as a whole in the euro zone.

[8] See our October 2021 economic forecasts published
in Policy Brief no. 94: Le prix de la reprise [The Price of the Recovery].

[9] See the OFCE post
of 4 January 2022 on inflation targets and expectations [in French] and the
detailed analysis of Blot, Bozou and Hubert (2021).

[10] See Gagnon and Sack (2018) for a comparison of these two strategies.

[11] Measured in GDP points, the size of the balance
sheet fell slightly earlier, from 26.4% in Q1 2015 to 18.8% in Q2 2019. Prior
to the implementation of unconventional measures, the Federal Reserve’s balance
sheet was between 6% and 7% of GDP.

[12] This is the scenario that emerges from the Minutes. The Federal Reserve publishes a detailed report
of the FOMC meeting three weeks following the meeting.

[13] See Blot, Bozou, Creel and Hubert (2021) for a more in-depth discussion of the
objectives and effects of the ECB’s sovereign asset purchase programmes.

[14] The 16 December press release does indeed state
that: “We expect net purchases to end shortly before we start raising the
key ECB interest rates.”

by Elliot Aurissergues, Christophe Blot and Caroline Bozou

The latest inflation figures for the United States
confirm the trends seen over the last few months. In October 2021, consumer
prices rose by 6.2% year-on-year. While rising prices is a global phenomenon, among
the industrialized countries this has been particularly marked in the US. Inflation
in the euro zone over the same period was 4.1%. This level of increase in
inflation has not been seen since the late 1990s, so it is attracting
considerable attention in the US policy debate, not least because it echoes a
controversy that began early in Joe Biden’s mandate over the fiscal stimulus
passed in March 2021. Although inflation is being driven in part by rising energy
prices, the fact remains that tensions have rapidly increased. Excluding energy
and food components, inflation has exceeded 4% since June 2021, suggesting a
risk of overheating for the US economy. While the European macroeconomic
context does not allow us to identify an equivalent risk for the euro zone, the
fact remains that a sustained rise in US inflation could have repercussions for
the zone. Beyond the impact on competitiveness, the dynamics of US inflation
could influence decisions on rate changes and the conduct of monetary policy by
the Federal Reserve and the European Central Bank.

Regardless of the indicator – consumer price index
or consumption deflator – prices have clearly accelerated since March 2021 (see the figure)[1]. The energy component is undoubtedly important,
but it does not fully explain this dynamic, since the latest figures for the
underlying indices, i.e. adjusted for energy and food prices, show a
year-on-year increase of 4.6% for the CPI and 3.6% for the consumption deflator[2]. Note too that this development reflects a
catch-up from 2020, when inflation was particularly moderate in the context of
the pandemic and the sudden halt in activity. Thus, on average over 2020 and
2021, up to October, the consumption deflator has risen by 2.1%, in line with
the target adopted by the Federal Reserve[3]. The recent tensions obviously reflect the
dynamics of the post-lockdown global economic recovery, which the United States
is clearly part of, and which has led to strong pressure on energy prices, but
also on supplies, as evidenced by the supply difficulties for certain goods and
the soaring cost of maritime freight.

Beyond these global factors, there is the question
of an inflationary phenomenon that may be intrinsically linked to US economic
policy. Even before the recent discussions on the 2022 budget vote, the
measures taken to deal with the Covid crisis first by the Trump administration
and then by the Biden administration amount to a grand total of USD 5.2
trillion, representing more than 23 points of GDP for the year 2019. This
spending over 2020 and 2021 represents an unprecedented level of stimulus over the
last forty years. While there was undoubtedly a consensus on the need for the
measures proposed by Biden and approved by Congress in March 2021, their
magnitude nevertheless caused a great deal of debate, as the recovery was
already underway and the economy was already benefiting, as it still is today,
from the fiscal support measures voted in 2020 and from a highly expansionary
monetary policy[4]. Could this expansionary economic policy – both fiscal
and monetary – be causing the economy to overheat, fuelling the return of
inflation, as economists such as Lawrence Summers and Olivier Blanchard fear,
or, on the contrary, is the effect on inflation being overestimated, as other
analyses suggest? We plunge into this debate in an OFCE
Policy Brief,
specifying in particular the conditions that could lead to a sustainable
increase in inflation. The risk will depend on the size of the multipliers
measuring the effect of the stimulus plans on activity and unemployment, the
position of the US economy relative to its potential, and changes in inflation
expectations, all of which are subject to some uncertainty.

---

[1] The consumer price index (CPI) is calculated from
a survey of the prices of a basket of average goods consumed by a
representative household. The consumption deflator is derived from the national
accounts and represents the price system that allows the transition from
consumption in value to consumption in volume. See La désinflation importée [Imported
Deflation] in OFCE Review, 2019, No. 162, for more details on the
difference between these two measures of inflation.          

[2] Unadjusted for energy and food prices, the
consumption deflator rose by 4.4%. The data for the deflator refer to the month
of September, while the publication of the consumer price indices is more
rapid, the latest figures published being those for October.

[3] The consumer price deflator is the indicator used
by the Federal Reserve to assess price stability in the United States.

[4] Two other projects were then announced: an
infrastructure investment plan (American Jobs Plan)
and a household package (American Families Plan).
These are not crisis-specific measures, but measures that are supposed to mark
the direction of fiscal policy over the next eight years. These plans are
currently being discussed in Congress as part of the 2022 budget vote.

by Christophe Blot, Caroline Bozou and Jérôme Creel

In August 2021, inflation in the euro area reached
3% year-on-year. This level, which has not been seen since November 2011, exceeds
the European Central Bank’s target of 2%. This recent momentum is being driven partly
by oil prices, but there has been a simultaneous rebound in underlying inflation,
which excludes the energy and food price indices from the calculation.
Inflation in the United States is also returning to levels not seen for several
years, fuelling the debate on a potential return of inflationary risks. Given
the central banks’ mandate to maintain price stability, it is legitimate for them
to examine the sources of renewed inflation. In a recent paper in preparation
for the Monetary Dialogue between the European Parliament
and the ECB,
we discuss the temporary rather than permanent nature of this episode of
inflation.

The recent development of inflation cannot be
dissociated from the overall economic situation, which today is still strongly affected
by the health crisis. After a sharp fall in activity – GDP contracted by 6.5%
in 2020 – the macroeconomic performance of the euro area remains erratic. The
crisis has been unprecedented both in terms of its scale and in terms of its
sectoral characteristics and the nature of the shocks that have hit the euro
area economies. The Covid-19 crisis has in reality been characterised by a simultaneous
negative shock to both supply and demand (see Dauvin and Sampognaro, 2021).

The factors driving current inflation appear to be
temporary in nature. Indeed, a review of recent data suggests that the rise in
inflation is mainly due to energy prices, to changes in Value-Added Tax rates
and to the recovery from the most dramatic one-year recession since World War
II (Figure 1). However, at a disaggregated level, it appears that for most
goods, prices are often below the December 2019 level, while prices for some
services are higher (Figure 2).

Nevertheless, there are many factors that could
influence inflation over the medium term, and they leave some uncertainty about
future pressure. The demand shock from the European fiscal stimulus and from labour
market pressures is likely to be small. The inflationary cost of a fall in euro
area unemployment is now very low – there is talk of a flattening of the
Phillips curve, see Bobeica, Hartwig, and Nickel, 2021)  – and job
vacancies, though high, are below the levels of 2018 when there were no fears
of a return of inflation. However, agents’ dissaving behaviour is generating
inflationary pressures that could herald a more uncertain path. A surge in
demand could fuel future price increases, especially if the difficulties in supply
adjustment observed recently in certain sectors were to persist. As for supply
difficulties and the rising cost of maritime transport, the latter’s strong
correlation with oil prices suggests this will fall over the next two years
(see the US
Energy Information Administration bulletin). 

However, if we take a longer view, we can see that the upturn in inflation in no way makes up for the many years during which inflation fell below the 2% target (Figure 3). Thus, as long as the surge observed in recent months remains contained, this return of inflation could be seen as good news for the ECB, enabling it to finally reach its target and even possibly make up for past under-adjustments.

by Christophe Blot, Caroline Bozou and Jérôme
Creel

The Covid-19 pandemic has led governments and
central banks around the world to implement expansionary fiscal and monetary
policies. The United States stands out for its substantial fiscal support,
which is much greater than that in the euro area. In a recent paper prepared
for the Monetary Dialogue between the European Parliament
and the European Central Bank,
we review these measures and discuss their international implications. Given
the size of the US stimulus packages and the weight of its economy, we can
indeed expect significant spillover effects on the euro area. However, the
impact will depend not only on the orientation of economic policy but also on
the precise nature of the measures adopted (transfers, spending and the
articulation between monetary and fiscal policy).

Expansionary monetary policy is generally perceived
as a policy based on self-interest, since a fall in the US interest rate should
lead to a depreciation of the US dollar that is unfavourable to America’s trading
partners. However, the literature shows that the exchange rate channel can be
dominated by a financial channel and by increased demand from the US economy,
both of which generate positive spillovers (see Degasperi, Hong and Ricco, 2021).

The international spillover from US fiscal policy
should also be positive, once again via demand effects, and
also due to an expected appreciation of the dollar (see Ferrara, Metelli, Natoli and Siena, 2020) as well as from expectations of a return to
balanced public finances à la Corsetti,
Meier and Müller (2010).
The favourable impact on the rest of the world might also be attenuated if the
US fiscal expansion were to lead to a rise in the global interest rate. Ultimately, the magnitude of the international
spillover effects of US fiscal policy will depend on the response of the
exchange rate and the interest rate. Faccini, Mumtaz and Surico (2016) confirm the importance of financial effects but nevertheless
show that the real interest rate could fall after a US expansionary shock.

In this paper, simulations conducted using a macroeconomic
model and empirical analysis confirm the positive effects of US expansionary
monetary policy on euro area GDP. There is, however, uncertainty about the
timing and duration of these positive effects.

As regards fiscal policy, empirical analysis
suggests that the spillover from the US measures implemented since the outbreak
of the Covid-19 crisis will be positive, at least in the short term (in the
first two years). Given the size of the fiscal impulse, the impact would not be
negligible.

The global spillover from US macroeconomic policies
is therefore expected to be positive, but there is some uncertainty beyond
2022.

However, it should be borne in mind that the euro
area’s growth will depend primarily on the path taken by its own policy mix. The euro area should not therefore rely only on
US policy to consolidate and accelerate its recovery. The contrasting fiscal
impulses in 2020 and 2021 between the US and the euro area already indicate a
risk of increasing divergence between the two regions.

We also briefly discuss that the main repercussions from the US may come
not from macroeconomic policies but from financial risks. Asset prices have
risen sharply in 2020, sparking fears of a financial bubble, at least in the
US. This risk could have a significant impact on the euro area in the medium to
long term.

by Éloi Laurent, Fabio Battaglia, Alessandro Galli, Giorgia Dalla
Libera Marchiori, Raluca Munteanu

On 21 May, the Italian Presidency of the G20 together
with the European Commission will co-host the World Health Summit in Rome. A
few days later, the World Health Organisation will hold its annual meeting in
Geneva. Both events will obviously focus on the Covid tragedy and on reforms
that could prevent similar disasters in the future. “The world needs a new
beginning in health policy. And our health renaissance starts in Rome,”
said European Commission President Ursula von der Leyen on 6 May. We share this
hope and want to see it succeed.

As members of civil society, we have been called
upon to contribute to the collective discussion that will lead to the drafting
of the “Rome Declaration”. Based on a report we are releasing today as part of the
Well-being Economy Alliance (WeALL), we believe that the notion of an
environmental health policy should be at the heart of the Rome Declaration and,
beyond that, it should inspire the overhaul of health policy at all levels of
government. In essence, we are calling on the delegates at these two crucial
summits to recognise the fruitful interdependencies between the environment,
health and the economy.

The key principle is to make the link between
health and the environment the core of global health and move from a cost-benefit
logic to co-benefit policies. Our inability to respond effectively to the twin
crises hitting health and the environment stems in large part from our
perception of the costs that resolute action would have for the “economy”. But
we are the economy, and the economy forms only part of the true source of our
prosperity, which is social cooperation. The health-environment transition does
of course have an economic cost, but it is clearly lower than the cost of not
making the transition. The limits of the monetarisation of life are becoming
more and more apparent, and every day it is becoming clearer that the supposed
trade-offs between health, the environment and the economy are wrong-headed and
counter-productive. Conversely, the gains in terms of health, jobs, social cohesion
and justice from co-benefit policies are considerable. Health systems are the
strategic institutions in this reform, so long as much greater emphasis is
placed on prevention, but other areas of the transition are also involved: food
production and consumption, energy systems, social policy (particularly the
fight against inequality and social isolation) and educational policy.

To take simply the example of energy, it is
abundantly clear that today’s global energy system, based 80% on fossil fuels,
makes no sense from the point of view of humanity’s well-being, as it is simultaneously
destroying current and future health. Air pollution resulting from the use of fossil
fuels is playing a grave role in the health vulnerability of Europeans facing
Covid-19 (responsible for 17% of deaths according to some estimates); yet reducing air pollution in Europe’s cities
would bring a key health co-benefit: it would reduce the risk both of
co-morbidity in the face of future environmental shocks such as respiratory
diseases but also of heatwaves, which are becoming increasingly frequent and
intense on the continent. When all the co-benefits are taken into account,
first and foremost the reduction of morbidity and mortality linked to air
pollution (which, according to recent studies, are much higher than previous
estimates, with 100,000 premature deaths in France each year), the switch to renewable energies would
lead to savings of around fifteen times the cost of their implementation.

Beyond these areas we have identified, there are
many others where health, the environment and the economy are mutually
reinforcing. Together they form a foundation on which to erect policies that
aim for the full health of a living planet. As the Rome Summit and the WHO
Assembly approach, we therefore want to challenge the participants with two
simple questions: What if the best economic policy were a genuine health
policy? What if the best  health policy were
a genuine environmental policy? As the countries of Europe know very well,
crises are the cradle of new worldviews, the catalysts of new approaches that
can gain traction. Rome was not built in a day, but the co-benefit approach can
light the way to a renaissance in health.

by Xavier Ragot

A heated debate is currently taking place in
macroeconomics. The change in US economic policy following the election of Joe
Biden has sparked debate over what to expect from “Bidenomics”. The debate has
seen radical Keynesian proposals being promoted by the “modern theory of money”
(MMT). This movement advocates massive stimulus packages and the monetization
of public debt. This post discusses the MMT proposals through a review of two
recent books that have recently appeared in French: Stephanie
Kelton, The deficit myth (John Murray, 2020) and
Pavlina Tcherneva, The case for a job guarantee (Polity, 2020).

Before criticizing MMT, we should briefly summarize
its proposals: the first key idea is the promotion of monetary policy in the
service of fiscal policy. MMT supports the systematic purchase of public debt
by central banks, the so-called fiscal dominance of
monetary policy, in order to allow for an increase in public spending. For
economists, fiscal dominance is opposed to monetary dominance,
which defends the idea that the primary role of monetary policy should be to
control inflation and leave the financing of public expenditure and debt to
taxation.

The second proposal is the promotion of the state as
the employer of last resort. The state should be in charge of providing jobs that
are useful to the public to all unemployed people, i.e. a public employment
service to avoid falling into poverty.

The rather benign criticism of the modern theory of
money offered here can be summarized as follows: it is difficult to see
anything really new. MMT is not really a theory of money, nor is it modern, though
it does stimulate debate!

Should public debts be financed by money?

First of all, let’s not deny ourselves the pleasure
of acknowledging that Stephanie Kelton’s book is a good mainstream economics
book, and a lively and controversial introduction to macroeconomics. The book
is of course not perfect, but prior to any criticism, let’s first note that it
is a pleasure to read. Stephanie Kelton’s thesis is that money creation is carried
out on behalf of states, for countries such as the United States or Great
Britain that do not belong to monetary unions. In these countries, the state
can ask the central bank to buy up as much public debt as it wants by creating
money: it is the state that sets the statutes of its national central bank.
This monetary sovereignty allows the state to finance policies, with the only
constraint being inflation. For MMT, monetary policy should serve fiscal
policy, which should manage inflationary risks by stabilizing aggregate demand.
This approach is interesting because it evokes certain economic truths, or simply
accounting truths. Let’s consider a couple of these before offering some criticism.

The first is that public debt is held by someone: a
state’s debt is someone else’s wealth. Consequently, it makes no sense to write
that “we” are indebted because the state is indebted. On the contrary, we are enriched
by the public debt we hold on the state. The impact on our wealth depends not
on the debt itself, but on how the financing of the debt interest is
distributed. This way of thinking leads to restoring the accounts of agents.
When the state issues debt, other actors hold it, and will receive the interest
on the debt and the eventual repayment of the principal. Public debt therefore
contributes to the formation of other actors’ wealth.

The value of Stephanie Kelton’s book is that it
presents these accounting relationships in a lively and polemical manner,
directly attacking politicians in the US who do not understand these
macroeconomic realities. Indeed, it should not be assumed that there is a broad
understanding of these macroeconomic features. In France, there are still
people who believe that the public debt represents “indebtedness to future
generations”, which makes little sense, as has been discussed elsewhere. Stephanie Kelton’s fight on behalf of macroeconomics
is therefore salutary, and much remains to be done.

The second accounting truth is more interesting for
the public debate. In our economies, central banks belong to states that have a
monopoly on issuing central bank money, such as the banknotes, coins and
currency held by banks. By force of law, this money cannot be withheld from
transactions. The existence of cryptocurrencies will not significantly
challenge this monopoly in the near future. Furthermore, we can expect a
vigorous response from the states aimed at ensuring their central bank’s control
over the issuance of money. This public monopoly holds in the euro area as
well, even though the European Central Bank “belongs” to different
states. However, overall money creation is for the benefit of the states. So
how does a macroeconomist think about all this? At an abstract level, the state
can finance itself either by issuing public debt or by issuing money. The
latter possibility is called “seigniorage” in the economic literature, because
it stems from the monetary sovereign’s monopoly on issuance. This general view
is taken for granted in monetary economics. For example, the standard textbook
on monetary economics devotes an entire chapter to it (see chapter 4 in Carl
Walsh, Monetary Theory and Policy, MIT Press). The fact that
government debt is held by non-residents does not change the logic, as they are
paid in the national currency. As long as inflation is low and not very
volatile (and that is the point!), the national currency is accepted in the
exchange. The problem with monetary financing is that it can create destabilizing
effects and generate inflation, which reduces household purchasing power, with
complex effects on inequality. Predictable inflation is nowadays said to be a
public good, because it allows people to avoid unpredictable fluctuations in
their income.

So there are really no new theories in MMT. In my
opinion, the importance of this “theory” is rather different, and does
not involve convincing the macroeconomist or the monetary theorist. The point
is to promote an alternative economic policy, stimulating activity through higher
public debt and the eventual monetization of public debt, while accepting a
higher inflationary risk. The book defends the historic post-WW2 economic
orientation, so-called traditional Keynesian policy, which involved drawing on fiscal
tools to achieve full employment, even if this leads to moderate inflation. In
doing this Stephanie Kelton rehabilitates Abba Lerner who, from the 1940s
onwards, promoted policies that would later be described as Keynesian, and
which he called functional finance. Abba Lerner emphasized
that his contribution was to show the coherence of Keynesian thought: the aim
of economic policy is full employment, the means are public debt and money
creation, and, because of the possibility of issuing money, the risk is
inflation and not the unsustainability of public debts. In 1943, he presented
his conception in fourteen pages written in a very accessible form. The
history of inflation in the 1970s showed that the use of these policies to
revive economies with production constraints (linked to oil at the time) could
lead to high and volatile inflation. Clearly identifying a demand shock is necessary
to control inflation.

Again, there is nothing radically new here in the
United States, where the central bank’s mandate is to ensure low inflation and
maximum employment. It is in the euro area that this statement implies a
profound change, as the ECB’s sole mandate is price stability, not economic
activity. Making changes to the ECB’s mandate is an old topic that is mentioned
in passing, and dealt with at greater length here
in the wake of the 2008 financial crisis.

Let us turn now to a critique of the book. The
limit on debt monetization or monetary financing of public expenditure is
inflation, as the author reminds us. However, nothing precise is said about the
link between economic policy and inflation. Yet this link is essential to
properly calibrate the amount and the format of the stimulus package in the US,
and which we need to develop in Europe. The ECB holds around 23% of France’s public debt. How far can we go?
What are the economic and social costs of higher inflation? How can we ensure
that inflation expectations do not rise dangerously?

This subject has been studied extensively from
various angles: the relationship between economic activity and inflation, the
famous Phillips curve, for example, covered in a recent
article
here. The relationship between the quantity
of money and inflation has also been analysed extensively, for example here. To understand the effects of inflation, it is
necessary to study in detail who holds money and why, which we do here.

The work of Stephanie Kelton and the MMT economists
carefully avoids citing the work of other approaches in order to foster the
appearance of a new school of economic thought. At this point, however, that is
not the case. Stephanie Kelton’s book is a good introduction for those who want
to learn about the macroeconomic policy debate through topical issues from a
polemical angle. But MMT has to be criticized for its relative macroeconomic
naivety and empirical weakness.

The second revendication of the MMT authors is the
promotion of a job guarantee for all employees. This second aspect is
independent of the macroeconomic management of aggregate demand and the
financing of the public deficit. It concerns the residual part of
underemployment that exists in the business cycle. The proposal set forth by
Pvalina Tcherneva is simple: it consists of proposing an additional tool, an
offer of public jobs paid at least at the minimum wage (which Pvalina Tcherneva
wants to increase to $15 for the United States). These jobs would not be
compulsory, but would constitute a universal right for the whole population. They
would be linked to training, accreditations and apprenticeships, with the goal
being that when those employed in these jobs leave they should be suited to
find a job in the private sector. According to the author, these jobs are not
intended to compete either with public employment with identified objectives or
with private employment, which responds to a solvent demand.

The French reader will find these jobs familiar:
they could be subsidized jobs in the non-market sector, which we know can boost
the returns on employment, when the qualification achieved is effective, as is
shown in evaluations. The proposal is to make the number of such jobs
endogenous through the demand of workers over the cycle. While a deep-going reform
of the training and apprenticeship system is necessary, the proposal of a
counter-cyclical use of this type of job is interesting and already in partial
use.

Paradoxically, perhaps, the interest is in thinking
not an opposition to the market economy, but a policy of stabilization, which
gives rise to radical criticism of MMT! The cyclical employment deficit
is compensated for either by vigorous and potentially inflationary management
of aggregate demand or by a policy of generating public jobs. These Keynesian
policies are developed within the so-called post-Keynesian approach, which is one of 50 shades of Keynesianism
(neo-Keynesian, historical Keynesian, post-Keynesian, circuitist, etc.).

MMT, post-Keynesianism, and Joe Biden’s new
economic policy

We are witnessing a profound change in US economic
policy with plans for investment stimulus packages, higher taxes on
corporations and wealthier households, and a plan to increase the federal
minimum wage, all with an accommodating central bank that seems to have little
concern about short-term inflationary pressures. These developments are in line
with the MMT recommendations (without taking up all the recommendations). One legitimate
question is to identify the role of this school of thought in these
developments. This can only be answered imperfectly, as the mysteries of
economic policy are so obscure, sometimes for the decision-makers themselves.
The MMT proposals were first taken up by Bernie Sanders, who leads the left
wing of the Democratic Party and whose economic adviser for the 2016 campaign
was Stephanie Kelton. As a result, the proposals have become part of the
American economic debate.

However, one can trace a completely different
intellectual genealogy of the change in US economic policy, from either the
neo-Keynesian or Keynesian stream, and this seems to me to be more realistic.
The work of Paul Krugman on the liquidity trap in Japan, of Lawrence Summers on secular stagnation, and of Olivier Blanchard on the role of multipliers (among many others) have
for several years now led to developments within the IMF and the OECD in a much
more Keynesian direction. These developments are independent of MMT, which
presents fewer empirical proposals than some of the work cited here. Thus,
Biden’s economic turn seems to me to be much more imbued with the pragmatic
experience of the real world than with a new “alternative” body of theory. What
is described as pragmatism is in fact above all an empirical approach to
economic mechanisms, in a context of low interest rates that give states a new capacity for debt.

European lessons?

To conclude, what are the lessons for Europe of MMT
(and the Keynesian turn in US policy)? The expansionary use of fiscal policy
and the monetary financing of public deficits can of course take place only at
the level of the euro area, as it is the central banks of the Eurosystem that
have the monopoly on issuing money. The problem therefore is not so much
economic as political. The different economic situations in the euro area are
giving rise to different requirements for a recovery. Germany’s economy is
stimulated by strong external demand due to a favourable internal exchange
rate. Germany’s public debt is expected to be around 65% in the coming
quarters. The Italian economy is experiencing weak growth and a public debt of
160%. More than any theoretical debate, it is this economic and political
divergence that is paralysing Europe. The judicious use of European recovery packages
can bring about re-convergence and job creation, but that is another matter.

By Éloi Laurent and Paul Malliet

On the eve of the climate summit organized by the
Biden administration on 22 and 23 April, which will be attended by 40 heads of
state and government, we offer here some initial reflections on a critical issue
facing international climate negotiations: how should the effort to reduce
emissions be shared between countries within the framework of the United
Nations?

The news on the climate emergency front at the
start of 2021 is mixed, which might not be so bad: the new US administration’s
willingness to assume leadership on the climate agenda, within a multilateral
framework, contrasts with the obscurantist obstructionism of the previous
administration. Furthermore, 110 countries have announced their commitment to
achieving carbon neutrality by 2050, with China sharing this goal, but by 2060[1].

But in order to close the gap between the speed being
attained by natural energy systems and the inertia inherent in today’s economic
and political systems, these encouraging geopolitical dynamics must pick up the
pace. In this respect, one key indicator is the gap between the status quo of
current policies (“business as usual”) and the full
implementation of the commitments made in the wake of the Paris Agreement: if
all the commitments currently formulated and described in the States’ respective
national contributions were really met, we would be heading towards 2.6° of
warming by the end of the century; if everything continues as it is today, we
are heading towards 2.9° of warming. As it stands today, the Paris Agreement
(which has led to undeniable progress) is therefore worth only 0.3 degrees, or
about a decade and a half of warming at the annual rate observed since 1981[3].

A new global climate strategy must therefore be developed
and implemented, and it needs to bear fruit starting from the COP-26 meeting next
November in Glasgow. The Biden administration is organizing a summit on 22 and
23 April, which will be attended by 40 heads of State and government. In line
with the American Jobs Plan, the agenda for this meeting  emphasizes the economic gains expected from decisive
climate action. But it fails to address the need for coordination: how should
national efforts at emissions reduction be shared among the world’s countries?
On the basis of what criteria? In other words, how can we map out the path
towards the orientation indicated by the Paris Agreement?

We are proposing here an embryonic reflection
(which we will elaborate on in the run-up to COP-26) on the question which, in
our view, is now the raison d’être of international climate negotiations: how
to share the effort to reduce emissions between countries within the framework
of the United Nations?

In the light of the IPCC’s Special Report on 1.5°
published in 2018, we determine a global carbon budget, which in 2019 amounted
to 945 GtCO₂e; this corresponds to an intermediate target
between the 1.5° and 2° budget associated with the 67th percentile of the Transient
Climate Response to Emissions (TCRE),[4] in line with the goals set in Article 2 of the
Paris Agreement.

The question of the fair distribution of this
global carbon budget has been the subject of numerous studies (for a summary and
proposals, see for example Bourban, 2021), but there is currently no work that integrates a
complete vision of the three justice criteria identified in the academic
literature – equity, responsibility and capacity – in order to determine an operational distribution
of national efforts to avoid the climate catastrophe.

With this in mind, we focus our analysis on the top
20 emitting countries,[5] which accounted for 77% of emissions in 2019. We
assume that the emissions reduction target will be shared by all countries by
2050 and that the carbon budget therefore covers the next 30 years, which
translates into an average annual budget of around 30 GtCO₂e (for comparison, 36 GtCO₂e
were emitted in 2019). We take as a starting point an equal distribution among
all members of humanity in 2019, meaning an initial allocation of 122.5 tCO₂e
up to 2050, i.e. about 4 tCO₂e per year (a country’s budget being the
aggregation of the individual allocations of its total population).

We interpret the equity criterion as meaning equal
access of the world’s citizens to the greenhouse gas (GHG) storage capacity of
the atmosphere (this corresponds to a universal carbon endowment corrected for
each major emitter for its population and for population growth by 2050).

Our responsibility criterion is the amount of GHGs
already emitted since 1990 in consumption, thus combining a spatial justice
criterion with a temporal criterion, reflecting the global as well as the
historical responsibility of individual countries.

Finally, the capacity criterion is expressed here by the United Nations Human Development Index (HDI), which by construction ranges from 0 to 1, and which we relate for each country to the world average (which in 2019 was 0.737). Thus, countries whose HDI is lower than this world average would see their budget increase in proportion to their human underdevelopment, and vice versa for developed countries, i.e. they would see their budget decrease in the opposite direction (Figure 1).

The equity criterion generally operates a
reallocation from countries with a falling population to those with a rising population,
which are almost entirely located in sub-Saharan Africa. In this respect, based
on this criterion China undergoes a reduction in its budget of 44 GtCO₂e
(almost 25%), while the rest of the world benefits from an increase of 86 GtCO₂e.
The responsibility criterion appears to be the main determinant leading to a
reallocation of the global budget between countries, with a transfer of nearly
263 GtCO₂e from the OECD countries to the so-called
developing countries. The capacity criterion also leads to a reallocation
towards developing countries, but much less (almost 34 GtCO₂e
in total)[6].

Thus each criterion plays out differently (either
by the nature of the rebalancing or by its extent), suggesting that the
interplay of this relatively simple set of three criteria does indeed enable different
understandings or conceptions of climate justice to be translated into a
distribution of the burden of the mitigation effort (Figure 2).

Note: Each bar indicates the effect of each criterion,
taken independently of the others, on the average annual carbon budget per
country. For example, while each American citizen has an initial allocation of
4 tCO₂e, the equity criterion leads to this budget being reduced to 3.73 tCO₂e, the application of the responsibility principle leads to the
initial allocation turning negative and corresponding to a debt of 13 tCO₂e, and the capacity criterion reduces the initial allocation to
3.25 tCO₂e. The aggregation of these
different criteria results in a total negative budget[7] of 9.5 tCO₂e per capita per year.

However, this representation does not tell us
anything about the future emissions trajectories of the different countries,
the instruments that will be implemented and the justice criteria specific to
each country that will govern the deployment of these instruments. In a second
stage of our analysis, we will propose possible distributions of the budget
globally determined for France in order to appreciate the issues of climate
justice, moving from the global to the national and finally to the individual. In
any case, this first step informs us about what could be a fair distribution capable
of more explicitly capturing the guiding principle of the international
community since the Rio summit in 1992 of “shared but differentiated
responsibility”.

In the light of this initial analysis, one point
seems perfectly clear: if the new US administration does indeed intend to
reassume global climate leadership, in association with the European Union, it will
have no choice but to face the existence of a climate debt to the rest of the
world. Given its level, it is illusory to believe that this can be offset by
hypothetical negative emissions, and should therefore be subject to one form or
another of compensation[8]. This could for example mean much more significant
amounts than those currently paid into the Green Climate Fund, which is still
largely underfunded in relation to the initial stated ambition of reaching a
budget of $100 billion in 2020.

A second point is that China can no longer claim to
be a major emerging country in the climate negotiations, with an exploding
emissions trajectory that is supposedly part of its right to development and
economic growth. In 2020, and taking into account all the criteria adopted, its
carbon budget, at 21 Gt, would be close to that of Indonesia, which has one-fifth
of China’s population.

It seems that the Biden administration wants to
mark Earth Day on 22 April with two announcements: one concerning new 2030
climate ambitions for the United States and the other concerning further
emissions reductions by the invited heads of State and government. These
announcements will be fully credible only if the US manages to reconcile its
national ambition with its global responsibility, and thereby convince China to
do the same.

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[1] This represents about 50% of the population as well
as global GHG emissions.

[2] Climate Action Tracker, December 2020 projection https://climateactiontracker.org/publications/global-update-paris-agreement-turning-point/

[3]  Source: NOOA.

[4] The TCRE translates the average variation of
average temperature with the stock of carbon in the atmosphere with an
associated probability. In our analysis this translates into the following:
There is a 67% chance that the carbon budget in question will lead to a
temperature rise limited to 1.75°.

[5] The top 20 emitting countries in 2019 were: the United
States, Canada, Saudi Arabia, Australia, Germany, Japan, Russia, the United
Kingdom, Italy, South Korea, Poland, France, South Africa, Iran, China, Mexico,
Turkey, Brazil, Indonesia, and India. We also include the 27-Member European
Union to provide a basis for comparison.

[6] Note that among the countries we distinguish, only
India would see its budget increase, but just by 3%.

[7] A negative budget here reflects the fact that the
historical emissions taken into account via the responsibility criterion is
higher than the current carbon budget allocated via the other criteria.

[8] The question of the monetary valuation of past
emissions is a research topic in itself that we do not address in this text. As
an illustration, a valuation of one tonne of CO2 at $1 would lead to a global
amount of $263 billion, and for a valuation at $20, it would be $5260 billion.

Elliot Aurissergues (Economist at the OFCE)

As
the health constraints caused by the pandemic continue to weigh on the economy
in 2021, the challenge is to get GDP and employment quickly back to their
pre-crisis levels. However, companies’ uncertainty about their levels of
activity and profits in the coming years could slow the recovery. In order to
cope with the possible long-term negative effects of the crisis, and weakened
by their losses in 2020, companies may seek to restore or even increase their
margins, which could result in numerous restructurings and job losses. Economic
recovery could take place faster if business has real visibility beyond 2021. While
it is difficult for the current government to make strong commitments, on the
other hand mechanisms that in the long term are not very costly for the public purse
could make it possible to take action.

Post-pandemic uncertainty will hold back a recovery

In economic terms, the pandemic represents an atypical crisis. It combines both goods and labour supply shocks and a fall – largely constrained – in consumption (Dauvin and Sampognaro, 2021). There are not many recent episodes that can provide useful points of comparison for economic actors. Some elements do indicate a rapid return to normalcy, including the dynamism of some Asian economies, in particular the Chinese economy, and the resilience of the US economy and the Biden administration’s economic policy. On the other hand, there are other factors that may limit economic growth in the coming years. The heavy losses of some companies could lead to a wave of bankruptcies (Guerini et al., 2020; Heyer, 2020), with possible negative effects on productivity or the employment of certain categories of workers. Some consumption patterns could be modified permanently, with a heavy impact on sectors like aeronautics and retailing. The trajectories of some of the emerging economies are another unknown, as they cannot afford the same level of fiscal support as do the US and Europe. Finally, the concentration of the shock on sectors that tend to employ low-skilled workers risks increasing inequalities within countries, and thus generating a further rise in global savings. Some indicators reflect this still high uncertainty. The VIX index, which captures market expectations for the volatility of US stock prices, remains twice as high as before the crisis and is comparable to the levels reached during the Dotcomcrisis (see Figure 1). In France, the business and jobs climate has rebounded strongly from its historical low in March-April 2020, but is still at the same level as during the low point of the eurozone crisis in 2012-2013 (see Figure 2).

The literature shows that uncertainty about the medium-term path of the economy affects the way companies behave today. By identifying uncertainty with stock price volatility, Bloom (2009) suggests that it has had a significant negative impact on GDP and employment in the US. A number of other studies have used different methodologies to confirm this idea [1]. Given the severity of the recession in 2020, uncertainty could have an even greater impact. Effects that are usually second-order may be enough to derail an economic recovery.

A proposal for giving visibility to businesses

The
measures in France’s current stimulus package basically focus on 2021 and 2022
and do not give any visibility to businesses about their activity or cash flow
beyond 2022. It is true that it is difficult for the current government to
commit to major expenditures that would have to be assumed by future
governments. However, it is possible to envisage relatively strong measures that
have limited budgetary costs over the next ten years (and therefore a limited
impact on the fiscal manoeuvring room of future governments).

Proposal: Give companies the following option: a subsidy of 10% of their wage bill (wages under 3x the minimum wage – the SMIC) between 2022 and 2026 in exchange for an additional tax of 5% on their gross operating profits (EBITDA) over the period 2022-2030.

For
firms applying for the scheme, this is the fiscal equivalent of a temporary
recapitalization. They exchange a subsidy today for a fraction of their
profits tomorrow. The implicit cost of capital would be particularly
attractive. The scheme is calibrated so that its “interest rate” (given by the
ratio between the sum of additional taxes over 2022-2030 and the sum of
subsidies over 2022-2026) is close to 0% for the “average” French company. This
rate would be lower a posteriori for companies that will have performed
less well than expected. Compared with other recapitalization methods such as
direct public shareholdings or the conversion of loans into quasi-equity, there
is no risk that the current shareholders will lose control of the company.

The
advantage of the scheme is that it automatically targets the companies that
face the greatest need. The businesses that anticipate possible economic
difficulties over the next few years and that have employment-intensive
activities will self-select, while others will have no interest in applying for
the subsidy. As the subsidy is disbursed gradually, companies that maintain
employment over the period will be favoured. Capital-intensive and high-growth
companies would not be penalized, as the scheme would remain optional. The
additional tax on EBITDA is temporary and should not have a negative impact on
investment by those applying for it.

The
cost in terms of public debt up to 2030 would be low: about 10 billion euros[2], or 0.4 percentage points of GDP, if all companies
were to apply. The self-selection effect of the scheme would increase the
average cost per beneficiary company but would also decrease the number of
beneficiaries, thereby having an ambiguous impact on the total cost. This does
not take into account the beneficial impact of the scheme on the public
finances in so far as it prevents job losses and the non-repayment of certain
guaranteed loans. The fiscal impulse over 2022-2025 could on the other hand be
quite strong, on the order of 1 to 1.5 GDP points per year (i.e. 4 to 6 GDP points
over the four years) but would be counterbalanced by an automatic increase in
revenue over 2025-2030[3].

Bibliography

Bachmann R., S. Elstner and E. Sims, 2013,
“Uncertainty and Economic Activity: Evidence from Business Survey
Data”, AEJ
macroeconomics, https://www.aeaweb.org/articles?id=10.1257/mac.5.2.217

Belianska A., A. Eyquem and C. Poilly, 2021, “The
Transmission Channels of Government Spending Uncertainty”, working paper, https://halshs.archives-ouvertes.fr/halshs-03160370

Bloom N., 2009, “The impact of uncertainty shocks”,
Econometrica, https://onlinelibrary.wiley.com/doi/abs/10.3982/ECTA6248

Dauvin M. and R. Sampognaro, 2021, “Behind the
Scenes of Containment: Modelling Simultaneous Supply and Demand Shocks”, OFCE working papers, https://www.ofce.sciences-po.fr/pdf/dtravail/OFCEWP2021-05.pdf

Fernandez-Villaverde J. and P. Guerron-Quintana,
2011, “Risk Matters: The Real Effects of Volatility Shocks”, American Economic Review, https://www.aeaweb.org/articles?id=10.1257/aer.101.6.2530

Fernandez-Villaverde J. and P. Guerron-Quintana,
2015, “Fiscal volatility shocks and economic activity”, American Economic Review, https://www.aeaweb.org/articles?id=10.1257/aer.20121236

Guerini M., L. Nesta, X. Ragot and S. Schiavo,
2020, “Firm
liquidity and solvency under the Covid-19 lockdown in France”, OFCE policy brief, https://www.ofce.sciences-po.fr/pdf/pbrief/2020/OFCEpbrief76.pdf

Heyer E., 2020,
“Défaillances d’entreprises et destructions d’emplois: une estimation de
la relation sur données macro-sectorielles”, Revue de l’OFCE, https://www.ofce.sciences-po.fr/pdf/revue/7-168OFCE.pdf

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[1] Fernandez-Villaverde, Guerron-Quintana,
Rubio-Ramirez and Uribe (2011) show that increased interest rate volatility has
destabilizing effects on Latin American economies. In a 2015 paper, the same authors
suggest that increased uncertainty about future US fiscal policy leads firms to
push up their margins, reducing economic activity. This result has been confirmed
by Belianska, Eyquem and Poilly (2021) for the euro zone. Using consumer
confidence surveys, Bachmann and Sims (2012) show that pessimistic consumers
reduce the effectiveness of fiscal policy during a recession. Finally,
uncertainty among CEOs has a negative impact on output, as shown by German data
analysed by Bachmann, Elstner and Sims (2013).

[2] The total of wages below 3 SMICs in 2019 was
on the order of 480 billion euros (the total of gross wages and salaries came
to 640 billion for non-financial companies, and the latest INSEE data suggest
that wages below 3 SMICs represent 75% of the wage bill, an amount that seems
consistent with the data on the cost of France’s CICE tax scheme). The EBITDA
of non-financial companies was 420 billion euros. Based on these 2019 figures,
and if all companies were to apply for the scheme, the total subsidy would
amount to 0.1 x 480 x 4 or 196 billion euros. The EBITDA tax would under the
same assumptions yield 0.05 x 420 x 8 + 0.05 x 196 (5% of the subsidy will be
recovered viathe extra EBITDA) or 186 billion euros.

[3] This additional tax revenue should not penalize
activity over this period because (1) it will concern capital income for which
the marginal propensity to consume is rather low, and (2) the beneficiary
companies should be able to anticipate it correctly.