Ahead of the Midterms: An Eye on the Economy From Both Sides of the Atlantic

As a result, authorities may have to cut the use of power and gas through rationing, all because you don’t let the market price signal be conveyed. 

The rationale for this "inflation shield" in France was to ease the wage-price loop that would be triggered by the automatic indexation of the statutory minimum wage on inflation, and, as a consequence, low wages in general. This is very costly in terms of budget, and unfair, in the sense that it protects everyone, not just those in the lower income bracket. However, the macro-economic reasoning behind this initiative is to avoid a wage-price loop that would lead to sustained inflation in France, and the loss of competitiveness that it would cause, compared to neighboring countries.

Policy reactions and challenges 

It is still very hard for EU countries to agree on a common energy policy. Some countries, such as Spain, have decided to go their own way, while Germany is pursuing its own policy by increasing its reliance on coal. As the German industry increases its usual share of the carbon quota, carbon prices rise, thus crowding out less financially solid companies from other EU member states, since the carbon quota is for the EU as a whole. We are not really in a cooperative framework in this sense because each country is looking out for itself.

For a long time, the European Central Bank considered that since monetary policy can't produce oil or gas, they just have to be patient and wait out a supply-side shock. Then inflation, even non-energy inflation, started to rise and the Fed stepped in. The ECB had to follow suit because the appreciation of the dollar ends up exporting inflation to the rest of the world, including the Euro area. The ECB will continue to raise rates, but as soon as there are concrete signs of recession, I think they’ll have to stop.

Looming government and corporate debt 

Government debts in Europe - already high after Covid-19 - will only increase with the energy crisis. But what is often overlooked is private sector debt, which is mostly coming from the corporate side: private sector debt in the Euro area represents 175 percent of GDP; in France, it accounts for 230 percent of GDP. 

We are entering choppy waters. This is a strange recession, a supply-side type recession in the context of very high private corporate debt, which could have consequences on banks' balance sheets. If there are difficulties, and if we start to see bankruptcies (exactly what the government wants to avoid) a vicious circle could ensue by which banks would suffer because of losses degrading their assets' quality. This would imply less bank lending, which could slow down the recovery from the energy crisis, whenever it ends. Experts estimate this situation to last between two to three years.

How does the economic situation differ in the US?

Inflation in Europe is quite different from that in the US for several reasons. First, inflation in Europe stemmed essentially from the energy crisis. This was not the case in the US, where the main determinant was more of a classical textbook example: too much money chasing too few goods. A pandemic-related shock means has disrupted supply. On the other hand, there have been massive interventions from governments, whether from the Trump or Biden administrations. As a result, there is a huge cushion of household savings, and inflationary tensions were unavoidable.

Incidentally, this mechanism also generates some unwelcome externalities. When the Fed increases rates, it has a cooling effect not just on the US economy but also on other economies. This consequence is not fully taken into account. 

A serious concern, in the US and in Europe, is the emergence of a price/wage spiral: faced with higher prices, workers ask for higher wages, and firms accept to raise wages because they expect to raise prices. This is how inflation could become entrenched. For the moment, inflation doesn't seem to be in the US. Financial markets appear to expect inflation to spike this year but to come back to a more moderate trend (perhaps around 3%) in the medium term. However, expectations are volatile. This is key to understanding the Fed’s current strategy: it is crucial to control inflation before it becomes entrenched.

Overall, financial risk is less acute in the US than in Europe - but it remains there. The biggest risk that inflation could bring is not with individuals but from corporate debt, which could impact the banking sector. Some recent IPOs saw severe losses for some parties involved. The Fed is aware of this risk but it won't dissuade it from continuing to fight inflation. 

How significant is the threat of recession in the US? 

The very definition of a recession differs between Europe and the US. The US does not use a mechanical definition (GDP contracting over two consecutive quarters) but instead, there is a committee at the National Bureau of Economic Research (NBER) which analyzes data and can declare when a recession has started. This task is increasingly complex because currently GDP and the labor market are giving very different signals. GDP has contracted, but the labor market was, and still is, doing quite well. Non-farm employment increased by 260,000 in September, and the unemployment rate is around 3.5%.
 
All in all, the US will most likely not avoid a recession, but its impact should be milder than in Europe, if only because the US is much less dependent on imported energy. There are two caveats to keep in mind. First, the impact of higher interest rates is only just beginning to be felt - monetary tightening always affects the real economy with some delay. Second, the Fed seems to be decided to maintain its credibility, even if this may lead to temporary overreaction.

How will the US economy impact the upcoming midterm elections? 

The most likely scenario in the midterms is that Democrats will keep the Senate but lose the House. Recent polls suggest a shift in favor of Republicans, mostly guided by economic motivations. Inflation remains a serious concern for many Americans; the Biden administration bears a clear responsibility for its emergence. The stimulus plan adopted during the first months following the election injected almost $2 trillion into the economy; at that time, many economists, including Democrats, expressed reservations about the amount, which was too large and likely to generate overheating, particularly given the constraints affecting supply. Unfortunately, they were right. The paradox is that the aspects American people are most sensitive to - prices of energy, gas or food - are precisely those for which the current administration bears little or no responsibility. 

This helps explain some surprising policies, like Biden's promise to cancel $10,000 to $20,000 of student debt for low- to middle-income borrowers. This might not be the best way to help poor people - they are not necessarily the ones most affected by student debt - but at least it could be done without the Senate's approval. Should the Republican party control the House, one can fear that the gridlock will only get worse - starting with the vote on the US government debt ceiling, which was already a thorny issue during the Obama presidency.

What are the biggest challenges facing both the US and Europe? 

In the long term, we are hoping that the energy crisis won’t last more than two years, although it is difficult to predict the future of the war in Ukraine. But one challenge we are certain will remain is climate change. This is a reality that everyone is finally being forced to confront. Economists have been saying for decades that any serious action about climate change requires higher prices for carbon emissions, either through a carbon tax or an emission market with a restrictive supply of emission rights. There used to be a strong resistance against what certain politicians termed "punitive ecology"; a common illusion was that we could somehow fight climate change at no cost. This is just false - and the latest report by Olivier Blanchard and Jean Tirole is a very useful reminder of this basic fact. Fighting climate change will be costly, but the cost of acting now is still much smaller than what it will be 20 or 30 years from now if we do nothing. 

But here is a silver lining. As recently as a few months ago, a high carbon tax was considered either unacceptable or politically unfeasible because it would drive up energy prices. Well, current prices are now much higher than anything that would have been considered in the past. As a result, our economies will have to adapt to higher energy prices; innovation will have to take place. And the main advantage of our market-oriented system is its ability to innovate. In the coming years will see a wave of innovations that will (eventually!) lead to significant progress. 

What types of measures are effective in this complicated context? 

Helping low-income households facing serious economic difficulties because of sky-high energy prices makes sense, but the form in which this help will be delivered is crucial. Energy prices are skyrocketing because of a severe supply shock. In such a context, the last thing you want to do is subsidize demand - which is exactly what some government actions (such as capping energy prices) are doing. 

This includes fundamental research. The EU will spend several hundred billion euros over the next months to protect its citizens from higher energy prices. At the same time, the budget of the European Research Council, which is a major source of funding for fundamental research in Europe, is slightly more than €2 billion per year. Somehow, priorities do not seem right. 

What joint initiatives could France, Europe, and the US take? 

On the European side: defense and climate change

In these two areas, in particular, intelligent transatlantic cooperation would be useful. First, defense. We were previously living in a fantasy world "where there were no bad guys" in Europe. Now we are facing a nuclear threat. Working together on defense is key. NATO is useful and will only become more useful. Second, climate policy. We have a large-scale supply-side shock. Free energy is over. At the same time, Europe is emitting more CO₂ than before because of the closure of many nuclear power plants in Germany, Belgium, and France, as well as the lack of gas supply, which fuelled the return of coal as a primary source of energy. This is bad news in the short term and a place where transatlantic cooperation is the most welcome. One possibility is an agreement on carbon adjustment at the border, designed to equalize the price of carbon charged to EU-based companies and imports. Without border adjustment, governments have to distribute free allowances to emit CO₂, which is in total contradiction with the net-zero goal pursued by the EU for 2050.

But most EU trade partners are against this border adjustment. I recently discussed this with Moroccan experts. They said, "You guys have loaded CO₂ in the atmosphere for 150 years and now you’re asking us to pay for it". The US, too, thinks this type of policy is an example of European protectionism. But here should be reasonable common ground. Neither side would be totally satisfied yet, combined, the US and the EU have the largest carbon footprint in the world, and by far the largest domestic markets. Therefore, an agreement would make a big difference to cut global emissions. My hope may be misplaced, but cooperation on climate is of paramount importance if we want to make progress. 

The Carbon Border Adjustment Mechanism (CBAM)

The carbon adjustment (CBAM system) for imports of carbon-intensive products is a positive measure that most economists support. We know the risk: it might lead to protectionism, and we have to be careful, but it is still indispensable. The counterargument from developing countries - that they're paying now for our past mistakes - is very strong but an agreement can still be found. What matters is that carbon-intensive imports be taxed to avoid "carbon leakage". But the question of who reaps the benefit is an open one. We could think of a mechanism through which the revenues generated by the tax would be shared with developing countries.

New perspectives to reduce carbon intensity 

The silver lining in all of this is that without Russian gas, economies will have to adapt to a world with less carbon-intensive sources of energy. This is a difficult task to achieve. The Yellow Vest protests that began in November 2018 in France had political consequences spilling over France's borders. President Biden initially had a carbon tax in his platform but, ultimately removed it, likely out of fear of social and political backlash. There are similar consequences in Europe. The EU Commission Fit for 55 plan advocated for a 55 percent reduction of 1990 emissions levels by 2030, to make the net zero by 2050 goal more credible. There were many good ideas in this plan, starting with the extension of the carbon trading system to a larger part of the economy, but the far-Right and far-Left in the European Parliament opposed these propositions for being either excessive or insufficient. In this regard, maybe Putin will help Europe move faster and more seriously toward decarbonization. We have to increase the production of decarbonized power. This should be a logical consequence of no more Russian gas.

Copyright: Ludovic MARIN / AFP