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

Analysis - 20 October 2022

The United States will hold midterm elections on November 8th, 2022 in what will be a critical turning point for the remainder of Biden’s presidency. This event calls for a Franco-American dialogue to help us understand the issues affecting both sides of the Atlantic, namely the challenges posed by the war in Ukraine compounding on those from the pandemic.

Russia's invasion of Ukraine threatens the global economic recovery by affecting energy prices and inflation rates - a shared concern by Europe and the US. Other factors, including supply chain issues, the rising cost of housing and household, and student debt, are also shaping the economic debate today. How will this play out in the run-up to the midterms? Eric Chaney, Institut Montaigne's Economic Advisor, and Pierre-André Chiappori, Professor of Economics at Columbia University, share their respective views. This feeds off of exchanges from Institut Montaigne and Columbia's first webinar, as part of our new partnership with Columbia Global Centers (Paris) and Columbia’s Alliance Program.

This paper was written with the help of Marie Doezema.

A few weeks before the midterms, where is Europe headed in terms of policy reactions and risks? 

The current situation is very strange. Companies and consumers are starting to worry about the economy mostly because of a spike in energy prices. But behind this spike is a major supply-side shock. Economists are convinced there will be a significant recession starting in the fourth quarter of this year, which will affect countries differently depending on their respective levels of dependence on Russian gas. Eastern Europe will be hit the hardest, followed by Germany and Italy, then France, and lastly Spain.

But worries aren't manifesting, whether in consumer or business sentiment. The French banking sector still receives clients asking for loans despite the fact that the shock is already here. Spending on energy has risen from 5 to above 10 percent of the GDP. This is huge and has already translated into much higher inflation than in mid-2021 (before the energy crisis). As for August, Eurostat data indicate 9.1 percent in the Euro area, ranging from 25 percent in Estonia, 9 percent in Germany, and 6.6 percent in France, which is at the bottom of the scale because of government decisions to shelter people from price shocks (more on France in a moment). In the United States, inflation is broadly based whereas in Europe it largely stems from energy costs. But the European inflation mix is changing. As a consequence of Covid, there has been a higher demand for goods rather than for services, and there is also indirect evidence that wages are starting to accelerate. According to Eurostat again, wage costs were growing at 4.4 percent in the second quarter in the Euro area and are probably still accelerating now. Unions are asking for higher wages to compensate for the higher cost of living, both in France and across Europe. 

A temporary sense of denial

War is at the doors of the European Union but there doesn't seem to be a significant drop in confidence. One potential explanation is the high level of savings accumulated during the pandemic. In the EU, the personal savings rate (flow of savings as a percentage of the amount of disposable income) has increased from between 12 and 13 percent before the Covid crisis, to 15 percent as of June 2022. Despite the rise of inflation, people across income brackets are looking at their savings accounts and may feel reassured.

This sense of security will be reinforced by shields against a higher cost of living. In the UK, for example, as well as in Germany and France, numbers are astronomical. Germany is going to spend 8 percent of its GDP to protect consumers and companies, especially SMEs, against the price of energy shock. The UK will be spending 6 percent of its GDP and France 4 percent. These massive fiscal expenditures aim to protect people against the rise of energy prices and their resulting consequences on the price of other items.

Will this prevent a recession? 

Such measures will not prevent a recession, which is inevitable. Fiscal policies designed to protect people from inflation don't produce natural gas or power, so the supply-side shock is still here. The paradox is that we will have a deep recession but people will by and large be protected. Europe will not see significant job losses if companies are kept afloat by subsidies. As a consequence of this spending, there will be another sharp rise in government debt in the EU.

The paradox is that we will have a deep recession but people will by and large be protected. 

It's worth noting that inflation is lower in France than in Germany and the Netherlands (14 percent) due to power and gas tariff shields. The cost of electricity to consumers won't rise by more than 4 percent, though market prices have jumped by more than 50 percent. Fiscal spending to keep inflation low has been criticized by economists because if you don't let the price signal operate, people won’t cut spending on scarce energy. 

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.

Another difference is that, in practice, the US has exported some of its inflation. The Fed has started to increase rates earlier, and more significantly than the ECB. Additionally, whenever there is general uncertainty, if not anxiety, about the future of the economy, people tend to favor what's safe - and the dollar is perceived as safe. All this has boosted the exchange rate of the dollar. This higher exchange rate tends to reduce the cost of imports by the US, thus cooling down US inflation, while increasing the cost of imports by other countries with an inflationary outcome.

The US has exported some of its inflation. The Fed has started to increase rates earlier, and more significantly than the ECB. 

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. 

The most likely scenario in the midterms is that Democrats will keep the Senate but lose the House. 

If Republicans end up controlling Congress, the resulting gridlock may be quite similar to the final two years of President Obama's term. If you look at US history, such situations of power divide were typically good for the economy, because everyone understood that bipartisan initiatives were needed, and in the end bipartisan legislation tends to be more balanced and more effective. This is no longer the case. There is complete polarization, and bipartisan initiatives have all but disappeared.

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. 

Lump sum compensations targeting poorer households are much better; as a general rule, the government should avoid toying with prices. Another concern relates to innovation which will be crucial. Europe is losing ground, particularly when it comes to "new" technologies like AI or biotechnologies. France already spends less than the US on R&D; moreover, French R&D investments continue to largely concentrate on "mature" sectors like automobiles or aircraft. France and Europe in general are losing ground in the most promising sectors, and if they do not step up their game and invest now, the long-term consequences will be dire. 

France and Europe in general are losing ground in the most promising sectors, and if they do not step up their game and invest now, the long-term consequences will be dire. 

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

 

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