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Facing the Threat of Recession: Focus on the Long-Term

Analysis - 22 June 2022

The Russian invasion of Ukraine significantly weakened European and global economic outlooks. In Ukraine, this downturn is evident with the destruction of entire cities, forced migration and the blockade of hundreds of ships with Ukrainian grain exports in the Black Sea. We are also seeing a deep recession in Russia, where the downswing of its exports suggests a contraction of economic activity worse than the 8.5% drop, forecasted by the International Monetary Fund (IMF).

The global economy is facing a tipping point. According to estimates by the Dutch CPB, international trade had already begun shrinking in March 2022, and foreign orders reported by major exporters, such as Germany, China or the United States, have since taken a nosedive. Over the past three months, manufacturers all over the world have revised their expectations downwards. According to the Munich-based Ifo institute, the six-month growth outlook has fallen more than two standard deviations below the long-term average in all sectors of the German economy.

The current constraints on global supply chains are likely the most telling indicator of the rough waters we are now in. The New York Federal Reserve’s Global Supply Chain Pressure Index had already surged since the first Covid lockdowns, before falling back to its historical average at the end of 2020. Since then however, it has exploded remaining between three and four standard deviations above its long-term average, an unprecedented event.

A traditional supply shock? Not quite

At first glance, the diagnosis seems clear: the world economy faces a large-scale supply shock,  caused by persistent production bottlenecks, China's "zero-covid" policy and the war in Ukraine, responsible for cuts in exports of raw materials in the industrial and agricultural sectors, and a booming demand for liquefied natural gas (LNG) far exceeding global transport and delivery capacities. As in 1974 and 1979, the negative impact of supply shocks on production is closely followed by a sharp rise in inflation, higher prices being needed to clear the balance between supply and demand. It is therefore safe to say we are experiencing stagflation again. Two additional features, however, are making this supply side shock different from previous ones. 

First, the inflationary dynamics started as early as 2019, with a gradual acceleration in labor costs in the United States. Since then, inflation has virtually spread to all sectors, and all countries. In fact, business surveys reveal an unprecedented situation.

The inflationary dynamics started as early as 2019, with a gradual acceleration in labor costs in the United States. Since then, inflation has virtually spread to all sectors, and all countries. 

55% of manufacturers surveyed by the French National Institute of Statistics INSEE in May 2022 say that their prices will rise further, a level that is five standard deviations above the long-term average. Previous peaks, in 1992 and 2008, which preceded severe recessions, had only reached two standard deviations. A survey by Ifo shows an even higher proportion of companies announcing price increases, reaching about 58%. While inflation is a complex phenomenon that has often defied economic models, one thing is clear: it’s all about the prices set by producers and paid by consumers.

Inflation will continue, if not accelerate. We have not yet entered a full blown inflation regime, since long-term inflation expectations embedded in inflation-proof financial products remain stable. It has become evident however that current trends go beyond a simple short-term surge in energy prices.

This is already acknowledged by policymakers on both sides of the Atlantic. In a presentation of his book 21st Century Monetary Policy at the Brookings Institution, former Federal Reserve Chairman Ben Bernanke noted that "the pandemic was a bigger and more persistent [supply] shock, and one that perhaps threatened to unanchor inflation expectations, than the Fed expected". In contrast to many European observers, ECB Executive board member Isabel Schnabel makes the astute observation that there are more similarities between the Eurozone and the United States than one might think by simply looking at unemployment rates. First, because local inflation is driven by global trends. Second, because the pent-up demand during the COVID-19 pandemic gave manufacturers a certain freedom to raise their prices.

Isabel Schnabel highlights another defining feature of the current supply shock: fiscal countermeasures that responded to the health crisis led to massive excess savings. Let's look at France again. According to INSEE’s quarterly national accounts, the personal savings rate at the end of March 2022 stood at 16.7% of gross disposable income. To put this into perspective, the savings for all five years preceding the COVID-19 pandemic averaged only 14.3%. In 2020 and 2021, the flow of financial savings (excluding housing purchases) reached €168 billion. This means that the excess savings at the end of 2021 amounted to €130 billion or 8% of annual gross disposable income. Most industrialized countries are exhibiting excess savings, ready to be spent on consumption of goods rather than services.

Blindly stimulating demand might just curtail it

In short, we are facing a recession characterized by constrained supply and a demand propped up by excess savings. Therefore, any policy aiming at stimulating demand would in fact worsen the recession, rather than cushion it. Indeed, stimulating demand while supply cannot increase at the same rate can only result in higher prices with no increase in production and employment. We are already very close to this scenario: 42% of French industrial companies surveyed by INSEE in April 2022 reported they were running at full capacity, something we have never seen since the trimestrial survey started in 1976.

The only consequence of an all-out fiscal stimulus policy would be a reduction of households’ purchasing power - the exact opposite of the desired goal. For low-income households, who have accumulated little savings during the Covid period, lower real income implies lower consumption. For households with larger financial capacities, the additional drop in real income will reduce it more quickly than if there had been no stimulus. In both cases, the risk of recession increases.

The only consequence of an all-out fiscal stimulus policy would be a reduction of households’ purchasing power - the exact opposite of the desired goal. 

Price fixing policies are equally illusory. The increase in energy and food prices comes from a reduction in supply. In this situation, demand has no other option but to fall. Market-induced price increases have precisely this effect. Attempting to reject market clearing with price controls, will increase demand, not supply. Such policies would need to go hand-in-hand with rationing, as in the immediate post-war period, when everything was in short supply. Funnily enough, not one of the advocates for price fixing mentioned ration cards.

If we give up on illusory solutions, what else can we do?

Aggregate macroeconomic reasoning looks through financial diversity. Low-income households are affected by the supply shock in two ways. In these households, energy and food account for a much larger share of their consumption basket than in wealthier households. Low-income households will therefore experience the drop in purchasing power more intensely. Since most of these households lack savings to outbalance the drop in purchasing power, the shock is immediately reflected in a reduction of consumption. For over indebted households, this risk is even higher. This is why policy measures targeted specifically at low-income households and their primary goods of consumption (energy and food) are perfectly justified.

Since we are dealing with a supply shock, the most effective measures should aim at loosening supply constraints. This is obviously more complex than implementing fiscal stimuli, by increasing debt, or calling for wage increases. Also, since supply constraints are global, national decisions have a limited impact. This is where the European Union should come into play. In a situation where the supply of fossil fuels from Russia is highly uncertain, it would be absurd to deprive ourselves of nuclear-powered electricity. 

Since we are dealing with a supply shock, the most effective measures should aim at loosening supply constraints.

Yet, countries like Germany and Belgium continue closing down nuclear power plants. The "green" taxonomy of the EU prevents investments in this decarbonized energy source. Japanese Prime Minister Kishida’s announcement on the reopening of nuclear power plants, shut down since the Fukushima-Daiichi accident, is a rational response to the supply shock. It is also possible to act at the national level by encouraging energy savings and investments in energy efficiency. 

To avoid wastefulness and dissuade opportunity-seekers, any energy supply policy should be built around an indicative carbon price trajectory, which we might call a "merit price", to borrow economist Richard Musgrave’s term. This should allow companies to choose among different energy saving and decarbonization technologies. Another question that we will need to ask ourselves is whether the radical ban of gas extraction by hydraulic fracturing technologies is justified if we want to do without Russian gas? Currently, all research and exploration in this area is prohibited in France. Finally, global constraints also affect the food sector. Since we do not have the option to expand agricultural production areas, we need to make sure that EU or national agricultural policies do not negatively impact agricultural productivity.

It is time to commit to a long-term supply-side policy

Favoring supply-side policies to avoid a possible recession implies focusing on the long-term, while questioning some long-held taboos. That is precisely the point of these supply-side policies which, unlike demand-side policies, have long-term objectives. Below are two areas in which taboos continue to hinder effective long-run supply policy.  

Energy policy: get ideology of the way, drive the lobbies to their knees and invest.

Undoubtedly, Europe needs to reduce its dependence on Russian fossil fuels while also decarbonizing  its economy. Eliminating fossil fuels from transportation and home heating requires producing much more "decarbonized" energy. This does not refer to ambiguous terms such as "green" or "clean" energy, political verbiage prone to all sorts of partisan distortions, but decarbonized energy, the only measurable concept that can meet the challenge of climate change. The only judge in the court of the energy technology market should be the cost per ton of CO2 avoided, also called abatement cost. For instance, according to Henri Prévot and Matthieu Glachant, the abatement cost of replacing an oil-fired domestic heating system with a heat pump is much lower than the cost of thermal insulation. Still, public authorities choose to subsidize the renovation of buildings, to the joy of the construction sector. This is not surprising, as the official National Low-Carbon Strategy (Stratégie Nationale Bas-Carbone, SNBC) only mentions the price of CO2 incidentally, not even as a merit value that could help discriminate within various investment opportunities. There is still a real taboo in France’s political class around price signals.

Moreover, the increase in electricity production capacity should be free of constraints imposed by political agreements. For instance, the French target of producing no more than 50% of its electricity from nuclear energy is entirely based on a political agreement by François Hollande and ecologists in 2015. Emmanuel Macron later retained this target. This old compromise seems obsolete, since the ecologist party EELV (Europe Ecologie – Les Verts) has joined the left-wing coalition NUPES (Nouvelle Union populaire écologique et sociale), showing that it is not interested in a compromise with the Parliament majority.

The increase in electricity production capacity should be free of constraints imposed by political agreements. 

The latter could therefore abandon this baseless constraint at no political cost, against the backdrop of a sharp energy price spike, which would have been much worse had we not had nuclear-powered electricity, as shown by the examples of Spain and Germany for instance. 

The financing of new nuclear power plants raises the issue of cross-subsidies between different energy sources. The Regulated Access to Historic Nuclear Electricity framework (ARENH) allows operators to purchase nuclear electricity at a price and quantity set by the French Energy Regulation Commission (CRE). This price is currently set at 46.2€/MWh for 120 TWh (quota for 2022). Yet, since October 2021, the market price of electricity has been fluctuating between 100 and 300€/MWh. The current energy supply shock is likely to be persistent, as the EU opts out of Russian energy imports, in the face of strong increases in electricity needs. The ARENH would then amount to a subsidy for alternative energy suppliers, thus reducing the return on investment for operators of nuclear power plants. To produce more decarbonized electricity at a reasonable price, it is legitimate to remove constraints on EDF (literal Electricity of France, the French electricity utility company). Even if French electricity is among the most carbon-free in the European Union, the goal of any responsible energy policy should be to reduce further CO2 emissions while providing more electricity at the lowest cost possible.

A decarbonized energy policy will require massive investments in transport and charging infrastructures, as well as research and development in energy storage technologies and new energy sources. Unfortunately, most of the investments in SMR fission technologies, or subcritical reactors (which some call Rubbiatron in honor of Physics Nobel Prize winner Carlo Rubbio) or even small-scale fusion reactors, are almost exclusively in the United States and China. It is certainly telling that the official SNBC policy does not mention a single one of these technological innovations in its section about basic and applied research.

Competition: we can do better. 

According to World Bank data from 2016, competition in France remains less intense than in many of its peers’ namely the United States, Germany, the United Kingdom or the Netherlands (though France scores better than Italy or Sweden). Relying on recent data, the OECD indicator of market regulation (indicating heavier regulation) places France well above Germany, the Netherlands, or the United Kingdom. The French economy is even slightly more regulated than the OECD average. The tools for regulating competition exist in France. In this sense, the appointment of renowned economist Benoit Cœuré as head of the Competition Authority should bode well. The challenge is twofold: in the short-run, stronger competition would reduce prices and thus increase household purchasing power. In the long-run, competition stimulates innovation and competitiveness.

In conclusion, we cannot solely rely on ambitious energy policies and strengthened competition to form a comprehensive supply policy. Corporate taxation, the cost of capital, regulatory barriers, scientific education, research and innovation must also be part of the equation. Yet, to mitigate the supply shock and a possible recession in the short term, we should quickly redefine our energy policy and strengthen competition. In the long term, this would help us to strengthen a sustainable, low-carbon growth path of our economy.

 

 

Copyright: SPENCER PLATT / GETTY IMAGES NORTH AMERICA / Getty Images via AFP

 

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