Thomas Aubrey / Sep 2023
Christine Lagarde’s speech at Jackson Hole in August 2023 highlighted that the global economy is potentially moving into a new economic regime. The President of the European Central Bank (ECB) indicated that in this new world where global competition is reduced, ‘we will have to be extremely attentive that greater volatility in relative prices does not creep into medium-term inflation through wages repeatedly “chasing” prices.’ In response to this shift, Lagarde reaffirmed the ECB’s constitutional mandate to keep inflation at 2% over the medium term and that, ‘monetary policy should not itself become a source of uncertainty.’
Lagarde is right to be concerned about this new regime - which may well be more inflationary. But this new regime may also end up undermining the European monetary framework for a number of reasons.
First, is the nature of the inflation target. The ECB’s mandate does not take into account the sources of inflation which can either be related to excess demand – something the central bank can control or global negative supply shocks which the central bank is unable to control. Indeed, the monetary economist Ralph Hawtrey criticized Keynes for supporting an inflation target because this would cause interest rates to react to things that are not directly related monetary variables. This is precisely the error made by the Federal Reserve in 2008 when it pushed up interest rates due to its concern of rising commodity prices, thereby exacerbating the global financial crisis.
Second, is the lack of flexibility of the ECB’s mandate. The notion that economists have sufficient knowledge to set a specific monetary target at the constitutional level is flawed. Our fundamental lack of knowledge of the behaviour of complex systems indicates that targets should be set by the central bank in response to changing conditions to achieve a specific goal such as currency stability or stabilizing wage levels. During the 1970s, the Bundesbank was given a free rein to meet its goal of safeguarding the currency which it did more successfully than any other central bank using a combination of an inflation goal alongside guiding those involved in wage bargaining of the potential outcomes of excessive nominal wage growth. The economist Adam Posen warned in 1997 that the blind pursuit of price stability may not necessarily result in a successful outcome given that central banks might have to act in a more flexible manner in response to events.
Third, as I discussed in my last book All Roads Lead to Serfdom, critics of inflation targeting have argued that it can result in an unequal distribution of income with productivity increases not always feeding through to wages. Indeed since 1990 when inflation targeting started to become the norm, the returns to capital have increased at the expense of the returns to labour reflecting a more rapid growth in labour productivity compared to average labour compensation. An inflation target makes sense only if productivity is stable through time – which we know is not the case. Instead central banks should target nominal variables such as wages as recommended by Hawtrey.
Fourth and more worrying is that there is increasing evidence that the cost of capital across the eurozone is now close to the return on capital generated by firms. As the difference between these two rates or the Wicksellian Differential falls below 1%, the potential for capital destruction increases. This was the case during the early 1980s in the United Kingdom when interest rates were set so high to bring inflation down – and in the process resulted in a large jump in unemployment as it was no longer profitable for firms to continue to operate.
The return on capital in 2022 for France was 5.4%, Germany 5.8%, Spain 6.6% and Italy 7.5%. Current data does not indicate that this is likely to increase, however, the cost of funding is rising. For comparison purposes, the US is not impacted as much by a higher cost of funding given the return on capital is nearly 5 percentage points higher.
Chart 1: Comparison of Wicksellian Differential by Country 2022
Source: LSEG Datastream, Credit Capital Advisory
If we assume that the return on capital remains at 2022 levels, the best case scenario for the Wicksellian Differential for eurozone countries is around 1% indicating monetary policy is too tight, resulting in potential capital destruction, particularly in France and Germany.
Chart 2: Projected Wicksellian Differentials for 2023
Source: LSEG Datastream, Credit Capital Advisory
However, if monetary policy becomes too tight resulting in capital destruction, opposition towards the single currency in countries such as in Finland, and Germany will only strengthen further. Moreover, the lack of democratic accountability between national electorates on how monetary policy ought to be conducted weakens the legitimacy of the ECB given that any monetary policy target has to be a compromise with all other eurozone countries.
What ultimately matters for the stability of a single currency is the willingness of wealthier areas of a union to support a substantial redistribution of income to poorer areas – which in turn is likely to require much deeper political integration. This is something that the Bundesverfassungsgericht noted in 1994 on its opinion on the Maastricht Treaty stating that, ‘a currency union, especially between States which are oriented towards an active economic and social policy, can ultimately only be realised in common with a political union’.
Although the Covid 19 Recovery Fund was a small shift in this direction, there does not appear to be widespread support for wealthier member states to provide the kind of large scale redistribution that currently takes place today within nation states. European officials, therefore, must start to rethink how they can stabilize and strengthen the EU without reverting to the traditional response to European crises of just more integration.
All EU members with the exception of Denmark are obliged to join the euro as a result of the Maastricht Treaty, but not all countries seem too bothered about implementing this rule. Sweden, for example, appears to have ignored this requirement following a non-binding referendum on the matter in 2003 which voted against joining. Hence at the very least the Treaty on European Union should be amended to withdraw this requirement. In addition, officials should also seek to provide the option for eurozone countries to issue a parallel currency, and if necessary, to revert to that currency. Plans should also be developed for those countries who do want to pursue a political union, which would clearly strengthen the single currency.
The traditional approach to resolving European policy issues through deeper political integration is less likely to work given the increasingly hostility towards the euro from member states. The reality is that a monolithic approach to European integration cannot take into account the diverse desires of European voters. Indeed, the variable geometry debates of the 1990s appear far more appropriate to the nature of the current challenge.
Such a shift in policy is, however, unlikely to happen until ECB monetary policy has tamed inflation but with a significant negative impact on the European economy. Sadly the ECB does not have a choice given its mandate is to maintain inflation at 2% in the medium term, no matter what the cost.
 A 2 percentage point spread on top of the relevant 5 year benchmark is used to proxy a BBB cost of funding