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Peter Praet (ex-ECB): “The economic shock of this war is underestimated”

The former chief economist of the European Central Bank (ECB) is worried about a significant risk of stagflation in the euro zone: “For the second half of this year, there is clearly a risk of recession.” In such a context, the ECB is walking on eggshells.

Peter Praet has remained a very attentive observer of the economic and financial situation since he left the European Central Bank in May 2019. He still takes part in numerous conferences as a speaker. In his eyes, the war in Ukraine, which follows a series of shocks since 2000, will cause profound upheavals.

We are not yet out of the covid crisis and here we are in an inflationary crisis and a war on European soil. Have you ever experienced such a succession of shocks?



I think that even if we end up with a kind of compromise with Russia in this war, a fundamental break has been made.

No, it’s pretty amazing. And that’s why I think the world is going to fundamentally change. You cite the various most recent shocks, but we have actually experienced repeated shocks since the beginning of the 2000s, starting with the terrorist shock with the September 11 attacks. This was followed by the shock of the great financial crisis of 2008 and then the euro crisis. Then came the arrival of Donald Trump in power in the United States and the return of protectionist policies. This was the beginning of a paradigm shift with the questioning of globalization. That’s when we started to talk about the relocation of activities in a context of tensions with China. Until then, we believed that free trade was a win-win solution for everyone. We thought that trading with even more authoritarian regimes like China or Russia would contain political and security risks, because we had too much to lose in conflicts as the economies were intertwined.

Then came the covid crisis and then the political shock with this war in Ukraine, a shock which is terrible, which can also create a migratory shock, with these millions of displaced Ukrainian refugees. And we should not forget either the climate shock and the awareness of the need for efforts to be made in the context of climate transition. This accumulation of shocks is, I repeat, quite extraordinary. It is our mode of economic and social organization that is called into question. I think that even if we end up with a kind of compromise with Russia in this war, a fundamental break has been made. If we put ourselves in the shoes of a leader of a multinational company, it is clear that the economic and geopolitical environment has changed quite brutally.

What could be the impact of this war on economic growth in the euro zone?



I worry about rising inequality. The current crisis, which is causing an increase in the prices of energy and certain foodstuffs, could cause new tensions.

If the situation does not change, I think the war is going to cost us 1.5 to 2.5 percentage points of growth in the euro zone. It’s quite substantial. I am also concerned about the rise in inequality. It is this rise in inequality that has created a backlash against globalization and against elites. The covid crisis has only accentuated these inequalities. And the current crisis, which is causing a
rise in the prices of energy and certain foodstuffs, could cause new tensions.

Economies ultimately held up well to the covid crisis because states got into deep debt. We thought that States could begin to reconstitute budgetary room for manoeuvre, but the current crisis has reshuffled the cards since States must this time intervene to soften the impact of rising energy prices and food prices. And
this occurs in a context where the demand for collective public goods is particularly high: needs in terms of internal and external security, education, health care, etc. The question of financing these measures will inevitably arise. I think fiscal policies will remain expansionary in future years. At the national level, however, the room for maneuver is limited given the high debt ratios and the high levels of fiscal pressure. Hence the idea of ​​developing European budgetary capacities, in particular to finance European collective goods, such as defence. As the Germans recommend, we should start by using some of the funds that are not yet available under the NextGenerationEU plan.

The current situation also complicates the task of central banks. If you were still working at the ECB, what would your advice be?



We have both an inflation problem and a growth risk that I believe is still underestimated.

The situation in the euro area is much more complicated than that of the United States. We have both an inflation problem and a growth risk that I believe is still underestimated. With the inflation figures as we know them, the ECB was obliged to give a certain signal in order to normalize its monetary policy in a prudent and gradual manner. But one of the problems for the ECB is that it does not yet know what the budgetary policies will be in the years to come. The more expansionary they are, the more monetary policy will be able to pursue its cautious normalization.

The ECB has announced a more rapid reduction in its asset purchases, which opens the door to a rise in key interest rates this year. Is this a good decision?

This decision probably reflects more difficult discussions within the Board of Governors. This recalibration is somewhat unnecessary and in my view complicates the central bank’s message. For my part, I would have simply said that the central bank expects to complete its purchase program by the end of the year. This allows him to see how things are changing in terms of growth. She could also have added that she is waiting to hear about developments in budgetary policies. In fact, the ECB is walking on eggshells in the current environment.

Can an increase in key rates thwart inflation?

Even if the key rates return to zero by the end of the year, which is a possibility (they are at -0.50%), the impact on inflation will be moderate. There may certainly be an impact on real estate prices following the rise in mortgage rates, but the slowdown will undoubtedly come more from the context of uncertainty and the reduction in the real disposable income of
households.

The ECB still refuses to talk about stagflation, this mixture of economic stagnation and inflation. Is it a taboo word for Christine Lagarde?



For the second half of this year, there is clearly a risk of recession in the euro zone.

I think the ECB should at least say that there is indeed a significant risk of stagflation. Even the extreme economic scenario presented by the Frankfurt institution still seems too optimistic to me.. For the second half of this year, there is clearly a risk of recession. Some German industrialists think that the current situation is even worse than that of the beginning of the covid. Let’s not forget either that the health crisis is not over.

Can we speak of a mistake by central banks who have long spoken of “transitional” inflation as it takes hold of the landscape?

This is especially the case in the United States where the Federal Reserve (Fed) underestimated the impact of the very expansionary budgetary policy and the solid recovery of the labor market. With its first rate hike announced recently, the Fed is acting late. Faced with an economy that is overheating, monetary policy should be more restrictive than expected by the markets. US rates could therefore rise more than expected. In Europe, the situation is different. The eurozone had barely returned to pre-covid levels and the economy is sure to slow down substantially. Unlike the United States, Europe is experiencing an external shock.

However, we have seen yields on European bonds tighten in the wake of US rates. Is it worrying?

I think that European long rates have risen enough for the moment. In view of the latest developments, I would even say that there is a risk that the ECB will lose control of the ‘medium term’ part of the yield curve: German two-year bond yields have risen around 0.70% since the ECB’s March meeting, as it communicates that rate normalization will be “gradual”. It should not be forgotten that this war affects much more Europe than the United States. Consumer confidence is falling in many
many euro area countries. Business confidence is more resilient but expectations are deteriorating sharply. European long rates must therefore decouple from changes in US rates. In 2013, when the Fed’s reduction in purchases (tapering) was announced, the ECB succeeded in decoupling European rates from the American level thanks to its monetary guidance. This is what will still have to be done, especially if US rates were to rise sharply.

So far the international financial system seems to be holding up well. There were no accidents like during the Russian crisis of 1998 which forced the authorities to intervene to come to the rescue of the hedge fund LTCM.



Decentralized finance (DeFi) and cryptos could eventually cause financial stability issues.

After the financial shock of 2008, we reformed and strengthened the banking system. During the shocks that followed, the financial system functioned relatively well even if certain parts of the system remain fragile. We must not forget that at the start of the covid crisis, the US Treasury bond market had lost all liquidity and central banks had to intervene massively. We cannot say today that all the weaknesses have disappeared. In particular, we can ask questions about technological developments in financial matters: “decentralized finance” (DeFi) and cryptos which could eventually cause financial stability problems.

The stock markets have digested the recent shocks rather well. Does that surprise you?

Many analysts remain positive for equities because real interest rates will remain negative. And also because fiscal policies will remain expansionary. But, in the realm of equities, there are also changes. The war in Ukraine prompts a reassessment of ESG (environment, social and governance) investment criteria. The defense sector, considered harmful
yesterday, is now reconsidered in the context of greater strategic autonomy at European level. This is another example of upheaval linked to this crisis
.

The key phrases

  • It is our mode of economic and social organization that is called into question.
  • “If you put yourself in the shoes of a leader of a multinational company, it is clear that the economic and geopolitical environment has changed quite abruptly.”
  • “The situation in the euro area is clearly more complicated than that of the United States.
  • “Even if the key ECB rates go back to zero by the end of the year, which is a possibility, the impact on inflation will be moderate.

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