The Difficult Course of Western Economies

The succession of the two crises, first the pandemic and then the energy crisis in Ukraine, overturned the expected and largely discounted consequences of the initial fiscal easing on both the EU and US economies.

The second round of fiscal “relaxation” made the first round unexpectedly toxic. He dismissed the expectation that after the end of the pandemic, rapid resumption of production, supply chain clustering and gradual equilibrium of supply and demand would restore a general balance with minor inflationary upheavals and limited need for restrictive fiscal policy.

The first tsunami was a warning but controlled, but the second tsunami is devastating. Fiscal “relaxation” from medicine becomes poison.

  1. What will happen if the energy crisis continues next winter, and increases in the production of products, services and wages?
  2. What will happen to the purchase of bonds by the ECB, especially for countries with high debt such as Italy and Greece?
  3. What will happen when the suppression of inflation requires successive interest rate increases, something that will negatively affect investment, consumption and the labor market?

At this point we are obliged to record the contradiction or at least a more optimistic version. Mario Draghi, the Italian Prime Minister and former President of the ECB, said in a recent speech (May 8, 2022) that rising inflation is more controlled and less destructive than the rate recorded in recent months (8.1% in EU).

The reasons cited are perfectly valid. More specifically, high inflation does not reflect excessive demand, does not show signs of overheating of the economy, which would make its de-escalation a much more difficult task. Here we have the case of an acute crisis: the dramatic rise in energy, which, by the way, is unprecedented and different from the 1973 and 1979 crises.

About 50 years ago the problem was only oil, while now we have an oil crisis, a gas crisis and an electricity crisis. That is, three energy sources that move everything. In the past, one form of energy could replace another. Limiting the readily available alternatives creates perfect storm conditions.

Mario Draghi also pointed out that when food and energy are excluded, “inflation is only about half”. Given that unemployment remains fairly low and consumption remains below pre-pandemic levels, there is evidence of untapped potential in western economies and we can hope that de-escalation of inflation can be achieved without central bankers sending Eurozone economies in intensive care.

However, Mario Draghi reminds us that in order to achieve the optimistic version he expresses, wages must regain their purchasing power, but without creating a price-wage vortex that would result in even higher interest rates.

But the problem for Western economies, which makes their path difficult, is summed up in the fact that the central banks, as well as their governments, cross the threshold of the new policy without having solved a age-old dilemma:

How to reconcile the need to fight inflation – which requires restrictive monetary policy – with the need to support the economy due to the energy crisis – which requires a “relaxing” fiscal policy, especially in the form of direct subsidies and favorable lending terms.

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