The obvious response to inflation is to rein in demand via monetary policy—except supply, not demand, is the problem.
Inflation is back. The last time prices increased by 8 per cent per annum was in the early 1980s.
A decisive catalyst has been Vladimir Putin’s war against Ukraine, causing energy prices to soar to unimagined heights. A phenomenon long of little relevance prevails—scarcity. And not only scarcity of energy but also of various raw materials and intermediate products, as well as skilled workers.
The conventional response to inflation and shortages is well known: the central bank raises interest rates, companies and households borrow less and buy less, so demand matches supply again. This price mechanism does not however fit Europe today: elevated prices are not the result of excessive consumption but of uncertain energy and gas supplies, disrupted international supply chains and overdue investments in green technology.
Shrinking demand to fit restricted supply would be painful—and unnecessary. With the right strategy, it is possible to grow out of the current situation.
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Key to this is the market. Yet only the state can get the market going. It plays an essential role—enabling investment by setting the rules of the game (such as a price for carbon), planning large-scale infrastructure (such as the energy system) and subsidising otherwise not-yet-profitable projects (such as the ecologically-driven).
Accomplishing the green transition in the time required by climate goals—years, not decades—is a monumental task. Just consider the investments in electricity grids, infrastructure for hydrogen and transport, industrial plant and buildings which have to go hand in hand with the massive scale-up in renewable energy. Realising those will not be possible in the time left without a co-ordinating actor.
Hence, fighting inflation effectively today requires more than a monetary-policy response. Equally, simply focusing on the demand side to counter the recession won’t do the trick. A new supply-side policy is required, under which the state pulls out all the stops to enable necessary investments, set positive incentives, expand potential and so slow price growth.
One such ‘stop’ is shortage of skilled labour. Without workers, any effort to accelerate the transformation will only exacerbate bottlenecks. A well-developed care and nursing infrastructure is key: it enables women to pursue a full-time career and allows for improved career development. Abolishing incentives to remain in marginal or part-time jobs, for instance through the tax code, would work in the same direction.
Migration is becoming increasingly important to expand workforces. Yet migrants suffered most from the Covid-19 crisis across Europe and integration must be improved to make the best use of their potential. Before the long-term unemployment caused by that crisis becomes permanent, wage subsidies and further training incentives could help those affected get back on their feet today.
Finally, publicly-supported re- and upskilling would enable people mid-career to help shape the transformation, instead of being left in its wake. For such an educational policy to develop individuals’ strengths rather than just correct deficits, it must be proactive and continuous.
An overly successful labour-market policy would however be self-defeating under the current fiscal rules set by the Stability and Growth Pact: if the economy exceeds potential, the government has to start saving money to cool it down. Today, the labour market is estimated to have reached its potential when people work roughly as much as in the past.
That may yield counter-intuitive results: the Spanish economy, for instance, is estimated to exceed its potential when unemployment falls below 12 per cent. The method for estimating potential output under the pact should therefore be adjusted, so that public investment can be supportive of labour-market and climate policy.
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Public investment which effectively supports an expansion of potential requires long-term planning. If contractors have no idea what orders will look like in two years, they will be reluctant to invest in new machinery and expand their workforce. Thus, increases in government spending at short notice will only lead to higher prices. A new supply-side policy requires predictable investment, not stop-go.
The same applies to the regulatory framework. Chemical companies, for example, invest with horizons of ten years or more. An annually fluctuating carbon price or even unclear carbon-pricing mechanism makes it difficult for companies to present a convincing business case to their investors.
Given such uncertainty, it can often be more attractive to return funds to investors rather than to invest. And that seems to be happening across industries: record dividends are expected this year. For the market to play to its strengths and for companies to invest, a predictable set of rules is needed.
A new supply-side policy inevitably goes hand in hand with specifying an industrial policy. This should be designed and delivered through a transparent process, which defines societal objectives and time horizons, evaluates results systematically and identifies where adjustments are necessary. This should help deal with issues of protectionism, bad planning and persistence.
The European Semester or the process for drawing up National Recovery and Resilience Plans could be a model, especially since key questions of industrial policy can only be answered in the European context: how to create new green value chains cost-effectively and how to combine the potential of globally integrated markets with greater diversification and resilience.
Answering these questions and delivering a coherent supply-side policy is not a trivial exercise. To meet the new challenges, administrations will require additional analytical capacities, as well as mechanisms for cross-departmental co-ordination and implementation of common goals.
Today, the question is not whether the state engages in strategic economic development but rationally how. The litmus test for a new supply-side policy—the rapid switch to renewable energies—is already in full swing.