Germany – Political renewal after Merkel?
After sixteen years under Angela Merkel's leadership, Germany is preparing to elect a new chancellor following the parliamentary elections on 26 September. The uncertainty about the formation of the new government coalition and the choice of the future chancellor is growing in the light of the polls. Here we briefly present the main candidates and their key measures, and then analyse the latest opinion polls on the possible coalitions and their consequences for the country's economic policy.
European Union Carbon Border Adjustment Mechanism
On 14 July 2021, the European Commission unveiled a list of 12 proposals for reaching its target of achieving carbon neutrality by 2050. These proposals include the idea of setting up an EU Carbon Border Adjustment Mechanism (CBAM – see article [in French] here).
This proposal aims to achieve the goal of decarbonising the European economy by putting a tax on imports of goods manufactured in countries where carbon legislation is less stringent. Pollution generated by the EU comes not only from production within its own borders but also from imported goods and services used by European countries – and products imported into Europe have a large carbon footprint. The process of manufacturing them outside the EU and then transporting them into the EU generates greenhouse gas emissions that are not necessarily taken into account by legislation and pricing in the countries where they are made.
The idea of taxing imports in this way is justified by the current expansion of European environmental policy: the gradual upward trend in carbon prices risks increasing carbon leakage outside the EU by inadvertently encouraging manufacturers to relocate their operations outside the region. There is a serious risk of increasing pollution in developing countries and rendering global efforts ineffective. The proposed mechanism also aims to curb the competitive weakening of European companies faced with less scrupulous competitors.
The idea of a CBAM builds on the “climate clubs”, alliances of countries that have harmonised carbon prices by pooling their rights to pollute – something Switzerland, Liechtenstein, Iceland, Norway and the EU have done through the EU Emissions Trading System (EU ETS) (see Europe – État des lieux de la fiscalité écologique [article in French]).
Under the EU ETS, a cap is placed on CO2 emissions and allowances are then allocated to companies in sectors covered by the scheme. These rights to pollute can be exchanged between production sites. A company whose marginal cost of pollution abatement is lower than the price of a permit will opt to abate its pollution rather than use its right to pollute, which can resold. Rights can be traded up to the cap, though the latter gradually decreases. Allowances are freely allocated for the sake of protecting against the risk of carbon leakage: auctioning allowances can lead to a loss of competitiveness and large-scale relocations, rendering the scheme ineffective.
The Commission wants the CBAM to become an alternative to the EU ETS, with freely allocated allowances to be phased out from 2026 onwards. The CBAM will be based on a system of certificates representing emissions embedded in imported products, with carbon prices aligned with the average price of ETS allowances and no option to trade allowances. Until 2035, when freely allocated emissions allowances will be completely phased out, the CBAM will only apply (in those sectors covered by the scheme) to that proportion of emissions not covered by free ETS allowances. The plan is to gradually expand the mechanism; the CBAM will initially apply to sectors particularly at risk of carbon leakage: cement, iron and steel, aluminium, electricity and fertilisers.
The mechanism will bring with it some disadvantages in terms of acceptability, effectiveness and ease of implementation; how many will depend on its scope and how it is calibrated. To implement an adjustment mechanism, carbon prices need to be the same whether a product is manufactured at home or abroad so as to prevent unfair competition. The first is issue, then, is the carbon price stability: prices of tradable permits in the European market are constantly changing as supply and demand fluctuate. A price floor will also have to be introduced within the EU ETS. Otherwise, the mechanism will not offer sufficient incentives, especially at times of recession when prices can fall sharply.
Moreover, the need to take into account not only emissions arising from the manufacturing process but also those arising from goods being transported and imported as a baseline for the EU’s carbon footprint so as to be able to set emissions reduction targets means careful thought must be given to the calculation methodology.
The question of how to compare technological intensity between countries and how to choose a carbon intensity measurement framework is not an easy one to answer. Indeed, while measurement of carbon intensity for some primary goods such as cement and steel is standardised, the same cannot be said for all products. But the choice of one framework over another will significantly impact how effective the instrument is.
The CBAM also appears to be an attempt to reconcile two priorities that are fundamentally at odds: free trade and environmental policy. Because the manufacturing process is so fragmented along the value chain, the CBAM must be compatible with the World Trade Organisation (WTO) principles on fair competition. To ensure that this is the case, two rules must be taken into consideration to prevent the mechanism being co-opted for the purposes of “green protectionism”: the “most favoured nation” clause (also known as the principle of non-discrimination) from the General Agreement on Tariffs and Trade (GATT), which entails giving products the same treatment whether they are manufactured domestically or imported, and subsidy clauses from the Agreement on Subsidies and Countervailing Measures (SCM agreement). This is why applying the mechanism by means of certificates representing carbon emissions embedded in imported products, using the same price as that applicable to domestic manufacturers, could level the playing field between the EU and third countries without giving rise to unfair competition. Applying the same carbon price whether a product is manufactured at home or abroad would prevent the additional cost to importers (or exporters to the EU) being seen as a form of support for European businesses or a penalty on businesses exporting to the EU and would make the mechanism compatible with WTO principles.
Aligning the fight against climate change with the demands of international trade requires the EU, as well as finding a shared approach within its single market, to step up diplomatic efforts to persuade its trading partners of the benefits of greater multilateral cooperation in pursuit of carbon neutrality. Before they can congratulate themselves on having created a new own resource to fund the EU’s budget, Europeans will have to succeed in this diplomatic offensive, hampered by third country perceptions that it is little more than a protectionist campaign.
Memorandum written by Thaïs Massei, eurozone intern, under the supervision of Paola Monperrus‑Veroni
 The sum of domestic and imported emissions net of exported emissions.
The lurking BEAST: the ECB's risk scenario and its implications
The consensus eurozone GDP growth forecast for 2021 has been upgraded in December: at 4.8% it is still very optimistic, though the consensus forecast for 2022 has been downgraded slightly, anticipating growth of 3.1%. The OECD, on the other hand, is more cautious on the short-term outlook. In its December forecasts, it projected growth of 3.6% in 2021 and 3.3% in 2022, with GDP returning to pre-crisis levels at the end of 2022.
The ECB's missed opportunity: gearing up for the next war… or the last one?
Expectations as regards changes in the ECB’s monetary policy reaction function were modest. Most observers had priced in the fact that the conclusions of the ECB’s strategic review would not go as far as those of the Fed in terms of changing the institution’s objectives and instruments.
And the Fed had already delivered a dose of disappointment. Its new average inflation targeting strategy lacked precision: by not specifying the time period over which the average was calculated, it left lingering uncertainty (quickly captured by markets) as to just how far the US central bank would be prepared to tolerate higher inflation. Moreover, while the Fed’s strategic review provided an explanation of the past dynamics that had resulted in lower inflation and a lower equilibrium interest rate, it did not ask many questions about the future and whether those trends could and should be projected forwards.
For the ECB, the need to develop a shared narrative about why its target had been consistently missed in the past was even more pressing: its credibility was on the line more than the Fed’s. The ECB has less flexibility to act, and the consequences – not only redistributive but also political – of divergences in national inflation trajectories are more significant in a monetary union. An analysis of the drivers of these divergent price, income and productivity trajectories and their impact on the conduct of monetary policy would have been desirable.
The ECB has clearly identified that a large part of the reason why inflation is less sensitive to monetary policy and economic activity lies in the slippage in inflation expectations. To anchor inflation expectations, it is therefore necessary to develop a very clear narrative on past mistakes, the over-dependence of the ECB’s policy on the personality and beliefs of its governor, the causes of this slippage and the way past inflation influences future inflation.
But looking at the past is not enough. A strategic review must, by definition, be forward-looking, since it will shape action to be taken over the coming decades. Monetary policy must be based not on what has happened but on what will happen. The resulting policy trajectory is both pre-emptive and time-consistent.
We know that, in the period that followed the great economic and financial crisis, slack in the economy was underestimated, the equilibrium interest rate fell, inflation expectations became more sticky and the Phillips curve flattened. Against this backdrop, it made sense to adopt a wait-and-see policy to allow time to understand underlying trends.
Today, concerns of a different nature are beginning to surface: a declining participation rate among older cohorts, entailing a decline in labour market slack; quickening productivity linked to digitalisation and the Covid crisis, which could boost potential growth and raise the equilibrium interest rate; rising inflation expectations on the back of price increases, even where these are temporary; and a non-linear Phillips curve that may steepen when unemployment is low.
It would therefore have been appropriate to ask some far-reaching questions. Are these trends established and permanent? Could they be the very trends that will dominate over the coming decades? If so, the cost of a monetary policy too firmly wedded to a wait-and-see philosophy could increase.
These questions are admittedly more relevant to the United States than the eurozone. Nevertheless, the ECB might have been expected to answer one crucial question: are the key trends that have constrained central banks’ room for manoeuvre over the past few decades likely to persist over the coming decades (or even just the coming years)?
More specific questions should also have been asked about monetary policy instruments. Besides a comprehensive understanding of the dynamics underpinning inflation, there is also a need to develop a detailed understanding of the relationship between the ECB’s actions and its objectives, the effectiveness of monetary policy instruments and the results of the various potential targets and their assorted interpretations.
We think about these questions every day, drawing on the latest academic debate. We had been expecting answers from the Fed’s analysis, and the ECB’s even more so. We – and with us all those who were looking for solid foundations on which to build their medium-term expectations – were disappointed.
Without this kind of clarification, without guidance on expectations and with the little additional room for manoeuvre the ECB has allowed itself, the weight of the challenge of supporting potential growth and inflation will fall on fiscal policy. And, in this regard, one might legitimately wonder how much room the fiscal authorities will have to achieve these objectives so as to be able to regain some monetary policy leeway.
World – Macroeconomic Scenario for 2021-2022: a (very) disorderly exit from the crisis
While the United States prepares to take a generous lead, the Eurozone, where each country seems to be heading down its own path to recovery, is lagging behind, and fragmentation continues in emerging markets. The Fed looks on serenely as long-term interest rates rise, but the ECB seems more concerned. Once the inflationary push dissipates, accommodating monetary policy does leave room for a less ‘disordered’ and more gradual increase in long-term rates, regardless of any ‘reflation trade’.
World – Macroeconomic Scenario for 2021-2022: painfully divergent trajectories
Before we provide hasty diagnoses about the fallout from a crisis that will continue to impact us for some time, but that remains difficult to see (and analyse), there is cause for optimism in the short term. Growth is returning and strengthening. But let's save our enthusiasm for developed markets, given how fragmented emerging markets still are. US monetary tightening is expected to start earlier, and should remain gradual and measured: tapering first, then interest rates, and not before 2023. It is unlikely to set off any storms on the markets.
Italy – 2021-2022 Scenario: the year of recovery
There's an air of optimism blowing through Italy even as the Delta variant appears to be battering Europe. Will 2021 mark a turnaround for Bel Paese? After a second quarter when growth was fettered by lingering pandemic restrictions in April, all the elements are in place for a summer economic rebound.