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What can happen if the scenario underlying all the economic policy measures to face the epidemic shock is not the right one? What could happen if the health crisis continues?

Philippe Waechter, director of economic research, Ostrum Asset Management, provides commentary from the European market.

What can happen if the scenario underlying all the economic policy measures to face the epidemic shock is not the right one? What could happen if the health crisis continues? Risk of hyperinflation is likely.

In Europe, states and central banks are ready to make every effort to make the impact of the epidemic as small as possible.

The constraint of the stability pact no longer exists, the deficits will widen since governments wish to substitute itself to the economic mechanisms the time necessary for the absorption of the shock. On monetary side, the ECB has launched a 750 billion euro plan and will buy, with all of its programs, around 1,000 billion assets in 2020. It will thus have considerable power on the bond market in the area Euro.

Governments are putting in place exceptional means to cope with the epidemic shock and the ECB will buy the assets issued by governments in order to keep interest rates very low.

The strongest assumption is that at the end of April the epidemic crisis will be over. The French Minister of Education, Jean Michel Blanquer, indicated in an interview, this Sunday, with the French newspaper “Le Parisien” that “the preferred scenario for school is a return to class on May 4”.

This means that on May 4, there are no more possible repeat cases.

If this scenario prevails then the choices that are made are credible and one can imagine a considerable collective effort to deal with almost 2 months of inactivity. The temporary measures (partial unemployment, deferral of charges, etc.) will have been of sufficient magnitude for the economy to start again in early May. The cost is high but this collective care is the least harm. As the ECB was active during the period, interest rates are low and financial conditions accommodating.

All the conditions would then be met for a return to growth which could even be encouraged by a recovery plan to put the economy back on the right path.

It may be too optimistic to think that in late April, the epidemic risk will have completely disappeared

Some analysis (see that of Imperial College London) suggest that this scenario is too optimistic and the hypothesis of emerging from the crisis, from the end of April, could be premature and too optimistic. The health crisis could be longer, forcing the containment strategy to be maintained until collective immunity has been observed or until there is a vaccine.

What could happen on the economic side?

The ECB’s 750 billion plan is a measure of the cost of the crisis if it lasts until the end of April.

A longer crisis would explode the cost, while at the same time, everyone’s confidence in governments may fade since the scenario that is emerging is not the one that was favored before.

On the government side, if the crisis is longer than expected, the choice will be either to stop all the measures because of the associated costs, or to extend them until the health situation finally stabilizes.

The first option implies that all the adjustments that have been postponed due to governments’ intervention will be made upon governments’ withdrawal.

Unemployment could then explode and civil society could be deeply destabilized. This may seem like the worst solution. The consequences of the deep shock on the activity were thus delayed but at the end, governments’ intervention lead to an unstable situation. It appears highly undesirable because of the economic cost and consequently of the political cost which could result from it .

It seems preferable to extend the measures taken in order to limit the risks of adjustments mentioned above.

Governments maintain their commitments

Government spending is growing at a very high rate and the intervention of the central bank is increasingly important. The monetization of public debt has never seemed so marked or so direct and visible for decades. Governments are even forced to step up the measures because the underlying economy is deteriorating for lack of recovery. Productive capital is gradually becoming obsolete and the perception, by all observers, is that the recovery that will emerge one day will not be up to the sums committed nor the expectations of all.

The acceleration of spending and its funding by the central bank then appear to be an ineffective strategy because the economy continues to deteriorate for lack of investment.

The risk is a loss of confidence in the money in the face of the excessive economic policy and the considerable issuance of money while the economy continues to deteriorate for lack of sufficient investment spending.

In 1923, in Germany, this situation resulted in a period of hyperinflation. This made it possible to erase the consequences of the First World War on the German economy and the difficulties in finding a good growth trajectory.

The risk is there. If the health crisis continues beyond April, governments will take over the economy more and more and the financing of the measures by the central bank will appear limitless.

Unconstrained and increasingly important financing in the face of an economy that no longer has the resources and the capacity to invest effectively in order to renew itself is likely to provoke a deep adjustment via very high inflation.

Economic agents will no longer have the feeling that due to the policy at work, a return to an equilibrium consistent with the one that prevailed before the crisis will be possible.

All the options are then possible and that of hyperinflation appears to be the most credible given the economic policy which, in fine and contrary to the credible commitments of the beginning of the health crisis, does not allow macroeconomic adjustments. At the same time, monetary financing continues on an unsustainable pace. All these elements are not mutually consistent and hyperinflation appears as a strong possibility.

The above article was originally published on Philippe Waechter's blog.

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