It is time for the ECB to depart from orthodoxy!

Since ChatGPT burst onto the scene in late 2022, AI has both invigorated and transformed the economy. The amount of investment needed to install AI by end-2030 is expected to be seven times greater than the investment during the internet bubble, in constant USD.¹ In Europe, the dearth of AI multinationals stands to limit the boost to the economy, but the rearmament that Trump is imposing on the region will serve as another growth driver. Meanwhile, the increasingly frequent extreme weather events across the northern hemisphere and the failure of carbon-emissions reduction policies will result in heavy spending to adapt to climate change. These three factors will provide welcome sources of growth for the global economy. What’s more, inflation has the wind in its sails: the increasingly belligerent geopolitical climate is pushing up the prices of oil and petroleum derivatives, disrupting supply chains, and ushering anti-immigration parties into power. In the coming years, we could therefore see strong nominal GDP growth as a result of high real GDP growth plus lastingly higher inflation. What would this shift in macroeconomic conditions mean?

The economic trajectory taking shape before us is very different from the one that prevailed in the previous two decades, which were marked by weak GDP growth, anaemic inflation, persistently low interest rates, and a relentless expansion in public debt to the point where it’s starting to look unsustainable. Given the prospect of a decent growth rate in the global economy, it could be time to take an iconoclastic view and ask the following question: if weak GDP growth, low inflation, and low interest rates resulted in an upswell in public debt, then wouldn’t the opposite conditions – stronger GDP growth, sticky inflation, and higher interest rates – give us the perfect opportunity to reduce public debt? Recent experience shows this could be the case. Global public debt fell from 100% to 93% of global GDP between 2020, at the height of the pandemic, and 2024² – a period of high inflation and robust real GDP growth. A dig back through economic history reveals that many developed countries saw a decline in public debt towards the end of the 30-year post-war economic boom, when both inflation and GDP growth were high. More recently, countries including Spain, Italy, and Switzerland were able to shrink their debt levels around the turn of this century when both components of nominal GDP growth – that is, inflation and real GDP growth – were firm.

The mechanism behind a drop in public debt is relatively simple: a country’s debt-to-GDP ratio falls when its nominal GDP growth is high enough above its average borrowing cost to cover its primary deficit.³ It’s also important to prevent inflation expectations from becoming unanchored in order to keep a lid on interest rates. This combination of factors is precisely what occurred after the pandemic. Italy, Spain, and other European countries were able to steadily reduce their public debt – a process that’s continuing today – thanks to solid real GDP growth, resilient inflation, and a shrinking fiscal deficit. They’ve been helped by the ECB’s policy rates, which are low relative to the inflation and economic-growth rates in those two countries. Rates have been “too low,” but over time this decision has proved its merits. France, on the other hand, followed the opposite trajectory – its nominal GDP growth slid to nearly its average borrowing cost, while its fiscal deficit widened and public debt skyrocketed.

For public debt to keep shrinking, the ECB needs to update its monetary policy and give up some of the habits it acquired when inflation was low and economic growth was sluggish – habits that include the highly arbitrary 2% inflation target. By clinging to this simplistic orthodoxy – which we might even say lets the ECB of the hook – the central bank risks preventing GDP from growing at a potentially robust pace thanks to clearly identified drivers, but without achieving the goal of eliminating inflation, now that inflation has become partly structural owing to confirmed demographic and geopolitical trends. In this climate, a 2% target doesn’t make sense. The ECB’s mandate is based exclusively on price stability, which gives it little scope for accommodating periods of high nominal GDP growth. However, the Fed’s dual mandate – based on price stability and full employment – gives it much more flexibility in handling inflation. In fact, inflation has exceeded the Fed’s target every month for over five years.⁴ GDP has grown by a total of 8.0% in the US since 2023⁵ versus just 2.7% in the eurozone. Because the ECB doesn’t have a US-style dual mandate and is unable to bolster nominal GDP growth since its hands are tied by an inflation constraint, Europe could be letting a rare opportunity pass by to both kick-start GDP growth and reduce public debt.

Revising the Treaty on the Functioning of the European Union in order to change the ECB’s mandate is a long process, beginning with a proposal for revision by one of the Member States. But such a proposal would at least have the advantage of sparking what is a very important debate. The only battles you’re sure to lose are the ones you do not fight.