The Question of Debt Sterilization is not for Today. But it Needs to be Discussed

Yesterday I read an interesting FT piece (signed by the editorial board) arguing against debt cancellation. The piece is interesting and in my opinion its title (The case against cancelling debt at the ECB) is misleading. Summarizing, the piece argues that today countries like Italy have no market access problem, that spreads and interest rates are at an all time low, that debt cancellation would not free cash for Italian immediate needs. This are all reasonable arguments, but they would be relevant in assessing benefits of debt cancellation for a country facing a sovereign debt crisis. The current discussion on debt cancellation is nothing of that sort. It is more similar to debates that in the past were common after extraordinary shocks such as wars or… pandemics.

So, what is wrong with the FT way to approach the issue of debt cancellation (or sterilization, as I would prefer to call it for reasons to be clear below)? First, the excessive focus on Italy is off the mark. Any serious discussion on sterilizing the exceptional debt that was generated by the contrast to the pandemics should concern all EMU countries. All of them have had a spike in deficit and debt. Second, as I said, the piece focuses on the short run arguing that debt sterilization would not bring fresh cash. Of course it would not, and of course it would not be needed. EMU public debt is today (and for a long period to come) in excess demand. On top of that, we learned yesterday to no surprise that the ECB will keep the PEPP umbrella open for a while: March 2022 at the earliest, with no tapering to begin before 2023.

Thus, the discussion should not be on short term market access or liquidity needs (nor on the macroeconomic impact of debt sterilization in the current situation). Sterilizing the EMU pandemics-related public debt is a medium term issue, related to future fiscal space. The question to ask is whether the exceptional stock of debt that built in the past few months will constrain EMU countries in their ordinary fiscal policies in the future. If the answer is yes (I believe it is), then sterilizing that debt is eventually going to be an issue to be dealt with. And in that case it is hard to imagine that the ECB will not be part of the solution. In the end, this is what the FT editorial board seems to suggest too (this is why the piece is more nuanced than the title would make it believe), when they argue that

Italy could act by itself to make its debt easier to deal with over the long run, in case the ECB ever decides to sell its holdings back to the private sector and rates go up. In particular it could issue much longer dated debt to lock in the current low rate of funding, and gain more time to fix the country’s sluggish growth rate. Italy could even try to sell perpetual debt.

In short, the piece suggests that extending the maturity of debt (in principle to perpetuity) should be a strategy for the medium term. If the ECB were to buy that debt, we’d have monetization.

As a side note: The macroeconomic impact of cancellation and of monetization are alike. But cancellation poses a number of (mainly political) issues. I think it is wise to take it off the table and discuss pros and cons of a permanent increase of the ECB balance sheet size. Furthermore, I do not enter into the issue of monetization vs QE (that yielded “reservization”). That issue is very neatly addressed by my colleagues Christophe Blot and Paul Hubert (in French).

The FT editorial board then goes on with a discussion of helicopter money (making a link with debt write-off that I don’t quite see, but whatever) in managing deflationary pressures; once again the verbatim is instructive:

There may be monetary reasons to cancel government debt holdings. Many economists argue that “helicopter money” — a permanent increase in the money supply, likened by the economist Milton Friedman to central bankers dropping cash from a helicopter — will be necessary to rescue the eurozone from potential deflation. This would be most easily enacted by simply writing down the ECB’s existing holdings of government debt to zero. Any move towards this policy should come from central bankers keen to hit their inflation targets and not politicians playing with populist slogans.

What is interesting is the last sentence of the paragraph: The initiative should come from the ECB in pursuing its objectives, not from governments. I made the exact same point a couple of days ago (in Italian, unfortunately). Interestingly, the strong independence of the ECB in this case could help in making the one-off nature of monetization credible and to avoid triggering expectations of fiscal dominance.

So in the end the FT editorial board case against cancellation boils down to timing and to the opportunity that politicians (especially Italians) bring it up now. But the FT acknowledges that the issue of dealing with the Covid related extra debt is on the table and that some sort of ECB sterilization of that debt may in the future be part of the equation.

I am perfectly fine with this article. In spite of the title!

A Plea for Semi-Permanent Government Deficits

Update (1/7/2016): The whole paper is now available on Repec.

I have recently written a text on EMU governance and the implementation of a Golden Rule of public finances. I will provide the link as soon as it comes out. The last section of that paper can be read stand alone (with some editing). A bit long, I warn you, but here it is:

Because of its depth, and of its length, the crisis has triggered an interesting discussion among economists about whether the advanced economies will eventually return to the growth rates they experienced in the second half of the twentieth century.
One view, put forward by Robert Gordon  focuses on supply-side factors. Gordon argues that each successive technological revolution has lower potential impact, and that in this particular moment, “Slower growth in potential output from the supply side, emanating not just from slow productivity growth but from slower population growth and declining labor-force participation, reduces the need for capital formation, and this in turn subtracts from aggregate demand and reinforces the decline in productivity growth.”

In a famous speech at the IMF in 2013, later developed in a number of other contributions, Larry Summers revived a term from the 1930s, “secular stagnation”, to describe a dilemma facing advanced economies. Summers develops some of Gordon’s arguments to argue that lower technical progress, slower population growth, the drifting of firms away from debt-financed investment, all contributed to shifting the investment schedule to the left. At the same time, the debt hangover, accumulation of reserves (public and private) induced by financial instability, increasing income inequality (on that, I came first!), tend to push the savings schedule to the right. The resulting natural interest rate is close to zero if not outright negative, thus leading to a structural excess of savings over investment.

Summers argues that most of the factors exerting a downward pressure on the natural interest rate are not cyclical but structural, so that the current situation of excess savings is bound to persist in the medium-to-long run, and the natural interest rate may remain negative even after the current cyclical downturn. The conclusion is not particularly reassuring, as policy makers in the next several years will have to navigate between the Scylla of accepting permanent excess savings and low growth (insufficient to dent unemployment), and the and Charybdis of trying to fight secular stagnation by fuelling bubbles that eliminate excess savings, at the price of increased instability and risks of violent financial crises like the one we recently experienced.

The former IMF chief economist Olivier Blanchard has elaborated on the meaning of Summers’ conjecture for macroeconomic policy. If interest rates will remain at (or close to) zero even once the crisis will be over, monetary policy will continuously face the Scylla and Charybdis. The recent crisis is a good case study of this dilemma, with the two major central banks of the world under fire from some quarters, for opposiite reasons: the Fed for having kept interest rates too low, contributing to the housing bubble  and the ECB for having done too little and too late during the Eurozone crisis.

Drifting away from the Consensus that he contributed to consolidate, Blanchard concludes that exclusive reliance on monetary policy for macroeconomic stabilization should be reassessed. With low interest rates that make debt sustainability a non-issue; with financial markets deregulation that risks yielding more variance in GDP and economic activity; and with monetary policy (almost) constantly at the Zero Lower Bound, fiscal policy should regain a prominent role among the instruments for macroeconomic regulation, beyond the cycle. This is a very important methodological advance.

Nevertheless, in his plea for fiscal policy, Blanchard falls short of a conclusion that naturally stems from his own reading of secular stagnation: If the economy is bound to remain stuck in a semi-permanent situation of excessive savings, and if monetary policy is incapable of reabsorbing the imbalance, then a new role for fiscal policy may appear, that goes beyond the short-term stabilization that Blanchard (and Summers) envision. In fact, there are two ways to avoid that the ex ante excess savings results in a depressed economy: either one runs semi-permanent negative external savings (i.e. a current account surplus), or one runs semi-permanent government negative savings. The first option, the export-led growth model that Germany is succeeding to generalize at the EMU level, is not viable, except for an individual country implementing non cooperative strategies, because aggregate current account balances need to be zero. The second option, a semi-permanent government deficit, needs to be further investigated, especially in its implication for EMU macroeconomic governance

There are a number of ways, not necessarily politically feasible, to allow EMU countries to run semi-permanent government deficits. A first one could be to restore complete national budget sovereignty, (scrapping the Stability Pact). This would mean relying on market discipline alone for maintaining fiscal responsibility. As an alternative, at the opposite side of the spectrum, countries could create a federal expenditure capacity (which would imply the creation of an EMU finance minister with capacity to spend, the issuance of Eurobonds, etc.). Such an option is as unrealistic as the previous one. In an ideal world, the crisis and deflation would be dealt with by means of a vast European investment program, financed by the European budget and through Eurobonds. Infrastructures, green growth, the digital economy, are just some of the areas for which the optimal scale of investment is European, and for which a long-term coordinated plan would necessary. The increasing mistrust among European countries exhausted by the crisis, and the fierce opposition of Germany and other northern countries to any hypothesis of debt mutualisation, make this strategy virtually impossible. The solution must therefore be found at national level, without giving up European-wide coordination, which would guarantee effective and fiscally sustainable investment programs.

In general, the multiplier associated with public investment is larger than the overall expenditure multiplier. This is particularly true in times of crisis, when the economy is, like today, at the zero lower bound. With Kemal Dervis I proposed that the EMU adopts a fiscal rule similar to the one implemented in the UK by Chancellor of the Exchequer Gordon Brown in the 1990s, and applied until 2009. The new rule would require countries to balance their current budget, while financing public capital accumulation with debt. Investment expenditure, in other words, would be excluded from deficit calculation, a principle that timidly emerges also in the Juncker plan. Such a rule would stabilize the ratio of debt to GDP, it would focus efforts of public consolidation on less productive items of public spending, and would ensure intergenerational equity (future generations would be called to partially finance the stock of public capital bequeathed to them). Last, but not least, especially in the current situation, putting in place such a rule would not require treaty changes, and it is already discussed, albeit timidly, in EU policy circles.

To avoid the bias towards capital expenditure that the golden rule could trigger, we proposed that at regular intervals, for example in connection with the European budget negotiation, the Commission, the Council and the Parliament could find an agreement on the future priorities of the Union, and make a list of areas or expenditure items exempted from deficit calculation for the subsequent years.

A Piketty Moment

Update (10/27): Comments rightly pointed to different deflators for the two series. I added a figure to account for this (thanks!)

Via Mark Thoma I read an interesting Atalanta Fed Comment about their wage tracker, asking whether the recent pickup of wages in the US is robust or not.

The first thing that came to my mind is that we’d need a robust and sustained increase, in order to make up for lost ground, so I looked for longer time series in Fred, and here is what I got

This yet another (and hardly original) proof of the regime change that occurred in the 1970s, well documented by Piketty. Before then, US productivity (output per hour) and compensation per hour  roughly grew together. Since the 1970s, the picture is brutally different, and widely discussed by people who are orders of magnitude more competent than me.

[Part added 10/27: Following comments to the original post, I added real compensation defled with the GDP deflator.  While this does not account for purchasing power changes, it is more directly comparable with real output. Here is the result:

The commentators were right, the divergence starts somewhat later, in the early 1980s. This makes it less of a Piketty moment, while leaving the broad picture unchanged.]

Next, I tried to ask whether it is better for wage earners, in this generally gloomy picture, to be in a recession or in a boom. I computed the difference between productivity (output per hour) and wages (compensation per hour), and averaged it for NBER recession and expansion periods (subperiods are totally arbitrary. i wanted the last boom and bust to be in a single row). Here is the table:

Yearly Average Difference Between Changes in Productivity and in Wages
	In Recessions	In Expansions	Overall	% of Quarters in Recession
1947-2016	1.51%	0.40%	0.57%	15%
1947-1970	1.62%	-0.14%	0.19%	19%
1970-2016	1.42%	0.67%	0.76%	13%
1980-1992	0.64%	0.84%	0.81%	17%
1993-2000	N/A	0.68%	0.68%	0%
2001-2008Q1	4.07%	1.10%	1.41%	10%
2008Q2-2016Q2	2.17%	0.12%	0.49%	18%
Source: Fred (my calculations)
Compensation: Nonfarm Business Sector, Real Compensation Per Hour
Productivity: Nonfarm Business Sector, Real Output Per Hour

No surprise, once again, and nothing that was not said before. The economy grows, wage earners gain less than others; the economy slumps, wage earners lose more than others.  As I said a while ago, regardless of the weather stones keep raining. And it rained particularly hard in the 2000s. No surprise that inequality became an issue at the outset of the crisis…

There is nevertheless a difference between recessions and expansions, as the spread with productivity growth seems larger in the former. So in some sense, the tide lifts all boats. It is just that some are lifted more than others.

Ah, of course Real Compensation Per Hour embeds all wages, including bonuses and stuff. Here is a comparison between median wage,compensation per hour, and productivity, going as far back as data allow.

I don’t think this needs any comment.

The Sin of Central Bankers

I read, a bit late, a very interesting piece by Simon Wren-Lewis, who blames central bankers for three major mistakes: (1) They did not see the crisis coming, while they were the only one in the position to see the build-up of leverage; (2) They did not warn governments that at the Zero Lower Bound central banks would lose traction and could not protect the economy from the disasters of austerity. (3) They may be rushing in declaring that we are back to normal, thus attributing all the current slack to a deterioration of the supply side of the economy.

What surprises me is (2), for which I quote Wren-Lewis in full:

Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy. In my view the biggest failure occurred very early on in the recession. Monetary policy makers should have said very clearly, both to politicians and to the public, that with interest rates at their lower bound they could no longer do their job effectively, and that fiscal stimulus would have helped them do that job. Central banks might have had the power to prevent austerity happening, but they failed to use it.

The way Wren-Lewis writes it, central banks were not involved in the push towards fiscal consolidation, and their “only” sin was of not being vocal enough. I think he is too nice. At least in the Eurozone, the ECB was a key actor in pushing austerity. It was directly involved in the Trojka designing the rescue packages that sunk Greece (and the EMU with it). But more importantly, the ECB contributed to design and impose the Berlin View narrative that fiscal profligacy was at the roots of the crisis, so that rebalancing would have to be on the shoulders of fiscal sinners alone. We should not forget that “impeccable disaster” Jean-Claude Trichet was  one of the main supporters of the confidence fairy: credible austerity would magically lift expectations, pushing private expenditure and triggering the recovery. He was the President of the ECB when central banks made the second mistake. And I really have a hard time picturing him warning against the risks of austerity at the zero lower bound.

And things are not drastically different now. True, Mario Draghi often calls for fiscal support to the ECB quantitative easing program. But as I argued at length, calling for fiscal policy within the existing rules’ framework has no real impact.

So I disagree with Wren-Lewis on this one. Central banks, or at least the ECB, did not simply fail to contrast the problem of wrongheaded austerity. They were, and may  still be, part of the problem.

The problem is one of economic doctrine. And as long as this does not change, I am unsure that removing central bank independence would have made a difference. Would a Bank of England controlled by Chancellor  Osborne have been more vocal against austerity? Would an ECB controlled by the Ecofin? Nothing is less sure…

 

Whatever it Takes Cannot be in Frankfurt

Yesterday I was asked by the Italian weekly pagina99 to write a comment on the latest ECB announcement. Here is a slightly expanded English version.
Mario Draghi had no choice. The increasingly precarious macroeconomic situation, deflation that stubbornly persists, and financial markets that happily cruise from one nervous breakdown to another, had cornered the ECB. It could not, it simply could not, risk to fall short of expectations as it had happened last December. And markets have not been disappointed. The ECB stored the bazooka and pulled out of the atomic bomb. At the press conference Mario Draghi announced 6 sets of measures (I copy and paste):

1. The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting from the operation to be settled on 16 March 2016.
2. The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25%, with effect from 16 March 2016.
3. The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, with effect from 16 March 2016.
4. The monthly purchases under the asset purchase programme will be expanded to €80 billion starting in April.
5. Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases.
6. A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility.

Items 1-3 depict a further decrease of interest rates. Answering a question Mario Draghi hinted that rates will be lower for a long period, but also that this may be the lower bound (sending markets in an immediate tailspin; talk of rational, well thought decisions). The “tax” the ECB imposes on excess reserves, the liquidity that financial institutions keep idle, is now at -0,4%. Not insignificant.

But the real game changer are the subsequent items, that really represent an innovation. Items 4-5 announce an acceleration of the bond buying program, and more importantly its extension to non-financial corporations, which changes its very nature. In fact, the purchase of non-financial corporations’ securities  makes the ECB a direct provider of funding  for the real sector. With these quasi-fiscal operations the ECB has therefore taken a step towards what economists call “helicopter money”, i.e. the direct financing of the economy cutting the middlemen of the financial and banking sector.

Finally, item 6, a new series of long-term loan programs, with the important innovation that financial institutions which lend the money to the real sector will obtain negative rates, i.e. a subsidy. This measure is intended to lift the burden for banks of the negative rates on reserves, at the same time forcing them to grant credit: The banks will be “paid” to borrow, and then will make a profit as long as they place the money in government bonds or lend to the private sector, even at zero interest rates.

To summarize, it is impossible for the ECB to do more to push financial institutions to increase the supply of credit. Unfortunately, however, this does not mean that credit will increase and the economy rebound. There is debate among economists about why quantitative easing has not worked so far. I am among those who think that the anemic eurozone credit market can be explained both by insufficient demand and supply. If credit supply increases, but it is not followed by demand, then today’s atomic bomb will evolve into a water gun. With the added complication that financial institutions that fail to lend, will be forced to pay a fee on excess reserves.

But maybe, this “swim or sink” situation is the most positive aspect of yesterday’s announcement. If the new measures will prove to be ineffective like the ones that preceded them, it will be clear, once and for all, that monetary policy can not get us out of the doldrums, thus depriving governments (and the European institutions) of their alibi. It will be clear that only a large and coordinated fiscal stimulus can revive the European economy. Only time will tell whether the ECB has the atomic bomb or the water gun (I am afraid I know where I would place my bet). In the meantime, the malicious reader could have fun calculating: (a) How many months of QE would be needed to cover the euro 350 billion Juncker Plan, that painfully saw the light after eight years of crisis, and that, predictably, is even more painfully being implemented. (b) How many hours of QE would be needed to cover the 700 million euros that the EU, also very painfully, agreed to give Greece, to deal with the refugee influx.

The Italian Job

A follow-up of the post on public investment. I had said that the resources available based on my calculation were to be seen as an upper bound, being among other things based on the Spring forecasts of the Commission (most likely too optimistic).

And here we are. On Friday the IMF published the result of its Article IV consultation with Italy, where growth for 2013 is revised downwards from -1.3% to -1.8%.

In terms of public finances, a crude back-of-the-envelop estimation yields a worsening of deficit of 0.25% (the elasticity is roughly 0.5). This means that in the calculation I made based on the Commission’s numbers, the 4.8 billions available for 2013 shrink to 1.5 once we take in the IMF numbers. It is worth reminding that besides Germany, Italy is the only large country who can could benefit of the Commission’s new stance.

And while we are at Italy, the table at page 63 of the EC Spring Forecasts (pdf) is striking. The comparison of 2012 with the annus horribilis 2009 shows that private demand is the real Italian problem.  The contribution to growth of domestic demand was of -3.2% in 2009, and -4.7% in 2012! In part this is because of the reversed fiscal stimulus; but mostly because of the collapse of consumption (-4.2% in 2012, against -1.6% in 2009). Luckily, the rest of the world is recovering, and the contribution of net exports, went from -1.1% in 2009 to 3.0% in 2012. This explains the difference in GDP growth between the -5.5% of 2009 and the -2.4% of 2012.

Italian households feel crisis fatigue, and having depleted their buffers, they are today reducing consumption. I remain convinced that strong income redistribution is the only quick way to restart consumption. Looking at the issues currently debated in Italy, this could be attempted  reshaping both VAT and property taxes so as to impact the rich and the very rich significantly more than the middle classes. The property tax base should be widened to include much more than just real estate, and an exemption should be introduced (currently in France it is 1.2 millions euro per household). Concerning VAT, a reduction of basic rates should be compensated by a significant increase in rates on luxury goods.

Chances that this will happen?