Germany’s longing for the Ancien Régime is a Threat for Europe

Note: this is a rough translation of a piece published on the Italian neswpaper Domani, with a few edits and additions.

While the campaign for the election captures all the attention of the Italian establishment, we should not stop looking beyond our borders. In particular, the lack of interest in what is happening in Germany is striking and worrisome. The difficulties Europe’s largest economy is experiencing will in fact have far more significant consequences for many European countries than their domestic political struggles.

Last week, the ministry of economy and ecological transition (headed by the vice-chancellor and number two of the Green party, Robert Habeck) published a report on the reform of the stability pact, which, although we tend to forget it, will be THE topic of the coming months. The guiding principles for reform that the report outlines are basically a re-proposal of the existing rule, as if the disasters of the sovereign debt crisis and the Covid tsunami were a parenthesis to be closed as soon as possible by returning to the old world.

Under a gleaming hood, the German engine has been in crisis for years

There will be time to return to the inadequacy of this proposal (Carlo Clericetti does it well in the Italian magazine Micromega) and to the issue of European governance. What I would like to emphasise here is that the German elites, with this frenzy to return to the past, do not seem to fully grasp at least two things: First, the fact that after the experience of the last ten years it is not possible to return to an idea of economic policy for which the only beacon is fiscal discipline, neglecting public investment, industrial policy, social protection and so on. Second, and this is more surprising, they do not grasp the fact that the German growth model seems to have hit its boundaries. As a reminder, we are talking about a model aiming at export-led growth, that was based on the one hand on the compression of domestic demand (with wages that for decades grew much less than productivity); on the other hand it was based on an export sector that took advantage of both the dualism of the labour market and of value chains rooted in the countries of the former Soviet bloc. Germany could therefore import intermediate goods and low-cost components and re-export finished products, often with a high technological content, to non-European markets. This is the main reason why it remained a manufacturing power while most advanced countries had to cope with de-industrialisation and relocation.
Many, including myself have criticised this model, which during the sovereign debt crisis Germany successfully managed to generalise to the rest of the eurozone. In 2020, in concluding an essay on Europe, I pointed out how that model has come to an end. The public and private investment deficit, the result of decades of self-imposed frugality, has progressively depleted the capital stock and reduced the competitiveness of German industry. Meanwhile, while the growth of emerging countries has helped to provide outlets for German goods, it has also seen these countries develop high value-added production that competes with German exporting firms. But there is more: I also noted that the progressive distortion of the ordoliberal model, the increase in inequality and precariousness (which contributes to demographic stagnation and to the ageing of population), and the growing dependence on foreign demand, more problematic than ever in an increasingly uncertain geopolitical context, have all contributed to making Germany a giant with feet of clay.

A Giant with Feet of Clay

Feet of clay that today are cracking. The bottlenecks that appeared during and after the pandemic, due to lockdowns and to the recomposition of global supply and demand, have (not surprisingly) proved to be more persistent than many expected. Furthermore, the acceleration of investment in the ecological transition, obviously welcome and all too late, creates shortages particularly in sectors that are key for the German economy, such as the automotive. Finally, geopolitical tensions, the slowdown in emerging economies, and of course the war in Ukraine greatly reduce the outlets for the German export sector and have laid bare the short-sightedness of the past German leadership’s choice to rely on Russian oil and gas, admittedly reducing costs, but creating a dependency for which the country is now paying the price. It is important, however, to emphasise again that the events of the last two years have only come to add to the structural problems of a model of growth and organisation of production that was beginning to show its limits even before the pandemic.

The German elites at a crossroads

In 2020, I concluded my essay by stating that the crisis of the German model could have been an opportunity for Europe, as it would have forced Germany to worry about the imbalances within the eurozone, to promote public and private investment, to rethink industrial policy, to support (German and European) domestic demand; not out of altruism, but to create a stable European market in an international context that had become structurally uncertain and turbulent. The heartfelt support for Next Generation EU seemed to confirm the feeling that something had changed in Germany. The recent turn of the German debate is therefore worrisome and should be looked at closely. Habeck’s paper and the recent stances of the Minister of Finances, the liberal Lindner, point to a kind of “ostrich syndrome” of the German elites, who seem to long for a return to the past in order not to have to deal with the structural problems of Germany and of European integration. If this tendency prevails, not only the German citizens but the whole of Europe, which will slip into irrelevance, will pay the price in the coming years. On the contrary, representatives of the German government at European tables need to be called upon to contribute to the rethinking of industrial and energy policy and public investment policies, to the development of a European welfare state, to the definition of budget rules that allow for active and sustainable policies, to the development of the internal market, to the completion of the banking union, and the list could go on. In short, an ambitious and wide-ranging European discussion is needed to make the German elites look away from their navels and try to restore Europe’s centrality at a time of great geopolitical turbulence (which will certainly extend well beyond the war in Ukraine). France and Italy, because of their size and the influence they have had in Europe in the recent past, would obviously play a key role in countering the return to the past of the German elites. This is why the absence of European issues from the (pre-electoral) Italian and (post-electoral) French debate cannot but cause concern.

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Christine Lagarde’s “Whatever it Takes… But” Might be a Wet Bullet Against Speculation

Note: this is a rough translation of a piece published on the Italian neswpaper Domani, with a few edits and additions.

On July 21st, the ECB definitively closed the emergency phase that began with Mario Draghi’s whatever it takes in 2012. The Frankfurt institution announced two important decisions. First, it raised interest rates for the first time in eight years, ending the anomaly of negative rates. The increase was more significant than the ECB had previously announced (half a point instead of a quarter). While it is true that a normalisation process had to begin, this acceleration is somewhat puzzling. Christine Lagarde and her colleagues have rushed to explain it by the need to signal to the markets that they are determined to return to 2% inflation in the medium term. However, since the ECB itself recognises that inflation is mainly imported and linked to energy and food prices, the tightening mainly sends a signal that the ECB is prepared to push the eurozone economy into recession in order not to appear weak in its fight against inflation.

Markets are not efficient

The second measure, the real novelty, is the anti-spread shield, on which the ECB has been working for the past few months. The TPI (Transmission Protection Instrument) should keep spreads under control and thus allow the ECB to fight inflation without generating instability on markets: if in the future speculation or markets’ panic movements were to lead to changes in sovereign interest rates that are not linked to the actual public finances’ state of health, the ECB will intervene and with its purchases will ensure that spreads are realigned with the so-called ‘fundamentals’. The anti-spread shield (anti-segmentation, in ECB terminology) should shelter eurozone countries from the speculation that, for example, we observed in the spring of 2012 and which led to Mario Draghi’s famous whatever it takes.
The introduction of the TPI is certainly a positive sign. With it, the ECB officially recognises what all non-ideologised economists have known for a long time: markets are often (too often!) unable to correctly assess the health of public finances. Between 1999 and 2010, for example, in the EMU the risk associated with the behaviour of some governments was not adequately taken into account and markets financed these countries at excessively low interest rates. Then, between 2010 and 2015, they went all the way to the opposite excess, demanding excessive yields that were in no way justified. In short, the introduction of TPI merely certifies the fact that markets cannot be relied upon to discipline eurozone countries’ fiscal policies.

The anti-spread shield is a wet cartridge

However, for the way the instrument is designed, the risk that it ends up being a wet cartridge is quite significant. The shield should mainly function as a mechanism to signal to markets that the central bank is ready to do whatever it takes to prevent speculation from pushing a State whose public finances are fundamentally sustainable into default. Just think of 2012, when Mario Draghi’s whatever it takes speech was enough to immediately calm speculation; those who had been trying to gain by pushing Italy and Spain into default understood that they would not succeed because the ECB was ready to intervene with unlimited purchases, allowing the two countries to continue to finance themselves; a sort of insurance, in short, whose announcement alone rendered speculation vain and quickly brought Spain’s and Italy’s spreads back to acceptable levels.

With the TPI the ECB would like to put in place a similar insurance mechanism, that nevertheless risks not being as effective. Let us see why. The ECB has announced that it will only intervene if the country’s debt is fundamentally sustainable, according to the criteria developed by the IMF and the World Bank in recent years. It could be argued that in certain situations it would also be desirable to intervene to rescue insolvent countries, to secure the system and allow for bankruptcy or debt restructuring under stable conditions. But putting this consideration aside, it is not illogical that the ECB does not want to serve as a backstop for fiscally irresponsible behaviour. However, for reasons probably related to the power struggle between hawks and doves in the bank’s Governing Council, the list of conditionalities is much broader. For instance, the country must comply with European fiscal rules and not be in excessive deficit procedure; or, again, be in compliance with the conditionalities related to the Next Generation EU National Recovery and Resilience Plans (NRRP). It is not clear what is the rationale for these conditions. Why, for example, should a country’s delay in passing a reform scheduled in its NRRP make its debt less sustainable and thus preclude it from accessing the TPI? Or, again, why should excessive private debt deprive the country of the shield, when it is precisely in the case of financial fragility of the country that a speculative attack on its sovereign bonds would be more likely? In short, these conditions seem to invoke the generic notion of a country’s trustworthiness which, in accordance with what Paul Krugman would call zombie ideas, is linked only to fiscal discipline and not to the general conformity of public policies with the objective of balanced and sustainable growth.
The TPI is thus a conditional shield, a sort of ‘whatever it takes… but‘ that might not work to stop speculation, since markets could always decide to test the ECB’s resolve not to intervene to protect a country. A lender of last resort (because this is what we are talking about) is only such if market participants never doubt its intervention. If it only does so under certain (tortuous) conditions, it risks being ineffective as a deterrent to speculation. But there is more: what would happen if a country not fulfilling the conditions were under attack and financial stability were at risk? Of course, the ECB would intervene, thus undermining its own credibility.

A European Debt Agency to control spreads

The TPI wet cartridge is further proof that one cannot continue to rely on the ECB to ensure at the same time the traditional tasks of monetary policy and the financial stability of a sovereign debt market that is segmented by its very nature (remember that as long as there is no real federal budget, fiscal policies will remain the almost exclusive competence of the member states). I have several times discussed the creation of a European Debt Agency that could protect member states from the mood of the markets while keeping them responsible for their fiscal policy choices. A debt agency (or a similar institution) would achieve the goals the ECB set itself with the TPI more efficiently, freeing the central bank itself from having to deal with spreads on top of everything else.

We Should Stop asking the ECB to carry the Eurozone on its Shoulders. It is time to Introduce New Tools for Debt Management

In the past couple of years I have had a hard time to feed this blog with original content. I have therefore decided that I will post the English translation of pieces that I write for other outlets; sometimes (always??) the translation will be rough I will start, today, with an article published in the Italian daily Domani on the ECB own impossible trinity (growth, supply-side inflation, spreads).

The last few weeks have shown beyond any doubt how complicated the task of central banks has become. In normal times, inflationary pressures go hand-in-hand with an overheating of the economy caused by increases in spending (public or private, it matters little); therefore, restrictive policy simultaneously achieves the result of keeping price increases in check and cooling demand. But we do not live in normal times. In a world of increasing geopolitical risks and supply-side shocks (the pandemics, the disruption of supply chains, structural change related to the ecological and digital transition), the two objectives of growth and inflation become contradictory: central banks are forced into complicated balancing acts to try to reduce an inflation they have few tools to control, without causing a collapse in consumption and investment that would send the economy into recession.
Even in the United States, where at least some of inflation is due to the overheating of the economy, it is difficult to understand the logic of the recent acceleration in tightening: the risk that the Fed’s moves will cause a recession in the coming quarters is real. In the Eurozone the demand push is less pronounced; in addition, the ECB’s task is further complicated by the coexistence of a single monetary policy with the nineteen fiscal policies of member countries, and the resulting risk of financial instability and segmentation of sovereign debt markets. Thus, not only must the ECB decide how far it is willing to take the risk of sending the economy into recession to try to keep inflation in check; it must also be prepared to manage the consequences its actions have on spreads.

Certainly, the turmoil of the past few weeks is due to less than flawless communication, which has given markets the feeling of an ECB uncertain about what to do. Moreover, it is frankly astounding to discover, when markets are already in panic mood, that the ECB is thinking about an anti-spread shield; the shield should have been ready months ago, to be deployed as soon as the announcement of a turn toward a restrictive stance had created tensions in the markets, which were widely predictable. However, mistakes and delays cannot hide the fundamental problem: the ECB is now asked to perform its classical tasks of closing the inflation and the output gap while ensuring the stability of financial markets, in the face of a fiscal policy that always does too little and too late. Even with firmer leadership and greater cohesion within the governing council, the ECB could not carry the entire weight of the Eurozone on its shoulders; especially in turbulent times such as we are currently experiencing. The erratic communication, the feeling that the ECB is perpetually behind the curve, then, cannot be attributed to the clumsiness of Christine Lagarde or to conflicts between hawks and doves; the ECB is probably being asked to do the impossible.

How do we get out of this? First, in the fight against inflation, monetary policy needs to be assisted by industrial policies that remove bottlenecks and release some of the supply constraints Second, the risk of segmentation of sovereign debt markets needs to be reduced. For this, the EMU should move forward decisively with the creation of a central fiscal capacity. Replacing part of the member states’ debt with common borrowing would not only stabilize financial markets with a safe asset, but also mechanically reduce the segmentation of sovereign bond markets.
However, the complete normalization of monetary policy could only take place with a solution that unburdens the ECB of the goal of keeping spreads under control. While the stated intention of creating an anti-spread tool is commendable, it will probably keep interfering with the classical tasks of central banks. One (only seemingly radical) way out is to establish a European Debt Agency (EDA). This agency would form a diaphragm between the member countries, to which it would offer perpetual loans, and the markets, from which it seek financing issuing Eurobonds. The EDA would protect member countries from the irrationality of markets while ensuring, through appropriate modulation of interest installments on loans over time, that national governments remain fully accountable for their fiscal behaviour: less virtuous countries (e.g., that fail to comply with fiscal rules) would be called upon to pay higher interest. The debt mutualization so feared by the so-called frugal countries would therefore be avoided. This is only a seemingly radical solution because in the recent past it has become customary for European institutions (the ESM, SURE, even Next Generation EU) to borrow at preferential rates and then transfer those rates to member states, effectively acting as guarantors and intermediaries. The European Debt Agency would take this mechanism to its extreme consequences.
The establishment of the European Debt Agency would create a single European sovereign debt market, mimicking the operation of a federal system. This on the one hand would provide the markets with a safe asset and, as in the United States, reduce the risk of speculative attacks to virtually zero. On the other hand, it would free monetary policy from the task of having to keep spreads down. The ECB would be free to set interest rates and decide of the size of its balance sheets with in mind only a central bank’s own goals of keeping inflation low and supporting growth. This seems the only structural way out of the present difficulties.

Zombie Arguments Against Fiscal Stimulus

Busy days. I just want to drop a quick note on a piece just published on the Financial Times that is puzzling on many levels. Ruchir Sharma pleads against Joe Biden’s stimulus on the ground that it risks “exacerbating inequality and low productivity growth”. The bulk of the argument is in this paragraph:

Mr Biden captured this elite view perfectly when he said, in announcing his spending plan: “With interest rates at historic lows, we cannot afford inaction.”

This view overlooks the corrosive effects that ever higher deficits and debt have already had on the global economy. These effects, unlike roaring inflation or the dollar’s demise, are not speculative warnings of a future crisis. There is increasing evidence, from the Bank for International Settlements, the OECD and Wall Street that four straight decades of growing government intervention in the economy have led to slowing productivity growth — shrinking the overall pie — and rising wealth inequality.

If one reads the two papers cited by Sharma, they say, in a nutshell, (a) that expansionary monetary policies have deepened income inequality via an increase in asset prices (while for low interest rates and bond prices there is no clear link); (b) that the increasing share of zombie firms drags down the performance of more productive firms thus slowing down overall productivity growth.

So far so good. So where is the problem? Linking these results to excessive debt and deficit, to the “constant stimulus”, is stretched (and I am being kind). A clear case of Zombie Economics.

Let’s start with monetary policy and its impact on inequality (side note: the effect is not so clear-cut). One may see expansionary monetary policies as the consequence of fiscal dominance, excessive deficit and debt that force central banks to finance the government. But, they can also be seen as the consequence of stagnant aggregate demand that is not properly addressed by excessively restrictive fiscal policies, forcing central banks to step in. Many have argued in the past decade that especially in the Eurozone one of the causes of central bank activism was the inertia of fiscal policies. Don’t take my word. Read former ECB President Mario Draghi’s Farewell speech, in October 2019:

Today, we are in a situation where low interest rates are not delivering the same degree of stimulus as in the past, because the rate of return on investment in the economy has fallen. Monetary policy can still achieve its objective, but it can do so faster and with fewer side effects if fiscal policies are aligned with it. This is why, since 2014, the ECB has gradually placed more emphasis on the macroeconomic policy mix in the euro area.

A more active fiscal policy in the euro area would make it possible to adjust our policies more quickly and lead to higher interest rates.

This is as straightforward as a central banker can be: in order to go back to standard monetary policy making, fiscal policy needs to step up its game. Notice that Draghi also hints to another source of problems: the causality does not go from expansionary policies to low interest rates, but the other way round. We have been living in a a long period of secular stagnation, excess savings, low interest rates and chronic demand deficiency which monetary policy expansion can accommodate by keeping its rates close to “the natural” rate, but not address. Once again, fiscal policy should do the job.

Regarding zombie firms, it is unclear, barring the current and very special situation created by the pandemics, why this would prove that stimulus is unwarranted. The paper describes a secular trend whose roots are in insufficient business investment and a drop in potential growth rate (that in turn the authors link to a drop in multi-factor productivity). The debate on the role of fiscal policy in these matters is as old as macroeconomics. In the past ten years, nevertheless, the cursor has moved against the Sharma’s priors and an increasing body of literature points to crowding-in effects: especially when the stock of public capital is too low (as is the case in most advanced countries), an increase of public investment — “constant stimulus”– has a positive impact on private investment and potential growth (see for reference the most recent IMF fiscal monitor and the chapter by EIB economists of the European Public Investment Outlook). Lack of public investment is also widely believed to be one of the factors keeping our economies stuck in secular stagnation.

Fifteen years ago one could have read Sharma’s case against fiscal policy on many (more or less prestigious) outlets. Even then, it would have been easy to argue that it was flawed and fundamentally built on an ideological prior. Today, it seems simply written by somebody living in another galaxy.

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!

The ECB Umbrella is here to stay

On December 10th the European Central Bank Governing Council will likely announce new measures to support governments that have to reach to their wallet again to try to cope with the economic effects of the pandemic second wave. It would not be surprising that the ongoing asset purchase programmes will be extended in size and duration (currently, the Pandemic Emergency Purchase Program, PEPP, is scheduled to run until June 2021). There have been rumors in recent days that the ECB could use this increase in its firepower to put pressure on countries that do not wish to make use of loans from the Recovery Fund and the ESM. ECB board member Yves Mersch yesterday also suggested that the ECB walk that path.

For those who are not into the European debate, it should be recalled that using the loans from European programmes (the ESM covid line, the SURE, and the quota of the Recovery Fund that is not grants) yields savings in interests: the EU will borrow on the markets at more favourable costs than many Member States and redistribute the amounts. If market rates are low, the gain in interest from European loans is reduced and may not be sufficient to offset the fact that these loans come with terms and conditions (and further problems in the case of the ESM). By reducing its purchases of reluctant countries’ assets, the argument goes, the ECB would raise market rates and thus make it convenient, if not inevitable, for them to use financing from European programmes.
I believe that it is very unlikely, if not impossible, that the ECB would engage in such nudging. Its umbrella will remain open for all eurozone countries for a long time to come. Instead of worrying about the presumed unsustainability of the debt that all European countries are accumulating, we should focus on how to spend the money quickly and well. Sustainability depends more on this than on unlikely ECB pressures or unlikely sudden reversals of market confidence.

There are three reasons to doubt that the ECB will use its purchasing programmes to interfere in the financing choices of European Governments. The first reason is technical. Since the Quantitative Easing program started in 2015, purchases of each country’s securities have been proportional to the so-called capital key, the shares of EMU countries in the capital of the ECB, which in turn are linked to population and GDP. This self-imposed proportionality was the price to be paid to avoid that the purchases were concentrated on peripheral countries’ securities, allowing them to pass on their debt to the supposed frugals through the ECB. When last March the new emergency purchase programme was introduced, the ECB relaxed the capital key so that purchases could initially focus on the debt of countries subject to market pressure and (contrary to what Lagarde has suggested just days before) keep spreads under control. However, even in this case, the ECB did not embrace complete discretion, as flexibility was only temporary: at a later stage purchases will have to be rebalanced in order to respect the self imposed proportionality at the end of the programme. Deciding now to move away from the capital key to put pressure on countries that do not want European loans would most likely meet the opposition of the core countries, that feel protected by them. It is interesting that Mersch himself, a few days before suggesting proportionality were scrapped to nudge Member States into EU loans, argued in an interview that “We are bound not by self-imposed limits but by red lines which are of a constitutional nature and which are in the treaty. The self-imposed limits only serve to respect those constitutional limits, which are not at our disposal.”

The second reason why ECB nudging is unlikely has to do with the current macroeconomic situation. One might in fact argue that, pretty much as in the current PEPP, flexibility and nudging could happen in the short run to eventually restore the capital key. But contrary to what many believe, today the ECB necessary to keep rates low. The crisis has generated an enormous mass of savings which, given the economic uncertainty, has mostly been channeled into demand for public debt of all countries. In October’s auctions alone Italy, one of the most problematic EMU countries when it comes to public finances’ sustainability, placed debt at different maturities (with rates close to zero) for around 33 billion euros against a market demand of more than 55 billion euros . Of course, it would be foolish to neglect the role of monetary policy: the ECB’s umbrella has contributed to making public debt safe and therefore attractive. But it is certainly not the only factor; the abundance of savings is increasingly a feature (and a problem) of our economies.
Last, but not least, political reasons, that encompass all th others, reduce the risk of ECB interference in countries’ financing choices. Since 2012, while it has struggled to convince markets of its credibility in sustaining growth and keeping inflation close to its target, the ECB has been very effective in curbing speculation. Ever since Mario Draghi’s 2012 whatever it takes speech, all it took to stop market pressure on peripheral countries, was the certainty that the ECB was ready to do everything (whatever it takes) to prevent speculative attacks to keep markets at bay, make public debt attractive and reduce spreads. A sort of (imperfect) lender of last resort, in sum. Even the PEPP programme, after some massive initial purchases, has settled on limited flows and proportionality is already almost restored. It is frankly quite implausible that the ECB will deliberately risk to increase uncertainty and let spreads widen again, squandering an hard-earned credibility capital just to push hesitant countries to apply for loans from European programmes.

Long story short, the ECB’s umbrella is set to remain open for a long time to come and will contribute, along with the mass of savings in search of placement, to keep the cost of debt low. We should resist getting entangled in the debate on how to finance (and repay) public debt, and focus on the use of the resources available. European countries need to efficiently invest in tangible and intangible infrastructures that will enable us to set out on a path of sustainable and sustained growth. After all, a healthy economy is the best guarantee of sustainable public debt.

There is no Trade-off. Saving Lives is Good for the Economy

At the beginning of the COVID pandemic, when policy makers were struggling to find ways to cope with a crisis that most of them had under estimated, the public discourse was dominated by a trade-off: should we shut down economic activity to enforce/facilitate social distancing and curb the pandemic curve before it leads to the collapse of health care systems, and to deaths by the hundreds of thousands? Or should we just let the death toll be what it has to be, and let the virus pass through our countries (build “herd immunity”), avoiding severe economic consequences? To put it somewhat brutally, should we save lives or the economy? This trade-off certainly is in the minds of most governments, even if most of them carefully avoided letting it surface in their public discourse. The countries that stopped the economy justified it as the price to pay “to save lives”; just a handful of governments made it explicit that they had made the opposite choice. The most reckless undoubtedly was Boris Johnson who initially argued that the best strategy was to build herd immunity by letting the virus reach 4O millions people, whatever the cost in human lives would be. Trump and Bolsonaro (a merry fellowship indeed) had a very similar stance, minimising the cost at first, and then arguing that the economy should not be stopped. But many other countries in Europe, with the same trade-off in mind, delayed going into lockdown in spite of Italy spiraling into the crisis just around the corner. They simply were less impudent than the British PM, while considering the same strategy.

It is reassuring that for most countries reality (and opinion polls) caught up, so that strategies eventually converged to giving priority to the health crisis over the economy: more or less compulsory social distancing, and the freeze of economic activity are now generalized, with almost half of the world population under lockdown.

This is reassuring not only because priority should be given to saving human lives. But also because, as I have always believed, the trade-off between public health and the economy is complete nonsense. I was glad to read a piece by Luigi Guiso and Daniele Terlizzese (in Italian) making this point. I just wish that they (or somebody else, including myself) had made it before. This would have been an immensely more valuable contribution by economists, than playing epidemiologists and fitting exponential curves on social networks (I never did!).

But why is the trade-off nonsense? Simply put, because the pandemic will cause enormous harm to the economy, whether it claims lives by the millions or not. Suppose the BoJo initial strategy was implemented, and a few dozens millions of British people were infected, many of them for several weeks. Abstracting from fatality rates, labour supply would drop for months, and disruption in production would follow. Fear of contagion would limit social interaction (a sort of self-imposed confinement) for many, impacting consumption, investment, but also productivity. Some sectors (travel, tourism, services) would see significant drops in activity. The global value chains would be disrupted, and trade would take a hit. Furthermore, the collapse or near-collapse of health care systems would impact the quality of life (and sometimes cause the death) not only of those affected by the virus, but also of the many that in normal times need to resort to health care services. Consumer confidence and corporate sentiments would remain low for months, consumption and investment would stagnate, government intervention would be needed as much as it is needed in the lockdown. Last, but not least, the heavy toll paid to the pandemic crisis would impact human capital (think of casualties among doctors), and thus productivity and growth in the long run.

A slowdown would therefore be inevitable, a harsh one actually. But still, it could be argued that such a scenario would not be worse than the total halt we are experiencing. I beg to disagree. Let me go back to Mario Draghi’s piece in the Financial Times. The former ECB boss there argues that the urgent task of policy makers is to keep the businesses that are short of liquidity afloat whatever it takes, so that when the rebound will happen, the productive capacity will be able to provide goods and services, and incomes will recover quickly. Said it differently, if policy makers manage to minimize permanent damage to the supply side of the economy, a short lived shock, however brutal, might leave few scars.

But there is more than that. In fact, the minimization of permanent damage becomes harder and harder, and probably costlier and costlier, the longer the crisis is. Following the crisis of 2008-2010, an interesting literature developed on the permanent effects of crises. This literature highlights how long and low-intensity slumps have an impact through hysteresis on the capital (human and physical) of the economy and permanently lower the potential growth of the economy. The conclusion to be drawn from this literature is that the risk of letting the economy in a slump for too long, and hence suffer permanent damage, is larger than the risk of over reacting in the short-run.

Applying this mindset to the current pandemic dispels once and for all the trade-off; more than that. It allows to rank the two policy options. Doing whatever it takes to save lives is causing a deep and hopefully short-lived economic slump. However devastating for the economy, such a slump is much easier to manage for policy makers than the (maybe) marginally milder recession but spread over a longer period of time, that one would have by not imposing a total lockdown of the economy. Shutting down the economy saves lives, AND it is better for the economy. A no brainer, in fact.

Even the most cynical among our leaders should understand this: Saving as many lives as possible is the best we can do to save the economy and their chances of reelection.

Lagarde: A Rookie Mistake?

So the ECB has spoken in response to the Coronavirus crisis, and it was a problematic response to say the least. I watched Christine Lagarde’s Q&A with journalists, which as usual was the most interesting part of the press conference. But boy, I wish today it had not taken place…

The bottom line is that Lagarde made a huge misstep in stating that the ECB is not going to close the spreads. I hope it is just a communication misstep, otherwise Italy (and probably other countries) will pay a heavy price.

But let’s see what happened today.

First, there is an attempt to put on the Eurozone governments’ shoulders most of the burden of reacting to a shock that will be “significant even if temporary”. Lagarde said clearly, towards the end of the press conference, that what she fears most is insufficient fiscal response coming out from the Eurogroup meeting next Monday:

To the question "are you worried by the likely increase of public debt?" the answer is "I am worried about complacency and slow moving answer". Lagarde hopes that a fiscal response of appropriate size and scope will be announced by EMU countries

— Francesco Saraceno (@fsaraceno) March 12, 2020

It is hard to disagree with this approach. To target firms’ liquidity problems one cannot count on banks alone, (especially in countries where they have still not completely recovered from the sovereign debt crisis). As a side note, I welcome the provisions contained in the Italian €25bn package, such as the temporary lifting of short-term businesses obligations towards the government (VAT, social contributions, taxes). These seem to be the right measures to ease short term liquidity constraints.

But let’s look into what the ECB itself commits to do. Besides technicalities that I did not study yet, there will be two sets of measures:

1. The first set concerns (continued) provision of cheap liquidity to banks, in order to ensure continuing supply of credit to the real economy. This will be ensured through a new and temporary long-term refinancing scheme (LTRO), together with significantly better terms for the existing targeted loan programs. This amount to a large subsidy to banks. Loans conditions will be more favorable for banks lending to Small and Medium Enterprises, which are the ones more likely to become strapped for liquidity in the current situation. Furthermore, as a supervisor, the ECB engages in operational flexibility when implementing bank specific regulatory requirements, and to allow full utilization of the capital and liquidity buffers that financial institutions have built. I am unclear on how much this will work in order to keep the flow of credit flowing, but overall, my sentiment is that on cheap and easy financing to banks and (hopefully) to firms, there is little more ECB could do.
2. The second set of measure is a ramping up of QE, with additional €120bn (until the end of the year). Lagarde seemed to suggest that the ECB could use flexibility to deviating from capital keys, the quota of bonds the ECB can buy from each country. This means that maybe more help will be given to countries like Italy, and the ambiguity was probably on purpose.

But then came the Q&A, and with it, disaster. At a question by a journalist on Italian debt and yields, Lagarde replied the following:

Support to specific countries (Italy is named by the journalist asking the question) will be provided, but the ECB, says Lagarde, is not here to close the spread (this is BAD, she should not have said that!)

— Francesco Saraceno (@fsaraceno) March 12, 2020

This also made it on the ECB twitter feed:

Lagarde: We are not here to close spreads, there are other tools and other actors to deal with these issues

— European Central Bank (@ecb) March 12, 2020

This simple sentence was a reversal of Mario Draghi 2012 “whatever it takes“. Mario Draghi, in 2012, had basically announced that the ECB would act as a crypto-lender of last resort (conditional, way too conditional, but still), and since then the scope for speculation has been greatly reduced. Spreads have been much less variable since then (I wrote a paper with Roberto Tamborini, on that, that just came out).

Protection from the ECB against market speculation is what countries like Italy would need most. Fiscal policy is the tool that can be better targeted towards supporting the supply side of the economy and preventing liquidity problems from evolving into bankruptcies. Lagarde herself stated it many times in the past few days, and again today.

So, governments should be put in the conditions not to worry, at least for a while, of market pressure. Lagarde should have said the exact opposite: “we commit to freezing the spreads for n months so that governments can focus on supporting their productive sector, and restoring more or less normal aggregate demand conditons”. Lagarde said the opposite. And here is the effect of that on Italian ten year rates. Look what happened at around 3pm, when she answered the question:

The yields Other Eurozone peripheral countries had similar behaviours. Why did Lagarde say that? Maybe Because she wanted to appease fiscal hawks ahead of the Eurogroup meeting of next week, so that they are more willing to agree on a fiscal stimulus? Or because she was afraid to be accused to be too soft on Italy? Or to actually care about one single country, which is what the ECB is not supposed to do? Or was it simply a communication misstep? A rookie mistake? Whatever the reason, it is clear that Lagarde made a huge mistake, and even apparently she partially backpedaled in a NBC interview shortly thereafter, this is what remain of today’s press conference.

So, my assessment of today’s ECB move is mixed. It was as good as it gets on financing the banking sector, and we just have to cross finger that this is enough to keep credit flowing.

But it is disappointing on the support of expansionary fiscal policies. All the more disappointing that the ECB and Lagarde have insisted on the need for a fiscal response “first and foremost”.

My only hope is that that was a misstep, or just lip service to fiscal responsibility. If market pressure prevents governments from supporting their firms, and if liquidity problems evolve into solvency problems, a “significant but temporary” shock will become a permanent hit to long-term growth capacity. And let’s not forget that the Eurozone economy is today more diverse and less resilient than it was in 2008.

Brace yourself

ps. You can find my live tweeting during the Q&A (a bit confused at times. Live tweeting is not my thing!) here:

Lagarde is speaking right now. Continued liquidity availability is crucial. -|- ECB Governing Council Press Conference – 12 March 2020 https://t.co/KFscoydoOx

— Francesco Saraceno (@fsaraceno) March 12, 2020

Squeezing a Balloon

Via the Financial Times I have read the Asian Development Bank Asian Development Outlook 2019 Update. The outlook has an interesting section on the impact of the US-China trade war on the region. Let me simply quote the relevant paragraph: “Recent trade data also provide evidence of trade redirection. In the first 6 months of 2019, US imports from the PRC fell by 12% from the same period in 2018. At the same time, US imports from the rest of developing Asia rose by about 10%, with notably large increases of 33% for Vietnam; 20% for Taipei,China; and 13% for Bangladesh” (page 14). I also copied and pasted the figure in the following page:

This was to be expected. Of course trade diversion is not automatic, nor costless. Supply chains need to be reorganized, bottlenecks may appear. But it is obvious that as long as US demand for the goods produced abroad remains strong, if the price of these increases in China, the demand will look elsewhere. Now, the US has been recording substantial negative net lending (the sign of an excess of domestic demand over supply) since at least the early 1990s:

The source of this excess demand has not always been the same. Sometimes corporations, rarely households (most notably in the run-up to the crisis), and most of the times the government.

In particular, in recent years households have experienced excess savings, initially joined by corporations which then gradually went to equilibrium. The government is keeping demand high, and as a consequence the trade deficit alive.

The tariffs on China, in this context, are just like squeezing a balloon. As long as US domestic demand remains strong, compressing Chinese imports simply pops imports from Vietnam, or Bangladesh, or who knows what other country next. As long as American excess demand will persist, somebody elsewhere will provide the supply for it. Reducing bilateral trade deficit with China is not a solution to persistent excess domestic demand.

Of course, the US could impose barriers to imports from all countries. This would solve the problem and reduce the trade deficit. Higher import prices and competition between households, firms and the government, would reduce purchasing power and, together with excess domestic demand, the welfare of American voters. Mr. Trump should try this before November 3rd, 2020.

My Two Cents on the “Yellow Vests” Movement

In a widely commented televised address President Macron  has made a last-minute attempt to stop the “yellow vests” wave, that is investing France and his presidency. After a dramatic (a bit too much to seem sincere, if you ask me) mea culpa on past arrogance, and a promise to “listen to the suffering of the people”, Macron announced a few changes to the French budget law, to sustain the purchasing power of the lower part of the income distribution. The most important and immediate changes are: an increase of minimum wage (more precisely of the “employment subsidy” that is given to most people working at or around minimum wage): the exemption from taxes and social contribution of extra hours (a very popular measure that had been introduced by Nicolas Sarkozy and later abolished by François Hollande); and last but not least, the repeal of the increase of social contributions for retirees, and the confirmation of the freezing (for at least the year 2019) of the “ecological tax” on fuel. Macron also signaled the intention to backtrack on his vertical leadership style (the président jupitérien); he pleaded for renewed role for intermediate bodies (most notably the mayors and local politicians) in putting in place a concerted effort (a “social compact”) to boost growth and social cohesion.

Will Macron’s announcement appease the uprising that inflames France? Most probably not, because they suffer from an original sin, a contradiction that the President is unwilling (or incapable) of seeing. The yellow vest protest originates from the gas price increase, that affected rural households and farmers in particular? But the malaise has much deeper roots, that are widespread. The French economy feels, after ten years, the full weight of a crisis that has hit very hard the middle and lower classes: Unemployment that fell too slowly  (costing re-election to François Hollande ; austerity that, although less marked than in the peripheral eurozone countries, has reduced the perimeter and coverage of public services and of the welfare system, while increasing the tax burden; and, finally, the reduction of family allocations and welfare in general, which particularly affected the most disadvantaged categories. All of this led to what Julia Cagé, on French daily Le Monde, called “the purchasing power crisis”, that simmered for a long time, before exploding in the past weeks.

Emmanuel Macron has an enormous responsibility for the bursting of the crisis. True, the increase in the tax burden for the middle class is mainly due to François Hollande (under the impulse of an ambitious undersecretary, and then minister of the economy, named … Emmanuel Macron). One might even argue that the budget law for 2019 reverses the trend as that the reduction of some taxes (in particular the elimination of the housing tax for the majority of households, and the flat tax on capital income) has more than offset the reduction in social benefits.

What explains then the fact that the discontent emerges, so violently, just now? The explanation is simple: it is to be found in the approach that the French President pursued since he beginning of his mandate. Like Donald Trump, with whom he disagrees on almost everything, Emmanuel Macron believes in the so-called “trickle down” theory: shifting the tax burden away from the rich is the best strategy to revive growth, because these people are more productive than the average, and invest the extra income in innovative activities. The fruits of higher growth would then percolate to everyone, even those who were initially penalized by the tax reform. From the beginning of his mandate, Macron’s choice to give France a pro-business image was clear, leading to a drastic reduction of taxes on the richest, and making the taxation, for the upper part of the distribution, fundamentally regressive.

The last budget law represents the clearest proof of this approach. The “Institute for Public Policies” has shown (see the figure, taken from a Le Monde article appeared last October) that while the overall disposable income slightly increases, the bottom 20% and the upper-middle class see a substantial worsening of their situation, while the very rich (the top 1%) see their purchasing power increase of 6%.

The problem is, as an increasing body of evidence shows, that trickle down does not work. Favoring the richest does not increase productive investment (it rather tends to boost non-produced asset prices and unproductive consumption), and the impact on growth is both negligible and not shared; these days’ demonstrations stand to prove it. History cannot be rewritten, but the attempt to twist the tax system in favor of the ecological transition would probably have been met with much more enthusiasm, in a country like France where environmental awareness is high, where it not accompanied by the sentiment of increasing social injustice that Macron’s economic policies have deepened.

It is interesting to notice, in this regard, that traditional media have given a somewhat distorted image of the protest movement (which is very hard to clearly decrypt). A group of researchers from Toulouse University uses lexicographic analysis to show that the narrative of traditional media was centered on revolt against taxes (ras-le-bol fiscal), and therefore in contradiction with the request of better public services;  this does not correspond to the message coming from social networks that organized “from the bottom” the movement, in which instead the predominant mood was revolt against social injustice and against the elites that grow richer and richer, while leaving the check for the others to pay. To sum up, a plea for a more equal and cohesive society.

How will this end? It is hard to say. The yellow vests have obtained a partial win, with the freezing of the gas increase, and with the measures announced by Macron on Monday. But it is unlikely that we will see a substantive change of economic policy, precisely because of the President’s views outlined above. He rushed to rule out any reinstatement of the wealth tax, because “in the past unemployment increased even when the wealth tax existed” (a rather unconvincing argument, to say the truth).

If higher incomes are not called to contribute to the effort (towards ecological transition, but more generally towards the financing of the French social model), even the measures just announced will have a very limited impact. The State will somehow have to take back with one hand (for example by reducing public services, that benefit lower income most, or increasing other taxes) what it just handed out with the other hand. The demand for social justice that confusedly emerges from the yellow vests movement will once more go unanswered, leaving untouched the tension that is ripping the French (and not just the French) society.

To meet these needs, a new political proposal would have to put the complex theme of the redistribution of resources in a globalized world at the center of its project. It would be necessary to rediscover the “Regulatory State” which, in the golden years of social democracy (and of the social right), guaranteed social and macroeconomic stability, and thus laid the foundations for investment, innovation, and growth. That role is more difficult to define in a globalized world in which individual States have limited room for maneuver, and in which therefore international cooperation, however difficult, is now the only way forward. But this challenge can not be avoided if we do not want movements such as those of yellow vests to fall prey to nativist autocratic populism.

 

(This is the translation of a piece I published in Italian on the Luiss Open website)