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Lagarde: A Rookie Mistake?

March 12, 2020 Leave a comment

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:

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:

This also made it on the ECB twitter feed:

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:

Public Debt. I can’t Believe we are Still There

January 25, 2018 3 comments

The crisis is supposedly over, as the European economy started growing again. There will be time to assess whether we are really out of the wood, or whether there is still some slack. But this matters little to those who, as soon as things got slightly better, turned to their old obsession: DEBT! Bear in mind, not private debt, that seems to have disappeared from the radars. No, what seems to keep policy makers and pundits awake at night is ugly public debt, the source of all troubles (past, present and future).

Take my country, Italy. A few days ago this tweet showing the difference between the Italian and the German debt made a few headlines:

 

The ratio increased, so DEBT is the Italian most pressing problem. Not the slack in the labour market. Not the differentials in productivity. I can’t stop asking: why aren’t Italians desperately tweeting this figure?

2018_01_25_Public_Debt1

This shows the relative performance of Italy and Germany along two very common measures of productivity, Multifactor productivity and GDP per capita. I took these variables (quick and dirt from the OECD site), but any other measure of real performance would have depicted a similar picture.

So what? The public debt crusaders will argue that precisely because of debt, Italy has poor real performance. The profligate public sector prevented virtuous market adjustments, and hampered real convergence.  The causality goes from high debt to poor real performance, they will argue. Reduce debt!

Well, think again. Research is much more nuanced on this. A paper by Pescatori and coauthors shows for example that countries with high public debt exhibit high GDP volatility, but not necessarily lower growth rates. High but stable levels of debt are less harmful than low but increasing ones. In a recent Fiscal Monitor the IMF has shifted the focus back to private debt (which, it is worth remembering is the root cause of the crisis), arguing that the deleveraging that will necessarily continue in the next few years will require accompanying measures from the public sector: on one side, renewed attention to the financial sector, to make sure that liquidity problems of firms, but also of financial institutions) do not degenerate into solvency problems. On the other side, the macroeconomic consequences of deleveraging, most notably the increase of savings and the reduction of private expenditure, may need to be compensated by Keynesian support to aggregate demand, thus implying that public debt may temporarily increase in order to sustain growth (self promotion: the preceding paragraph is taken from my book on the relevance of the history of thought to understand current controversies. French version available, Italian version coming out in March, English version coming out eventually).

In just a sentence, the causal link between high debt and low growth is far from being uncontroversial.

Last, but not least, it is worth remembering that Italy was not profligate during the crisis; unfortunately, I would add.  Let’s look at structural deficit (since 2010; ask the Commission why we don’t have the data for earlier years), which as we know washes away the impact of cyclical factors on public finances.

2018_01_25_Public_Debt2

The Italian figures were slightly worse than the German ones, but not dramatically so. And if we take interest expenditure away, so that we have a measure of what the Italian government could actually control, then Italy was more rigorous (Debt obsessive pundits would use the term “virtuous”) than Germany.

The thing is that the Italian debt ratio is more or less stable, in spite of sluggish growth (current and potential) and low inflation. It is not an issue that should worry our policy makers, who should instead really try to boost productivity and growth. Said it differently, it is more urgent for Italy to work on increasing the denominator of the ratio between debt and GDP than to focus on the numerator. And I think this may actually require more public expenditure and a temporary increase in debt (some help from the rest of the EMU, starting from Germany, would not hurt). It is a pity that the “Italian debt problem” is all over the place.

Confusion in Brussels

October 17, 2014 13 comments

already noticed how the post-Jackson Hole Consensus is inconsistent with the continuing emphasis of European policy makers on supply side measures. In these difficult times, the lack of a coherent framework seems to have become the new norm of European policy making. The credit for spotting another serious inconsistency this time goes to the Italian government. In the draft budgetary plan submitted  to the European Commission (that might be rejected, by the way), buried at page 12, one can find an interesting box on potential growth and structural deficit. It really should be read, because it is in my opinion disruptive. To summarize it, here is what it says:

  1. A recession triggers a reduction of the potential growth rate  (the maximum rate at which the economy can grow without overheating) because of hysteresis: unemployed workers lose skills and/or exit the labour market, and firms scrap productive processes and postpone investment. I would add to this that hysteresis is non linear: the effect, for example on labour market participation, of a slowdown, is much larger if it happens at the fifth year of the crisis than at the first one.
  2. According to the Commission’s own estimates Italy’s potential growth rate dropped from 1.4% on average in the 15 years prior to the crisis (very low for even European standards), to an average of -0.2% between 2008 and 2013. A very large drop indeed.
  3. (Here it becomes interesting). The box in the Italian plan argues that we have two possible cases:
    1. Either the extent of the drop is over-estimated, most probably as the result of the statistical techniques the Commission uses to estimate the potential. But, if potential growth is larger than estimated, then the output gap, the difference between actual and potential growth is also larger.
    2. As an alternative, the estimated drop is correct, but this means that Italy there is a huge hysteresis effect. A recession is not only, as we can see every day, costly in the short run; but, even more worryingly, it quickly disrupts the economic structure of the country, thus hampering its capacity to grow in the medium and long run.

The box does not say it explicitly (it remains an official government document after all), but the conclusion is obvious: either way the Commission had it wrong. If case A is true, then the stagnation we observed in the past few years was not structural but cyclical. This means that the Italian deficit was mainly cyclical (due to the large output gap), and as such did (and does) not need to be curbed. The best way to reabsorb cyclical deficit is to restart growth, through temporary support to aggregate demand. If case B is true, then insisting on fiscal consolidation since 2011 was borderline criminal. When a crisis risks quickly disrupting the long run potential of the economy, then it is a duty of the government to do whatever it takes to fight, in order to avoid that it becomes structural.

In a sentence: with strong hysteresis effects, Keynesian countercyclical policies are crucial to sustain the economy both in the short and in the long run. With weaker, albeit still strong hysteresis effects,  a deviation from potential growth is cyclical, and as such it requires Keynesian countercyclical policies. Either way, fiscal consolidation was the wrong strategy.

I am not a fan of the policies currently implemented by the Italian government. To be fair, I am not a fan of the policies implemented by any government in Europe. Too much emphasis on supply side measures, and excessive fear of markets (yes, I dare say so today, when the spreads take off again). But I think the Italian draft budget puts the finger where it hurts.

The guys in Via XX Settembre dit a pretty awesome job…

The Italian Job

July 8, 2013 1 comment

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?

Wishful Thinking

March 1, 2013 Leave a comment

Yesterday I published a note on OFCE le blog (in French), analyzing one possible outcome of the recent Italian elections: A center-left minority government, with external support of the Cinque Stelle movement led by comedian Beppe Grillo. The last part of the post argues that if a convergence between the Democratic Party and Beppe Grillo were to be found (at the moment the scenario is rather unlikely), it would happen on a number of progressive issues, like for example minimum citizenship income. But then, I conclude, this has implications for Europe as a whole. Here is a translation of the last paragraphs: It is clear  that the convergence could hardly happen within the bounds of the current fiscal consolidation. An agreement would therefore need a prior reversal of austerity that, it is worth repeating, was disavowed by the voters. This would not be easy for the Democratic Party that, like the Socialist Party in France, made the choice of fiscal discipline, and has kept a very ambiguous position along all the electoral campaign. But in turn, this has implications for Europe as a whole. European leaders in the next weeks may face a choice between demanding that Italy stays the course of fiscal consolidation, condemning the third economy of the eurozone to political paralysis and probably social chaos; or, accept that a new government is formed, that will most likely abandon austerity.  In both cases it will be impossible to act as if nothing had happened. Europe could be forced to rethink its own economic strategies, that are failing not only in Italy. An some countries reluctantly embracing fiscal consolidation (France to name one) could take the opportunity to challenge austerity as the only policy for growth.

Let’s be clear, here. I am totally aware that at the moment this is nothing more than wishful thinking. But hey, you never know…