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Austerity. The Past That Doesn’t Pass
[As usual lately, this is a slightly edited AI translation of a piece written for the Italian Daily Domani]
The European Commission recently revised downwards its forecasts for both growth and inflation, which continues to fall faster than expected. In contrast to the United States, there is no “soft landing” here. As argued by many, monetary tightening has not played a major role in bringing inflation under control (even as of today, price dynamics are mainly determined by energy and transportation costs). Instead, according to what the literature tells us on the subject, it is starting, 18 months after the beginning of the rate hike cycle, to bite on the cost of credit, therefore on consumption, investment and growth.
This slowdown in the economy is taking place in a different context from that of the pandemic. Back then, central bankers and finance ministers all agreed that business should be supported by any means, a fiscal “whatever it takes”. Today, the climate is very different, and public discourse is dominated by an obsession with reducing public debt, as evidenced by the recent positions taken by German Finance Minister Lindner and the disappointing reform of the Stability Pact. The risk for Europe of repeating the mistakes of the past, in particular the calamitous austerity season of 2010-2014, is therefore particularly high.
In this context, we can only look with concern at what is happening in France, where the government also announced a downward revision of the growth forecast for 2024, from 1.4% to 1%. At the same time, the Finance Minister Bruno Le Maire announced a cut in public spending of ten billion euros (about 0.4% of GDP), to maintain the previously announced deficit and debt targets. This choice is wicked for at least two reasons. The first is that it the government plans making the correction exclusively by cutting public expenditure, focusing in particular on “spending for the future”. €2 billion will be taken from the budget for the ecological transition, €1.1 billion for work and employment, €900 million for research and higher education, and so on. In short, it has been chosen, once again, not to increase taxes on the wealthier classes but to cut investment in future capital (tangible or intangible).
But regardless of the composition, the choice to pursue public finance objectives by reducing spending at a time when the economy slows, down goes against what economic theory teaches us; even more problematic, for a political class at the helm of a large economy, it goes against recent lessons from European history.
The ratio of public debt to GDP is usually taken an indicator (actually, a very imperfect one, but we can overlook this here) of the sustainability of public finances. When the denominator of the ration, GDP, falls or grows less than expected, it would seem at first glance logical to bring the ratio back to the desired value by reducing the debt that is in the numerator, i.e. by raising taxes or reducing government spending. But things are not so simple, because in fact the two variables, GDP and debt, are linked to each other. The reduction of government expenditure or the increase of taxes, and the ensuing reduction of the disposable income for households and businesses, will negatively affect aggregate demand for goods and services and therefore growth. Let’s leave aside here a rather outlandish theory, which nevertheless periodically re-emerges, according to which austerity could be “expansionary” if the reduction in public spending triggers the expectation of future reductions in the tax burden, thus pushing up private consumption and investment. The data do not support this fairy tale: guess what? Austerity turns out to be contractionary!
In short, a decline in the nominator, the debt, brings with it a decline in the denominator, GDP. Whether the ratio between the two decreases or increases, therefore, ends up depending on how much the former influences the latter, what economists call the multiplier. If austerity has a limited impact on growth, then debt reduction will be greater than GDP reduction and the ratio will shrink: albeit at the price of an economic slowdown, austerity can bring public finances back under control. The recovery plans imposed by the troika on the Eurozone countries in the early 2010s were based on this assumption and all international institutions projected a limited impact of austerity on growth. History has shown that this assumption was wrong and that the multiplier is very high, especially during a recession. A public mea culpa from the International Monetary Fund caused a sensation at the time (economists are not known for admitting mistakes!), explaining how a correct calculation gave multipliers up to four times higher than previously believed. In the name of discipline, fiscal policy in those years was pro-cyclical, holding back the economy when it should have pushed it forward. The many assistance packages conditioning the troika support to fiscal consolidation did not secure public finances; on the contrary, by plunging those countries into recession, they made them more fragile. Not only was austerity not expansive, but it was self-defeating. It is no coincidence that, in those years, speculative attacks against countries that adopted austerity multiplied and that, had it not been for the intervention of the ECB, with Draghi’s whatever it takes in 2012, Italy and Spain would have had to default and the euro would probably not have survived.
Since then, empirical work has multiplied, with very interesting results. For example, multipliers are higher for public investment (especially for green investment) and social expenditure has an important impact on long-term growth. And these are precisely the items of expenditure most cut by the French government in reaction to deteriorating economic conditions.
While President Roosevelt in 1937 prematurely sought to reduce the government deficit by plunging the American economy into recession, John Maynard Keynes famously stated that “the boom, not the recession, is the right time for austerity.” The eurozone crisis was a colossal and very painful (Greece has not yet recovered to 2008 GDP levels), a natural experiment that proved Keynes right.
Bruno Le Maire and the many standard-bearers of fiscal discipline can perhaps be forgiven for their ignorance of the academic literature on multipliers in good and bad times. Perhaps they can also be forgiven for their lack of knowledge of economic history and of the debates that inflamed the twentieth century. But the compulsion to repeat mistakes that only ten years ago triggered a financial crisis, and threatened to derail the single currency, is unforgivable even for a political class without culture and without memory.
Wages and Inflation: Let Workers Alone
[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]
Last week’s piece of news is the gap that opened between the US central bank, the Fed, and the European and British central banks. Apparently, the three institutions have adopted the same strategy, deciding to leave interest rates unchanged, in the face of falling inflation and a slowdown in the economy. But, for central banks, what you say is just as important as what you do; and while the Fed has announced that in the coming months (barring surprises, of course) it will begin to loosen the reins, reducing its interest rate, the Bank of England and the ECB have refused to announce cuts anytime soon.
To understand why the ECB remains hawkish, one can read the interview with the Financial Times of the governor of the Central Bank of Belgium, Pierre Wunsch, one of the hardliners within the ECB Council. Wunsch argues that, while inflation data is good (it is also worth noting that, as many have been saying for months, inflation continues to fall faster than forecasters expect), wage dynamics are a cause for concern. In the Eurozone, in fact, these rose by 5.3% in the third quarter of 2023, the highest pace in the last ten years. The Belgian Governor mentions the risk that this increase in wages will weigh on the costs of companies, inducing them to raise prices and triggering further wage demands; As long as wage growth is not under control, Wunsch concludes, the brakes must be kept on. Once again, the restrictive stance is justified by the risk of a price-wage spiral, that so far never materialized, despite having been evoked by the partisans of rate increases since 2021. Those who, like Wunsch, fear the wage-price spiral, cite the experience of the 1970s, when the wage surge had effectively fueled progressively out-of-control inflation. The comparison seems apt at first glance, given that in both cases it was an external shock (energy) that triggered the price increase. But, in fact, it was not necessary to wait for inflation to fall to understand that the risk of a wage-price spiral was overestimated and used by many as an instrument. Compared to the 1970s, in fact, many things have changed. I talk about this in detail in Oltre le Banche Centrali, recently published by Luiss University Press (in Italian): Automatic indexation mechanisms have been abolished, the bargaining power of trade unions has greatly diminished and, in general, the precarization of work has reduced the ability of workers to carry out their demands. For these and other reasons, the correlation between prices and wages has been greatly reduced over three decades.
But the 1970s are actually the exception, not the norm. A recent study by researchers at the International Monetary Fund looks at historical experience and shows that, in the past, inflationary flare-ups have generally been followed with a delay by wages. These tend to change more slowly than prices, so that an increase in inflation is not followed by an immediate adjustment in wages and initially there is a reduction in the real wage (the wage adjusted for the cost of living). When, in the medium term, wages finally catch up with prices, the real wage returns to the equilibrium level, aligned with productivity growth. If the same thing were to happen at this juncture, the IMF researchers believe, we should not only expect, but actually hope for nominal wage growth to continue to be strong for some time in the future, now that inflation has returned to reasonable levels: looking at the data published by Eurostat, we observe that for the eurozone, prices increased by 18.5% from the third quarter of 2020 to the third quarter of 2023, while wage growth stopped at 10.5%. Real wages, therefore, the measure of purchasing power, fell by 8.2%. Italy stands out: it has seen a similar evolution of prices (+18.9%), but an almost stagnation of wages (+5.8%), with the result that purchasing power has collapsed by 13%.
Things are worse than these numbers show. First, for convergence to be considered accomplished, real wages will have to increase beyond the 2021 levels. In countries where productivity has grown in recent years, the new equilibrium level of real wages will be higher. Second, even when wages have realigned with productivity growth, there will remain a gap to fill. During the current transition period, when real wages are below the equilibrium level, workers are enduring a loss of income that will not be compensated for (unless the real wage grows more than productivity for some time). From this point of view, therefore, it is important not only that the gap between prices and wages is closed, but that this happens as quickly as possible.
In short, contrary to what many (more or less in good faith) claim, the fact that at the moment wages are growing more than prices is not the beginning of a dangerous wage-price spiral and the indicator of a return of inflation; rather, it is the foreseeable second phase of a process of rebalancing that, as the IMF researchers point out, is not only normal but also necessary.
The conclusion deserves to be emphasized as clearly as possible: if the ECB or national governments tried to limit wage growth with restrictive policies, they would not only act against the interests of those who paid the highest price for the inflationary shock. But, in a self-defeating way, they would prevent the adjustment from being completed and delay putting once and for all the inflationary shock behind us.
The damage of monetary tightening is about to begin
[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]
The past weeks brought us four pieces of news on the inflation front. Well, actually, two pieces of news and two non-news. Let’s start with the latter. It is no longer news that central banks continue with their strategy of monetary tightening. Both the Fed and the ECB have raised rates by a quarter point, and the two presidents, Powell and Lagarde, are not revealing what will happen in September. What is certain is that, after the ninth consecutive hike, the rate for the eurozone is at its highest since 2001 when the ECB sought to support the value of the newborn single currency with high interest rates.
The second non-news is that inflation continues to decrease faster than expected. Data for France and Germany showed record lows since the invasion of Ukraine, while Spain’s inflation was slightly higher than expected. The tightening, therefore, continues while inflation falls. The official line of central banks is that this needs to happen because inflation has been “too high for too long,” and the risk is that it may become chronic, affecting expectations and wage negotiations.
No price-wage spiral
This argument is extremely weak, and, unfortunately i should add, there is no sign of wages chasing inflation. The OECD confirmed this only a couple of weeks ago in its 2023 Employment Outlook, which included a chapter on the generalized decline of real wages (a sign that nominal wages have grown less than prices).
Even expectations remain under control. After the two non-news items, the first news from last week is the results of the quarterly Survey of Professional Forecasters conducted by the ECB. According to the survey, professional forecasters expect inflation to return to 2% by 2024 (and to 3% in the last quarter of 2023). The ECB, on the other hand, continues to believe that reaching 2% will not happen before 2025. As a result, even among those who have supported the restrictive turn of the ECB in the past, voices calling for a pause in rate hikes are multiplying.
The decrease in inflation is mostly not due to the ECB
The hawks, on the other hand, base see the the decline in inflation as a justification of past rate hikes and as lending support for further increases in the autumn. The argument is that the tightening works and must continue until inflation returns to the 2% target. Unfortunately, this argument is flawed. The empirical literature has extensively studied the impact of central bank decisions on the economy. This mainly happens through the credit channel: the increase in central bank interest rates is transmitted to bank interest rates charged to businesses and households for investment projects and mortgages. The higher cost of capital implies less spending and and the cooling of the economy. This process is not immediate. While it is true that bank rates react fairly quickly to central bank decisions (especially to rate increases), spending is much stickier. For example, investment is a process that takes time, often years. It is unlikely that businesses will abandon an ongoing project just because the cost of money has increased. Therefore, the rate hike is transmitted with a certain delay, only as businesses complete ongoing investment projects and decide whether to start new ones. The same can be said for the other channel, that of exchange rates. The increase in interest rates causes an appreciation of the exchange rate and thereby a deterioration in trade balances, which cools the economy. Again, this process is not immediate because there are contracts to honor, spending habits to change, and so on.
For all these reasons, the transmission lags of monetary policy are measured in semesters, if not in years. The literature is abundant. A meta-analysis published a few years back tries to summarize these findings and reports that, on average, it takes 12-18 months to see the effects of a rate change on the real economy, and for the transmission to be complete, it takes about two and a half years. The delays are particularly long for countries with more developed financial systems, because there it is more difficult for the central bank to influence credit creation by the banking sector. This means that the impact of the credit tightening started in the spring-summer of 2022 is beginning to be felt now, and central banks have little to do with the decrease in inflation.
This brings us to the last news of the week, also from a survey. The results of the latest (July) quarterly Bank Lending Survey conducted by the ECB show (for the second consecutive quarter) a sharp decline in corporate credit demand (firms, anticipating an economic slowdown, are unwilling to borrow at increasingly prohibitive rates). Even for households and consumers there is a contraction in credit.
In short, while inflation has a life of its own, influenced only marginally by central bank decisions, these decisions are pushing us into an economic slowdown, which is showing multiple signals. In Germany, the Ifo business confidence index is at its lowest since last autumn, and the economy is stagnating after two quarters of slight contraction. Things are not much better in Italy, even though a recession is not currently forecasted in spite of negative growth in 2023 Q2. The “Congiuntura Flash” report published by Confindustria on July 29 shows a slowdown in the Italian economy mainly due to the weakness in industrial production and investment, with uncertain consumption and declining exports. Only the services sector (especially tourism) is keeping the Italian economy afloat.
We need to stop relying solely on central banks.
What does this picture tell us, besides the obvious fact that central banks persist in a futile and harmful strategy? First, in the coming months, measures will need to be implemented to mitigate the impact of monetary tightening, which will begin to fully unfold and, as usual, hit the most vulnerable categories. Second, the era of delegating the solution to all our problems solely to monetary policy must end. Since at least 2010, when the sovereign debt crisis began, monetary policy has been the only player in town, for better or for worse. It’s time to rethink the policy mix, the attribution of different economic policy tools and objectives to various actors. But this subject will need to be tackled in a future post.
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.
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!
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:
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:
- 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.
- 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:
Could Central Banks do More during the Crisis?
I rarely disagree with Martin Sandbu’s Free Lunch. But today’s piece on central banks is one of these cases.
In short, Martin argues that while the main culprit for the slow recovery is fiscal policy, almost everywhere too timid if not outright procyclical (we are all on board on that!), the mistakes of fiscal authorities do not exempt central banks from bearing part of the responsibility. In particular, he dismisses the claim that it was technically impossible to lower long-term interest rates further, and/or bring policy rates even more into negative territory.
I agree with this point. Interest rates could have been lowered further. Nevertheless, I think that this would have made very little difference, because after 2008 central banks were essentially pushing on a string. This point of disagreement between us can be traced to a different view about what is the liquidity trap.
I recently published a book, La Scienza inutile (a general public account of a century of debates in macroeconomics. For the moment it is in Italian and in French, English translation in progress), in which I discuss the different notions of liquidity trap. Here is the quote (sorry, a bit too long):
The first source of trouble that Keynes considers is the most extreme, the so-called liquidity trap: `There is the possibility, […] that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest’ (Keynes 1936, p.207). In slightly more technical terms, the interest elasticity of money demand is near-infinite: no matter how much liquidity the central bank injects into the economy, it is entirely hoarded by agents and hence it leaks out of the system in its entirety. Monetary expansion is not effective in lowering interest rates.
There may be different reasons why the economy enters a liquidity trap. Keynes argued, by looking at the great depression, that this usually happens at very low (but not necessarily nil) levels of the interest rate, because in this case agents would expect interest rates to rise in the future and thus would be willing to hold any extra amount of money and postpone the purchase of bonds to the moment when interest rates will be up again. More recently the liquidity trap has been defined as a situation in which the interest rate that equates savings and investment is negative, and therefore cannot be attained by the central bank (the so-called Zero Lower Bound, or ZLB; see e.g. Krugman 2000). This latter definition leaves some room for monetary policy effectiveness: if the central bank manages to trigger the expectation of positive inflation, the real interest rate (the nominal interest rate minus the inflation rate) will become negative and lead to the full employment equilibrium.
So, if we think in terms of ZLB, it exists a real interest rate at which the output gap would be closed. If that interest rate is negative, then it is harder to reach, as central banks need to raise inflation expectations and try to push short term rates as much as possible in negative territory, which requires boldness and creativity (we have seen this). But, once again I agree with Martin on that, this can be done. If instead private expenditure becomes irresponsive to interest rates, the ‘Keynes definition’, then there is little central banks could do. I had noticed, back in 2016, that while it succeeded in easing credit conditions, EMU Quantitative Easing seemed to have done little to boost confidence and expected demand (the ultimate driver of firm’s credit needs). The EMU most recent Bank Lending Survey seems to confirm the prediction of the time. Both chart 4 (enterprises) and chart 12 (households) depict a flat demand for loans, that picks up only when the EMU economic outlook brightens.
This is by no means hard evidence (I am not aware of any papers thoroughly investigating the impact of QE on credit demand). But stylized facts seem to acquit central bankers.
ps
The two works cited in the quote:
Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. London: McMillan.
Krugman, P. (2000). Thinking About the Liquidity Trap. Journal of the Japanese and International Economies 14(4), 221–237.
Democratising Europe begins with ECB nominations
I repost here a post from Thomas Piketty’s Blog, originally published as an op-ed on Le Monde, which I was happy to sign.
This collective op-ed was initially published on January 22 2018 in Le Monde (in French) and in VoxEurop (in English).
While our eyes are glued to the interminable vicissitudes of the German Groko, a no less important story is playing out in Brussels, but has so far met with indifference. On January 22nd and February 19th, Eurogroup finance ministers will hold private meetings that will mark the beginning of a profound renewal of the European Central Bank executive board. The first big change will be the planned replacement of current Vice-President, Vitor Constancio. In the next two years, no less than 4 of the 6 members of the executive body of the ECB, Mario Draghi included, will be replaced.
All signs indicate that the future of economic, fiscal and monetary policy in eurozone countries is at stake in this series of nominations. The ECB of 2018, after all, barely resembles that earlier organisation which spent its relatively quieter days at the periphery of European policy, protected by its independent status. Built by governments and financial markets as an institutional recourse, the ECB started wielding more power thanks to the 2008 economic and financial crisis. Whether it’s telling member states how to finance their market debts, suggesting the adoption of a budgetary treaty (Fiscal Compact), notifying Irish or Italian heads of state that they should undertake without delay a raft of onerous reforms, or directly intervening in negotiations on the Greek crisis by controlling access to liquidities, it is always as a veritable co-ruler of the eurozone that the ECB operates.
After a decade of crisis, the ECB is no longer the same institution that was drawn up by the Treaties and consecrated to the sacro-saint goal of price stability: it has established itself, estimates at the ready, as Chief Economist of the eurozone; it has acquired executive power via the troika (with the European Commission and the IMF), which defines and ensures the execution of memoranda in countries being “helped”; it plays a central role in eurozone and Eurogroup summits which coordinate national economies; it has become a regulator of the banking world, deciding on the life and death of the largest banks in the eurozone; it has established itself as a reformer, working with coalitions built on prioritising “structural reforms” (labour markets), “competitiveness” (restrictive salary policies), etc.; it speaks on equal terms with the four other “presidents” of the Union (of the Commission, the Council, Eurogroup, and, finally, the European Parliament) when it comes to designing the political and institutional future of eurozone government, etc.
And yet, it as if the coming nominations are just another technicality. While there is in fact a rare occasion for leading parties and actors of representative politics to make their weight felt on the crucial issue of eurozone governance, everything seems set to keep nominations behind closed doors. Finance ministers are wary of having their decisions in Brussels held to account by their national parliaments; Eurogroup, an institution barely recognised by European treaties but which in fact plays a decisive role in the matter, has no form of political control. As is often the case, the European Parliament, which will hold a hearing for the chosen candidate, will arrive after the dust has settled, after negotiations have been concluded and compromises have been accepted, to give its… consultative opinion.
Meanwhile, there’s no lack of questions concerning the future of ECB policies and the role it should play: what position should it take in the reform of eurozone governance? What will its commitments be with regard to the European Parliament? What will become of its monetary policy when inflation has disappeared? What support can to bring to the Union’s policies? What are its priorities for the next eight years in terms of banking regulations? What place will be given to social partners? What form of policy will there be against conflicts of interest for the banking regulator? What redistributive effects can we expect from ECB policies? No doubt, the responses to these questions will determine the future course of the government of the eurozone. Candidates need to be questioned, and their responses should be known and debated.
Financial markets and governments seem satisfied with the current situation, happy to throw a veil of ignorance over the nomination process. And the signals coming from Brussels are hardly reassuring, leading us to suspect that Spain, imagining that its time has come, will propose it’s current minister for the economy, Luis de Guindos, for the vice-presidency on January 22nd. One of de Guindos’s main claims to fame is having been the executive president for Spain and Portugal’s branch of the Lehman Brothers during the peak of the financial crisis…
In the absence of the eurozone parliamentary assembly called for in the treaty for the democratisation of the eurozone (T-dem), of which one function would be precisely the political supervision of ECB nominations, there is still nothing preventing finance ministers from making public the criteria which justify their preferences for this or that candidate, and the conditions they want to impose on them.
The nomination process does not have to be conducted in private. It doesn’t have to be yet another game of European musical chairs. Nothing, in effect, is stopping finance ministers from making their decisions, and the reasons behind those decisions, public. Nothing is stopping candidates, those for the presidency most of all, from stepping forward in the coming months, being heard by national representatives, and stating their commitments.
And nothing, finally, is stopping the European Parliament from making its participation in the nomination process conditional on its own basic political requirements. This is how European parties, unions and NGOs can cut a path and begin weighing in on the decisions which will decide economic, fiscal and monetary policies within the eurozone. This would be the first real step – however modest – towards the democratisation of Europe.
Last September, in Athens, Emmanuel Macron called emphatically Europe to bring more « democracy, controversy, debate, building through critical spirit and dialogue ». It is now time that words and deeds go hand in hand.
First signatories :
Sébastien Adalid, jurist, professer at the University of Le Havre
Michel Aglietta, economist and professor emeritus at the University of Paris Nanterre
Peter Bofinger, economist, professor at Saarland University
Loïc Blondiaux, political scientist, professor at the Paris 1 University
Julia Cagé, economist, professer at Sciences Po, Paris
Amandine Crespy, political scientist, professor at the Université libre of Brussels
Anne-Laure Delatte, economist, director of research at CNRS
Bastien François, political scientist, professor at the University of Paris 1
Ulrike Guérot, political scientist, professor at the Danube University
Stéphanie Hennette, jurist, professer at Paris Nanterre University
Justine Lacroix, political scientist, professor at the Université libre of Brussels
Rémi Lefebvre, political scientist, professor at the University of Lille 2
Nicolas Leron, political scientist, think tank EuroCité
Ulrike Liebert, political scientist, professor at the Bremen Univeristy
Paul Magnette, political analyst, mayor of Charleroi
Francesco Martucci, lawyer, professor at Paris 2 University
Thomas Piketty, economist, director of studies at EHESS
Ruth Rubio Marín, lawyer, professor at Sevilla University
Guillaume Sacriste, political analyst, lecturer at Pantheon-Sorbonne University
Francesco Saraceno, economist, OFCE
Frédéric Sawicki, political scientist, professor at the University of Paris 1
Laurence Scialom, economist, professer at Paris Nanterre University
Xavier Timbeau, economist, principal director of OFCE
Antoine Vauchez, political analyst, director of research at CNRS
Translated by Ciaran Lawles
Keynes Blog
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- Le conseguenze economiche della pandemia: Mario Draghi e le scelte di politica economica ai tempi del coronavirus
- A lezione da Keynes, ripensando la macroeconomia. Recensione de “La scienza inutile” di F. Saraceno
- L’euro è una cosa troppo seria per lasciarla in mano ai soliti europeisti (e ai noeuro)
- Squilibri nell’eurozona: non è un problema di competitività di prezzo
- Intervista a Francesco Saraceno: “Sta cambiando la narrativa dell’economia ma non nella politica europea”
- Un nuovo errore di Blanchard sulla Grecia?
- La “germanizzazione” dell’Eurozona
- La politica monetaria della BCE: una sola misura non va bene per nessuno
Sparse Thoughts of a Gloomy European Economist 
