Category: Economical and financial crisis

Categories
Economical and financial crisis Euro zone

The debt issue : risk of financial instability and of a loss of trust in money.

First, I am very grateful to Euro 50 for this invitation to debate the issue of debt in the Europe.

We all know that the fiscal and monetary policies currently in force are essential to limit the damage caused by the pandemic. And everything that governments and central banks have undertaken was absolutely necessary. We also know that it would be a serious mistake to drop our guard too quickly.

But, given the huge size of the debt generated by the crisis, coming on the back of a widespread increase in debt over at least 20 years, should we not be concerned about what is likely to happen when the health situation and growth return to normal? Should we not be worried about debt?

The non-repayment of public debt to private creditors would have significant consequences for the economy and for society, with a catastrophic impact on household savings and pensions. Clearly this is not a viable option. And not repaying the public debt to the central bank alone, even if this were possible, would be playing a zero-sum game insofar as the shareholders of central banks are States, so the situation must therefore be analysed in a consolidated manner. 

One could possibly imagine that only the additional debt resulting from the pandemic would be refinanced at very long maturities by the central bank. But can we envisage this option being extended to future increases in public debt?

How, therefore, do we avoid succumbing to the allure of “magic money”? Particularly as during the pandemic we have ultimately found the financial resources needed to fund what previously seemed impossible. Under these conditions, it could appear to some that there is no reason not to continue down this road.

But a policy of quantitative easing with no end in sight would not work and must be avoided at all costs. Allowing the state to spend without limits and private agents to amass debt indefinitely with no constraints would have major consequences on the financial instability thus caused. With the return to a more normal rate of economic growth, keeping interest rates too low for too long would encourage or even trigger financial cycles. This would lead to even bigger speculative bubbles which, sooner or later, would inevitably burst. These well-known phenomena are the causes of major financial, economic and social crises. This point is key. In recent decades, every time that interest rates have remained too low for too long, we have seen inflation in the price of financial and/or real estate assets, with no inflation in the price of goods and services. This is because globalisation and the digital revolution have not allowed wages and prices to rise.

Finally, over the longer term, we could end up seeing a flight from money. The absence of a payment constraint, i.e. a monetary constraint, due to a policy of quantitative easing that is too strong and continues for too long, allowing debts to be financed over the long term without constraint, could give rise to a crisis of confidence in the “official” currencies insofar as the monetary system is essentially a system for settling debts, providing consistency for trade. The effectiveness of the economy depends on this. In fact, the only companies that are likely to survive over the medium and long term are those that do not incur continuous losses. Failing that, economic effectiveness would be impossible, and no Schumpeterian growth would be conceivable. The same applies to households, which cannot spend more than they earn on a lasting basis.

The entire system depends on this trust. In essence, trust is the ability to rely on someone’s word or on a signed agreement. In this case, agreements for debts and receivables, on which the whole system is based, must be respected. Trust in the banks themselves is also essential. So is trust in central banks. This is a key point, as central banks are responsible for monetary regulation, i.e. confidence in money, which is the keystone that holds the whole economic system together. If they were to issue too much central bank money for too long and without limits, a major crisis could occur, comparable to the collapse of the assignat during the French Revolution or hyperinflation during the Weimar Republic. Beyond an unspecified threshold, the national or regional currency may be rejected. This situation would lead to the disintegration of the debts and receivables system and, consequently, the potential disintegration of our whole society. This trust must be protected, or there is a risk of flight to a foreign currency. And even if all central banks acted in the same way at the same time, it would be possible to find a safe haven in gold, physical assets such as real estate, or a cryptocurrency issued someday by one of the GAFA companies that has become more solvent than the governments themselves.

Currency is an institution and must be managed as such. It must be based on trust and respect for the rules that are the alpha and omega of solid institutions. Insofar as debts undertaken by companies and governments are generally repaid by the issue of new debts, the monetary constraint is therefore based on the obligation to maintain a sustainable debt trajectory. Keeping interest rates at extremely low levels will not on its own be enough to guarantee this necessary sustainability, firstly because there is no long-term guarantee that interest rates will never rise again. Fears about future inflation already show this. But also because central banks will eventually stop buying any new debt issues and the financial markets will not step in to take their place, if the solvency trajectory is not realistic.

It is therefore possible to temporarily suspend monetary constraints, as is currently the case, but this cannot go on forever.

The legitimacy of the central banks depends on their ability to rise above private and public sector interests. In other words, making sure they protect themselves against any domination by governments or by the financial markets. Ultimately, it is the central banks’ duty to defend the public interest and preserve their credibility. Otherwise, they will not be able to maintain an efficient economic system and confidence in the currency, nor will they be able to use expansionary monetary policy in a meaningful way if it becomes necessary again. This is how they contribute to the common good and to the preservation of the social order itself. Governments and central banks will therefore quite quickly need to announce their commitment, when the time comes, to resuming fiscal, structural and monetary policies that give rise to credible trajectories.

Thank you.

Categories
Economical and financial crisis Economical policy

Not repaying debt: risk of a loss of trust in money and risks for society – complete version

Budgetary and monetary policies are vital to limit the damage brought about by the pandemic. And lowering our guard too hastily would be a serious mistake. But given the substantial debt resulting from the crisis, what is likely to occur once the situation returns to normal ?

The failure to repay public debt to private creditors would have considerable consequences for both the economy and society, impacting household savings and pensions. This is definitely not a correct option. Even supposing now that the law allowed us to not repay the debt to the central bank alone, then given that the Governments are its shareholders, we would be playing a zero- sum game.
We maybe could figure out that the additional debt resulting from the pandemic could be financed on a near-perpetual basis by the central bank at a rate close to zero. But, could this possibility be extended to future increases of public debt ?

Then, how does one avoid succumbing to the idea of magic money, and that, ultimately, since we have found the financial resources for what previously appeared impossible to finance ? Under these conditions, there would be no reason for not continuing in this manner.

A policy of endless quantitative easing would not work and should be rejected. Allowing the state to spend limitlessly, and private agents to amass debt indefinitely with no constraints, would have substantial consequences on the financial instability, thus triggered. With the economy returning to more normal growth, maintaining too low interest rates for too long would be tantamount to encouraging and even engendering financial cycles. This would create ever larger speculative bubbles and their inevitable bursts. These well-known phenomena give rise to major crises.

Lastly, in the longer term, people could end up turning their back on sovereign currencies altogether.
The lack of payment constraints, that is to say of monetary constraints, could lead to a crisis in our trust in money, as the monetary system is essentially a system of debt payments conferring consistency to trade and vital to economic efficiency. The entire system is based on that trust.
If you buy something, you must pay for it; if you sell something, you must be paid for it. And we borrow because we bet that the income generated by the investment will enable us to repay what we borrowed.

Trust essentially is the ability to rely on someone’s word, or on a signed contract. In this case, contracts for debts and receivables, which underpin the entire system, must be respected. Trust in banks themselves is also crucial, as they create money out of nothing by offering credit. The same applies to trust in the central bank. Not only because it is the bank’s bank, but above all because it is in charge of monetary regulation, regulating the growth rate of money, the linchpin that holds everything together.

If the central bank were to emit too much money for too long and with no limits, a major crisis could arise, similar to the collapse of the assignat currency in revolutionary France. Beyond a theoretically undetermined threshold, there is a risk that the official currency will be spurned, resulting in the disintegration of the system of debts and receivables, and, in turn, the potential disintegration of our entire society.

This trust must be protected, otherwise people may decamp to a foreign currency. And even if all the central banks were to do the same thing at the same time, people could potentially take refuge in gold or physical assets such as real estate. The day could even come when we take refuge in a cryptocurrency issued by a GAFA having become more solvent than states. The cryptocurrency would become a private currency, and a way to circumvent official systems.

Money is an institution, and must be managed as such, as an entirety founded on trust and rules. By rules, I mean the repayment of debt, i.e. monetary restrictions. In other words, while company and government debts are generally repaid by the introduction of new loans, by the obligation to maintain a sustainable debt trajectory. Keeping interest rates extremely low will not suffice alone to ensure this requisite sustainability, as there are no assurances over the long term, and incomes can also contract during a recession, even in an environment of extremely low interest rates. It is thus possible to suspend monetary restrictions temporarily, as is the case today, but not on a lasting basis.

The legitimacy of central banks thus hinges on their being above private and state interests alike by guarding against fiscal dominance and financial market dominance. They must be dominated neither by states, which would oblige them to maintain excessively low interest rates on a lasting basis, nor by the financial markets and their ongoing calls for more monetary injections.

The duty of central banks, then, is to defend the general interest and safeguard their credibility. Failing this, they will be powerless to make valid use of monetary policy in the event of a further need, for the economy and its effectiveness, and for social order itself.

Categories
Economical and financial crisis Economical policy Global economy

Not repaying our debt: risk of a loss of trust in money and risks for society

The members of the round table were:

  • Michel Aglietta, Professor Emeritus, Paris X Nanterre University, Advisor to the French Institute for Research into International Economics;
  • Agnès Bénassy-Quéré, Chief Economist to the Treasury;
  • Anne-Laure Delatte, Head of Research at the French National Centre for Scientific Research;
  • Olivier Klein, CEO of BRED and Professor of Financial Macroeconomics and Monetary Policy at HEC Business School.

Here is a transcript of my talk for Printemps de l’Economie.

Not repaying our debt: risk of a loss of trust in money and risks for society

We are in the middle of an unprecedented and potent crisis due to the pandemic. The response from Governments and central banks has so far been strong and appropriate. The budget and monetary policies that have been put in place come down to a temporary lifting of monetary restrictions, in other words, of spending limits. Households were still been paid if employers were no longer able to settle wages, which was crucial to avoid the economy collapsing altogether, thanks to furlough schemes. Funding has been set aside to cover the losses of several companies who, during this time, were quite simply unable to find the money to pay their costs since their fall in turnover. This was entirely necessary to protect not only demand, but also our future supply capacity. However, during normal times monetary restrictions are, strictly speaking, essential for the economy to function. 

Governments who have drastically increased their spending and continue to do so, despite a slump in tax revenues, have themselves benefited from a lifting of the monetary restrictions placed on them thanks to the central banks who have been buying up public debt at will. 

Central banks have injected a lot of liquidity into the financial markets to help them stay on tracks. They have also been supporting companies by buying their debt. In this way, the central banks have both directly and through the banks helped ensure sufficient funding for the economy. 

However, going on the basis that these policies were unavoidable in our attempts to protect the front line, we have to ask what happens next, once we return to normal, and have to deal with the massive debt?

Failure to repay public debt to private creditors would have serious consequences for both the economy and society. Even supposing that the law allowed us to get way with not repaying only the central bank – which is not in fact the case – then given that the Governments are its shareholders, we would in fact be playing a zero-sum game.

The only option would be to set up near-perpetual funding of public debt from the central bank at a rate close to zero.

Even were it possible to repay the additional debt generated by the pandemic in this way, could this solution be extended to all debt, including to future rises in public debt?

Surely this is akin to believing in a magic money tree? Put another way, the question is this: we have found ways to fund things that, yesterday, we thought were impossible to fund; so why can’t we continue doing so forever? Especially since interest rates are very low and below the rate of growth, so the solvency position of private lenders and Governments could, in theory, be protected. However, current interest rates and growth rates are only two contributory factors of solvency – a further crisis could be triggered by a fall in incomes and not only by a rise in interest rates -, of financial stability and, more generally, of confidence.

What is needed is large-scale theoretical analysis to determine whether permanent and increasing degrees of quantitative easing would be possible i.e. keeping interest rates close to zero, allowing the Government to spend more without limits, and private parties to increase their debt without restriction. 

However, a policy of endless quantitative easing would not work and should be rejected. Primarily due to the massive repercussions it would have for financial instability. Keeping interest rates too low for too long, whilst the economy returns to normal growth – which we are far from achieving – would ultimately encourage, or even generate and develop financial cycles. In other words, it would encourage larger and larger speculative bubbles which would then pop. We are all too familiar with this phenomenon of financial cycles driven by rapid credit growth combined, in a self-sustaining loop, with a speculative stock or real estate bubble. These phenomena are widely documented and are extremely dangerous because they give rise to major economic and financial crises. 

Finally, in the longer term, people could end up shunning the currency altogether. If the spending limits, and therefore monetary restrictions, remain lifted for too long, it is people’s trust in money that will be affected, because the monetary system is essentially a system for the repayment of debts. And as we know, it is the system that gives transactions their coherence and, more importantly, makes the economy work. A crisis of confidence could therefore be triggered by a loss of trust in the validity of receivables and debts, either today or in the future. The whole system is based on that trust. If you buy something, you must pay for it. If you sell something, you are owed for it. And we borrow because we are betting on the future, betting that the investment we make will generate future income, which we can use to repay what we borrowed in order to make the investment in the first place. 

A crisis therefore arises when there is mistrust in the payment system, in the debt collection system. Mistrust in financial contracts which are what give us this ability to look ahead to the future. Ultimately, mistrust in money itself.

But what is trust? It’s the ability to rely on someone’s word, or on a signed contract. And this is clearly valuable for an economy; contracts for debts and receivables, which underpin the entire system, must therefore be respected.

Trust in banks is also crucial, because they are the ones that create money ex nihilo by offering credit. The same applies to trust in the central bank. Not only because it is the bank’s bank, but above all because it is in charge of monetary regulation, the linchpin that holds it all together. 

If the central bank issues too much central bank money – and without knowing in advance where the cut-off point lies – for too long, and if monetary restrictions are not restored within a foreseeable time period, a serious crisis could occur, on a par with the collapse of France’s assignats during the French revolution, hyperinflation in Germany at the start of the twentieth century, or the recurring monetary crises experienced by certain countries in South America. After that point, there is a risk that the official currency will be spurned. Which could lead to disintegration of the debts and receivables system, in turn triggering disintegration of the monetary system i.e. the potential disintegration of our entire society. In the words of Michel Aglietta, trust in money is the alpha and omega of society. 

This trust must under no circumstances be destroyed, otherwise people may decamp to a foreign currency. This is common in less developed countries, but is by no means exclusive to them. That said, if all central banks do the same thing at the same time, it is obviously harder to escape from your own currency by transferring your assets into another currency. Then again, many are able to take refuge in gold. The day could even come when we take refuge in a cryptocurrency issued by GAFA, having become more solvent than the Governments. The cryptocurrency would become a private currency, and a way to circumvent official systems.

In conclusion, money is an institution, and must be managed as an institution, in other words as a whole entity relying on trust and rules. By rules, I mean repayment of debt i.e. monetary restrictions. These rules can be temporarily set aside, but not for long and we must not be fooled into thinking we have found a magic formula for keeping everything working without ever having any restrictions. 

Central banks must therefore remain above private interests and the interests of the State, since this is precisely what gives them their legitimacy. There is therefore no room for fiscal dominance i.e. dependence on Governments which would force them to adopt policies resulting in extremely long periods with very low, zero, or even negative interest rates, below the rate of growth, and to inject central bank money into the markets on a continuous basis. At the same time, they must also avoid financial market dominance i.e. the central bank should not be dominated by the financial markets. Central markets must avoid being dictated to by markets clamouring for yet more injections of liquidity under the threat of a stock market crash.

On the contrary, the central bank must defend the public’s interests. It must also protect its credibility. Otherwise in the future it will be powerless, in the event of genuine further need, to use monetary policy effectively and efficiently to support the economy and keep it working, and to keep society itself in check. 

Categories
Economical and financial crisis Global economy

“Low interest rates: too much of a good thing”

OPINION. When a very serious economic and financial crisis occurs in a context of near-zero short-term interest rates and prior over-indebtedness, central banks turn to unconventional monetary policies.

Some push interest rates below zero, and all launch a Quantitative Easing (QE) programme to control the long-term rates and risk premiums (spreads) of both public and private debt. This means central banks can use their conventional and unconventional policies to bring short and long interest rates to very low levels and prevent spreads from rising to levels that would trigger a catastrophic chain of bankruptcies due to a sharp rise in insolvency. Very low rates also have a direct positive effect on demand, as well as on the value of capital assets (real estate and equities in particular), which has a positive impact on demand and supports credit.

During these crises, monetary policy – even of the unconventional type – has the de facto objective of lowering nominal interest rates below the nominal growth rate. This clearly helps revive the economy and facilitates deleveraging by making debt easier to repay.

So what could possibly be the danger of such a monetary policy that protects the economy against systemic crisis and a deep recession? The risk lies in adopting a monetary policy which, in fact, is asymmetric. While it is very useful – essential, even – when central banks adopt this type of policy in such situations, in reality we are witnessing a problematic asymmetry: when growth returns with a noticeable recovery in credit, central banks fail to sufficiently reverse their policy, increase their interest rates or scale down their QE – that is, the quantity of central bank money – if they do so at all.

In the eurozone, the official reason has often been that inflation was still too low, meaning the inflation target had not yet been reached, which justified maintaining an ultra-accommodative monetary policy. However, isn’t inflation structurally, and not cyclically, very low, due to the effects of globalisation and technological progress (automation) – which exert downward pressure on wages – combined with the ageing of the world’s population? In this case, is monetary policy capable of increasing it? If monetary policy cannot raise inflation that is fundamentally very low, it obviously becomes dangerous to continue to pursue such a policy for too because it then keeps interest rates below growth rates for too long – “too low for too long”. This causes a financial loop: debt rises faster than economic growth, which leads to over-indebtedness all over again and the return of real-estate or stock bubbles.

It is a vicious cycle, because debt is also used to buy these capital assets, which feeds the bubbles and facilitates more debt. That is how the entire economy becomes more financially vulnerable, with risks embedded in the balance sheets which only grow:

1/ In the assets of financial investors and/or savers

They are looking for even a small return at any cost, since interest rates are too low. So they’re going to take more and more risk in order to get it. The risk premiums are thus compressed in a way that is completely abnormal and obviously dangerous, because when the bubbles burst, the spreads will simply not have covered the cost of the proven risk. The assets of savers and financial investors (who work for the savers: pension funds, insurers, investment funds, etc.), are thus made vulnerable. Pre-pandemic, this led to, among other things, a sharp historical drop in yields on investments in infrastructure, historically low credit spreads, very high valuations for listed and private equity companies, and investment funds holding assets that were more and more illiquid and/or with very long maturities, while ensuring the daily liquidity of these same funds, etc.

2/ In borrowers’ liabilities

Borrowers’ are taking on too much debt under these conditions, which leads to excessive leverage. Among other things, there has been a great deal of share buybacks by companies themselves, notably in the United States. So now it’s the liabilities themselves that are becoming vulnerable. They are vulnerable to a drop in cash flows linked to a slowdown in growth as well as a rise in interest rates. This, in turn, leads to a significantly larger risk of insolvency.

When the above two points combine, there is growth in the number of “zombie companies”, that is to say companies which survive, but which are not structurally profitable and which would go bankrupt at normal interest rates. This phenomenon naturally contributes to a less-efficient economy and lower productivity gains.

Maintaining interest rates that are too low for too long, when they are no longer necessary to fight against insufficient growth of the economy and loans, therefore creates a very risky situation in the long term. An asymmetric monetary policy reaction can thus lead to more financial instability, the progressive loss of economic efficiency with a decline in productivity gains and, ultimately, a succession of financial crises. This was the pre-COVID-19 situation.

The financial situation thus became catastrophic at the very beginning of the COVID crisis because the pandemic produced a dizzying drop in production and violent contractions in income and cash flow for companies against a prior backdrop of significant financial vulnerability.

By the end of March, the financial crisis caused by COVID was already more severe than that of 2008-2009, with stock-market volatility twice as high, spreads which shot up, and very problematic liquidity shortages, particularly in investment funds. Fortunately, the central banks responded at lightning speed: they lowered their rates when it was still possible – in the United States in particular – though not on the European side because they had not come back up even after growth returned in previous years. They also began to buy public and private debt, including high-yield debt, and sometimes even equities, by increasing their quantitative easing considerably. They also adopted macroprudential adjustment measures.

Central banks thus quite rightly made it possible to relieve a catastrophic financial situation within a few weeks and have supported the efforts of governments in favour of the economy through the massive use of an unconventional monetary policy. But, very soon, we’ll have to answer the following question: When growth does return to a satisfactory level, how can we exit this monetary policy if governments and companies are even more indebted? Of course, right now the central question is how to get out of an unprecedented economic crisis. And yet, despite everything, we must now think about how we will eventually escape from an exceptional situation where central banks have rightly suspended the logic of the market temporarily, by intervening deliberately and massively to ensure the liquidity of the markets and the solvency of governments and, in conjunction with government action, the solvency of companies by controlling interest rates and spreads.

First of all, the exit will need to be a very gradual one. The situation will indeed be problematic, because at the end of the crisis a number of companies will be over-indebted, especially because they will have had, and fortunately will have been able, to finance their losses, and many governments will be over-indebted, too. In addition, we will have to deal with bubbles on capital assets; prices are already rising sharply, both for residential real estate and equities. If we then raise rates too quickly by a poorly-planned withdrawal of QE, and if we hastily put an end to negative interest rates, it could have a disastrous effect on solvency in the private and public sectors. This, of course, could lead to the risk of a crash in capital-asset markets, which would reinforce widespread insolvency. The exit must, therefore, be very gradual.

Central banks would also be in a bind if inflation recovered in two or three years. If it did, should they maintain the solvency of economic agents at the cost of potentially uncontrollable inflation? Or do the opposite?

But, even if inflation did not recover, should central banks continue their QE ad infinitum if governments and companies – whether by necessity or by choice – did not deleverage? This would result in structurally increased financial instability, both in terms of over-indebtedness and increasingly extreme bubbles, with all the dangers such instability would involve. There would be an increasing moral hazard since borrowers, both private and public, would no longer fear over-indebtedness. Investors would believe that central banks would always rescue them from crashes with no repercussions, and would thus be encouraged to underweight the price of risk in their financial calculations in the long-term. Lastly, the economy would see more and more zombie companies and less of the creative destruction necessary for growth. This would lead to a lasting decline in productivity gains that would, among other things, structurally slow down gains in real purchasing power.

Ultimately, the risk of the unlimited monetisation of debts would lead to a catastrophic flight from currency.

First conclusion: to maintain their credibility, and therefore their efficiency, including during systemic crises, central banks must protect themselves, not only against the well-known risk of fiscal dominance, but also against that of financial market dominance to avoid falling into increasingly strong, violent and potentially very dangerous crises. In other words, they must not be dominated either by governments which might want their continuous intervention to “guarantee” their solvency, or by the financial markets. Central banks need to be in a strategic relationship with financial markets. And they should not be afraid to channel collective images and average market opinions into sustainable fluctuation ranges, insofar as possible, or to counter them if need be. Even if the markets today are always asking for more aid to continue their upward momentum. As Fed Chair Jerome Powell said recently, and quite rightly: “The danger is that we get pulled into an area where we don’t want to be, long-term. What I worry about is that some may want us to use those powers more frequently, rather than just in serious emergencies like this one clearly is”. 

Second conclusion: alongside the policies implemented by central banks – which need to start thinking about how they will eventually escape their ultra accommodative policies – we need fiscal policies that are sustainable in the medium-term. Not immediately, however, because we need to avoid austerity at all costs in the coming years. Structural reforms will also be necessary to increase the growth potential of each economy. Ultimately, this is the best way to escape over-indebtedness.

That includes policies that aim to increase corporate equity. To reduce excess debt – without hindering growth – we will need much more investment in equity and quasi-equity (equity loans, convertible bonds, etc.). Incentives will therefore be needed to direct household savings towards riskier capital, as well as measures targeting the cost of excess reserves of banks and insurers so as not to make their investments in corporate equity prohibitive. Temporarily, a system where the government partially guarantees the invested capital may prove necessary.

Central Banks cannot do everything on their own. Expecting too much of them can be dangerous, even for their efficiency, when it becomes necessary again.

Categories
Economical and financial crisis Economical policy Global economy

Low interest rates to save an indebted economy?

When a very serious economic and financial crisis occurs in a context of near-zero short-term interest rates and prior over-indebtedness, central banks turn to unconventional monetary policies. Some push interest rates below zero, and all launch a Quantitative Easing (QE) programme to control the long-term rates and risk premiums (spreads) of both public and private debt. This means central banks can use their conventional and unconventional policies to bring short and long interest rates to very low levels and prevent spreads from rising to levels that would trigger a catastrophic chain of bankruptcies due to a sharp rise in insolvency. Very low rates also have a direct positive effect on demand, as well as on the value of capital assets (real estate and equities in particular), which has a positive impact on demand and supports credit.

During these crises, monetary policy – even of the unconventional type – has the de facto objective of lowering nominal interest rates below the nominal growth rate. This clearly helps revive the economy and facilitates deleveraging by making debt easier to repay.

So what could possibly be the danger of such a monetary policy that protects the economy against systemic crisis and a deep recession? The risk lies in adopting a monetary policy which, in fact, is asymmetric. While it is very useful – essential, even – when central banks adopt this type of policy in such situations, in reality we are witnessing a problematic asymmetry. When growth returns with a noticeable recovery in credit, central banks fail to sufficiently reverse their policy, increase their interest rates or scale down their QE – that is, the quantity of central bank money – if they do so at all.

In the eurozone, the official reason has often been that inflation was still too low, meaning the inflation target had not yet been reached, which justified maintaining an ultra-accommodative monetary policy. But isn’t inflation structurally, and not cyclically, very low? In this case, is monetary policy capable of increasing it? If monetary policy cannot raise inflation that is fundamentally very low, it obviously becomes dangerous to continue to pursue such a policy for too long, because it keeps interest rates lower than growth rates, so interest rates remain too low for too long.  This causes a financial loop: debt rises faster than economic growth, which leads to over-indebtedness all over again and the return of real-estate or stock bubbles. It is a vicious cycle, because debt is also used to buy these capital assets, which feeds the bubbles and facilitates more debt.

The entire economy becomes more financially vulnerable, with risks embedded in the balance sheets which only grow:

  • First, in the assets of financial investors and/or savers: they are looking for even a small return at any cost, since interest rates are too low. So they’re going to take more and more risk in order to get that tiny return. The risk premiums are thus compressed in a way that is completely abnormal and obviously dangerous, because when the bubbles burst, the spreads will simply not have covered the cost of the proven risk. The assets of savers and financial investors (who work for the savers: pension funds, insurers, investment funds, etc.), are thus made vulnerable. Pre-pandemic, this led to, among other things, a sharp historical drop in yields on investments in infrastructure, historically low credit spreads, very high valuations for listed and private equity companies, and investment funds holding assets that were more and more illiquid and/or with very long maturities, while ensuring the daily liquidity of these same funds, etc.
  • Second, borrowers’ liabilities: borrowers are taking on too much debt under these conditions, which leads to excessive leverage. Among other things, there have been numerous share buybacks by companies themselves, notably in the United States. So now it’s the liabilities themselves that are becoming vulnerable. They are vulnerable to a drop in cash flows linked to a slowdown in growth or a rise in interest rates. This, in turn, leads to an increased risk of insolvency.
  • When the above two points combine, there is growth in the number of ‘zombie companies’, that is to say companies which survive, but which are not structurally profitable and which would go bankrupt at normal interest rates. This phenomenon naturally contributes to a less-efficient economy and lower productivity gains.

Maintaining interest rates that are too low for too long, when they are no longer necessary to fight against insufficient growth of the economy and loans, therefore creates a very risky situation in the long term. An asymmetric monetary policy reaction can thus lead to more financial instability, the progressive loss of economic efficiency with a decline in productivity gains and, ultimately, a succession of financial crises. This was the situation before COVID.

The financial situation thus became catastrophic at the very beginning of the COVID crisis because the pandemic produced a dizzying drop in production and violent contractions in income and cash flow for companies against a prior backdrop of significant financial vulnerability.

By the end of March, the financial crisis caused by COVID was already more severe than that of 2008-2009, with stock-market volatility twice as high, spreads which shot up, and very problematic liquidity shortages, particularly in investment funds. Fortunately, the central banks responded at lightning speed: they lowered their rates when it was still possible – in the United States in particular – though not on the European side because they had not come back up even after growth returned in previous years. They also began to buy public and private debt, including high-yield debt, and sometimes even equities, by increasing their quantitative easing considerably. They also adopted macroprudential adjustment measures.

 Central banks thus quite rightly made it possible to relieve a catastrophic financial situation within a few weeks and have supported the efforts of governments in favour of the economy through the massive use of an unconventional monetary policy. But, very soon, we’ll have to answer the following question: When growth does return to a satisfactory level, how can we exit this monetary policy if governments and companies are even more indebted? Of course, right now the central question is how to get out of an unprecedented economic crisis. And yet, despite everything, we must now think about how we will eventually escape from an exceptional situation where central banks have rightly suspended the logic of the market temporarily, by intervening deliberately and massively to ensure the liquidity of the markets and the solvency of governments and, in conjunction with government action, the solvency of companies by controlling interest rates and spreads.

First of all, the exit will need to be a very gradual one. The situation will indeed be problematic, because at the end of the crisis a number of companies will be over-indebted, especially because they will have had, and fortunately will have been able, to finance their losses, and many governments will be over-indebted, too. In addition, we will have to deal with bubbles on capital assets; prices are already rising sharply, both for residential real estate and equities. If we then raise rates too quickly by poorly calibrated QE’s withdrawal, and if we too rapidly put an end to negative interest rates, it could have a disastrous effect on solvency in the private and public sectors. This, of course, could lead to the risk of a crash in capital-asset markets, which would reinforce widespread insolvency. The exit must, therefore, be very gradual.

Central banks would also be in a bind if inflation recovered in two or three years. If it did, should they maintain the solvency of economic agents at the cost of potentially uncontrollable inflation? Or do the opposite?

But, even if inflation did not recover, should central banks continue their QE ad infinitum if governments and companies – whether by necessity or by choice – did not deleverage? This would result in structurally increased financial instability, both in terms of over-indebtedness and increasingly extreme bubbles, with all the dangers they bring. There would be an increasing moral hazard since borrowers, both private and public, would no longer fear over-indebtedness. Investors would believe that central banks would always rescue them from crashes with no repercussions, and would thus be encouraged to underweight the price of risk in their financial calculations in the long-term. Lastly, the economy would see more and more zombie companies and less of the creative destruction necessary for growth. This would lead to a lasting decline in productivity gains that would, among other things, structurally slow down gains in real purchasing power.

Ultimately, the risk of the unlimited monetisation of debts would lead to a catastrophic flight from currency.

First conclusion: to maintain their credibility, and therefore their efficiency, including during systemic crises, central banks must protect themselves against the well-known risks of fiscal dominance and financial market dominance to avoid falling into increasingly strong, violent and potentially very dangerous crises. In other words, they must not be dominated by governments which might want their continuous intervention to ‘guarantee’ their solvency, attempting to resist rate hikes for too long. But central banks should not be dominated by financial markets, either. They need to be in a strategic relationship with financial markets.

 And they should not be afraid to channel collective images and average market opinions into sustainable fluctuation ranges, insofar as possible, or to counter them if need be. Even if the markets today are always asking for more aid to continue their upward momentum. As Fed Chair Jerome Powell said recently, and quite rightly: “The danger is that we get pulled into an area where we don’t want to be, long-term. What I worry about is that some may want us to use those powers more frequently, rather than just in serious emergencies like this one clearly is”.

Second conclusion: alongside central bank policies, we need fiscal policies that are sustainable in the medium-term. Not immediately, however, because we need to avoid austerity at all costs in the coming years. Structural reforms will also be necessary to increase the growth potential of each economy. Ultimately, this is the best way to escape over-indebtedness.

That includes policies that aim to increase corporate equity. To reduce excess debt – without hindering growth – we will need much more investment in equity and quasi-equity (equity loans, convertible bonds, etc.). Incentives will therefore be needed to direct household savings more towards capital, i.e. riskier saving, as well as measures targeting the cost of excess reserves of banks and insurers so as not to make their investments in corporate equity prohibitive. Temporarily, a system where the government partially guarantees the invested capital may prove necessary.

Central banks must adopt symmetric monetary policy rules. But they can’t do it all on their own. And asking too much of them can be very dangerous, even for their credibility and efficiency, the next time they are needed.

Categories
Economical and financial crisis Euro zone

ELEC High Level Opinion : Let us use the “Next Generation EU” Fund, imbedded in an ambitious Multi-Year Financial Framework, as a driver for change in the European Union

5 June 2020 – European League for Economic Cooperation – Fondation Universitaire Rue Egmont 11 – Brussels

This High-Level Opinion is a follow-up to the Opinion adopted by ELEC on 2 April 2020 on “Audacious solidarity and coordination to save EU citizens and the EU project”. It builds on contributions from several ELEC national sections, including ELEC-Spain and ELEC-France. Now that lives have been saved and measures have been taken to keep infection rates low and contagion at bay, jobs and entire sectors of the economy need to be saved. The proposed “New Generation EU” Fund unveiled by President von der Leyen on 27 May could be a game changer in restoring hope, demonstrating that sacrifices have not been vain and becoming a model of European solidarity.  ELEC wants to express its full support for that initiative.

It is complementary to the previous agreements and initiatives that ELEC also welcomes and supports:

  • The agreement at the European Council of 23 April on a comprehensive economic policy response to the Covid-19 crisis, with three components, providing safety nets respectively for workers (SURE), businesses (the EIB Guarantee program) and sovereigns (ESM Support) for a global package worth 540 billion euros. However, these safety nets are using only loan instruments, which have the disadvantage of increasing the debt of their beneficiaries.
  • On the monetary policy side, the ECB program of asset purchases against the pandemic (PEPP) at € 1.35 trillion euros after the increase of 600 billionn euros announced on June 4th; the extension of the horizon for net puchases under this program until June 2021; and the commitment to conduct such  net purchases until it judges that the coronavirus crisis phase is over. This is a crucial program to maintain confidence in financial markets and prevent an unwarranted increase in interest rates paid by Member States. However, the May ruling of the German Constitutional Court shows that the ECB bond-buying programs are meeting resistance and have to be complemented by bolder initiatives, demonstrating fiscal solidarity among countries of the euro-zone.
  • The joint initiative announced on 18 May by German Chancellor Angela Merkel and French President Emmanuel Macron. The way of raising funds up to an unprecedented size by European Commission   borrowing on capital markets and their allocation in the form of grants (rather than loans) are a real breakthrough towards a Fiscal Union –albeit limited-. Fiscal Union, whichhas been until now the most significant missing piece of the Economic and Monetary Union, needs in fact to be further developed in the European architecture. These 500 billion euros, to be allocated in the form of grants, would now be complemented by 250 billion euros in the form of loans, forming together a new recovery instrument called “Next Generation EU”. ELEC very much hopes that, despite objections voiced by some Member States, the size and design of this recovery instrument will be accepted, bearing in mind that the funds will be spent on commonly agreed programs and priorities.

In ELEC’s view, this constructive initiative is a step in the right direction, significant in terms of policy message but still rather small in macroeconomic terms. The dynamic approach must be maintained, including the link to an ambitious Multiyear Financial Framework (2021-2027). The new MFF proposal appears well balanced. ELEC supports the idea of contemplating the introduction of new resources (linked to the Emissions Trading Scheme, a Carbon Border Adjustment Mechanism, a digital tax, etc.).  New impulse should be given to the discussion of a minimum corporate income tax level in the EU to prevent fiscal dumping.

Now kick-starting the economy is essential. Even though Member States have given their agreement in principle for a recovery plan considering the exogenous, global and symmetric nature of the shock, there is a considerable asymmetry among the countries in the consequences of the crisis and the resulting financing needs in this post-lockdown period. Economic positions of countries differ indeed with regard to their labour markets, public finances and fiscal space to support their domestic economy[1], their sectoral structure (exposure to services dependent on person-to-person such as tourism and leisure) and their belonging or not to the eurozone while some were already more vulnerable than others when the health crisis hit. No countries nor regions should be left behind. EU needs to start thinking strategically on the purpose of the fund and the way it will implement it in building a more resilient economy and a stronger European Union.

“Next Generation EU” should focus on the broader EU societal goals, in particular the green and the digital transitions

“Next Generation EU” should concentrate on investment: public investment –which has been lagging behind at least  for a decade- and support to private investment, which could be paralyzed by the crisis. It should serve as a trigger for a new and ambitious growth strategy. The funds must be applied throughout the European territory, targeting the regions, the sectors and the companies, including SMEs, that have been most severely hit by the pandemic. Its design should promote the broader E.U. societal goals and the priorities adopted by the von der Leyen Commission.  A more proactive industrial policy should complete the encouraging EU4Health program aiming to invest in prevention, crisis preparedness, procurement of vital medicines and equipment through enhancing R&D:

  • “Next Generation EU” should support, even accelerate the EU’s Green Deal ambition and the transition towards new forms of economic organization such as the circular economy.
  • As concerns the Digital Strategy, funds should be dedicated in priority to facilitate the transition from the installation phase to a deployment phase of the digital economy in order to benefit from productivity effects[2] A digital strategy can help support key sectors such as tourism and the sectors involved in the transition towards a zero-carbon economy. A proper strategy for digital infrastructure throughout the E.U. territory should be elaborated, making sure that infrastructure also covers remote areas in order to avoid a social divide between those who have access to digital instruments and those who are not connected.
  • The crisis also put light on the vulnerabilities of global supply chains. Companies will review and restructure their supply chains, tending towards diversifying out of Asia and re-shoring some elements of the chain. A proper industrial strategy is needed in Europe in order to benefit from a coherent redeployment of supply chains within E.U. member states.
  • Education, up-skilling  and retraining should be a priority in order to ensure that the labor force is properly prepared to foster disciplines in urgent need: health, environmental science, digital technologies, artificial intelligence, cybersecurity, etc.  … This is the only way to fight long – term unemployment.
  • Finally, debt issuance by the European Commission on a large scale would create the much wanted “common safe asset”, which is essential for the future development of the Capital Market Union3. CMU would facilitate the allocation of capital to long-term projects and the financing of innovation by mobilizing household savings towards longer-term instruments dedicated to growth and innovation. It would also foster the development of the euro into a full-fledged international currency. As many companies will face solvency issues in the coming months because of the sudden interruption of businesses and the sluggishness of aggregated demand, it would be appropriate to initiate some forms of harmonization of insolvency rules throughout the E.U (inspired by Chapter 11 in the US for example).

A crisis is an opportunity to move the EU forward and it should not be missed. Let us not miss this one.

Bernard Snoy et d’Oppuers (President ELEC International), Rainer Boden (Vice-President ELEC International), Servaas Deroose (Special Advisor to President ELEC International), François Baudu (Secretary General ELEC International), Andreas Grünbichler (ELEC Austria), Branco Botev (ELEC Bulgaria), Olivier Klein (ELEC France), Wim Boonstra (ELEC Netherlands & Monetary Commission), Maciej Dobrzyniecki (ELEC Poland), Antonio Martins da Cruz (ELEC Portugal), Radu Deac (ELEC Romania), Frances Homs Ferret (ELEC Spain), Thomas Cottier (ELEC Switzerland), Philippe Jurgensen (President ELEC Economic and Social Commission), Senén Florensa (President ELEC Mediterranean Commission), Javier Arias (ELEC International).www;elec-lece.eu

[1] Example: Some countries have provided state aid and risk capital to companies e.g. risk capital : Germany at national and regional level, Austria, only regional, City of Vienna.

[2] Bart van Ark, University of Groningen, The Conference Board, The Productivity Paradox of the New Digital Economy; Antonin Bergeaud, Gilbert Cette, Banque de France, Current and past recession, a long – term perspective.

3 See in this connection the  ELEC « T-Bill Fund » proposal on https://ec.europa.eu/economy_finance/articles/governance/pdf/elec.pdf