Category: Economical and financial crisis

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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

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Conjoncture Economical and financial crisis Global economy

Post-lockdown: neither austerity nor voodoo economics

The central banks took swift and effective action. States also acted rapidly in an attempt to handle the cost of the unprecedented fall in production as effectively as possible. They did so by enabling the financing of company losses and by taking on the cost of labour, since businesses generating zero revenue cannot continue paying their employees. The aims are to prevent layoffs and bankruptcies, protect production capacity and avoid an appalling rise in poverty.

The set of measures temporarily lifts monetary constraint – vital in normal circumstances to the efficient functioning of the economy – from economic players, businesses and households.

Monetary constraint

But in today’s economic meltdown, the normal exercise of monetary constraint would be catastrophic, leading to bankruptcies and countless irretrievable job losses. For their part, the central banks, while ensuring the liquidity necessary to the financial system, have wisely suspended the monetary constraint of states.

Once the health crisis is over, putting an end to this exceptional suspension will not be an easy task, and it would be dangerous to let people believe that monetary constraint at all levels could be durably lifted simply by central banks buying state and company debt on an ad lib basis.

While monetary constraint should not be abruptly reintroduced, as this could send the economy into a new downward spiral, neither should it be suspended for too long. This is because we must absolutely avoid a flight from currency, the value of which is wholly dependent on the trust placed in the effective exercise of monetary constraint, and hence in banks and central banks, as well as in the quality of debt, including public debt.

Fatal illusion

Central banks should make a part of the additional public debt resulting from the health crisis interest-free on a practically indefinite basis to lighten the load and foster the return of growth. But they must do so in a precise and strictly circumscribed manner. The idea of central banks permanently suspending monetary constraint is a fatal illusion. The major risk involved in acting as if monetary and economic constraints no longer exist is thus not a return of traditional inflation but a loss of confidence in currency. Sooner or later, this would lead to the appearance of a form of hyper-inflation and deep financial instability.

Pressure from public opinion

The reopening could thus entail elevated risks of economic policy mistakes. Under pressure from public opinion, policy may seek to return too swiftly to orthodoxy or assume that we are exempt indefinitely from any and all constraints.

A solid supply policy must be led to rebuild the country’s production capacity and even increase it to reduce its strategic dependence. The process will require all the capacity for work and entrepreneurial spirit of everyone involved. The supply policy must further mobilise labour and include a substantial focus on recapitalising businesses and facilitating investments. Failing this, companies will exit lockdown heavily in debt and may well be unable to invest sufficiently on a lasting basis.

The supply policy must be accompanied by a policy to boost demand, since both have suffered considerably during the crisis. Increasing taxes will not be compatible with either policy. Consequently, we will need to accept budgets with extremely gradual deficit reductions and the fact that monetary policies can only return to their unconventional practices in a cautious fashion. But to salvage trust in state debt and in currency, this should be achieved as part of a highly explicit plan.

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Conjoncture Economical and financial crisis

Post-lockdown: neither austerity nor voodoo economics (complete version)

Read the complete version of my column in the 14 May 2020 issue of Les Echos

The central banks took swift and effective action. States, including France, also acted rapidly and appropriately in an attempt to handle the cost of the unprecedented fall in production as effectively as possible. They did so by enabling, as far as possible, the financing of company losses and by taking on the cost of labour, since businesses generating zero revenue cannot continue paying their employees. The key objectives are to prevent layoffs and bankruptcies, protect production capacities, in some measure, and avoid an appalling rise in poverty.

In essence, the set of measures introduced temporarily lifts the monetary constraint from the various economic players, businesses and households. Monetary constraint applies in normal periods as it is vital to the efficient functioning of the economy.

The sole businesses that are likely to survive in the medium and long term are those that do not bleed money in an uninterrupted fashion. Otherwise, economic efficiency – which French politician Michel Rocard famously said was the only good way to spare human suffering – would not be possible and no Schumpeterian growth permitted. The same applies to households, which cannot spend more than they earn on a lasting basis.

But in today’s economic meltdown, the normal exercise of monetary constraint would be catastrophic, leading to bankruptcies and countless irretrievable job losses.

For their part, the central banks, while ensuring the liquidity necessary to the financial system, have wisely suspended the monetary constraint of states.

Once the health crisis is well and truly over, reactivating monetary constraint will not be a simple matter. But it will be indispensable. And it would be misleading and dangerous to let people believe that monetary constraint at all levels could be durably lifted simply by central banks buying state and company debt on an ad lib basis.

While monetary constraint should not be abruptly reintroduced, as this would send the economy into a new downward spiral, neither should it be suspended for too long. This is because we must absolutely avoid a flight from currency, the value of the latter being wholly dependent on the trust placed in the effective exercise of monetary constraint, and, hence, the trust placed in banks and central banks, as well as in the quality of debt, and public debt in particular.

In this respect, I believe that central banks should make a part of the additional public debt resulting from the health crisis interest-free on a practically indefinite basis to lighten the load and foster the return of growth. But they must do so in a precise and strictly circumscribed manner. The idea of central banks permanently suspending monetary constraint is a fatal illusion.

While there has not been a correlation between the money supply and inflation since the 1980s, the major risk involved in acting as if monetary and economic constraints no longer exist is not a return of traditional inflation (which would be welcome if it were to remain limited) but a loss of confidence in currency through widespread mistrust.

Sooner or later, this would lead to the appearance of a form of hyper-inflation and major financial instability. Economic history, right up to the present day, is littered with examples of interminable ruin and crises with terrible social impacts resulting from the illusion that no constraint exists and that everything is possible without having to produce the requisite wealth.

The reopening could thus entail elevated risks of economic policy mistakes. Under the sway of emotion and the pressure of public opinion, policy may seek to return too swiftly to orthodoxy or believe that we are exempt indefinitely from any and all constraints.

A solid supply policy must be led to rebuild the country’s production capacity and even increase it to reduce its strategic dependence. The process will require all the energy, capacity for work and entrepreneurial spirit of everyone involved. The supply policy must further mobilise labour and include a substantial focus on recapitalising businesses and facilitating investments. Failing this, companies will exit lockdown heavily in debt and unable to invest sufficiently on a lasting basis.

The supply policy must be accompanied by a policy to boost demand, since both have suffered considerably during the crisis. Increasing taxes will not be compatible with either policy. Consequently, we will need to accept budgets with extremely gradual deficit reductions and the fact that monetary policies can only return to their unconventional practices in a cautious fashion. But to salvage trust in state debt and in currency, this should be achieved as part of a highly explicit plan.

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Economical and financial crisis

The three-headed crisis: pandemic, economic and financial – macroeconomic analysis of the current crisis I wrote on April 4

On the financial markets, the “black swan”, feared by those who, like me, thought that the possibility of the occurrence of a powerful financial crisis was singularly on the rise, has taken the form of the coronavirus.

And since, through the almost global confinement measures, this pandemic alone has abruptly brought production to a standstill, it has submerged us in a crisis of unprecedented violence taking the shape of a pandemic crisis, an economic crisis and a financial crisis.

It has arrived against a backdrop of extreme financial vulnerability, the result of an accumulation of high risks over the last few years on the part of lenders and investors alike. The latter trend itself owes to an overly long period of extremely low interest rates. All of which makes the financial crisis resulting from the coronavirus that much stronger and dangerous.

As a result:

  • The money market has shut down and banks can no longer finance themselves, even for three-month periods, except for central banks, which fortunately are taking action;
  • Securitisations are no longer being invested and the conduits of investment banks carrying securitised assets are no longer financing on the money market, requiring them to finance their “warehousing” themselves and carry all the risks that they involve;
  • More and more investment funds are no longer able to respond to margin calls and some are going bankrupt. And I am afraid this is just the start;
  • It is pointless commenting on the equity market, which appears bottomless thus far;
  • Meanwhile, risk premiums on bonds, after being far too low, are now increasing rapidly, making life hard for many investors.
  • Numerous businesses that previously were over leveraged are finding it difficult to refinance. In the United States, this has been reinforced by share buybacks by the companies themselves, which has become a common practice for generating artificial returns for shareholders.

In addition, shale gas firms, generally small and highly leveraged, are being brought to their knees by the oil prices on the international markets. Which in turn is seriously impacting the banks and funds that have provided them with substantial financing.

A vicious circle is emerging that I have pointed to as a threat since my conferences last summer on the clearly visible rise of financial vulnerability and the preparation for the future financial crisis.  Given the violent deterioration in company cash flows and the very high pre-existing debt levels of numerous businesses, the ratings agencies have begun to downgrade corporates across the board. Around half of the companies rated in the OECD countries are in the BBB category. If these businesses lose a grade, they drop out of the investment grade category and into the speculative category. This will necessarily require a number of funds committed to holding only corporates with investment-grade scores to sell them, leading to an ever-steeper rise in spreads.

And this will generate further contractions in share prices. Fortunately, the central banks have committed to buying considerably more corporate bonds. Hopefully, this will suffice to quell the vicious circle.

The central banks have acted soundly and swiftly, even though I ascribe the strong financial vulnerabilities that have significantly heightened the current financial crisis to the fact that they failed to exit their unconventional policies in time and thus pushed the financial cycle upwards owing to extremely low interest rates for far too long, “to low for to long”. They encouraged borrowers and lenders/financiers, including numerous investment funds, pensions funds and insurers (more on average than banks), to take reckless risks.

We are also fortunate that governments are reacting well on the whole in terms of shouldering the cost of this unprecedented decline in production, while protecting as much as possible the financing of businesses, i.e. the financing of their temporary operating losses. To avoid layoffs and bankruptcies as much as possible, governments are supporting the cost of work at companies that, with little or no revenue, can no longer pay their employees.

Governments are temporarily suspending the monetary constraints, which in normal times are vital to the efficient functioning of the economy, applying to the various economic agents, businesses and households. But this monetary constraint would be completely catastrophic if it were to apply in such a period. For their part, the central banks have momentarily(?) suspended the monetary constraints of countries, while endeavouring quite rightly to ensure the liquidity necessary to the entire economic and financial system.

Let us hope that this transitional phase is as short as possible, though it is clear that the recovery will be difficult and far from immediate, as supply chains – and value chains –cannot instantly resume their correct functioning. The lifting of confinement measures, either country by country or all countries at the same time, will probably not happen at once or in simultaneous fashion.

Furthermore, once the health crisis is truly over, the exit from the exceptional suspension of monetary constraint will not be an easy matter. It will be long and hazardous. We must avoid causing a flight from currency, the latter having value only if trust is placed in the effective exercise of monetary constraint, and thus trust in banks and central banks which are supposed to enforce it.

The end of confinement could also be accompanied by high risks of mistakes in economic policy that, under the influence of emotion and pressure from public opinion, could seek to return to orthodoxy either too swiftly or too slowly. Moreover, at a time when all purchasing power needs to be harnessed and when we need everyone’s energy and entrepreneurial spirit to stimulate both supply and demand, it would be politically unsound to generate a massive increase in taxes, either on income or wealth. A strong policy of structural reform, one that increases the potential growth level rather than decreasing purchasing power, will be essential, along with a policy on bolstering demand.

We will need to accept budgets with very gradual reductions in deficits and monetary policies that will transition back from their unconventional practices slowly and on a cautious basis. And all of this with a sufficiently clear time frame to maintain trust in country debts and currency.

This, then, is my analysis, offered with all the modesty called for in this entirely unprecedented situation.

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Economical and financial crisis Finance

When will the next financial crisis happen?

Panel discussion with Lorenzo Bini Smaghi, Chairman of the Board of Directors of Société Générale and former member of the ECB Board; Charles Calomiris, Professor, Financial Institutions at Columbia University; Antoine Lissowski, Chief Executive Officer of CNP; Shubhada Rao, Chief Economist at Yes Bank; Wilfried Verstraete, Chairman of the Management Board of Euler Hermes; and Olivier Klein, Chief Executive Officer of BRED and Professor of Financial Economics at HEC.

The most recent major financial crisis led to a risk of deflation that justified unconventional monetary policies, with zero or even negative short-term and long-term interest rates approaching zero because of Quantitative Easing. Setting long-term interest rates below the nominal growth rate helps those with excessive debt regain their financial well-being more easily. At the same time and in conjunction, it also revives the economy.

Today, we are no longer exposed to the risk of deflation, given our undeniable growth and a sharp recovery in credit, albeit earlier in the US than in the eurozone.

The risk of a financial crisis therefore does not come directly from this, but from maintaining a very accommodating and even exceptional monetary policy, which is no longer necessary once there’s no longer any risk of deflation. In the United States though, this policy has slightly shifted with the Fed raising key interest rates beginning in 2016 and phasing out Quantitative Easing since 2017. Also in the Eurozone, net securities purchases due to Quantitative Easing have stopped since the end of 2018, with stabilisation of the ECB’s balance sheet without any reduction, but its zero or even negative key interest rates have remained unchanged.

In addition, there is now talk in both the US and the Eurozone of going back to rate cuts and possibly resuming net QE purchases.

Why? Because inflation is not where the central banks want it to be. Will it get there in the short term? That is not what we are discussing here, but it is not obvious that inflation will achieve its target in the short term. The effects of globalisation and of the technological revolution, as well as the current regulation in the labor market, seem to induce a flattering of the Phillips curve. Without a significant rise in inflation, can we constantly pursue this goal with near-zero or negative short-term and long-term interest rates?

More likely, the central banks tacit reason to do so is that they fear a rate hike that would end up posing serious insolvency problems for the private sector. But that is also the case for the public sector. The issue of fiscal dominance therefore seems to be coming into view, since the central banks seem to be under pressure to avoid compromising the solvency of States.

There is also the current fear of an economic downturn that explains the desire of central banks to pursue even more accommodating policies.

So, for all these reasons, it is generally agreed that very low interest rates are here for the long haul. In other words, they are “low for long”. I believe that this leads to a dangerous vicious circle, because keeping nominal interest rates below nominal growth rates for too long doesn’t help economic players to reduce their debt. It actually just encourages them to continue taking on even more debt. This also drives borrowers as well as savers and institutional investors to be increasingly reckless in taking risks: some in terms of their financial structure and others with regard to the future value of their investments so that they can gain at least some returns.

This leads directly to increased financial instability and therefore an increased risk of a financial crisis. If we look at all the financial crises historically and analytically, we can very clearly identify the signs of a rather mature financial cycle, which may cause a potentially significant financial crisis to return sooner or later. Of course, we never know exactly when. The three canonical forms of systemic crises are those associated with the bursting of speculative bubbles on wealth assets such as stocks and real estate, those associated with the bursting of a credit bubble, and liquidity crises. And of course, these three forms can combine with each other.

Where could the crisis come from this time? Probably not from a stock market bubble. P/E ratios are not excessive in relation to their past trends, even though indexes are breaking records and certain sectors seem to be overvalued. The real estate bubble, facilitated by extremely low interest rates, also doesn’t seem to have been an extremely serious problem so far. However, housing and commercial property prices continue to rise. Even general price index adjusted, in many countries they have returned to near or above where they were before the crisis, which itself was triggered in 2007 by a bursting real estate bubble tied to a credit bubble.

But above all, what is disturbing today is the credit bubble itself. It is not specifically a banking issue, because it touches on all forms of indebtedness also permitted by all the financial investors, investment funds, insurers, pension funds, and so on. The global debt ratio has increased dramatically over the last 10 years since the Great Financial Crisis. As we have said, this has been facilitated by interest rates that have been too low relative to the nominal growth rate for too long. 

For example, global debt, including both the public and private sectors, was around 190% of global GDP in 2001, 200% in 2008, and 230% in 2018 (source: BIS). Advanced countries rose from about 200% in 2001, to 240% in 2008, and to 265% in 2018.

 We therefore have not seen a global debt reduction, including in OECD countries, but there has been debt reduction only for certain economic agents and in certain countries.

However, this higher global debt ratio is not the only reason to fear the next crisis. As always during each identical phase of the financial cycle, it has been accompanied by stronger and stronger risk-taking by both borrowers and investors. These are individual savers or institutional investors (most of the time representing individual savers) who are seeking at least some returns, despite the interest rate structure grinding down to zero. It goes without saying that it is difficult to offer negative returns to savers. Given that, pension funds, insurers, investment funds, and banks are trying in good faith to find bonds and loans that pay off at least a little.

We are fully in the euphoric phase of the credit cycle in the sense that players are ignoring risk with the hope that interest rates will remain low for the long term and that growth will go on forever, so that the risks taken do not prove true. This type of phase is well identified historically, and the cycle even seems to be quite mature. Corporate loans are therefore being granted to firms with declining solvency, which in turn increases their financial vulnerability. Loans and credit are becoming longer and increasingly illiquid. More and more of these loans are granted in the form of bullet loans, with principal repayable on the final maturity date without regular repayments. This is an aberration for both the lender and the borrower, given that the borrower cannot repeat this process each year because of its medium size and “plays on” its ability to renew its loan on more or less favourable financial conditions once its loan or credit reaches its maturity. Even so, everyone is taking on more and more bullet debt.

And there is also more leverage, dangerously increasing the company’s financial risk intrinsically. In addition, the amount and quality of collateral or guarantees have fallen sharply in recent years. As for covenants, which allow contractual limits to be placed on the debt-to-equity ratio or EBIT, they have been completely distorted. Covenants are still quite frequent today, but since they are fixed at such low levels, this amounts to placing a limit that tends towards infinity. At the same time, risk premiums have fallen considerably, further increasing the vulnerability of lenders.

As such, banks, pension funds, investment funds, and insurers have begun to accumulate much more illiquid and much riskier assets with much lower risk premiums. Furthermore, for several years, borrowers have been increasing their leverage and resorting to longer and longer bullet loans with fewer and fewer financial constraints imposed by lenders, making their financial situation even weaker.

So, what are the factors that could cause the bubble to burst? Of course, everyone is talking about rising interest rates. And since the belief is that inflation – and therefore interest rates – won’t rise soon, it can ultimately be assumed that there won’t be any financial crisis.

But I do not agree.

Actually, a rise in interest rates would be detrimental to many players, especially zombie companies, those that would become insolvent if rates were to return to normal. I remind you that in the OECD, they represented 1% of companies in 1990, 5% in 2000, 12% in 2016.

But the risk is not just a potential rate hike that may not be on the horizon. It may also come from a sharp slowdown in growth because we have had coinciding financial cycles and real cycles. When that happens, the crisis is in full swing, and then there is a systemic crisis. In turn, a sharp slowdown may come from causes other than rising rates. For example, geopolitical causes may arise. Lorenzo Bini Smaghi mentioned several possibilities in this regard. Or simply a sharp slowdown may be due to the usual investment cycle, production or real estate investment.

A sharp slowdown in growth leads to a decline in revenues and cash flows. As a result, debt repayment becomes more difficult for both governments and businesses. This same slowdown leads to an increase in risk premiums and therefore an asset value that depreciates sharply, as well as a negative wealth effect that increases depression.

The problem of abrupt depreciation of assets is probably lower for insurers and pension funds, because the money is in principle locked in for the long term (although this characteristic is now less true for life insurers in France) and because of the protection of accounting rules specific to insurers in particular. Lastly, the prudential rules (Solvency 2) for insurers provide greater protection against this type of risk. However, this risk is much greater for investment funds, which, in the event of a significant downturn, would induce a major negative impact on the rating of their assets, which could lead them to suddenly sell off their assets, and all the funds at the same time. And if there is a sudden depreciation of the value of the assets held, investors could start to pull out of the funds. In addition, funds generally offer liquidity to their investors but are increasingly buying illiquid assets. By the way, I hope that “fund runs” we have seen quite recently are not indicators of a forthcoming crisis. On the banks side, they are much better capitalised than before. So, in my view, they are less risky. And they are better protected against liquidity risk because of the ratio (LCR) that they must respect in this regard.

In my opinion, the next risk of a major financial crisis will instead stem from shadow banking, in the general sense. All the more the case with the macro-prudential policies, which are supposed to stem the risk of the building up of financial instability, because they only target the banking sector and not shadow banking. In addition, the structure of the yield curve with rates flattened to zero, sometimes even with central bank deposit rates below zero and long-term rates very close to or below zero, as in the Eurozone, is gradually weakening banks. They will thus gradually be less able to lend at the same growth rate. But this shouldn’t be felt for a few more years. In the short term, banks are undeniably more secure than before.

In conclusion, the danger is that central banks, which have quite rightly fought catastrophic risks with highly innovative instruments, will want to use these same weapons to cope with downturns and to protect players carrying excessive debt for too long. The monetary policy regime will lead to a long-lasting situation of zero interest rates and will be one of the main determining factors of the financial cycle dynamics. In that case, it would undoubtedly delay the next financial crisis but would considerably increase its force.

Categories
Economical and financial crisis Euro zone Global economy

REAix 2017 : Is the euro still a true vector of wealth?

Aix en Provence Economic Conference (Rencontres économiques d’Aix en Provence) July 2017

The success of a currency area depends on the monetary policy which is implemented in it, but, more fundamentally, on the way it is organised. There are organisational modes and operating modes which facilitate or otherwise the creation of wealth and which we need to speak about here.

Firstly, when the eurozone was created it was to offer the citizens of the zone the possibility to share a single currency, which was a strong and very positive symbol for Europe. It was also to facilitate intra-zone exchanges because currency risk thus no longer existed. Yet we know that when we facilitate exchanges, we positively impact the growth rate. There was one final objective, that of displacing the external constraint of the borders of each country to the borders of the zone. It was a very important argument at the time. When you manage a series of highly interdependent countries and the external constraint is expressed at the borders of each country, you quickly encounter obstacles to growth. One country which has more need for growth than another, for example, because it has a stronger demographic, may experience a growth differential in its favour compared with its neighbours and partners and thus see its imports grow more than its exports.

Accordingly, it will rapidly encounter a current account balance deficit which is difficult to bear, which will limit its growth. This is what already happened to France, compared with Germany, before the eurozone. The idea that the external constraint in an optimal zone, in a complete monetary zone, is exercised at the borders of each country, obviously gives additional degrees of freedom to increase the overall growth level. The critical balance of the current account is that of the sum of the current account balances of the countries, some of which are positive and others negative. The principle of this is very interesting, therefore.

What happened in actual fact?

From 2002 to 2009-2010 we saw the per capita GDP of a large number of southern European countries catch up with the German per capita GDP. But nor can we fail to see that, since 2010, the difference has started to increase again. A few figures: in Portugal, the per capita GDP before the eurozone represented 50% of the German per capita GDP; it moved to 52-53% towards the mid-2000s, but it fell back to 48% in 2016. If I take a look at Greece, which is obviously an isolated case, it was 55% of German GDP in 2002, rose to 70% of German GDP but fell back well down on the level reached before the eurozone, to 42% in 2016. Spain was at 68%, it rose to 75%, then fell to 62%. Even Italy, which was at 88% – much closer to Germany  ̶ rose to 90% in 2005, then fell to 72% in 2016. France was at 96% – very close, therefore, to Germany – it rose to 100%, but fell to 88% in 2016.

We can clearly see the effects of the creation of wealth linked to the creation of the eurozone, but also the recessionary effects of the eurozone’s specific crisis from 2010 onwards.

Where does this double movement come from? In fact, the conditions of the sustainability of the stronger growth of the southern European countries after the creation of the euro were not there. Why? Precisely because the organisation of the eurozone did not provide for the institutional arrangements permitting this sustainability. And this growth, in part, was achieved on credit simultaneously during this first period, so there was a very contrasted change in industrial production. We saw the zone’s northern countries grow their industrial production and a decline in the industrial production of the southern nations, including France. Obviously in a quite correlated way, even if the correlation is not total, we saw the current account balance move totally differently between Germany and the Netherlands, for example, which had a 2% GDP surplus before the eurozone and which rose to an 8% surplus over recent years, from 2008 onwards. Yet the eurozone excluding Germany and the Netherlands, went from a current account balance of 0% in 2002 to -6 % in 2008-2009. We thus have the northern countries which top the group, if I take the example of Germany and the Netherlands, at an average surplus of 8% of their current account balance, in 2008, whereas the others are posting a deficit of 6%! The difference is considerable and caused, for most of the southern European countries, a serious balance of payments crisis from 2010 onwards. The growth differential over the same period was not sustainable, therefore. Clearly, whereas a catch-up was occurring in terms of per capita GDP, other differences were being created. All this is largely due to intrinsic defects in the construction of the zone, but also to divergent structural policies of certain countries with respect to others.

One of the reasons for the eurozone’s major economic crisis between 2010 and 2012 is that we did not create a complete monetary zone and that we did not put in place coordination of economic policies, encouraging the wealthy countries to drive growth upwards and provide fresh impetus, thus alleviating the pain for those which had to slow down. This is a great shame but I think that there is no reason why we could never achieve this. Secondly, we have no mechanism for mutualising public debt or budgetary transfers from the countries doing the best to those doing less well, as is the case between states in the United States. In a single monetary zone, in principle, these mechanisms must exist which enable excessively strong asymmetric shocks to be avoided.

In addition, upstream, due to structural policies not having been put in place by the southern European counties, the creation of the eurozone, of the single currency, has facilitated a dynamic of industrial polarisation to the benefit of the northern countries. Industrial production has partially moved to the countries which were the strongest industrially and which have thus accentuated their advantages, favoured by the creation of the eurozone. This was not done without efforts on their part, since they accentuated their advantages thanks to their structural reforms, but also thanks to the eurozone mechanics. Investments spontaneously move to where physical and institutional infrastructure (production conditions, networks of subcontractors, training, job market, etc.) are the most favourable whereas there is longer a currency risk between these countries. No more need to invest as much in production in certain southern European countries since the fear of being able to sell less in the event that they devalued their currency is gone. Moreover, since currency adjustments are no longer made, if we have no policy to help with convergence, the following phenomenon occurs: we give a bonus to the countries which are the strongest and which no longer incur the readjustment of competitiveness by the devaluation of the currencies of the other countries. This is the equivalent of a regular under-evaluation, of Germany in reality, over time.

The economic crisis of the southern countries, caused notably by this partial deindustrialisation, which has greatly contributed to the crisis in their balance of payments, has also been largely due to the single monetary policy which has resulted in creating an interest rate which corresponded to the requirements of the average of the countries in the zone and which, for this reason, for the countries which were growing the fastest and catching up, has given too low interest rates which has meant facilitating the development of, in particular, real estate bubbles or credit bubbles, very visible in certain countries, which later burst.

All this has been reinforced by the fact that the financial markets failed during the period, as from 2002 to 2009 there was no self-regulation of the long interest rates which, despite the circumstances described above, constantly converged towards the German interest rates, the lowest in the eurozone. Accordingly, the countries which constantly increased their overall debt level or their current account balance deficit, did not get a wake-up call. If the markets had worked correctly, their interest rates should have increased to ring the necessary alarm bells to ensure that countries regulate themselves better and limit their external debt and their current account balance deficit.

In fact, the lack of balanced and symmetrical adjustment mechanisms shared by all the eurozone countries, the lack of sufficient institutional arrangements (such as the coordination of the economic policies, the absence of budgetary transfers, etc.), but also the lack of structural reforms in each of the southern countries constituted the basis of the crisis which erupted in 2010. As previously explained, this was a classic balance of payments crisis, a sudden stop of the southern countries. With a stop to the mobility of private capital which stopped being poured into the southern countries whereas they were doing so naturally before that from the northern countries, which, symmetrically, experienced current account surpluses. This caused asymmetric adjustments. These countries, which did not have not the above-mentioned institutional arrangements which would have been opportune available to them, had but one possibility: to adjust downwards in isolation. By reducing their employment and social costs, by reducing their production costs, thus by implementing austerity policies, in order to reduce their imports on the one side – when demand is reduced, imports are automatically reduced – and on the other still reducing costs, by regaining competitiveness to drive their exports back up. This obviously has a high social cost and a very important political cost.

In conclusion it must be said, very fortunately, that the ECB saved the eurozone in 2012. It saved it because the ECB ended the vicious circles that had become rooted in it and which were having catastrophic effects. The vicious circle between the nations’ debt and interest rates. Interest rates which were going sky high, were increasing even further the weight of the nations’ debt, which were leading in turn to a further increase in interest rates. The ECB also interrupted the second vicious circle which existed between the nations’ public debts and the banks of the countries concerned. Since the banks held the nations’ securities, the banks increased the perceived risks as to their solvency, since the nations were in bad shape. But as the nations were obliged to refinance or recapitalise the banks, they seemed at greater risk themselves. The ECB, by various appropriate measures and stances, saved the eurozone.

But the ECB cannot permanently – and it says it itself very clearly – be the only one to bear all the efforts. It does so remarkably, but it does so to buy time from governments which have to do two things, which is also rightly and incessantly repeated by the central bank. For the southern European countries and France, structural reforms must be carried out because it is this which bring the extra potential growth and will facilitate their solvency trajectory. Germany will make no efforts if the other countries do not make structural reforms because, from its point-of-view, there is no reason to show solidarity with countries which would not make the necessary efforts to avoid being in a position to repeatedly call for aid. This is a crucial factor. At the same time – and the central bank says so too – new institutional arrangements are needed to re-establish the capacity of the euro to create wealth in the eurozone, and thus a few factors of solidarity, coordination and sharing of the steering of the zone’s economy and, undoubtedly, major European projects useful for growth.

If we achieve this we shall reunite with the promise of the euro and of Europe. France has a large contribution to make. It seems to have understood this.