Category: Economical policy

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Economical policy Global economy

HOW CAN WE AVOID THE DEBT TRAP AFTER THE PANDEMIC?

The longer the pandemic lasts, the more governments need to support the economy, and rightly so, particularly companies in the most affected sectors and the households that depend on them, and the more central banks need to support governments by buying their additional debt. As a consequence of this, debt is strongly increasing. Post-Covid, the question is how this sharp spike in debt will be managed, coming as it does after a period of rising debt globally for at least the last two decades. This is how the ‘debt trap’ is built.  Either central banks will gradually exit their quantitative easing policy and long interest rates will rise again, potentially causing the insolvency of a number of companies and States, if they have not returned to a credible debt trajectory before.  Or they will not do it and it will exacerbate the financial and real estate bubbles already present with soon or later their bust and their disastrous economic and social consequences.  And, ultimately, a possible loss of confidence in money. What policies can we then pursue to best avoid this trap?

 There are wrong paths and others to consider, as no solution is obvious or easy.

FIRST WRONG PATH

First wrong pathis the one defended by a number of economists who say that, fundamentally, debt can be limitless because interest rates are close to zero. More specifically, with nominal interest rates below nominal growth rates, debt sustainability would be assured. Thus, de facto, debt levels would ultimately have little importance. But the underlying model, which is well known, is only true under certain conditions.

FOUR REASONS WHY THIS MODEL SHOULD BE CALLED INTO DOUBT:

First, this situation of interest rates persistently lower than growth rates almost inevitably generates financial cycles, that is bubbles on assets (particularly equities and real estate, but also gold, art, etc.), with an excessively strong and under-rewarded trend towards over-indebtedness and risk-taking among investors (households and asset managers). Ultimately, this leads to greater vulnerability in both borrowers’ liabilities and investors’ assets. Major financial crises arise sooner or later, with now well-known economic and social consequences. In addition, these crises reduce potential growth over the long term. These issues are now well documented, so we will not make the case for this point here, as it is clearly explained elsewhere. Finally, we should add that macroprudential policies, however essential they are, remain wholly insufficient to counter financial cycles. On the one hand, because they remain national and it is difficult for authorities to act against the competitiveness of the banks in their own country, on the other, above all because they only affect banks at this time, while the relative weight of financial markets in the national and international financing system has been rising sharply over the last few decades.

Secondly, notwithstanding the financial crises caused, excessively low rates for too long are themselves weighing on growth trends. This is not always well understood. In the usual model, the natural interest rate, calculated on the basis of determinants that are real variables, has been getting ever lower for several decades. It has even been very low in recent years, or even below zero in the eurozone. The extremely low or even negative natural rate could be a sign that savings are above ex-ante investments and inflation is too low, below its target. This would therefore justify taking effective rates ever lower to drive savings down and investment up, and raising the inflation rate at the same time. However, perhaps there is an anomaly in this reasoning. This idea, while partly true, is also partly mistaken, because the monetary regime, that is the monetary policy that unfolds over the long term, also in reality influences the economy and growth over the long term.

Thus, if interest rates are below growth rates for too long, monetary policy affects the real economy by the resulting misallocation of capital. Some companies in fact stay alive, while if interest rates had been close to the growth rate, they would have continually shown a loss and would have actually disappeared (these companies are called “zombies”). They stay alive, distort capital allocation, disrupt the health of healthy and competitive companies, and prevent the natural phenomenon of destruction/creation necessary for any economic dynamism in developed countries. This is one of the reasons behind the decline in productivity gains. Moreover, excessively low interest rates for too long also facilitate debt. It is much easier to borrow when the interest rate is continually below the growth rate. And over-indebtedness inevitably leads to a decline in investment, which again has a negative impact on productivity gains.

To continue our demonstration, consider the traditional model according to which lower interest rates lead to lower savings and higher investment, which holds true in normal times. In reality, if interest rates are below the growth rate for too long and close to zero, this sooner or later leads to an increase in savings. We should accept that money illusion can play a role in this. We have seen this recently (even before the pandemic), with households accumulating much more savings to offset the lack of interest received, in order to reach the capital they deem necessary for their retirement despite everything.  We should add that persistently low interest rates for a long time also weigh on company expectations. Under this scenario, we are likely to see very low nominal growth in the future, which does little to encourage an entrepreneurial spirit. Moreover, zero or negative interest rates muddle all economic calculations.

Finally, if interest rates are excessively low for too long, this creates bubbles, leading to wealth inequalities that, in addition to the resulting social consequences, may have a negative impact on consumption. It is not the households with the highest propensity to consume that generate the most wealth.

For all the reasons set out above, there is therefore a clear trap in keeping rates too low for too long. A non-monetary and non-financial model has to be used to believe that finance and money do not have a significant impact on the real economy. Yet, history has proved the contrary.

In order to avoid deflation and allow the economy to rebound, it is clearly necessary to bring interest rates below growth rates during a major crisis, including through quantitative easing policies when interest rates are already very low, particularly during over-indebtedness crises such as that of 2007-2009. But keeping them very low and below the growth rate, when growth has returned, lending is back at its normal levels, etc., leads to a structural weakening in growth, through the mechanisms described above. And then, it leads in turn to ever lower interest rates.

Finally, note that in the usual model, the Phillips curve indicates that the more employment increases, the more inflation rises. Thus, the same model indicates symmetrically that while inflation remains very low, below its target, the economy is still far from full employment. That is, savings are higher than investment, ex ante. This also indicates that the natural interest rate, a modelled and unobservable variable, is below the effective interest rate, thus pointing to the need to push the latter further downwards. But for years, and up to the current period at least, the Phillips curve has not been working any more, with full employment no longer driving the rise in prices.

This means that taking interest rates ever lower during periods of “normal” growth, in search of a lower natural interest rate, may result from a partially erroneous interpretation. An interpretation that could have a negative impact on the economy, given the effects described above. The question, then, of the inflation target, during this inflation regime, at a level below but close to 2%, would become critical.

 We believe that too low inflation is dangerous, as it carries with it a significant probability of falling into deflation, due to the impossibility of making flexible adjustments allowing private agents to react to a recession without triggering massive lay-offs or numerous bankruptcies. Excessively low inflation means it is no longer possible to bring down real interest rates or real wages, factors in less economically and socially painful adjustments. But, if structural inflation remains very low, significantly below 2%, for a long period in the economy, due to the effects of globalisation and the technological revolution, does seeking to raise it at all costs, through a permanently ultra-accommodative monetary policy, not lead to all the very negative effects explained above due to interest rates being below growth rates for too long? We believe central banks must maintain an inflation target, that is to say must have a nominal anchor objective, but the chosen targets must be adapted to the long-term economic and financial regime in force. The monetary policy conducted by central banks must in fact make it possible to achieve both monetary and financial stability.

 Third reason: the idea that interest rates below growth rates ensure countries’ long-term solvency is based on a series of heroic assumptions. First, the assumption that inflation will not bounce back significantly for a long time. Indeed, inflation is unlikely to pick up in the immediate future, but, in a few years, who knows whether US policy will not revive inflation with a very high budget deficit, wage hikes, etc.? How will a possible very strong recovery after Covid affect prices? With bottleneck effects and a lack of well-trained labor forces adapted to the growing economic sectors.  What will be the effect of the reorganisation of certain production and supply chains? Finally, what effect will the cost of the necessary energy transition have on inflation in the middle and long term? A degree of inflation would be valid and useful, as long as it does not turn into an inflationary regime, that is to say generalized indexation. But if inflation were to stay above its target for the long term, either central banks would react, and given the considerable amount of debt, would induce private and public insolvencies that could trigger a catastrophic chain of events, specifically  if the announced debt trajectory is not under control or not credible; or central banks would not react, and would therefore expose themselves to a dangerous loss of credibility due to their inability to control inflation. They are indeed guarantors of the nominal anchor, i.e. moderate inflation.

Moreover, even without any significant increase in inflation, if central banks were no longer to buy almost all of the excess public debt, because growth returned to normal for example, there would need to be buyers replacing central banks themselves. The idea that investors would limitlessly be willing to buy debt at zero or negative interest rates seems unrealistic. This is why both retail and institutional investors, as we have seen, take disproportionate risks to obtain small returns. 

 Finally, it is not only for interest rates to rise for the usual sovereign solvency equation to indicate that conditions have not been met. Indeed, even if interest rates remained at their current levels for a long time, a fairly sustainable and strong shock could lead to a drop in the growth rate itself, thereby jeopardising the expected solvency trajectory. Even a prolonged worsening primary deficit could undermine solvency, even if facilitated in parallel by an interest rate that is lower than the growth rate.

  So, there is effectively a debt trap, whether there is a surge in long-lasting and undesired inflation or not.  If central banks let rise or raise rates, whether for reasons of a return  to normal growth and full employment or to meet their inflation targets if inflation climbs up, the effects on a heavily indebted economy  will only be bearable if both governments and private agents have announced and started a credible solvency trajectory.  And if central banks do not do this, they are the ones who will lose their credibility, triggering destabilizing monetary and financial, and ultimately economic and social, potentially catastrophic dynamics.  Including the destructive dynamic of flight from money, analyzed below.

Fourth reason: if debt increases constantly due to the effect of magic money, the monetary constraint, i.e. the payment constraint, will be increasingly ineffective. However, as Michel Aglietta rightly says, confidence in money is the alpha and omega of society. The monetary system is a debt settlement system. Confidence in money is therefore based on the fact that the debt settlement system gives us confidence by being effective. If households can spend more than they earn over the long term, if companies can finance their losses without limits, if governments do not have any constraints on growth in their debt, it is the monetary system itself that will no longer be effective or credible. The very value of money will thus be questioned, and sooner or later, a flight from the currency, with the appearance of non-bank private currencies, cryptocurrencies, etc. We can easily imagine, and it is already under way, that the GAFAs, more solvent than countries and managing gigantic quantities of trade and settlement, could issue their own currency. Will households ultimately prefer to have this type of currency in this case? It would be very dangerous and destructive for society. Gold, as well as some real assets, could also be lies of escape from money. Think of German hyperinflation, assignats, etc. The payment of compensation required by the winners of the World War I forced the German government to disburse much more than it was capable of. The central bank was forced to finance this. It then ran after hyperinflation, always printing the amount of money necessary to enable spending. This led to the emergence of local private currencies, such as those from large companies, which issued bonds with very small denominations that could serve as currency instead of the mark. This situation proved destructive for society.

SECOND WRONG PATH

Second wrong path: a number of other economists want to cancel partially or totally the debt held by central banks. Note that the idea expressed is uncorrelated to that on which the first path is based. Cancelling debt can only be indispensable if the amount of debt at stake is unsustainable. The two proposals are therefore antinomic.

 The idea of debt dumping by central banks does not hold up. On the one hand, governments and central banks must be considered as a consolidated entity in order to have a true vision of the mechanisms at stake. As central banks are mostly owned by governments, what a central bank earns is therefore earned by governments. Cancelling debt, on the other hand, would lead to a serious loss of credibility for both central banks and governments. Experience through history shows that public debt cancellations are only very rarely successful, and that on the contrary they lead to very heavy costs over time. The cancellation of the debt therefore seems outright unthinkable.

THIRD WRONG PATH

         Third wrong path: to raise taxes, particularly wealth tax. First, the amounts of these taxes are in no way comparable to the amount of debt. The scales are totally different. In some countries, where taxes are low, we can fully understand that increasing taxes helps towards the solutions to be put in place. In France, taxes over GDP are among the highest among developed countries, including the current capital tax rate, which remains, even after reform, one of the highest among comparable countries. Such an increase would therefore be very dangerous for demand. As it would be very dangerous for supply, as here, once again, it is necessary, during the reconstruction phase, to encourage entrepreneurs to do business and innovate, and to foster competitiveness. This would promote both an increase in production capacity and the country’s appeal. Moreover, the number of start-ups is increasing significantly at the moment. This phase of powerful mutation, which Covid did not create but is accelerating considerably, must be well supported.

FOURTH WRONG PATH

         Fourth wrong path: Mandatory Government issued Bonds consist of drawing off a portion of household savings to finance government debt. With savings abundant due to the pandemic, this idea seems to be gaining traction. It is undoubtedly true that savings have increased sharply during the pandemic among households, but also among companies that have been little or unaffected by it. However, there are several possible analysis errors in this idea. First, such a mandatory government issued bond would most likely be perceived as confiscatory, and would significantly reduce trust in governments, which, given the world’s current state, does not seem desirable. Secondly, there would be a subsequent reconstruction of assets, because households would be afraid of not being repaid in the future or seeing the amounts due to them eroded by long-term inflation. This would have an adverse impact on consumption, resulting in an increase in savings. What’s more, the situation is completely different from the immediate post-war era, which saw households hoarding their cash under their bed. The idea was then to mobilise unproductive savings. Today, the European economy is fully banked. 99% of households in France have one or more bank accounts. When they put money aside, it is mostly in bank deposits. Savings are therefore mobilised by banks to lend to the economy. This savings is neither idle nor unproductive. A mandatory government issued bond would move savings that finance the private economy to financing the government.

HOW THEN CAN WE GET OUT OF THE DEBT TRAP?

  First of all, corporate debt. In France, we know that the corporate debt-to-GDP ratio has risen significantly in the last decade, faster than the eurozone average, and has now exceeded it. We therefore need to increase companies’ capital in relation to debt. Participation loans are a way forward, but is not the only way of doing this, because they are still debt, even subordinated, and they are relatively expensive. Convertible bonds should undoubtedly also be considered, for example. In any event, households must be encouraged to mobilise part of their savings towards companies’ capital by improving their taxation in such cases or by guaranteeing a portion of the capital thus invested. We should also bear in mind that banks and insurance companies have seen their regulatory capital required on their capital investments in companies increase significantly under Basel 3 and Solvency II. Would it not, at least temporarily, be useful for the European economy and even ultimately favourable to banks’ risk exposure, to reduce the regulatory capital cost of such investments?

For public debt, it would be necessary first to distinguish Covid debt and accept that the excess public debt due to Covid could be refinanced for an extended period of time on a “rolling” basis by the central bank. Like that of companies, government debt is in reality not strictly speaking extinguished. At maturity, they are repaid by issuing new debt, at current market conditions. The important thing for the issuer is therefore not to reduce its debt whatever happens, but to ensure a solvency trajectory that allows subscribers to be found for its new issues at subsequent maturities, and this under “normal” conditions. In order to avoid overly burdening public debt market during future refinancing, in order to avoid compromising government solvency for a sufficiently long period of time, central banks could thus ensure over a sufficiently long period of time the refinancing of the excess public debt due to the pandemic alone. This would not correspond to any cancellation or permanent monetisation of public debt.

Raise the potential growth:

  Secondly, it is essential to raise the nominal growth rate in order to make public debt more easily sustainable. Stronger growth generates more income for governments, which has a favourable impact on the balance of public finances, as well as on GDP, and therefore on the numerator and denominator of the public debt ratio. The debt ratio is therefore improved in two ways.

 We must not pursue an austerity policy, because we must not enter this vicious circle. In order to increase growth rates, we must pursue policies to support demand, until we see a return to a “normal” growth rate. But structural policies are also essential. Their goal is to increase growth potential. The essential reform of the State in France would improve the efficiency of the money spent and ultimately improve the economy’s competitiveness factors. French public expenditure is higher, in proportion to GDP, than that of most European economies, and its ultimate efficiency is too low. Its comparative performance, measured in terms of PISA and PIAAC scores, or measured by the wage level of nurses, for greater expenses in the sector of education or health, which are just a few examples among many others, clearly shows this. The French poor ranking in terms of equal opportunities (and not equality of income after redistribution, which, conversely, is one of the best among OECD countries) is another example of the way forward to improve the value of the public money spent. But these reforms are difficult to implement during economic crises and do not have a rapid effect. However, they remain essential.

 Pension reform, consisting of increasing the number of annuities to take account of demographic change, is highly effective and has faster results. The deficit in the pension system is a major contributor to the public deficit. It is easy to understand that as we are living longer, as examples overseas clearly show, we need to increase the number of annuities we pay in order to be entitled to a full pension. This reform, which is invaluable in controlling public spending, would also be additional proof that France is taking the problem of debt seriously. Finally, pension reform does not undermine growth; on the contrary, it makes it possible to encourage French people to save less by easing or even dispelling their fear of not having a sufficient or predictable pension. And because this reform increases the active population, it increases the growth potential, at a time when we will need everyone in order to produce more.

 The reform of unemployment insurance may also be of use to potential growth. Even in this period, the number of jobs that go unfilled remains high. We would seem to need unemployment insurance that does more to encourage people to find a job, while creating a marker of the various allocation criteria according to labour market indicators. At the same time, however, we need to strengthen people’s security and protection, if we are justifiably to make jobs more flexible. Current and future accelerated economic changes will require us to change profession and company even more than before. Better personal protection, particularly through better initial training and more intensive and effective professional training, is therefore an essential corollary.

CONCLUSION

 Thus, in order to avoid a step backwards in renewed growth, monetary policy support and fiscal stimulus clearly need to continue until stable growth is restored.

But it will quickly be necessary to give a clear commitment from States, like central banks, to pursue a trajectory over several years making it possible to return to the “normal” and to stick to it in a scrupulous manner, to give confidence in the debt and in fine in the money. Unlimited debt development would cause very serious monetary and financial crises, even if the timing is difficult to predict.  Commitment to a medium-term path of sustainability of public finances, in particular by increasing growth potential and without excluding the necessary financing of investments that promote sustainable growth, is essential.  Equally necessary is the commitment to a gradual and prudent return of monetary policy to a practice of driving nominal interest rates towards nominal growth rates when growth is satisfactory.”

It has indeed been clearly known since the last great financial crisis that a satisfactory and steady growth rate and a controlled inflation rate and on target are not enough to lead to the absence of bubbles and financial crises.  Monetary policy must therefore simultaneously seek economic stability (by closing the “output gap”), monetary stability (by closing the inflation gap between the observed inflation rate and the target pursued) and financial stability (by preventing as much as possible – and not just repairing – bubbles in the financial and real estate markets, as well as abnormal increases in the debt-to-GDP ratio).

In the medium term, this is a narrow way out, but probably the only one feasible.

 Biography

Artus Patrick

“Does the ECB’s inflation target need to be revised?” 

Natixis Flash Economie, 22 October 2019, no. 1421

https://www.research.natixis.com/Site/en/publication/srO6u1dWo9TfV-S4A51_G5Yqna5_bOSvBCe_Ds2V9tI%3d?from=email

Banerjee & Hofmann

“Corporate zombies”

BIS Working Papers 882 – 2 September 2020

https://www.bis.org/publ/work882.htm

Blanchard Olivier & Pisani-Ferry Jean

“Monetisation: Do not panic”

(Vox EU) – 10 April 2020

https://voxeu.org/article/monetisation-do-not-panic

Blinder Alan S.

“Monetary and financial stability in a low interest rate environment: challenges ahead”

BIS Papers No. 98, July 2018

https://www.bis.org/publ/bppdf/bispap98.pdf

Borio Claudio

“Monetary policy and financial stability: what role in prevention and recovery?”

BIS Working Papers no. 440

https://www.bis.org/publ/work440.htm

Borio Claudio

“What anchors for the natural rate of interest?”

BIS Working Papers 777, 26 March 2019 – (page 1 to 16)

https://www.bis.org/publ/work777.htm

Borio Claudio

“The expectations on central banks are simply too great”

Speech, 21 November 2019

https://www.bis.org/speeches/sp191121.htm

Carstens Augustin

“Maintaining sound money compliance and after the pandemic”

Bis speech, 8 October 2020

https://www.bis.org/speeches/sp201008.htm

Couppey-Soubeyran Jézabel, Bridonneau Baptiste, Dufrêne Nicolas, Giraud Gaël, Lalucq Aurore, Scialom Laurence

“Cancel the public debt held by the ECB and ‘take back control’ of our destiny”

Le Monde, 5 February 2021, also published in the following European media: L’Avvenire (Italy), El Pais (Spain), La Libre Belgique (Belgium), Paperjam (Luxembourg), Der Freitag (Germany), Infosperber (Switzerland), Le Temps (Switzerland), Euractiv (EU)

https://cancellation-debt-public-bce.com/

Draghi Mario

“Monetary policy and structural reforms in the euro area”

Speech, Bologna, 14 December 2015

https://www.ecb.europa.eu/press/key/date/2015/html/sp151214.en.html

ECB

“The natural rate of interest”

December 2019

https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op217.en.pdf

de Larosière Jacques

“Breaking the monetary policy deadlock”

Les Echos – 12 September 2019

https://www.lesechos.fr/idees-debats/cercle/sortir-la-politique-monetaire-de-limpasse-1130969

François Villeroy de Galhau: The tale of the three stabilities: price stability, financial stability   and economic stability

https://www.banque-france.fr/en/intervention/tale-three-stabilities-price-stability-financial-stability-and-economic-stability

https://www.bis.org/review/r210304d.htm

Goodhart Charles

“Inflation after the pandemic: Theory and practice”

Vox, June 2020

https://voxeu.org/article/inflation-after-pandemic-theory-and-practice

Goodhart Charles, Schulze Tatjana and Tsomocos Dimitri

“Time inconsistency in recent monetary policy”

Vox, 4 August 2020

https://voxeu.org/article/time-inconsistency-recent-monetary-policy

Klein Olivier

“The Current Financial Crisis : something old, something new”

Article published in Revue Sociétal no. 65 – Q3 2009. 
https://www.oklein.fr/en/the-current-financial-crisis/  

Klein Olivier / Dubreuil Thibault

“Exiting the ECB’s highly accommodative monetary policy: issues and challenges”

Financial Economy Review – 5 December 2017
https://www.oklein.fr/en/exiting-the-ecbs-highly-accomodating-monetary-policy-stakes-and-challenges-2/

Klein Olivier

“When is the next financial crisis?”

Aix meetings, 6 July 2019
https://www.oklein.fr/en/when-will-the-next-financial-crisis-happen/

Klein Olivier

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

La Tribune, 1 September 2020
https://www.oklein.fr/en/low-interest-rates-too-much-of-a-good-thing/

Klein Olivier

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

EURO 50 Conference, 14 December 2020
https://www.oklein.fr/en/the-debt-issue-risk-of-financial-instability-and-of-a-lost-of-trust-in-money/

Lowe Philip

“Some Echoes of Melville”, Speech, 29 october 2019        https://www.bis.org/review/r191101b.pdf

Categories
Economical policy Euro zone

Central banks digital currencies : benefits and hazards

While cash payments shrink, a phenomenon accelerated by the pandemic, and in response to the growing attraction of private cryptocurrencies and the lead taken by certain countries including China, the European Central Bank (ECB) too is now considering the possibility of creating its own digital currency.

A digital central bank currency can be a “wholesale” currency used between banks and the central bank – in this case, other than technically, the economy of the monetary system as a whole scarcely changes – or a central bank currency held by the public, thus co-existing with physical banknotes, also issued by central banks.

For some of the public and depending on the country, the importance of fiat money to better protect privacy varies. This is why the ECB is careful to state that it will create a digital currency alongside and not instead of fiat money, and to specify that the ECB “cryptocurrency” could potentially guarantee the anonymity of its users. In countries where banks are relatively inaccessible because branch networks are much less dense, a central bank digital currency could well increase financial inclusion.

Why do central banks want to launch such currencies, beyond the legitimate interest of not lagging behind new technologies? The fundamental reasons are their no less legitimate interest in preserving the effectiveness of certain transmission channels from monetary policy to the economy. And their need to have (monetary) contact with the general public, which could diminish, and possibly vanish, with the gradual reduction in the use of banknotes. Competition with private cryptocurrencies does not seem to me to be an argument, however, because it is down to the banking currency denominated in the national currency (or in euros, in the case of the eurozone), and therefore down to the “official” currency system as a whole, to be more credible than private (crypto) currencies, and not down to central banks alone.

While the intentions are perfectly understandable, however, care should be taken to ensure that this desire to create a digital euro does not cause financial instability. It must not be the case that at the slightest concern, whether well-founded or not, about the banking system as a whole or a particular bank, massive transfers occur from bank accounts to the central bank’s digital currency. The possibility of panic would consequently be considerably increased. To guard against this hazard, the ECB is considering capping deposits in its digital currency. If the ceiling was not very low (less than an individual holds in banknotes in their wallet on average), the creation of such a currency would potentially precipitate the possibility of systemic risk.

Moreover, such a currency – whether it is held in accounts in commercial banks or not does not change anything – in insufficiently small quantities could raise fears that a significant portion of bank deposits will gradually evaporate, thereby automatically diminishing the role of commercial banks as financial intermediaries. In the long term, it is even conceivable that deposits could be entirely held in digital central bank currencies, ultimately forcing commercial banks to refinance almost exclusively on the financial markets or with central banks to secure credit. This would then seriously damage the economy; under-estimating the role of commercial banks, the fundamental economic role of which is to be a centralised centre for risk, would have serious economic consequences. By transforming deposits, the desired duration of which is generally very short-term, into loans with an average maturity in the medium to long term, banks essentially shoulder the liquidity and interest rate risks that economic stakeholders, households and businesses do not know about or want to take. This role is extremely useful, because it underpins the proper functioning of the financial system, which consists of aligning the financing capacities of some parties with the financing needs of other parties, given that they rarely spontaneously match in terms of maturities, liquidity, and appetite for credit risk.

Lastly, the creation of a dollar-denominated central bank digital currency by the Fed could precipitate dollarization of the economies of countries with weaker currencies, which would further reduce their room for manoeuvre in terms of economic policy.

It is therefore crucial that central banks make the right decision, and make their calibrations and adjustments, with due consideration of both the benefits and the challenges and hazards of such innovation in terms of the ultimate effectiveness of financing the economy and financial stability. The potential risks could, otherwise, be significant.

Categories
Economical policy Euro zone

The post-Covid economic paths are very narrow

This much is obvious: the longer the pandemic lasts, the higher the debt will be. To counter the economic effects of the lockdowns, governments and central banks have taken powerful and vital desensitising actions. After the pandemic, they will have to reduce, and then end them. With the very good outlook brought by the vaccines, fortunately; but this phase is when the economic crisis will gradually surface, with a rise in bankruptcies and lay-offs in the affected sectors. Then will come the “debt trap”. Either the central banks will pull out of their quantitative easing policy little by little, and long-term interest rates will rise, triggering the insolvency of many companies and governments, if the latter do not find a new credible trajectory for their debt. Or they do not, and fuel the financial and real estate bubbles that exist already, which after a while would pop, bringing disastrous economic and social consequences. And, ultimately, a possible loss of confidence in money. What paths could be taken to best escape falling into this debt trap?

Cancelling the debt, a mandatory government bond issue or tax hikes are not real solutions.

Cancelling the public debt is an idea that makes no sense – as it is a zero-sum game – which is very dangerous for the credibility of a country. A mandatory government bond would be considered confiscatory. It would lead to a drop in consumption to build up savings. Savings that these days are no longer stored under the bed, but used by banks to finance loans. Lastly, taxing wealth would not make any more sense given the extent of the stakes at hand and the absolute necessity to value entrepreneurs and innovators in these changing times. A general tax rise in France, where mandatory contributions are among the highest in the world, would have a negative impact on both demand and supply.

A “Covid debt”: It would be necessary for the ECB to continue warehousing the higher government debt resulting from the pandemic over a fairly long period of time, to avoid a loss of confidence of the markets if they suddenly had to take on this part of the public debt purchased by the central banks over the period.

But the fundamental solution lies in an increase in potential growth. In the hope that controlled inflation will also come and contribute to solving the debt issue. The vital reform allowing the government to improve its efficiency will have to be launched later. The pension reform can be made now. It would contribute greatly to reducing the public deficit. Longer life expectancy requires increasing the number of annuities. Which would increase potential growth, thanks to a rise in the participation rate, and incite the French to save less, having greater confidence in their future pensions.

The unemployment benefits system also has to be reformed: the number of jobs that go unfilled remains high. The formula currently proposed, which could adjust different allocation criteria according to job market indicators, appears to be well adapted. The essential corollary: the need for individual protection, notably via a more intensive and more efficient professional training strategy to support employees during the major transformations underway.

Lastly, coming out of the Covid era, what will the economic policy mix be? The support and stimulus fiscal and monetary policies need to remain in place as long as there has not been a return to a stabilised level of growth. Austerity must be avoided. But the governments and the central banks will quickly have to commit to following a path to a return to “normal” over several years to install confidence in the debt and money. The idea that near-zero interest rates mean that there is no need to worry about debt is based on a theory according to which money and finance are neutral. History has proven the contrary. The exit paths described here are narrow, but are probably the only ones possible without significantly further exacerbating the risks.

Original column from Les Echos 16th Feb 2021

This much is obvious: the longer the pandemic lasts, the higher the debt will be. The real economic difficulties are therefore ahead of us. To fight the effects of the pandemic, governments and central banks have taken powerful and vital desensitising actions. After the pandemic, they will have to reduce, and then end them. This phase is when the economic crisis will gradually surface, with a rise in bankruptcies and lay-offs. Then will come the “debt trap”. Either the central banks will pull out of their quantitative easing policy little by little, and long-term interest rates will rise, triggering the insolvency of many companies and governments, if the latter do not find a new credible trajectory for their debt. Or they do not, and fuel the financial and real estate bubbles that exist already, which after a while would pop, bringing disastrous economic and social consequences. And, ultimately, a possible loss of confidence in money. What paths could be taken to best escape falling into this debt trap?

Cancelling the debt, a mandatory government bond issue or tax hikes are not real solutions. Cancelling the public debt is an idea that makes no sense – as it is a zero-sum game – which is very dangerous for the credibility of a country. A mandatory government bond would be considered confiscatory. This would lead to a drop in consumption to build up savings. Lastly, taxing wealth would not make any more sense given the extent of the stakes at hand and the absolute necessity to value entrepreneurs and innovators in these changing times. A general tax rise in France, where mandatory mandatory contributions are among the highest in the world, would have a negative impact on both demand and supply.

Increasing potential growth will be key in order to face the debt problems. The vital reform allowing the government to improve its efficiency will have to be launched later. The pension reform can be made now. It would contribute greatly to reducing the public deficit. Longer life expectancy requires increasing the number of annuities. This would increase potential growth, thanks to a rise in the participation rate, and incite the French to save less, having greater confidence in their future pensions. The unemployment benefits system also has to be reformed: the number of jobs that go unfilled remains high. The formula currently proposed, which could adjust different allocation criteria according to job market indicators, appears to be well adapted. The essential corollary: the need for individual protection, notably via a more intensive and more efficient professional training strategy to support employees during the major transformations underway.

Lastly, coming out of the Covid era, what will the economic policy mix be? The support and stimulus fiscal and monetary policies need to remain in place as long as there has not been a return to a stabilised level of growth. Austerity must be avoided. But the governments and the central banks will quickly have to commit to following a path to a return to “normal” over several years to install confidence in the debt and money. The idea that near-zero interest rates mean that there is no need to worry about debt is based on a theory according to which money and finance are neutral. History has proven the contrary. The exit paths described here are narrow, but are probably the only ones possible without significantly further exacerbating the risks.

Categories
Economical policy Event

TASK FORCE Carbon Pricing in Europe

portrait Olivier Klein

I had the pleasure and the honor to introduce this webinar, the opportunity to recall our convictions and our strategy to leave a low carbon world to future generations :

« I am honored to introduce the topic of our meeting today.

Thank you, dear Edmond.

Of course, now, everybody is conscious of the real, huge and present danger of carbon emissions for the planet and of the urgency of the energy transition.

It is an usual issue in economics, by the way, because air is a common good. And non private goods, common goods, are always complex issues to deal with. The question is :  who is responsible for these common goods ?

  • As far as individuals are concerned, having a free rider attitude is always a human inclination.
  • As far as Nations are concerned, they can ask themselves how accountant are they, as a Nation, for global warming. They could easily expect other Nations to bear the costs of decreasing carbon emissions, leaving the others to do the job. And we should stress that some countries, and not the smallest, play or played this game.

To help the situation, we can think of several solutions :

  1. Norms : legal constraints.

Yes, but it is not obvious to establish these norms because a lot of them can be in effect inefficient, or even sometimes counterproductive. And they have to be simultaneously established in a lot of countries, because if some important countries are not on board, the efforts won’t be successful and there won’t be fair competition.

  1.  The same with subsidies.
  2. Public opinion, may be part of the solution, reinforced by name and shame. Though, with the risk of focusing on false solutions,  politically correct but sometimes of poor or nil efficiency.
  3. Carbon Price :

It’s now a consensus among the economists that it is the best approach. Because it is the only holistic method to influence individuals as well as corporates behavior. On top of that, this solution preserves entrepreneurial and consumer freedom.

Though, it is still complex to be implemented : price setting is still an issue. Should there be a market for emission rights ? Should there be a carbon tax ?

And there are some other pregnant issues :

  1. The difficulties for those who have to bear the brunt of the consequential increase in carbon price and its impact on their purchasing power (the “Gilets Jaunes” effect).

So, what system of compensation should be implemented, if any ?

  • There are still diverging interests among Nations :
    • between rich and poor Nations
    • between industrialized and less industrialized
  • As far as Europe is concerned, a carbon price increase should go hand in hand with taxes at the European Union boarders, to avoid seriously disadvantaging the EU.

But, is it possible for the 27 countries to agree on this point ?

Conclusion :

This is the reason our task force dedicated to the carbon pricing solution has been created by Edmond Alphandery.

In order to foster the spread of this idea and to push forward possible solutions to these crucial issues, in Europe and across the Globe.

That is why Bred, AXA and Meridiam decided to support the task force on carbon pricing in Europe. »

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.