Category: Economical policy

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Economical policy

The cancellation of public debt: a false solution and a real danger

Public debt has grown alarmingly in both advanced and emerging countries. Its rise was facilitated by the central banks’ policy of quantitative easing (with interest rates lower than growth rates and the purchase of public bonds) which hold around 30% of its current outstanding balance in the euro zone and have financed more than 60% of its growth since 2008. However, current interest rates have risen sharply, particularly given the return of inflation but also a certain normalisation of monetary policy. In France, interest on public debt will amount to more than 50 billion euros in 2023 and more than 70 billion in 2027.

The exit “from the top” of such a level of public debt is necessarily very restricted, given that in France the level of taxation on GDP is already one of the highest in the OECD countries. It is therefore a question of structurally improving the growth rate through reforms to increase both productivity gains and the available workforce. And to reallocate public spending – not exclusively that of the State – as efficiently as possible, while generating, without an austerity policy, a primary surplus (before payment of debt interest) of the budget.

Some, notably in France, are pushing the much more attractive, apparently easy and effortless, idea of ​​a total or partial cancellation of public debt held by central banks. Supposed to considerably alleviate the solvency constraints of public players, this cancellation is in reality not only prohibited by the euro zone treaties, but above all ineffective and dangerous for financial stability.

Let us focus on its real pointlessness, not always well understood. The accounts of central banks, most often subsidiaries of States, must be analysed once consolidated with those of States.

Moreover, their profit is paid in the form of dividends and thus directly contribute to the budget. If central banks agreed to cancel the bonds issued by the State which is their shareholder, this State would have to recapitalise the bank concerned, by issuing the same amount of public debt. Or, if it did not do so, thus apparently lowering the public debt to GDP ratio, it would have to consolidate with its own deficits or surpluses the recurring loss or shortfall thus imposed on the central bank. And even if central banks agreed to only be remunerated at an interest rate equal to zero on the public debts they hold, the state budgets would experience a shortfall of exactly the same amount. In short, from a budgetary point of view, it is a zero-sum game. Proceeding with such cancellations, however attractive it may seem, would in reality be completely pointless.

Vain, but not without danger! The announcement of such a decision would be very destabilising and the subsequent capacity of the State to finance its debt could be seriously compromised or dearly paid for in terms of risk premium. Especially since such an operation would amount to placing monetary policy completely under the controlof public authorities. And to render it ineffective in its control of monetary aggregates and in its fight against inflation. With obvious consequences for the disanchoring of expectations and the destructive risk of hyperinflation.

Finally, and to conclude with an absurd reasoning, if such a possibility existed, without risk and without pain, why have states not been allowed to develop deficits ad libitum for a long time, without spending limits? This would have relieved the woes of the world without any cost. Unfortunately, there is no magic money.

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Economical and financial crisis Economical policy Global economy

Monetary policy challenges put into perspective

Monetary policies, in practice as in theory, necessarily adapt to changes in the way the economy is regulated and, by construction, to successive changes in inflation regimes.

The appearance of high inflation during the 1970s led to a change in the use and theory of monetary policy at the end of the decade and in the first half of the 1980s. The literature of the time endorsed the idea that the monetary weapon must be dedicated to the fight against inflation, creating a consensus on the fact that there could be no effective arbitrage between the fight against unemployment and the fight against inflation. In the medium-to long-term, accepting more inflation to strengthen growth only caused an increase in structural inflation, without an increase in the pace of growth. From 1979, Volcker heavily restricted the expansion of the monetary base (the quantity of central bank money), which raised interest rates to record highs and, in doing so, caused a strong recession.

The resulting cyclical drop in inflation gradually led to a structural regime of low inflation. Monetary policy was not the only reason here, or even the major reason. The 1980s were in fact, on the one hand, a time of financial liberalisation (deregulation and globalisation) and, on the other hand, in the real sphere, the very beginning of globalisation, which was greatly accentuated during the following two decades.

The effects of technological developments

Financial globalisation has put increased pressure on long-term interest rates in countries experiencing comparatively high inflation. And globalisation has led to the emergence of a competitive workforce cheaper than that of developed countries, implying necessary wage moderation in advanced countries. But also symmetrically a massive exit from poverty in emerging countries.

The 1990s and 2000s also brought a new technological revolution. The digital and robotics revolution, while statistically it has not shown clear evidence of an increase in productivity gains, has nevertheless slowed the growth of wages, in particular for the least qualified workforce, via the possibilities of substituting work by automation which it facilitates for certain categories of tasks.

Thus, once again, as at the end of the 19th century and the beginning of the 20th, low inflation was established for the long term, made possible by the return of the globalisation of the capital and commodity markets as well as investments and by the development of a new technological revolution. As a result, the 1990s and 2000s meant that monetary policy could be used not only to combat inflation but also to further promote regular growth at a good level.

From money supply to interest rates

Hence a new evolution of economic theory, in support of this new practice. On the one hand, it justified abandoning the money supply as an instrument of monetary regulation, to highlight the essential role of interest rate rules, i.e. the setting of key (short term) interest rates by central banks. In practice as in theory, exit LM from theoretical and econometric models (see Jean-Paul Pollin, Une macro-économie sans LM, Revue d’économie politique, March 2003). And on the other hand, the new theory of monetary policy argued that there were optimal interest rate rules that simultaneously kept inflation at the desired target level (2% increasingly became the benchmark) and ensure regular and balanced growth. This gave central banks the new ability to institute a period of great moderation, during which real cycles were greatly attenuated and inflation was almost, if not completely, under control.

The reappearance of financial cycles

However, parallel to this apparent great temperance, another phenomenon has gradually gained momentum and has not been taken into consideration by most theoreticians as well as practitioners of monetary policy. This is the reappearance of financial cycles, interacting with real cycles but with a significant degree of autonomy due to their own dynamics. These financial cycles had, however, been concomitant, at the end of the 19th century and the beginning of the 20th century, with financial globalisation and globalisation. But their ability to cause severe financial instability, with profound economic consequences, was largely ignored until the new major financial crisis of 2007-2009. In the theory forged in the 1990s and prevailing until the great crisis, financial stability was in fact considered to be a given as long as regular growth and stable inflation were both established.

However, without much attention and therefore without much monitoring, financial cycles have once again developed, longer than real cycles, made up of several phases.

With long enough real growth, a phase of rising debt rates (in the private and/or public sector depending on the period) and the development of bubbles in property assets (mainly stocks and real estate) gradually begins. This leads to a phase of euphoria where we end up collectively thinking that growth will continue forever and that the prices of heritage assets will rise constantly, giving valid reasons for this each time. The financial cycle, in its paroxysmal phase, ends with a violent reversal, due to a sudden change of opinion, a rupture of previous conventions which until then legitimised the level of debt ratios, leverage, multiples of valuation, etc., although historically very high.

Ensure multidimensional stability

These reversals of phases are partly due to the fact that it becomes more and more difficult to rationally justify these phenomena, but also because euphoric anticipations always end up being disappointed sooner or later. Finally, let us note the role of chance in these sudden changes of opinion, in these mass stampedes. De facto, certain events, however significant, do not cause any rupture, while others, sometimes seemingly more insignificant, end up doing so. Thus begins the final, catastrophic phase of the cycle, with bursting of bubbles, a sudden rise in the insolvency of a number of economic agents and recession, in a context where borrowers then seek to significantly lower their leverage and where lenders can rationally, out of fear of the future, limit their credits. All of which drive each other into a vicious cycle and contain a high risk of depression and deflation.

Thus, in such a model of regulating the economy, the stability of prices at a low level and the regularity of growth do not automatically lead to financial stability. On the contrary, the low inflation policy that this mode of regulation generates leads to structurally low interest rates, which in turn encourage increasing debt and bubbles. Monetary regulation must therefore in reality, during these periods, ensure multidimensional stability. It must strive to promote monetary stability (inflation as its objective), a regular and an adequate level of growth (effective growth as its potential), but also financial stability (fighting against an unreasonable rise in public and/or private debt rates and against destabilising speculative dynamics).

Financial deregulation and globalisation, as the long history has taught us, thus facilitate financial instability, itself linked to the intrinsic pro-cyclicality of finance. Even if, moreover, they also produce favorable effects of which is not the issue here. In such a context, it is therefore not a question of wanting to re-fragment the financial markets, but, through appropriate regulations and ad hoc policies, of knowing how to limit this pro-cyclicality as much as possible beforehand and of limiting the potentially catastrophic effects when they occur.

Fundamental uncertainty

This intrinsic pro-cyclicality and instability of finance are thus due to this endogenous uncertainty, qualified as fundamental or radical uncertainty, different from risk situations which allow a probabilistic calculation. They are also due to the simultaneous existence of an information asymmetry between the co-contracting economic agents − here for example between the lender and the borrower − which does not allow prices (or interest rates) to always play their role of balancing supply and demand. But they are also due to the presence of cognitive biases which reveal the insufficient realism of pure rationality defined and assumed by canonical models. These concepts, which make it possible to develop a theory closer to reality, more faithful to the world as it is, do not, however, call into question individual rationality. On the one hand, they provide the means to take into account a rationality that is itself more realistic, that is to say a limited rationality (the cognitive power of individuals is not infinite) and a contextual rationality (it depends on the elements of knowledge at our disposal). On the other hand, they make it possible to analyse why the sum of individual rationalities does not systematically give rise to collective rationality. In other words, why the sum of the rationalities of each, in certain circumstances, comes out of a “corridor” in which the spontaneous way actors play leads to a return to balance, but in the opposite way builds cumulative imbalances which induce a generalised vulnerability of the system (See in particular Leijonhufvud, Nature of an Economy, CEPR, February 2011).

Equipped with the prevailing theories at the time, the monetary authorities were thus unable, before the huge financial and economic crisis of 2007-2009 violently erupted, to take into account these financial cycles which see debt and bubbles expand. However, from 1987 (equities), then during 1990, 1991 and the following years (real estate), in 1997 and 1998 (sudden stop crises in emerging countries), in 2000 (equities) and of course in 2007-2009 (debt and real estate), systemic crises have reappeared, consisting of the bursting of successive speculative bubbles and increasingly pronounced credit and overindebtedness crises.

On the other hand, the return of systemic financial crises has provoked, at the international level, a salutary reaction from central banks and regulators. First of all they were able to avoid catastrophic events in these crises and to avoid the return of long periods of depression which historically follow such situations (Reinhart and Rogoff, This time it’s different, eight centuries of financial madness, Pearson, 2013 ), as was the case during the crisis of 1929. And this, thanks to curative actions, with the reaffirmed role of the central bank as lender of last resort, and preventive measures, by limiting the risks taken by banks through imposing an increase, notably in equity capital in proportion to the risks taken, to absorb possible significant losses. Then, after the great financial crisis of 2007-2009, by additionally putting in place, among other things, so-called macro-prudential regulations, in order to limit the pro-cyclicality of credit and financial markets, notably through tightening or easing counter-cyclical prudential rules, and finally by imposing liquidity ratios on banks.

Insufficiently low long-term rates

As a curative action, in order to avoid the devastating effects of systemic crises once they are triggered, including long depression and deflation, central banks have, rightly, lowered their key rates towards zero, or for some even below zero (including the ECB). But they had to face the constraint of the minimum rate being zero (“zero lower bound”), or even the constraint of the minimum rate being a little below zero (“effective lower bound”). These rates have in fact proven to be insufficiently low to avoid the risk of deflation and to bring long-term rates down as much as needed. As a result, they became innovative by launching a policy considered unconventional, that of Quantitative Easing (QE), which consists of purchasing securities directly on the markets, of thus taking virtual control of long rates and risk premiums, particularly bond premiums. Note, however, that the central bank of Japan had implemented such a policy much earlier to deal with the consequences of the violent burst in 1990 and the following years (“the lost decade”) with their major bubbles on the stock market as well as on that of real estate, leading to lasting economic stagnation and deflation.

Central banks dramatically increased their balance sheets in doing so, causing a considerable increase in the quantity of central bank money. Hence the name quantitative easing. These policies thus prevented any self-destructive speculative hype. And, after the peak of the crisis, they facilitated the debt relief of the many players requiring it, by positioning long-term market interest rates below the nominal growth rate.

But, when economic growth became satisfactory again and loan output returned to a pre-crisis pace, the central banks did not end their QE policy (or tried to do so and then quickly abandoned it, as with the Fed). We can analyse the reasons why. In any event, this has caused a problematic asymmetry in the conduct of monetary policy, since, during a severe shock, they have rightly put in place unconventional policies which they have not removed, even carefully, when normal growth returns. By thus maintaining rates that are too low in relation to the growth rate for too long, monetary policies have gradually facilitated, in many countries, both advanced and emerging, a very high valuation of the stock market and an even more visible real estate market bubble, as well as a sharp rise in debt relative to GDP.

Structural inflation below 2%

What were the explicit or unspoken reasons that pushed central banks towards this asymmetry? The answer frequently put forward is the persistence of an inflation rate that is too low compared to the inflation target of 2%. And the existence of an extremely low natural interest rate, which can be an indicator for analysing the accommodative or restrictive nature of monetary policy. This rate, unobservable, but the result of a model, is defined as that which ensures that the effective growth rate is equal to the potential growth rate, with inflation stable and equal to the objective level. However, without going further into the debate (Cf How to avoid the debt trap after the pandemic? Olivier Klein, Revue d’économique financier, May 2021), let it be noted that the underlying model is open to criticism from different points of view and that the inflation policy induced by globalisation and the digital revolution very likely generated structural inflation below the 2% objective. Central banks have fought in vain, as the facts show, against inflation, probably wrongly considered too low, by keeping interest rates too low for too long. Let us add that a protracted policy of very low rates ends up lowering the interest rate itself in the long term (Cf What anchors the natural rate of interest, Claudio Borio, BIS working papers, March 2019).

The tacit reasons were probably, in the United States, to seek to push growth on a long term basis above its potential to increase the employment rate and, in the euro zone, to protect the integrity of the monetary zone, which could have suffered from a rise in interest rates, while the insufficient convergence of the structures and economic conditions of the different member countries was clear. Let us add that the fear of a rise in interest rates creating a strong impact on the valuations of heritage assets and the insolvency of many players, including public ones − even more so when inflation was not an issue − had to play a role in maintaining these unconventional policies.

The turning point of 2022

However, be that as it may, inflation made its comeback after the end of the lockdowns, generated by restricted supply and boosted demand, further fuelled by the impact of the war in Ukraine on energy and agricultural products prices. This brings us to the turning point for monetary policies in 2022 and the ridge path they must now follow. The sudden dramatic rise of inflation necessarily led central banks to sharply increase their key rates. On the one hand because inflation is very unfavourable for businesses and households which cannot easily match the price increases in their own prices or salaries. On the other hand, because high and unstable inflation results in the loss of the benchmarks necessary for an orderly, confident, and therefore uncontested, setting of prices and wages, essential to an efficient economy, and can lead to an inflationary regime of generalised indexation, leading to uncontrolled inflation. Additionally, it was necessary to finally emerge from a period where interest rates were too low for too long, with the consequences described above. All these reasons explain why after having hesitated over the transitory nature or not of inflation, the central banks raised rapidly and strongly their key rates. And at the same time the beginning of quantitative tightening which they proceeded.

But we must also highlight the unique situation that central banks are faced with today and which requires them to proceed very cautiously from now on and to move forward, implementing monetary policy in small steps, paying particular attention to the careful study of data between each decision, in order to identify the effect of their own policy on inflation, real growth, and financial stability.

Underlying inflation has not been defeated and requires higher rates or at least being maintained at current levels over the long term. But, at the same time, a rise that is too rapid or too strong can materialise the accumulated financial vulnerabilities generated by rates that have been too low for too long, on the liabilities side of balance sheets (too much debt) or on the assets side (highly or overly valued assets) of numerous private and public players. Interest rates at the current level, or even higher, have and will tend to put a strain on the financial robustness of many players and the continuation of a very high valuation of heritage assets. Moreover, real estate, in many countries, has started to show significant signs of weakness, even warning signs of a pronounced reversal of the cycle. The central banks have therefore begun a use of monetary policy which will constantly scrutinise the state of overall financial stability and the leading indicators of the economy. They will therefore be cautious. Without losing their essential credibility in their fight against inflation. Central banks must not in fact be dominated by either budgetary policies or financial markets.

Monetary policy cannot do everything

Finally, let us emphasise that we very probably expected too much from monetary policy alone. It can’t do everything. It is crucial that fiscal policy is shaped in a way that is compatible with the phase in which the economy finds itself. Until then, there is no need to support overall demand since the end of the lockdowns, even if it has been desirable to protect the weakest populations in the face of the very sharp increase in food and energy prices. It is no less crucial that the essential structural reforms are carried out. As inflation results in this case from the impact of supply and demand for goods and services, but also for work, it is particularly important to develop production and sustainably increase the number of people available in the the job market. Through structural policies, it is therefore essential to raise the level of potential growth in order to best avoid the detrimental effects of excessively high debt ratios, especially when interest rates return to normal.

Is it still possible to value financial assets objectively?

The propensity for financial instability is due to the fragility of conventions (common opinions), which are not based on the objective foundations of a probabilistic forecast of future financial asset prices. As the various states of the future world are recurrently difficult to predict, the possibility of a rational and objective (not self-referential) valuation of assets at any time, always leading to fundamental or equilibrium prices, is in fact an assumption that can regularly prove to be heroic.

The same applies to the assessment of the solvency of economic agents, which is essentially endogenous to the system, i.e. again self-referential. Solvency stems from the fact that everyone believes that the company or government in question will subsequently be able to refinance its debt under normal conditions. This obviously depends on future trends in economic data and the borrower’s specific financial ratios. But also, by construction, on what the average opinion thinks today will be tomorrow’s average opinion on these subjects. The average expectation of what will be acceptable to everyone in the future is crucial in determining the solvency of an economic agent. This is the hallmark of a self-referential phenomenon that is endogenous to the system.

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Economical policy Global economy

Turning points in Monetary Policy

For three decades, monetary policies have adapted to what has been a profound change in the methods of regulating the economy. After the successful fight against double-digit inflation in the first half of the 1980s, through a monetary policy which led to peaks in interest rates but which inevitably caused a deep recession in the process, the economy gradually changed its ways of self-regulation. Monetary policy also changed.

The cyclical downturn in inflation – essentially caused by the sharp slowdown in the economy due to skyrocketing interest rates – gradually led to a structurally low inflation regime. Monetary policy was not the only reason here, or even the major reason. The 1980s were indeed, on the one hand, the moment of financial liberalisation – financial deregulation and globalisation (cross-border liberalisation of capital movements), in the financial sphere. And, on the other hand, in the real sphere, the moment of the beginning of globalisation which was strongly heightened in the following two decades.

Financial globalisation puts increased pressure on the interest rates of countries experiencing more inflation.

And globalisation unquestionably leads to the emergence of competitive, cheaper labour, implying a necessary wage moderation in advanced countries (and a massive exit from poverty in emerging countries).

Finally, this moment was also that of the appearance of a new technological revolution, the digital revolution which, if it did not show a massive increase in productivity gains in the statistics, was a brake on the growth of wages in certain categories of human labor tasks through the possibilities of substitution with automation that it entails.

This double movement – a globalisation of the market of capital and goods as well as investments coupled with a technological revolution – was already known at the end of the nineteenth century and the beginning of the twentieth, with the same result in the appearance of a low inflation regime.

As a result of this new regime, since the 1990s monetary policy has not had to worry so much about fighting against possible excess inflation and has thus legitimately used its available means to promote a more consistent level of solid growth. To the point, moreover, that economic models have taken these in- depth changes into account and have provided a theoretical basis for the “new” monetary policy, going so far as to promote the hypothesis of a new capacity for the latter to allow a period of great moderation, in which real cycles were greatly mitigated and inflation was stable, if not completely, under control.

However, another phenomenon has not been taken sufficiently – if at all – into account, that of the reappearance of financial cycles. It was thought that financial stability increased when we ensured consistent growth and low and stable inflation. However, without much monitoring, parallel to this period of great moderation, phases developed – longer than the real cycles – of rising indebtedness (of the private and/or public sector depending on which instances) and the development of heritage asset bubbles (mainly shares and real estate, but art can easily be included).

Financial deregulation and globalisation, as the long view of history shows, facilitate this kind of phenomena linked to the intrinsic pro-cyclicality of finance.

The monetary authorities did not then take into account these financial cycles which see indebtedness and bubbles develop during the euphoric phase of the cycle, which then inevitably generate serious crises of solvency, liquidity and catastrophic explosions of the bubbles. Thus, from 1987 (equities), then in 1990-1991 and the following years (real estate), in 1997-1998 (sudden stop crises in emerging countries), in 2000 … (equities) and of course in 2007-2009 (debt and real estate), systemic crises have reappeared, with the bursting of successive speculative bubbles, as well as increasingly pronounced credit and over-indebtedness crises.

This return of financial crises provoked a wise reaction from international central banks and regulators to first of all avoid a catastrophic unfolding of these crises – and avoid the return of long periods of depression such as that following the crisis of 1929 – through remedial actions (the reaffirmed role of the central bank as lender of last resort) and also preventive efforts to limit the risks taken by the banks and in particular to impose on them sufficient capital requirements to absorb any significant losses.

prudential regulations were put in place, in order to limit the pro-cyclicality of credit and financial markets.

However an asymmetry became gradually rooted within monetary policy itself.

In order to avoid the effects of systemic crises, including the depression and deflation that could result from them, they made the correct decision of lowering their key rates (which are short-term interest rates) towards zero, or even for some below zero (including the ECB).

And faced with the limit of their action represented by the proximity of their rates to 0%, they launched in particular an innovative policy deemed to be unconventional, that of “Quantitative Easing”, which consists of directly taking full control of long term rates and risk premiums, particularly bonds, by purchasing securities directly on the markets, by significantly increasing their balance sheet in doing so. These policies prevented any self-destructive speculative boom, but also, by positioning long market interest rates below the level of the growth rate, they facilitated the deleveraging of the many players who needed it.

The problematic asymmetry in monetary policy stemmed from the fact that, for numerous reasons, central banks did not reverse (or tried to do so and then quickly abandoned) their Quantitative Easing even when growth had got back on track and the credit supply was returning to a satisfactory level. Thus, monetary policies have gradually facilitated, in both the advanced and emerging regions, a very strong valuation of the equity market and an even more visible bubble in the real estate market, as well as a sharp rise in the public and private debt relative to GDP in many countries. Even if rates had remained very low for even longer, the ensuing financial vulnerabilities could not have avoided becoming a marked financial instability forever.

But, in addition, inflation made a comeback as the lockdowns emerged, stoked by the effects of the war in Ukraine on energy and agricultural commodity prices… This brings us to the monetary policy turning point of 2022 and to the ridge path they must now follow.

The sudden revival of inflation necessarily led central banks to sharply raise their key rates.

On the one hand because inflation is very unfavourable to companies as well as households which cannot easily match the rise in prices through their own prices or wages. On the other hand, because a high and unstable inflation undermines the benchmarks necessary for an orderly, confident, and therefore uncontested price setting and wages, essential for an efficient economy. Moreover, it was necessary to finally move on from a period where interest rates were too low for too long, with the consequences described above.

All of this explains, among other things, after a moment of hesitation as to the transitory nature or not of inflation, the strong and rapid rise in central bank rates. And at the same time the beginning of Quantitative Tightening. But it also underscores the unique situation facing central banks today, which requires them to proceed very carefully and take small steps from now on.

Underlying inflation has not been defeated and therefore requires higher rates or at least being maintained for a long time at the current levels.

But at the same time, too fast or too strong a rise in rates can bring forth the accumulated financial vulnerabilities created by rates that are too low for too long. On the liabilities side of the balance sheets (too much indebtedness) as on the assets side (highly or overvalued assets) of many private and public players.

Interest rates at current levels, or even higher, have and will tend to strain the financial strength of many players.

Central banks have therefore entered into driving a monetary policy which will constantly scrutinise the state of global financial stability and will maintain a cautious approach. Without losing their essential credibility in their fight against inflation.

Finally, it should be noted that we have very probably expected too much from monetary policy alone. It is not a cure-all. It is crucial that fiscal policy is oriented in a manner which is compatible with the phase in which the economy finds itself and that the necessary structural reforms are carried out.

Categories
Economical and financial crisis Economical policy Global economy

Global fragmentation: economic and financial consequences

Growing geopolitical tensions have and will have lasting effects on international trade (including the reorganisation of goods flows) and on the international monetary system. These tensions are generating global fragmentation by heightening commercial and financial polarisation between the increasingly marked zones of influence of the two superpowers, the United States and China, even if many countries would like to keep them at an equal distance. This situation follows several decades of globalisation in terms of trade, investment and finance, having served to significantly reduce world poverty and the gap between advanced and non-advanced countries and resulting in a lasting period of disinflation. But they have also led to profound upheavals in national industrial structures, with necessary and sometimes painful reorientations.

The economic, financial and social risks involved in planetary fragmentation are the subject of increasing debate. And major international bodies are rightly concerned about the fragmentation process under way. Globalisation has significantly reduced inequalities between rich and poor countries. In 1981, 40% of the world’s population lived below the extreme poverty line, compared with just 10% today. In China and India, for example, two billion people have risen above the poverty line. And what is true of income is also true of health, with the difference in life expectancy between advanced and non-advanced countries having narrowed considerably. The effects of highly developed international trade and globalised capital markets are, by these standards, clearly established.

We also know that the optimal functioning of globalisation hinges on mutually accepted and respected rules regulating international trade and on national policies serving to support transformations in production structures and the nature of the resulting jobs. But in the last ten years, the acknowledgement of the indispensable nature of these international rules and regulations has been undermined, particularly by China’s growing thirst for power and the attendant reaction of the United States.

Sino-American tensions are clearly central to these concerns. The rise in US protectionism largely initiated in the policy proposals of Donald Trump has continued under the Biden administration, with security measures restricting technology exports and the recent introduction of the Inflation Reduction Act. In the opposite camp, China persists with its numerous anti-competitive policies, both explicit and implicit.

The consequences of COVID, Brexit and the war in Ukraine have also contributed to the reorganisation of trade routes and capital flows. The risk of fragmentation has been reinforced by the conflict in Ukraine and the resulting increase in sanctions affecting trade, investment and the assets of sanctioned institutions and individuals.

These observations, like the economic and financial implications mentioned here, are not analysed from a moral standpoint, nor from the realistic standpoint of the balance of power between nations with opposing political regimes. Today’s growing global fragmentation has de facto effects beyond the intentions having driven the trend.

Partial de-globalisation, such as the relocation of production plants, could have favourable consequences for the climate and, in all likelihood, for the number and nature of jobs for the middle classes in advanced countries. But the resulting rise in structural inflation will erode their purchasing power. Symmetrically, it will slow down catch-up on the part of less advanced countries, with the corresponding social impact. Lastly, the reduced mobility of capital resulting from fragmentation will create fewer opportunities for financing, especially for development projects in less advanced countries. And it will increase the cost of borrowing.

Increased geopolitical tensions and the resulting sanctions, de facto and de jure, reduce the international mobility of capital in financial markets as well as in cross-border bank lending.

Consequently, financial vulnerabilities are also expected to increase, as capital could become scarcer for some countries, banks less internationally financed and therefore more fragile, and “sudden stop” or currency crises more frequent. This could undermine global financial stability. And overall – trade, investment and finance combined – it is likely to reduce global growth.

This process of fragmentation will also impact the international monetary system, potentially transforming it. What role will the US dollar and Chinese renminbi play in the future? Can and will the dollar lose more and more clout in foreign exchange reserves and international payments? The issue is important both macro-financially and for US power itself.

The dollar’s share of international trade has held steady over the last 20 years, while the relative weight of the US economy in world trade and GDP has declined slightly, measured in purchasing power parity.

In contrast, the share of the US dollar in central bank reserves has fallen by over 10 percentage points. This has not benefited the euro, sterling or yen, which generally stand to gain from the diversification of foreign exchange reserves. Instead it has benefited the renminbi, for one quarter of the decrease, along with other currencies including those of Australia, Canada, South Korea and Singapore, for the remaining three quarters. In addition, gold has once again become a source of reserve diversification, particularly for emerging central banks.

The US fundamentally needs the US dollar as a de facto, if not de jure, international currency. The country’s current account is structurally and significantly in deficit and its net external debt is constantly growing (from 10% of GDP in 2000 to roughly 70% today).

As such, the US dollar’s role as the world’s reserve and transaction is essential to the United States’ maintaining its position as a superpower. It enables the country to refinance its deficits problem-free and reduces its borrowing costs. China perfectly understands this correlation between global power and global currency and is patiently building the basis for the internationalisation of its own currency. China is encouraging countries having entered its zone of influence to gradually break free from the greenback or invoice and trade less in the currency. It is also gradually building the necessary infrastructure by creating future offshore renminbi clearing houses.

In another key factor, the United States, by using the dollar to develop the extraterritoriality of its law, and to impose sanctions (including the freeze on Russian central bank reserves), could run the risk of precipitating the decline in the use of the dollar as both an international transaction currency and a reserve currency. The monetary weapon of power is thus double-edged, as the refinancing of deficits and the vertiginous external debt of the United States would not be able to withstand a gradual de-dollarisation of transactions and reserves.

Symmetrically speaking, as long as Chinese government policy largely dominates the economy, it will be extremely difficult for the renminbi to internationalise. To be successful, a currency needs to inspire trust. Money is a debt, a bank debt relative to non-bank economic agents in a country. And internationally, money stands as a country’s debt. Which is why across-the-board trust in political, military and economic power is essential. But this trust also depends on how the currency is regulated and, hence, on the validity and stability of the institutions that define and supervise the currency. If it were to occur, the de-dollarisation process would therefore be extremely gradual, taking place over the long term.

Today’s fragmentation trend is a clear consequence of ongoing global disorder and polarisation. Political, military, economic and demographic forces, as well as the greater or lesser wisdom of leaders and peoples, will determine the final shape (on a transitional basis at least) of today’s transformations. These developments will impact growth, standards of living, quality of life and financial stability around the world.

Bibliography:

  • Geo-economic fragmentation and the world economy
    Shekhar Aiyar, Anna Ilyina
    27 March 2023 – Vox Eu columns
  • Confronting Fragmentation Where It Matters Most: Trade, Debt, and Climate Action
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Categories
Economical policy Finance Finance

Text of my speech at the EURO 50 conference in June 2023

Can the risk of financial instability come from Non-Bank Financial Institutions?  (NBFIs)

Market finance and NBFIs (pension funds, insurers, investment funds, hedge funds) have seen a sharp increase in their share worldwide since the Great Financial Crisis. It now accounts for around 50% of global financing and 30% in the corporate sector. Obviously, because banks alone cannot guarantee the full amount to be financed, it is very useful that the NBFIs, as major players on the financial markets, take part in financing. As the NBFIs sector accounts a lot in global financial assets, the correct functioning of the non-bank sector is crucial  for financial stability. However, NBFIs potential fragility has been increasing for the last 15 years or so. All in all, there is a high level of financial vulnerabilities in the financial system. Recent stresses at some banks remind us of the elevated financial vulnerabilities built over years of too low for too long interest rates and ample liquidity. The recent manifestations of these strains – Silicon Valley Bank being a good example – appeared to be more idiosyncratic. This bank was in fact very badly managed and severely undersupervised. But, this bank was not the only bank to face this situation and the fast contagion we witnessed, shows in my opinion, that we are facing a potential systemic issue, rather than a simple idiosyncratic problem. As a matter of fact, as I said, too low for too long interest rates, with very abundant liquidity have led to a high level of vulnerabilities in many balance sheets. On the liability side, numerous firms and states, and even sometimes individuals, in both Advanced and Emerging Countries, have been able to run up debts painlessly, until over-indebtedness is proven when interest rates normalize. On the asset side, because of zero, or even negatives rates, final investors or their asset managers were incited to take more and more risk to get a little return. By lengthening the maturities, by increasing the mismatch between the asset and liability duration, by choosing higher and higher leverage, including by using more and more derivatives, etc. The rapid rise in rates has of course brutally interrupted this too long period of too low rates, during which the accumulation of vulnerabilities took place. As far as banks are concerned, since the Great Financial Crisis, the bank regulation has increased significantly, notably through the increase in the required capital adequacy ratios and the setting of restrictive ratios limiting liquidity risks. So, on average, banks are much more solid than before the Great Financial Crisis. But, there is no such regulation for non-bank financial institutions,  and specifically for funds. So, the former financial environment led the NBFIs, on behalf of savers, to seek returns, but increasingly taking on risks. Let me be more explicative: 1st. In terms of credit risks – including higher and higher leverage ratios, with squashed risk premiums. 2nd. In terms of liquidity, by further extending the securities of bonds or credit, and by lowering the expected level of their liquidity. And doing so, endangering their liquidity risk, with bigger and bigger liquidity mismatching. 3rd.The funds’ use of derivatives (futures, repo, etc.) amplified tremendously their own leverage. For example, between 2015 and 2022, the financial leverage (measured by derivatives over total assets) of macro-hedge funds came from 15% to more than 30%. And for relative value funds: from 15% to 25%. On top of that, Margin calls as well as collateral calls may be fatal.

All this has been highlighted by numerous organisations in charge of supervising financial stability around the world. So, all in all, financial risk could have been partly pushed out of the banking system onto NBFIs, without control.

A piece of evidence: The violent financial crisis of March 2020, triggered by the expected impact of the pandemic, was fortunately brought swiftly under control by the Central Banks. They acted very strongly and very quickly. The violence of this flash crisis was much more due to the vulnerability of many funds, than to banks which demonstrated, by the way, their resilience. Central Banks had to buy very large amounts of securities, including high yield bonds, from funds in difficulty. Central Banks had to prevent a catastrophic chain of events, due in particular to sudden withdrawal from final investors, that these funds could not absorb without incurring excessive losses or without a major liquidity crisis.

Of course, additionally, high levels of interconnectedness among NFBIs and with banks can also be a crucial channel of financial stress.

And, obviously, possible repeated Central Banks’ interventions to provide them with liquidity support during systemic stress events could bring a very dangerous moral hazard effect !

So, some ideas arising from these facts and analyses, converging with the IMF proposals: 1st.Robust surveillance, regulation (capital and liquidity requirements) and supervision are needed. 2nd.Public data disclosures are required to post the liquidity mismatch chosen, the level of leverage (including derivatives), etc. 3rd.Only under these conditions, access to Central Banks facilities liquidity at a high interest rate and/or fully collateralized should be envisaged. Otherwise, there would be a free option!

As NBFIs became more and more important in the financial intermediation, and because of their systemic risk and potential vulnerabilities, an appropriate international regulation of the NBFIs seems to me a priority.

Finally, I’d like to say that prudential and macro-prudential regulation cannot do everything. But it is essential to mitigate the intrinsic procyclicality of finance and to prevent -better then to cure-financial instability, as much as possible.
So, in my opinion, prudential and macro-prudential regulation must now be extended and adapted notably to investment and hedge funds.

> Agenda of the last EURO 50 session on the 19th of June 2023 in Luxembourg at the European Investment Bank

Categories
Economical policy Management

Are we unhappy at work or has work lost its value?

An increasing number of news stories are focusing on young people who have decided to stop working and simply scrape by, saying that minimum social security benefits are enough for them. As if it were normal to count on those who work to choose not to work. This signals a shift in how young adults think about work.

People point to sociological surveys to show that French companies are home to a quasi-pathological malaise at work, which would explain the refusal of the majority to postpone the retirement age.

Something appears to have broken between French people and their work, the latter having become a source of dissatisfaction and even psychological and physical disorders.

The urgency, then, is to address this distinctively French phenomenon of unhappiness at work, stemming from the poor organisation of companies and the insufficiently regulated “exploitation” of employees.

Naturally, job satisfaction depends on the particular situation of each company, and even more specifically on the company department and line managers. But numerous French companies are working to improve their management, identify what good management entails, and develop best practices.

What if the problem is not about this widespread sense of unhappiness at work? What if this new and oft-repeated discourse hides something else? A number of surveys and polls show that many employees trust their company and have struck a good work-life balance. More than a sense of malaise at work, perhaps the problem is about the erosion of the value of work itself? And this goes beyond the crucial improvements to be made regarding arduous or highly repetitive work and, notably in public hospitals and schools, cases of growing pauperisation and a lack of recognition of the importance of the work of these professionals.

Is it not the case in France over the last 40 years that the switch to a 35-hour week, the introduction of a fifth week of paid holidays and the decrease of the retirement age to 60, regardless of the obvious individual benefits and the justice of such measures, have undermined the essential value of work, both individually and collectively? Or do some people now see work as pointless, or perhaps as a necessary evil, but one that needs to be reduced to a minimum?

Our welfare society – an invaluable collective asset that needs to be safeguarded – has been considerably corrupted by requiring too few obligations for ever extended benefits.

During the Popular Front, for example, the unemployed were required to accomplish tasks of general interest in exchange for subsidies.

And financially, as well as for the social contract to remain widely acceptable, we are no longer in a position to grant more and more benefits; instead we are obliged to roll out revolutionary reforms, as in the Nordic countries since the early 1990s and in Germany since the early 2000s. This shift consists in putting a stop to the unquestioned provision of aid by introducing clear requirements and conditions for benefits, the aim being to save the country from economic and financial collapse and to preserve the social pact allowing a high level of social protection, as the Nordic countries did in the 1990s.

Our society as a majority is not suffering from a widespread malaise at work caused by businesses themselves; it is prey to a growing disaffection for work combined with the rise of unbridled individualism adroitly dressed in discourses of solidarity, alternative approaches to labour, and even the rejection of capitalism. Benevolence – a fine and increasingly advocated value – can be conceived only if accompanied by a parallel and equally strong sense of requirement. Failing this, under the pretext of understanding and explaining everything, benevolence allows anything and everything. This could destroy the relationships between benefits and obligations that form the basis of the social contract and harmonious co-existence. What we need, then, is benevolence with requirements, healthy demands on oneself and others, in families, work and school. This sense of requirement is free of any connotation of intransigence.

Constantly supported and protected while giving nothing in exchange, too many people have lost sight of the relationship between, on one hand, the right to income, health and a pension and, on the other, work.

If the value of work is not restored as soon as possible, a major economic, financial and social crisis may occur. We need to understand that the only source of wealth is work. And that the high standard of living and social protection enjoyed in France relative to other countries can only be defended in the short to medium term by the work of the French themselves.

Work is a source of liberation and socialisation rather than alienation. Socialisation, social ties, and the act of forging one’s place in the world all constitute a key social need and are most often made possible by work. Work enables shared projects to be achieved. It gives meaning. It organises social life. Companies and company departments need to constantly strive towards the best way of working and empowering individuals in their work and that of their teams, without idealising reality but also without systematically blackening it ideologically. We must not forget that work serves to collectively safeguard – and to improve – the standard of living and social protection of the entire population.