Category: Euro zone

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Euro zone Global economy

There is no such thing as magic money… or, how to get out of the debt trap

Conventional and unconventional monetary policies play an essential role during serious crises. They push both short and long interest rates to very low levels, below the growth rate. These very low rates have a direct, favourable impact on demand and an indirect impact by increasing the value of capital assets (notably, real estate and equities). The policies also facilitate deleveraging by making it easier to repay debt. Even spreads are pushed down to ensure that they won’t trigger a catastrophic bankruptcy chain reaction via a brutal increase in insolvency.

However, when these monetary policies are in place for too long, they can become a serious source of danger and a significant risk to financial stability. It is very important, and even indispensable, for central banks to adopt these types of policies in certain situations, from major financial crisis to the deep recession resulting from the handling of the economic consequences of the pandemic. However, they can lead to a problematic asymmetry when growth returns with a significant increase in credit and central banks fail to reverse their policies, do so incompletely, increase their interest rates by too little or fail to reverse their quantitative easing policies, or do so incompletely.

Growth in the eurozone recovered satisfactorily by 2017 and credit was again being issued at a high pace. However, the ECB’s policy remained unchanged. The reason given was that inflation was still too low, that is, the target inflation rate had not yet been reached. In the eyes of the central bank, this justified maintaining an ultra-accommodative monetary policy. However, could monetary policy cause inflation to increase? Wasn’t inflation structurally, and not cyclically, very low? In this type of situation, it became dangerous to continue the policy for too long because it maintained interest rates below the growth rate: interest rates were kept too low for too long. This caused the return of a financial cycle with debt rising faster than economic growth and the return of capital asset bubbles, notably in real-estate and equities. It was accompanied by a loop effect, as are all financial cycles, because, in this case, debt was also used to buy capital assets, which fed the bubbles and facilitated the accumulation of more debt.

Whenever interest rates are kept too low for too long, the financial vulnerability of the overall economy increases with significantly more serious risks on balance sheets, in the assets of some groups and the liabilities of others.

1. In the assets of financial investors and savers. In this type of interest rate situation, these players look for returns at any cost, since interest rates are too low. They take on more and more risk in order to obtain it. Risk premiums are thus compressed in a way that is completely abnormal and dangerous: when the bubbles burst, spreads simply cannot cover the cost of proven risk. The assets of savers and of the financial investors who work for them (pension funds, insurers, investment funds, etc.), are thus vulnerable. Starting before the pandemic, this led to a historical drop in yields on investments in infrastructure, to historically low credit spreads on high-yield and investment-grade debt, to very high valuations for listed and private equity companies, to investment funds holding increasingly illiquid assets and/or with very long maturities while ensuring the daily liquidity of those same funds, etc.

2. In borrowers’ liabilities. Borrowers tend to take on too much debt in this type of environment, since the cost of money is low compared to the growth rate, resulting in excessively high leverage. This includes, among other things, share buybacks by companies, notably in the United States, making those companies vulnerable as well. They are vulnerable to a drop in cash flows linked to a slowdown in growth as well as to an increase in interest rates. This, in turn, leads to a significantly greater risk of insolvency in the future.

The combination of the two points above creates a situation of strong global financial vulnerability. In addition, the situation results in an increase in the number of zombie companies, i.e., companies that continue to operate although they are not structurally profitable. They would go bankrupt with normal interest rates, that is, equal to the nominal growth rate. This makes the overall economy less effective and weakens productivity gains.

Maintaining interest rates too low for too long, when they are no longer required to fight insufficient economic growth and credit, therefore creates a very risky macroeconomic situation in the long term. An asymmetrical reaction in monetary policy can lead to serious financial crises.

This was the situation pre-COVID-19. The financial situation thus became catastrophic at the very beginning of the COVID crisis because the pandemic produced a dizzying drop in production and violent contractions in income and cash flows for companies in several sectors. By the end of March, the financial crisis caused by COVID was already more severe than that of 2008-2009, with stock-market volatility twice as high, spreads shooting up violently, and sudden very problematic liquidity shortages, particularly for investment funds. Fortunately, the central banks responded extremely quickly: they lowered their rates when it was still possible to do so, notably in the United States. They also began to buy public and private debt, including high-yield debt, and sometimes even equities, considerably expanding their quantitative easing policy. They also productively adapted the macroprudential adjustment measures. Central banks quite rightly made it possible to relieve a catastrophic financial situation within a few weeks and supported the efforts of governments in favour of the economy through the massive use of unconventional monetary policy.

If the pandemic doesn’t start up again, the question will arise as to how we can exit this monetary policy when growth returns consistently to a satisfactory level, given that government and company debt has increased much more than before the pandemic? Without abruptly ending the extraordinary support measures implemented by governments and central banks, we will have to start thinking now about the eventual exit from an exceptional situation in which central banks were right to temporarily suspend market logic by putting the monetary constraints for private and government borrowers on hold.

We will be faced with high levels of government and company debt as well as capital-asset bubbles. If we raise rates too quickly via a poorly-planned withdrawal from Quantitative Easing, it could have a disastrous effect on solvency in the private and public sectors. This could lead to a crash in capital-asset markets, which would increase overall insolvency. The exit must, therefore, be very gradual and controlled.

Note that, if inflation wasn’t merely a transitory phenomenon (it is currently increasing because the restrictions weighing down on economies have been lifted and the labour shortage experienced in many high and low added-value sectors is dissipating day by day) this would raise very complex issues for central banks. Should they maintain the solvency of economic agents at the cost of potentially uncontrollable inflation? Or do the opposite?

But, even if a new inflationary period doesn’t arise, should central banks continue their quantitative easing policy ad infinitum if governments and companies do not nolens volens pay down their debt? This would result in structurally higher financial instability, both in terms of over-indebtedness and increasingly extreme bubbles, with the very serious economic, financial and social instability inherent to the inevitable resulting crises. There would be an increasing moral hazard since borrowers, both private and public, would no longer fear over-indebtedness. In addition, investors would understand that they have a free hand thanks to the central banks, which will always protect them from crashes, with no repercussions, and would thus be encouraged to underweight the price of risk in their financial calculations over the long-term. Lastly, the economy would see more and more zombie companies and less of the creative destruction necessary for growth. This would lead to a lasting decline in productivity gains that would, among other things, structurally slow down gains in real purchasing power.

Ultimately, the risk of the unlimited monetisation of debt would also lead to a catastrophic capital flight. A healthy and effective monetary system is, in fact, a reliable and trustworthy debt settlement system. Therefore, if artificial solvency was achieved due to the long-term use of overly-low interest rates, the debt level could continue to rise without any apparent constraints until it created a real crisis of confidence in the value of debt and, eventually, of the currency.

To maintain their credibility and, therefore, their effectiveness, during future systemic crises, central banks must protect themselves against the known risk of fiscal dominance as well as against financial market dominance. In other words, they cannot be dominated by governments, which might demand continuous intervention by the banks to ‘guarantee’ their solvency. However, they shouldn’t be dominated by the financial markets either. Central banks need to be in a strategic relationship with the financial markets. However, they can’t be afraid of channelling them insofar as possible toward areas of sustainable fluctuation, or to counter collective perceptions and opinions when groupthink results in speculative bubbles. They must do so even though markets today are consistently asking for more monetary injections to continue their upward momentum. Jerome Powell, the chairman of the American Federal Reserve said recently, and quite rightly that: “The danger is that we get pulled into an area where we don’t want to be, long-term. What I worry about is that some may want us to use those powers more frequently, rather than just in serious emergencies like this one clearly is”.

However, alongside the policies of the central banks – which need to start thinking now about the best way to eventually escape their ultra-accommodative policies – we need fiscal policies that are sustainable in the medium-term, while taking care not to cause a recession by acting too quickly. It must also be made clear that there will be no ‘magic money’ and that the measures taken during the pandemic were extraordinary and cannot, under any circumstances, be continued over the long term. Governments must therefore implement structural policies (investments and reforms) which are indispensable to increase the growth potential of their economies. They must immediately start to explain that it is time to mobilise to facilitate growth through more work. In France, notably, via pension and labour market reforms, given that many French companies are facing bottlenecks, including in hiring. Ultimately, this is the best way to gradually escape over-indebtedness.

Central banks cannot do everything on their own. Expecting too much of them can be dangerous for the economy as well as for their own effectiveness, when they are called upon again.

Olivier Klein : The crucial role of commercial banks – Banque & Stratégie april 2001
https://www.oklein.fr/en/the-crucial-role-of-commercial-banks/

Olivier Klein : The post-Covid economic paths are very narrow – Les Echos February 16, 2021
https://www.oklein.fr/en/the-post-covid-economic-paths-are-very-narrow/

Olivier Klein : Not repaying debt: risk of a loss of trust in money and risks for society – complete version – Les Echos November 2020
https://www.oklein.fr/en/not-repaying-our-debt-risk-of-a-loss-of-trust-in-money-and-risks-for-society-complete-version/

Olivier Klein : Post-lockdown: neither austerity nor voodoo economics – Les Echos May 2020
https://www.oklein.fr/en/post-lockdown-neither-austerity-nor-voodoo-economics/

Olivier Klein : The debt issue : risk of financial instability and of a loss of trust in money – Conference EuroGroup 50, 12 décembre 2020
https://www.oklein.fr/en/the-debt-issue-risk-of-financial-instability-and-of-a-lost-of-trust-in-money/

Categories
Economical policy Euro zone

Europe’s response to the pandemic

The Next Generation EU recovery plan is a remarkable innovation that enables the European Commission to pay €750 billion (divided between grants and loans) to the twenty-seven member countries, based not on their ‘relative weight’ but on the needs of each country and shared objectives. But it is also a major innovation because this recovery plan also allows Europe, for the first time, to raise a common, joint debt of the same amount.

The result of the historic agreement reached between France and Germany, this plan represents an important step forward in the necessary construction of a stronger, more effective and more united European Union. It was particularly appropriate that this plan was welcomed as major European progress. Without, however, going so far as to describe it as Europe’s ‘Hamiltonian moment’. In 1790, Alexander Hamilton, the first Secretary of the Treasury of the United States, organised the takeover by the federal government of the debts of the various US states, which had been considerably increased by the War of Independence. At the same time, he established import duties, a source of recurrent federal revenue. Hamilton, leader of the Federalist Party, thus enabled the United States to take a decisive step in its federal construction. Europe has not gone that far.

To begin with, this significant development itself is currently hampered by several types of dysfunction and obstacles. The disbursement of grants and loans appears slow and complex to implement. Now that the European Parliament has adopted the plan, it must be approved and ratified by all twenty-seven national parliaments before it can be implemented, and the twenty-seven countries will have to justify to the European Commission the use of their subsidies and the reforms necessary for their economy. This is no doubt an understandable requirement before committing to such an act of solidarity, but it is unfortunately slow and complex and incompatible with the immediate financing needs of the States, at a time when a slower recovery is being announced for the European Union, with growth forecasts for 2021 of +4.4% compared with +6.4% in the United States, which will also have slowed down much less in 2020 (-3.5%, compared with -6.8% for Europe).

Moreover, there is no guarantee that such a Community budget will be maintained in the future and that the accompanying common debt can be renewed. Many so-called “frugal” countries have already suggested that this is just a “one off” operation, linked only to the existence of the pandemic. Therefore, the timely implementation of these instruments will not necessarily lead to the construction of a more federal Europe.

Moreover, the pandemic is considerably accelerating many changes that were under way in all areas. Europe is obviously not immune to these changes, but it is not well placed in the new growth sectors of the economy. It must therefore quickly consider pooling more resources to increase and accelerate investment in these areas. This is what the Next Generation EU plan intends to do, but perhaps not commensurate with the challenges of global economic and technological competition. In order to participate in the renewed dynamism of the world economy and be a player in the new sectors driving growth, it is necessary for Europe, an old civilisation, not to lose its vitality, its taste for innovation and its capacity to take risks. The precautionary principle alone cannot serve as a guide to prepare for the future.

Furthermore, it is becoming urgent to resume the institutional construction of the Union and at least of the eurozone. If it is to defend its integrity and its social market model in the long term, it must be both economically efficient and united. The necessary structural policies must therefore be conducted on a country-by-country basis in order to reassure the ‘frugal’ countries that they will not have to pay for the ‘spendthrift’ countries ad infinitum, in exchange for the implementation of elements of a transfer union. A European investment policy to re-industrialise the regions with a deficit is also an additional and essential condition. Structural policies alone – assuming they are effectively implemented – will not be enough. Europe will also have to face the fact that the countries that make up Europe will emerge from the pandemic with even greater disparities than when they entered it.

Lastly, it must develop a common strategy to exist on the international scene between the two superpowers, the United States and China, if it wishes to carry weight in the future in the international arena, by defending its values as well as its political, diplomatic and economic weight.

If Europe’s leap forward in the face of the pandemic is clearly to be welcomed, European ambition must bounce back with a certain sense of urgency, by making the essential changes, particularly in terms of institutional regulation, if it is to meet the substantial challenges of the present time. The road will not be easy, but time is running out.

Categories
Economical policy Euro zone

Europe’s response to the pandemic

“A crisis offers an unmissable opportunity to move forward.” This was the conclusion of ELEC international’s position paper last June: “Let’s use the Next Generation EU Fund as a driver for change.” With the adoption for the first time of a common recovery plan and a Community loan to finance it, Europe is moving forward and has a great opportunity to assert a better way of regulating the Union of 27.

The Next Generation EU recovery plan is a remarkable innovation that will enable the European Commission to disburse €750 billion (divided between grants and loans) to its twenty-seven member countries, based not on their “relative weight” but on the needs of each country and on shared objectives. But it is also a great innovation because, for the first time, this recovery plan also allows Europe to raise a common, joint debt of the same value.

Born of the historic agreement between France and Germany, this plan represents an important step forward in the necessary construction of a stronger, more efficient and more united European Union. It was particularly appropriate to see this plan being welcomed as a major European step forward. However, describing it as Europe’s “Hamilton moment” might be a little strong. In 1790, Alexander Hamilton – the first Secretary of the Treasury of the United States – arranged for the federal government to cover the debts of the various American states, which had been considerably increased by the War of Independence.

At the same time, it established import taxes – a source of ongoing federal revenue. In doing so, Hamilton – the leader of the Federalist Party – enabled the United States to take a decisive step forward in its federal construction. Europe has not gone that far. And promising developments are currently being held back by several types of failure and obstruction.

To begin with, the disbursement of grants and loans appears slow and complex to implement. Now that the European Parliament has adopted the plan, it must be approved and ratified by all twenty-seven national parliaments before it can be implemented, and the twenty-seven countries will have to provide evidence to the European Commission of the use of their subsidies and the supporting reforms necessary for their economy. Such a requirement is no doubt understandable before undertaking such an act of solidarity, but it is unfortunately slow and complex, and incompatible with the immediate financing needs of the States, at a time when a slower recovery is being predicted for the European Union, with growth forecasts for 2021 of +4.4% compared to +6.4% in the United States, which also experienced much less of a slowdown in 2020 (-3.5%, compared to -6.8% for Europe).

In addition, there is no guarantee that such a Community budget will be maintained in the future and that the accompanying joint debt can be renewed. Many “frugal” countries have already suggested that this is essentially a “one-off” operation, linked only to the existence of the pandemic. The expedient implementation of these instruments will not necessarily lead to the construction of a more federal Europe. This is why this hardly constitutes a “Hamilton moment” for the Union.

Furthermore, the pandemic is considerably accelerating many across-the-board changes that were already under way. Europe is obviously not immune to such changes, but it is not well placed in the new growth sectors of the economy. It must therefore quickly consider pooling more resources to increase and accelerate investment in these areas. Of course, this is what the Next Generation EU plan intends to do, but perhaps not to an extent that really addresses the challenges of global economic and technological competition. In order to participate in the renewed dynamism of the world economy and be a player in the new growth sectors, it is necessary that our Europe – an old civilisation – does not lose its vitality, taste for innovation and ability to take risks. The precautionary principle alone cannot serve as a guide to the future.

It is therefore becoming an urgent priority to resume the institutional construction of the Union, or at least of the euro zone. If it is to defend its integrity and its social market model in the long term, it must be both economically efficient and supportive. The necessary structural policies must therefore be conducted on a country-by-country basis in order to reassure the “frugal” countries that they will not have to go on subsidising the “spendthrift” countries forever, in exchange for the implementation of aspects of a transfer union. A European investment policy that reindustrialises regions running a deficit is also a complementary and necessary condition. Structural policies alone – even assuming they are effectively implemented – will not be enough. Europe will need to face the fact that its countries will emerge from the pandemic with even greater disparities than when they entered it.

It also needs to develop a common strategy for existing on the international scene between the two hyperpowers – the United States and China – if it wishes to be a player in the future in the international arena, where it can defend its values as well as its political, diplomatic and economic weight.

Finally, the example of the EU’s joint vaccination purchasing policy also reveals the various obstacles that can impede the construction of a united and ambitious Europe. The practical and generous idea of a “Vaccine Union” had the virtue of avoiding unhealthy competition between the twenty-seven Member States for doses – thus favouring the richest at the expense of the others – and could demonstrate the power of the European model by guaranteeing equitable access between the Member States by means of distribution in proportion to their populations. Negotiating on behalf of all countries, whether they had a pharmaceutical industry or not, meant giving priority to consensus-building, negotiating hard on prices, preferring European producers, and rigorous compliance with procedures. At a time when the United Kingdom and the United States were applying a “whatever it takes” policy in terms of vaccine purchases, the Union was losing precious time in the race to vaccinate, even though the health of all its citizens and its economic recovery depended on its speed.

Lastly, we should somewhat qualify the numerous criticisms and comments questioning the management of the pandemic by Europe, and by France for that matter. A simple reminder seems appropriate: no one is yet able to state the ultimate results, effects, consequences and outcomes… or even the exact origin of the virus! A recent study by France Stratégie aimed at identifying the true mortality rates of Covid at global level raises major questions over the international comparisons made since the beginning of the pandemic, and calculation methods in particular, which vary from one country to another. Using the excess mortality rate, i.e. the ratio of expected to observed deaths, as a basis for comparison, we can see that Europe is the second least affected region in the world, behind the Far East. It also appears that France has been much less badly affected than the average European country. The time to take stock will come later.

Although Europe’s response to the pandemic is clearly to be welcomed, Europe’s ambitions are facing many practical and institutional obstacles, too often based on differences of interest between EU members. Europe must bounce back with a clear sense of urgency, making the necessary changes, particularly in terms of institutional regulation, if it is to face up to the significant present challenges. The road will not be an easy one, but time is running out. It is for this reason that our League must continue its efforts by bringing its thoughts to the debate, in order to promote an efficient and dynamic Europe, strong in its values and its economy.

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 and financial crisis Euro zone

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

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

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

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

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

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

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

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

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

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

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

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

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

Thank you.