Category: Euro zone

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Bank Economical policy Euro zone

Fourth edition of the “Rencontres du financement de l’économie” (Financing of the economy conference) : the possible evolution of monetary policy and interest rate policy and the consequences on the economy and on banks.

Whereas the Euro Zone is at a crossroads and the governments of the member states are taking a close look at the way it works, Olivier Klein takes a look here at the possible evolution of monetary and interest rate policy in this context.

The possible evolution of monetary policy and interest rate policy and the consequences on the economy and the banks.

Are interest rates going to rise and what are the fundamentals which would justify it? What are the effects of the low interest rates on the economy and on the capacity to finance the banks?

An initial, rather general but fundamental thought: the very low interest rates are not a phenomenon due exclusively to the central banks. It can be seen that growth has started again, both in the United States and in Europe. This is good news. This will probably drive internet rates up. But since the financial crisis we have seen a period of very low growth with a global overproduction crisis, which has led to very sluggish supply and demand. Clearly low demand and a high level of saving combined with low investment are the manifestation of global overproduction. Similarly, low gains in productivity and declining global demographics – apart from in India and in Africa – are keeping supply sluggish. The simultaneity of sluggish demand and supply has resulted in very low growth rates and naturally reduces interest rates.

If the markets were working well and if the economy spontaneously self-regulated, interest rates would return to so-called natural levels. In economic theory these natural rates are those which equalise saving and investment at a level of full employment. It just happens that this is a rate which cannot be observed, it is a rate calculated by economists. And these calculations lead to extremely low interest rates. Sometimes it is even calculated that these rates should have been negative to equalise demand and supply, i.e. savings and investment, at a level of full employment. Particularly in the eurozone.

It can thus clearly be seen that it is not only the central bank which is pushing interest rates down.

This leads us to think that not so long ago we were in a period of secular stagnation, the effects and reasons of which we all know, in other words, at least since the crisis, a classic period of debt reduction with very low growth, which occurs after all the major over-indebtedness crises, such as that we witnessed from 2007 onwards. Both are possible at the same time, at least temporarily. In both cases this justifies extremely low interest rates.

To these considerations must be added the fact that the brutal financial crisis we have witnessed has brought us into a period of major deflagration with a very high risk of deflation. To fight against this deflation the central banks have pursued extremely aggressive but necessary policies. All the major central banks have acted by reducing interest rates even further than the markets pushed them to, in other words below neutral levels. As we know, the neutral level is equal to the actual growth rate plus the inflation rate, thus to the nominal growth rate. When interest rates are pushed below neutral rates this is done because we want to reinvigorate growth by pushing inflation up again – and thus avoid deflation – and, of course, in order to limit the risks of an over-indebtedness crisis to prevent the “snowball” effects on debt due to nominal interest rates above the nominal growth rate.

When there is extremely low growth and virtual nil inflation we face the zero lower bound. Monetary policy and self-regulation of the economy are thus constrained in principle by the impossibility of bringing interest rates below zero, whereas they should be to rebalance supply and demand at full employment level. In France, for example, the banks cannot propose deposits at negative interest rates, except to major institutional clients. We are limited to this zero rate. It can clearly be seen that this may be a trap for a lasting situation of under-balance. If interest rates cannot fall sufficiently low, the consequence may thus be to remain in a situation of under-balance, of under-production, with lasting under-employment and with a persistent risk of deflation. With interest rates which, although very low, no longer have enough spring to rise back, because they should be even lower.

If we now return to the effects on the economy of the very low rates, they are well known. In principle they drive growth back up by an in initial effect, the stimulation of consumption and investment and the reduction of the attractiveness of saving.

The second effect is the wealth effect. The drop in interest rates drives the price of wealth assets up, be it property or shares, which in turn bolsters consumption and investment for both households and companies.

In 2007 debt levels of private agents in the most advanced countries reached extremely high levels. This over-indebtedness crisis, which is the fundamental reason behind the financial crisis we witnessed in 2007-2009 led to an over-indebtedness crisis for countries. From 2008-2009 onwards countries ran up high levels of debt to meet this financial and economic crisis. This led a certain number of countries to situations of over-indebtedness, thus joining the situation of the private players.

This naturally led, as always in financial history, to great periods of painful debt reduction which potentially asphyxiate growth.

The effect of very low interest rates, lower than the neutral interest rates, enables these periods of debt reduction to be facilitated. As previously mentioned, this enables the well-known “snowball” crises to be avoided. If interest rates are above neutral rates and if there is a high level of debt, debt snowballs because the debt interest must be financed by increasing the debt itself. Conversely, if we have interest rates below neutral rates debt can be reduced less painfully. Obviously this is what the central banks have done by greatly reducing their short interest rates, down to zero. This is usual in monetary policy. The new feature by the central banks was to bring certain short interest rates below zero to avoid the zero lower bound. The ECB initiated a policy of negative interest rates on bank deposits at the central bank. We are at -0.40% today. If the ECB did it, it is probably because the natural interest rate in the eurozone is negative. It is also obviously a way of encouraging the banks not to hold on to cash reserves at the central bank but rather to use them to grant more loans. This is indeed what happened, moreover. The banks considered that it was better to grant loans, even at 1.50%, rather than lose -0.40% leaving cash in the central bank. This meant a differential of 1.90%. All the banks were therefore encouraged to grant more loans. And this pushed interest rates down again since the credit offer increased and competition between the banks was thus fiercer. So the banks lent more, within an intelligent central bank policy, even if it is not very usual and even if, obviously, it involved risks.

Moreover, as in the United States, but later, the ECB took more radical measures in the shape of quantitative easing, in other words developing its own bank balance by directly buying public and private debts. In reality this involved giving itself the means to control long interest rates, too, whereas the traditional practice of the central banks is to control the short rates. It had to control long rates to bring them to rates which were compatible, in particular, with the budgetary solvency trajectory of the nations. Between 2010 and 2012 we entered a major crisis in the eurozone, a highly risky period since a contagious defiance had set in where we had the following catastrophic dynamic: fear as to the solvency of the public debt which pushed interest rates on public debt upwards, which in turn reinforced the insolvency risk. The extraordinarily welcome policy of Mario Draghi was to initiate quantitative easing to reduce countries’ long interest rates, ending the vicious circles. Without this the eurozone would probably have exploded. His famous “whatever it takes” was a salvation.

We well know that quantitative easing has consequences on foreign exchange. The foreign exchange level may, however, under certain conditions, help increase the level of growth. There have been attempts to reduce the dollar or reduce the euro, etc. by the central banks concerned, via quantitative easing policies.

The question we are asking ourselves here, today, is how long can the very low, or even negative, rates continue and have we definitively moved into a phase of increased interest rates? And if the answer is positive, at what speed will this increase occur?

At the peak of the crisis in 2008-2009 I was persuaded that the very low long interest rates would be lasting. I wasn’t totally wrong as we are in 2017 and they are still extremely low. For me they were lasting due to the context and the reasons I just explained. Why might we change our paradigm now and think that the rates may rise again?

I said it earlier. Firstly, because there is a return to growth and nominal interest rates are quite strongly determined by the nominal growth rate. With the nominal growth rate rising all over the world, this is a good reason to think that interest rates must rise.

In other words there are brakes and problems that may ensure extremely low or even negative interest rates may last a long time. The first brake is that the very low long rates policy may not work. It is not enough to reduce interest rates to encourage companies and households to borrow. This was indeed the case in France in 2014, when interest rates fell sharply. Lending did not return to growth straight away, and this was not attributable to the banks, which would have liked to grant more loans. There was simply a problem of demand for credit, because everyone was in a sort of depression where nobody wanted to borrow more. Finally, at the end of 2014 and in 2015 growth in the loan mass was seen in France, due to the very low interest rate policy. This brake no longer exists, therefore, since we have demand for credit which is, in our opinion, insufficient, but in any case at a good level.

In parallel, in principle, very low interest rates discourage saving. But interest rates must be compared to inflation. We have very low interest rates but also very low inflation. Overall savers have not been badly treated, at any rate less than in the years where interest rates were much higher than today but lower than inflation rates. But there is a psychological effect to having very low interest rates. Many households consider that they are not managing to constitute gradually the savings they would like to have when they retire because interest is not high enough to capitalise at a sufficient level to reach these amounts; they will possibly save more and consume less to ensure themselves the levels they want later. In this case, the effect of very low interest rates may be exactly the contrary of what is expected according to traditional economic theory. Today the effect is not clear-cut. We can clearly see that the very low interest rates have not significantly discouraged saving. But this effect may occur sooner or later.

The third brake on very low interest rate monetary policy is that the wealth effects, which are strong in the United States, are less strong in Europe, notably because the composition of household savings financial portfolios is not the same at all. It is based far less on shares. It is composed more of money market products and property, etc. Thus, the wealth effects are much less evident econometrically across Europe.

Two risks must also be taken into consideration. The first is to see the return of speculative bubbles. As interest rates are very low, it is easy to borrow to become a buyer on the wealth assets market. This could lead to the development of bubbles.

Today, and at least a few months ago, we could not really see signs of a bubble. No property bubble is apparent in Europe. Nor is there a clear bubble on the stock market, at least in Europe, even if, in the United States, I am not at all sure that certain sectors are not already overvalued. This risk, although not yet proven, nonetheless exists, especially if such a situation regarding interest rates were to continue further.

It can also be seen that institutional players are having difficulty in meeting the yield obligations they may have, whether it be pension funds, health mutual insurers or investment funds. The buying of much more risky assets than those made previously is also starting to be seen. As everything which presents little risk has a virtually negative return, a trend towards much more risky assets can be seen. The next change in the economic environment and market may result in loan and bond defaults. In short, more fragile balance sheets.

There is also a risk on the banks. We well understand that they need an interest rate slope to ensure profit margins. Why? Because, basically, they borrow money from depositors at interest rates linked to short interest rates and they predominantly lend at long fixed rates. A drop in interest rates during the transition period is not, in general, good for the banks. But after the transition the banks should be able to restore their margins. If we were, before the transition phase, at a 5% credit rate on average on stock and at a 2.50% rate on deposits, for example, and if we return, after transition, to 2.50% and zero respectively, the bank’s margin rate is indeed reconstituted. Since today all the long and short rates are all around zero, the credit rates on stock are falling incessantly in banks’ assets and the deposit interest rates can practically fall no more since they are practically at zero and they cannot become negative. We are faced with the zero lower bound phenomenon. And this is leading the commercial banks in France to see their margin rates, and thus their income, fall inexorably.

But there are other effects that the central bank highlights, and rightly so. According to it, because interest rates are low, the credit volume may bounce back up. That’s true. As I said, from the end of 2014-2015 onwards, that’s what has happened in France. We have seen a positive volume effect on loans which has enabled the negative interest rate on commercial bank net interest margins to be compensated. This was exactly the case in 2015. In 2015 half the commercial banks in France had a net interest margin which fell slightly, the other half which increased slightly and, in total, the banks saw an aggregate net interest margin which was unchanged. This was no longer the case at all in 2016. In commercial banking in France in 2015, Net Banking Income did rise by 1.8 %, because the volume effect compensated the interest rate effect, as we have just seen, and commission rose slightly. But in 2016 NBI fell by 4% on average because the volume effect was less than the cumulative interest rate effect, despite the increase in commission. Even if interest rates are now stagnating, or even if they rise very slightly, the drop in the stock interest rate due to the natural repayment of old loans or renegotiations, or early repayments, would lead to a falling interest rate on stock.

The commercial banks are thus entering very troubled waters. The European Central Bank replies, rightly, that thanks to the fact that interest rates are very low, which has also reinvigorated the economy and French and European growth somewhat, the cost of the credit risk has also fallen. It is right. In 2015, commercial banks in France saw the credit risk cost fall by 12.2%. In 2016, it fell by 14.2%. So, if I now take the NBI variation less the credit cost variation to analyse the overall effect, what do we see? For all the commercial banks in France, in 2015, a net positive effect of +3%; but in 2016, a negative effect of -3.3%. In other words, the drop in the cost of loans in 2016 was not sufficient to compensate the fall in NBI caused by the interest rate effect.

Also, the fall in the cost of risk cannot be lasting. The effect of the falling credit stock interest rate is lasting, however. The fall in the cost of risk is not lasting, in fact, since a mere slowdown in the economy would drive this cost upwards. We cannot wager on that compensating lower NBIs in the long term.

The question which can be raised is, fundamentally, whether this very low or even negative interest rate policy in Europe is desirable or not. Certain economists say that it was and is very dangerous. I do not share this judgement. I think it was perfectly desirable and that the favourable effects, as the ECB rightly says, have far outweighed the risks taken. The risks it took had to be taken, because the risks which would have existed if it had not carried out this monetary policy would have been far greater: deflation, prolonged stagnation, etc.

Where does that leave us today? Firstly, it must be acknowledged that the return to growth in many parts of the world legitimises an increase in interest rates, as we said earlier. The Fed is pushing them slowly upwards, but with fresh uncertainty over Donald Trump’s policy and its possible consequences for the American economy. The dollar rose but is now falling again. It can clearly be seen that the markets are uncertain regarding the success of the Trump policy or, on the other hand, the problems it may cause. And then the Fed is increasingly sensitive, rightly in my opinion, to the effect of an increase in interest rates in the United States on emerging countries. To a certain extent, it is the Fed which defines the monetary policy of emerging countries which very often have currencies linked to the dollar. It can clearly be seen that if the Fed increases its interest rates too quickly, it will partially cut the financing of emerging countries. It is a classic effect which means that when interest rates are very low in the United States, stakeholders borrow dollars there to invest them in emerging countries which have far higher growth rates and thus far higher interest rates, thus benefitting from a highly favourable transfer. If interest rates rise in the United States the money will be withdrawn from the emerging countries and return to the United States. This can, then, create profound crises in the emerging countries, as we saw a little over a year ago, when the Fed increased or threatened to increase its interest rates. So the Fed will be prudent in increasing its interest rates, I am certain, being very conscious of these two phenomena.

As for the ECB, I think it understands the challenges very well and that it has manifestly acted well until now. It must nevertheless face up to several new phenomena. The first is that the effect of the low interest rates is starting to fade and even become dangerous, as stated earlier. I took the example of France but it is also true elsewhere and the French banks are among the most solvent. They are in excellent health compared with Germany or Italy. But you can see that even the French banks are affected in their commercial banking business in France.

At the same time, let’s not forget that we are asking the banks to increase their solvency ratios very significantly. In general, since Basel III, they have been asked to double their so-called “hard” equity. It is difficult, however, to ask the banks to greatly increase their solvency ratios, and thus their equity, at the same time as reducing their profits. Growth must not, for example, take off again more strongly while the banks are caught in a trap, unable to sufficiently follow the excess credit demand which would result from this.

Fundamentally we clearly understand that the ECB thus initiated this policy – even if it does not say so – to facilitate the budgetary solvency trajectories of the various eurozone countries, as we have observed. In reality it has bought some time. The ECB “deal” is clear. It is carrying out an extremely low interest rate policy pending two things from the nations. The first is that they carry out the structural reforms necessary to increase their growth potential and reduce their structural deficit, thus facilitating their future budgetary trajectory by protecting their solvency. The second is that they constitute the institutional conditions of a viable eurozone. We know today that the incompleteness of the eurozone is manifest in terms of institutional arrangements, in other words the ability to make the zone work without it necessarily always being up to the countries doing least well to incur the cost of the necessary adjustment, with the consequences on votes that we know. The ECB is saying to the member states: “Quickly organise the eurozone a little better”.

The problem we face today and which leads me to question the increase in interest rates in the eurozone, is that the countries which should have done so have not done this work. The structural policies have virtually not been carried through where they were necessary. This started in Italy but was stopped following the failed referendum. In France we have not done much. There will be no capacity for exiting the dangerous solvency areas of the countries concerned if there are not, on the one hand, these structural policy efforts and, on the other, the completion of a more complete, better regulated eurozone which works better, in other words less asymmetrically.

The Germans, however, severely criticise the ECB’s monetary policy which is not necessarily favourable to them. They have a higher growth rate; they therefore do not need such low interest rates. Furthermore, these rates reduce the return on Germans’ savings who, as we know, have a much older population. They thus need a higher return on their savings, even more so for institutional investors who had, in the past, sold annuities at fixed rates.

The head of the ECB is not wavering from his policy. As for the Germans, they are obsessed with the question of the moral hazard, insofar as they do not want the solidarity factors necessary to the eurozone. They refuse, and this can be understood, to be the only ones to pay for everyone if the others do not make their structural reforms, thus finding themselves sooner or later in a situation of being dependent on Germany in the long term.

Exiting low interest rate policies is therefore conditioned by the fact that France in particular is carrying out structural reforms which reassure the Germans who would thus accept a much better institutional arrangement for the running of the eurozone, with intra-zone solidarity factors so that the cost of the adjustments does not weigh on the weakest countries.

This is where we currently stand. The European Central Bank, it seems to me, is going to exit negative short rates sooner or later because this position is becoming difficult to maintain today. But exiting a very low interest rate situation will depend fundamentally on the capacity of countries to carry out their own reforms and simultaneously integrate the reforms of the eurozone necessary for its future. In 2019 when Mario Draghi’s term of office ends, everything will depend on the relative strength of the countries and on their respective abilities to be heard, in other words to have triggered the structural policies sufficient to be credible. This credibility of the major countries conditions the possibility of increasing the viability of the eurozone, by developing several federalist elements, such as the mutualisation of part of the sovereign debts or tax transfer elements, as exists between states in the United States. To support temporarily those going through asymmetric troubles, without asking them to act only by austerity measures.

Which would enable interest rates to be increased much more easily. If we increase them significantly without having done that the intrinsic risk of the eurozone is increased. If we don’t raise them, the risks of a very low interest rate policy described earlier will become increasingly strong, whereas growth is beginning to rise again, along with, to a limited extent, inflation.

Without thinking of a significant rise, what is most likely, in my opinion, is that we shall, at least, see a moderate increase in interest rates from the end of 2017 or early 2018. Short interest rates could come back from their negative territory towards zero. And long interest rates could be managed towards neutrality by the central bank, in other words between 2 and 2.5%. This would be compatible with the level of growth and inflation that we can currently anticipate. This moderate increase will stop facilitating countries’ debt reduction, without, however, propelling them into a snowball effect.

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Conjoncture Economical policy Euro zone

The effectiveness of monetary policy of very low interest rates will soon come to an end

Monetary policy of low, even negative, short-term and long-term rates unquestionably made it possible to avoid a catastrophic risk in 2007–2009, and then in the eurozone from 2010 to the present day. And subsequently to revive growth, if only at a low level, by stimulating the demand for credit and sustaining consumption and investment.

In the period of low growth we are currently experiencing, the monetary policy implemented by the ECB is helping the public and private sector to reduce indebtedness by guaranteeing nominal interest rates lower than the nominal growth rate, or at least at the same level. This was an essential move, lest we forget that the crisis of 2007-2009 occurred on the heels of a cycle of household and corporate debt accumulation that gradually became unsustainable. This major financial and economic crisis led in turn to a very sharp rise in public debt. Causing a drastic fall in long-term rates by buying government bonds, Mario Draghi succeeded in halting the infernal cycle based on the contagion of mistrust vis-à-vis the public debt of certain European countries. This mistrust led to a speculative hike in their interest rates, which in turn worsened both their public deficit and consequently national debt, causing a further loss of confidence.

This policy of very low, and even negative, rates was also intended to sustain global demand for credit. In principle, interest rates lower than the growth rate will sooner or later encourage lower savings and higher consumption and investment and, ultimately, stimulate growth. The current rates for property loans are a perfect illustration of this, with historically low levels. Finally, by increasing asset values (real estate, equity, etc.), lower rates also give rise to a favourable wealth effect on consumption and investment.

But if confidence fails to follow, the demand for credit can remain sluggish in spite of lower rates. In 2014 in France for example, demand remained below banks’ expectations in terms of the projects they wished to finance. Conversely, between late 2014 and early 2015, French companies rediscovered the taste for investment with a strengthening in the demand for credit.

What has been the impact on the banks? Very low rates unquestionably eat into the profitability of the banks. A bank’s net interest margin corresponds to the interest received on its outstanding loans less the interest paid on deposits. If the margin rate falls, coming up against the impossibility of lowering remuneration on deposits (which is virtually impossible to move into negative territory) relative to that received on loans, banks’ income will fall. The current challenge for the banks is therefore to offset this loss due to the rate effect by a positive volume effect. If total demand for credit increases, notably due to the lower rates caused by the central bank, every bank can take advantage. But should demand fail to grow sufficiently, the sector contracts.
The total volume of credits in France in 2015 increased sufficiently to offset the negative rate effect. But this volume effect tailed off in the first half of 2016.

However, the lower interest margin was offset during this period by the lower cost of risk. By supporting the economy, lower rates will mechanically lower the cost of credit risk. Since 2014, with the lower cost of risk having gathered pace, the banks have been able to offset the negative rate effect and inadequate volume effect. But we are now coming up against an impasse. Were the rate effect to persist, the cost of risk could not fall indefinitely and continue to produce its offsetting effect.

By sharply reducing banks’ future profitability, very low rates would ultimately restrict the supply of credit, at a time when banking regulation is demanding significantly higher solvency ratios with the corresponding strengthening of capital. All the more so as it is impossible to easily make capital increases due to the profitability of the banks falling below their cost of capital. The continuation of such a policy could therefore ultimately have a negative impact on growth. It should be noted that, unlike in the USA where the markets provide the majority of financing requirements, in Europe the situation is the opposite. Maintained at such low levels, sooner or later interest rates could also cause a property or equity bubble. Finally, they also undermine life insurance companies and pension funds.

The policy of very low rates has been essential. Which other monetary policy could have been implemented without taking even higher risks? It has also bought a certain amount of time, notably in the eurozone, providing room for governments to implement the structural reforms required to lift their growth potential and to make vital institutional changes within the monetary zone (genuine coordination of economic policy, certain elements of public debt pooling, etc.). But it is unclear if this time has been spent wisely. And time is of the essence.

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Bank Economical policy Euro zone Finance

Institut Messine – Thoughts on an economy with negative interest rates

SUMMARY

Acknowledgments

Foreword by Michel Léger

General introduction to the issue of negative interest rates by Michel Aglietta and Natacha Valla

Robert Ophèle, Deputy governor of the Banque de France

Maya Atig, Deputy CEO of the Agence France Tresor’s

Jesper Berg, CEO of the Financial Supervisory Authority of Denmark

Philippe Capron, Deputy CEO of Veolia, in charge of finance

Jean-Jacques Daigre, Professor emeritus of Banking and Finance Law

Ramon Fernandez, Deputy CEO of Orange, in charge of the group’s finances and strategy. Ramon Fernandez was previously Director of the Treasury and President of Agence France Tresor’s

Marc Fiorentino, Founder-Director of Euroland Corporate

Hervé Hannoun, former Deputy CEO of the Bank for International Settlements

Philippe Heim, Chief Financial Officer of Société Générale

Denis Kessler, CEO of SCOR SE

Olivier Klein, CEO of BRED, Professor of Financial Economy at HEC

The point of view of Olivier Klein*

What is your opinion on the conceptual complexity of negative growth rates? As a banking “boss” and Professor of Economics, did you ever think you would ever experience such a situation?

The very concept of negative rates rather worrying and so specific that I never thought I’d ever have to deal with it. Certain economic players are adapting quite well to it: some of our institutional customers are now investing money with us at negative rates. They prefer to place it with us at -0.15% rather than at -0.20% elsewhere[1].

Negative rates can be explained by the current macroeconomic set-up. The European Central Bank (ECB) is trying, with these negative rates, to find a balanced level of savings-investment which is more conducive to growth to ward off what some people are describing as the threat of secular stagnation. But this is also “just” an adjustment period after a phase of excessive debt as has often been observed since the 19th century after financial crises. In any event, what the ECB is trying to encourage agents not to just let money sleep and invest and encourage banks to extend credit, but also to encourage debt reduction, by maintaining low rates compared to the nominal growth rate.

The use of negative rates is currently limited to the field of transactions between institutional and financial professionals. This is not yet the case for businesses in France – whereas businesses are also beginning to deposit at negative rates in some European countries.

It also affects a very material limit of the capacity of the system to pass on lower rates throughout the economy: neither the banking system, which needs deposits to make loans, nor the authorities, for fiscal and security reasons, can afford to neglect the appeal that cash could have, especially for households, as an alternative to negative interest bearing deposits. France seems to be relatively preserved from this risk compared to countries like Germany, where the cash culture is much more developed.

Why do you think that there was a need to introduce negative interest rates in the euro zone, while the United Kingdom and the United States, which have nevertheless resorted to unconventional policies, have not had to introduce them?

I believe that this can be explained by the existence of a risk of deflation that is greater in the euro zone than in the United States, that the ECB, quite rightly, wanted to ward off. One reason is the crisis in the euro zone, which led to a second economic downturn just after the 2008 crisis, due to the incomplete nature of our monetary union which creates a slight “deflationary bias”. It is also possible to invoke the lesser impact of the “wealth effect”: in the United States, lower rates quickly led to a recovery in asset values,especially the stock market, which resulted in a reconstruction of the value of household savings – which is, across the Atlantic, much more invested in the markets because of the importance of pension funds. In all, it was necessary to hit even harder on rates in the euro zone. But it is a quantum issue, not an issue of principle: the ECB did not enter into negative territory just for the sake of it, but to cut rates as much as needed, and the Bank of England and the Federal Reserve did not remain in positive territory to avoid negative rates, but because the zero rate was sufficient in their respective cases.

How is the profitability of retail banks impacted by the environment of negative interest rates?

We have to distinguish between the effect of interest rates which are decreasing and that of negative rates. Structurally speaking, banks lend long-term and refinance short-term. In general, as we lend in France, at fixed rates, in the very short-term there is less hysteresis in bank liabilities than in assets – in other words, if rates fall at the same pace for all maturities, the cost of a part of our resources immediately decreases, whereas the product of loans only decreases over time, as our loan portfolio is gradually renewed. An homothetic drop in the rate curve will therefore play in favour of the banks in the first year. Nevertheless, this situation is only temporary, because very quickly, the portfolio entry of new loans granted at lower rates and the amortisation of old loans at higher rates, but also the mortgage renegotiation requests made by private customers, cause a decrease in the rates of our assets which is faster than that of our liabilities, that contain a lot of resources indexed at regulated rates which vary less rapidly. This brings us to a deteriorated intermediation margin rate, but in an acceptable and manageable quantum. Then, eventually, when the rate curve stabilises, if the slope of the curve remained constant, the net interest margin will gradually recover.

What is happening today is different. First of all, the net interest margin is compressed, through the evolution of the differential rate between the long and the short rate, that is to say the slope of the rate curve. For the last two years, central banks have indeed been looking to govern and bring down not just short rates, which they always set more or less directly, but also, which is new, long rates, through policies of quantitative easing (QE) and by clever management of agents’ expectations in the context of forward guidance. This policy works well, leading to a compression of the rate curve, and thus of the interest margin of banking institutions.
Negative rates introduce an additional element, which is frustrating for our business model. Since, for the most part, we do not pass on lower rates below zero to our depositors, the falling cost of our resource comes up against an obstacle.

In summary, the product of our loans, correlated with falling long rates, decreases, while our refinancing has a cost that can no longer decrease in parallel with it, considering the impossibility of getting the bulk of the interest paid on deposits into negative territory. The rate slope is therefore compressed even more. It is easy to see that this situation is very unfavourable for the profitability of our institutions. Our net interest margin, which was able to reach almost 6% in the early nineties, has been levelled off at 2% for years and since 2014-2015 we have entered a further phase of gradual decline, which is going to further accentuate in the next few years, with the amortisation of our old loans at higher rates and the entry into force of new loans at very low rates.

This development will be lasting, and banks must resign themselves to surviving for quite a long time in a context of very low interest margins: the movement cannot, in my opinion, be reversed for at least two or three years since the “renewed steepening” of the rate curve will only take place just in time, given the low potential growth rate of the Euro Zone, and its beneficial effects for us will only be felt through the renewal of our loan portfolios. The very specific monetary conditions we are experiencing – negative rates and QE – seem genuinely welcome to me in terms of the general economy: the ECB had no other choice. But we must be aware that they are specifically unfavourable to banks… But also to insurers, pension funds and all those who need a return on their assets to be able provide the services expected of them.

Are banks therefore being forced to seek new sources of income?

There is no doubt that the decline in interest margins that I have just mentioned has caused us to diversify our sources of income. Of course, the banks can first try to compensate for the erosion of margins with a volume effect on outstanding amounts, but we cannot go very far in this area: either we try to gain market shares – which, by definition, not everyone can do at the same time – or the banks, as an aggregate, rely on the general expansion of the volume of loans in the economy – which is highly seasonal due to the low level of growth.

Banks, if they are considered as an aggregate, can therefore think about playing on higher commissions, that is to say, looking for better and fairer billing for their services. Indeed, we have seen a slight shift in this direction in the past few months. But once again, it’s not as easy as people often imagine.

First of all, the supervision of our activities by the various consumer protection mechanisms limits the opportunities. But, in addition, there is keen competition which does not give much leeway. Furthermore, the context of low interest rates hangs over certain types of commission. It is understandable, for example, that “placement commissions” in the field of life insurance cannot be the same in a context in which contracts make 2.5% or 3% as when the standard remuneration for savers was 5% or 6%. The same applies to asset management. We can therefore see, with many products, our commissions fall progressively with falling interest rates.

The new services still remain. My feeling is that their spectrum is limited by the objective needs and expectations of customers with regard to their banks and through the necessity of maintaining a coherent and fair offer. So we would not seem to be very legitimate as a travel agency or computer salespeople, for example.

That is why many players, who are unable to increase their revenues to offset the erosion of interest margins, are now trying to reduce their operating costs, such as by reducing the number of bank branches. A new, more financial argument now needs to be added to the “technological” argument – the usefulness of branches is eroding since customers are using our digital platforms more and more intensely: if we cannot remunerate the conversion of deposits into loans by a sufficient margin, the cost of large networks of branches becomes prohibitive. If this vision, which I do not necessarily agree with, was to prosper over time, thousands of jobs would potentially be at stake in retail banking. So we can see that the operational impact of the monetary context we are discussing is not negligible! So although there are potential strategies for “coming out on top” for specific banks, the industry as a whole is doomed to have to deal with real profitability difficulties.

Is the compression of returns also forcing banks to take more risks?

You might think so, but this is not the case. The new prudential regulations in fact leave less and less room for taking risks[2].

What are your specific thoughts on the role of prudential ratios in the context of low growth and very low, or even negative rates, that we are currently experiencing?

As a banker and professor of economics, I have long been convinced that it is necessary to implement prudential rules and macro-prudential policies for the simple reason that markets do not self-regulate themselves – this was highlighted in many theoretical contributions, but above all, unfortunately, in practice, with the crisis of 2008. Finance is intrinsically procyclic. The potential for regulation therefore plays a crucial role in avoiding financial instability as much as possible.

But it turns out that the prudential standards put in place since the Basel 2 agreement, which are well founded on many points, also incorporated a problematic procyclic character. The risk calculated by RWA (Risk-Weighted Assets), based on historical measurements, with equal volumes of credit, in fact lowered during the euphoric phase of the cycle, which, all things being equal, made a rise in the leveraging effect of banks and the accompaniment of the increase in the general demand for credit possible.

This then promoted the build up of weak financial situations for both households and businesses, in a context in which the euphoria specifically led borrowers and lenders to underestimate the risk. By the same token, at the time of the turnaround, the established risk reappeared in bulk in the books of banks, which naturally weighed on their willingness to lend, but in addition, the constraints of prudential ratios stretched because the increase in the cost of the risks recorded resulted in a rise in RWA through an equity shortfall, thereby leading to an even stronger decrease of the capacity to lend. This method of banking regulation could then encourage the formation of bubbles, then their bursting, and accentuate the financial cycles. It was therefore necessary to rebuild them, which is what Basel III did, particularly through creating a countercyclical capital buffer.

Are prudential measures also a risk factor, as they contribute to creating a type of bond bubble, particularly with government Securities?

Banks have progressively been faced with a tightening of regulations with stricter solvency ratios since Basel 3: they are being asked to hold more equity for the same RWAs and the weight of the risk in calculating RWAs is stronger than before, especially for loans to businesses or for market risks. In the case of a stronger upturn in the economy, this could be a risk of the insufficient capacity of the banks to support the recovery. Furthermore, the liquidity ratios undeniably favour the fact that banks are investing in sovereign bonds.

Do you mean that the prudential regulations are ultimately leading to credit rationing for businesses?

Up to this time, people have really been wrongly accusing the banks in France. There has been no credit rationing to businesses, and the Bank of France and ECB indicators clearly demonstrate this. Let’s go back to the course of the seven years that have just passed. Much of the decline in the distribution of credit seen in the years following 2008 can be explained by a lower demand for credit: businesses cut their investment spending and borrowed less, because of the changing unfavourable economic conditions which they were facing and their lack of trust in the future. Even today, however, very low, or even negative rates, are not enough alone to make people want to borrow.

It is true, however, that when the real economy was on the ropes after the financial crisis, we were able to observe, for some months, less of the general reluctance to lend that the banks were accused of and greater selectivity, which is, for that matter, is perfectly understandable. Not lending to businesses whose future is seriously compromised is a part of the normal role of banks. It is an economic function of the profession, that it must fully assume: if banks do not fully exercise “monetary restraint”, granting loans to businesses that were destined to disappear, they would generate distortions in the markets of their customers and harm the proper development of other businesses that are healthy and sustainable.
We have now left this period behind. However, with the new liquidity and solvency ratios, it will now be progressively more difficult for banks to follow a trajectory of the demand for credit which would improve significantly.

Why do we find ourselves in this situation, even though the objective of the political and monetary authorities is to facilitate granting credit by any means to promote growth?

The truth is that banks were considered as being at fault for the crisis, which is, in my opinion, a vision that is at the very least fragmented, and doubtlessly false in Europe in any case, even if we can argue that they were inevitably a factor in spreading the crisis. As such, we are now in a post-crisis historically conventional phase of “financial repression” of indebtedness, marked by very low interest rates and tougher demands placed upon banks: we are saying that we must “avoid this” at all costs in the future. This concern is reflected in a number of new or tougher regulations, at the very moment when, in fact, a monetary policy aimed at reviving credit with the use of novel instruments, just like negative rates or quantitative easing, is being mobilised.

The most paradoxical thing is that, although they are aware of this contradiction, central bankers now seem, in order to get out of this, to be inviting the development of disintermediation and securitisation, which were held up to public obloquy a few years ago, purely because of the role they actually played in the accumulation of bad risks in the United States, which ultimately led to the crisis. So we are now seeing hedge funds, assets managers, insurance companies, mutual health organisations and pension managers lending to businesses, even though they do not have the historical expertise of the banks to do. There is a considerable asymmetry of information between these new lenders and those to whom they are lending. Some of them, such as hedge funds, are also barely regulated or not regulated at all.

Should we not, however, be pleased to see that some businesses, particularly some great intermediate size companies, finally have access to the market, particularly through the development of the Euro PP?

In theory, yes. My feeling is, however, that we need to be very careful, because not all medium-sized companies can effectively withstand such financing without endangering themselves, especially because of the depreciation method for such loans. Banks usually ask small and medium enterprises to make one annual repayment by providing them with depreciable loans. This is sound practice: the company therefore knows that it must dedicate part of its annual cash flow to repaying its loans and monitoring its management ratios. Euro PPs are very different because, by using them, businesses can be financed for as long as five years with bullet loans. The system is even more attractive today as both rates and spreads are very low.

In the case of large companies, which issue bonds as part of high annual issuance programmes, financing with bullet loans is in some ways similar to a redeemable loan, since we can see a kind of an amortisation schedule: if, for example, the average horizon of the bonds issued annually is seven years, then 1/7th of the outstanding borrowings must be repaid each year. However, only certain types of medium-sized companies are able to issue Euro PPs on a regular basis. Most therefore create a unique and extended due date ahead of them, which effectively means that when the time comes, they may find themselves facing a wall of debt that they can only overcome if they are able, at that time, to re-borrow the full amount of the loan that they have to repay all at once. There are two disadvantages: firstly, nobody knows what situation the company will find itself in that time and, secondly, over the duration of Euro PP, the cashflow constraint was lifted for it – which in some cases could be crime-inducing.

you mean that only the banks are capable of distributing credit without taking or running undue risks?

I quite obviously believe in the usefulness of banks and market financing coexisting! But I don’t think that the market is suitable enough for smaller companies. The role of banks cannot be reduced because banks have a good knowledge of borrowers and because they keep the risk on their balance sheets, which brings them, in their own interest, not to lend any old how and to “monitor” their customers over time.

We also know that, in the United States, securitisation was one of the factors that facilitated excessive indebtedness in the early 2000s: banks were partly responsible because, by not keeping risks on their books, they were less selective about borrowers and did not “monitor” them afterwards. There is a major problem of incitement to selection in market financing as soon as we leave the case of very large borrowers who can, through credit rating agencies, as well as through a lot of communication on their own situation, afford the cost of financial reporting, thereby reducing the asymmetry of information. This intrinsic fault in securitisation has partially been corrected by some of the Basel 3 provisions, which requires banks to maintain a quota of risks associated with the loans that they securitise.

The momentum towards greater disintermediation that we are currently experiencing could be a factor for increased financial instability, while bank credit itself is a factor of stability if it is properly regulated. In my opinion, the share of banking intermediation determines the level of stability of a financial system as a whole. Indeed, banks do not just mobilise savings to serve investment: these are centres of risk. They take counterparty risks in the credit act and interest rate and liquidity risks in the conversion act upon themselves (converting short maturity savings into longer maturities with average credit). Risks are not created by the banks, but managed by them, so that they provide relief to the economy. They manage them carefully, professionally and in a regulated environment. Markets are useful to the economy, but they leave interest rate credit and liquidity risks to lenders or borrowers, which is quite different!

By increasing the share of disintermediation, we will not reduce the risk, we will move it to a multitude of players that are less well equipped than the banks to manage it. The issue of the proportion between banks and markets, between intermediation and disintermediation, is therefore crucial for financial stability. Just like the quality, relevance and scope of the prudential regulation itself, which are also highly crucial.

However, as you said earlier, sociological and technological developments on the one hand, and the monetary context on the other hand, seem to be threatening the very purpose of banks, on the consumer market at least. Will the retail banking business model survive these shocks?

There are undeniably profound changes to our activity. This invites us to return to the economic constants that justify our existence, while ensuring the changes needed to take account of the “customer revolution” caused by the technological revolution. Private customers have, and will always need, a reliable and professional advisor to talk to them about their life plans and advise them about their main loans – with property leading the way- their savings, their retirement protection… But private customers now require greater convenience in their relationships with banks, such as with the strongly developing use of the Internet and Smartphones. They also want greater relevance of the advice that is given to them. But they still want to have access to a qualified contact person who knows them when they have to make important decisions. Building on human capital, giving more convenience and greater added value to banking advice, while using the technological revolution for both the use of its customers and to redesign their own organization, is certainly a crucial industrial and human challenge in retail banking that must be addressed quickly.

[1] This interview was conducted in November 2015.
[2] The new prudential rules prohibit banks from “playing” on markets with their own funds.

Categories
Euro zone Finance Global economy

The future of the euro zone

Some background to begin with. The European Monetary System (EMS) was put in place to create a fixed but adjustable peg for the various currencies within the zone. From 1979 on, it served to prevent sudden and disruptive fluctuations in the exchange rates of the currencies of the countries within the European Monetary System. However, while proving very useful, it remained a source of instability: external events could cause unsought asymmetrical shocks between the European countries concerned. For example, the weakening of the dollar against other currencies prompted market operators to seek refuge in the deutsche mark. This strengthened the German currency against the dollar but also against the French franc and other EMS currencies. However, the economic trends in Germany and in France or the other countries did not necessitate this movement in their exchange rates.

Moreover, since each country in the zone kept its own currency, the current account balance had to be monitored country by country. Any country needing stronger economic growth – due to faster population growth for example – was regularly hampered by an external constraint: an economic growth gap between two countries automatically resulted in a deterioration of the current account balance of the country with the strongest growth. The unavoidable effect of this phenomenon was a constraint of alignment on the slowest growth rates among the larger countries within the European Monetary System.

The single currency, created to substitute EMS, was structurally a part of this reflection. On the one hand, a single currency would allow the dollar to weaken with the same impact on all the countries in the euro zone. On the other hand, it could be thought that the creation of the single currency would generate greater leeway for economic policy: the current account balance would be considered at the level of the euro zone as a whole and not at the individual levels of each country. This would supposedly enable a country to stimulate its economy, if necessary, without immediately running into the external constraint, as long as there was no deterioration in the current account balance of the euro zone as a whole. Lastly, a single currency among the countries in question, without any possibility of devaluation or revaluation, would provide economic agents with a more stable forecasting basis for foreign investments and trade, imports and exports, without having to bear the costs linked to currency exchange. The example put forward was the United States, where an individual state can stimulate its economy without encountering any immediate obstacle linked to its current account balance.

Federalism versus convergence

There were two tacit schools of thought when the euro zone was created. Both perceived clearly that a monetary zone could not work properly on its own.

The first school of thought held that, to become efficient and develop a satisfactory system of auto-regulation, the euro zone needed to be gradually rounded out with a greater degree of federalism. On its own, the creation of a single currency was not enough to ensure the regulation needed in the event of difficulties. If a country within the zone experienced an isolated recession, it had to adjust without being able to benefit from any weakening or devaluation of its currency. In the absence of any type of federal regulation, the only possibility left to the country was to reduce labour costs and public spending in order to become more competitive, by provoking a sort of internal devaluation that was inevitably painful at social level and costly in terms of economic growth during the first years of adjustment.

Two conditions for avoiding overly costly downward adjustments were, in theory, clearly identified. Firstly, mobility of the labour force within the euro zone, enabling people who had lost their jobs in one country to find work in another country within the zone. Secondly, budgetary solidarity between the countries with a single currency, so as to organise budgetary transfers from the strongest growth countries to those in difficulty, thereby lightening the internal adjustment needed. This situation is exactly that of the United States, thanks to a shared language and a long tradition of mobility, and a federal budget that is large enough to allow such transfers.

Europe did not have this history of mobility nor the unified legal and social framework that would foster it. But, by continuing to build the union, Europe could achieve a greater degree of federalism that would enable budgetary transfers, on the strict condition of federal supervision of each country’s budget as no solidarity mechanism could be developed without ensuring that the policies implemented at national level were serious. This was the line of the first school of thought whose hopes were based on continuing European construction, based up to then on economic aspects, before going on to make the necessary progress at political level.

The other school of thought, which prevailed when people did not dare or want to express federalist aims, was to limit admittance to the European monetary zone to very similar countries that could be expected to continue being similar, which, quite justifiably in this context, led to the creation of convergence criteria. If the member countries of a monetary zone are on the same economic trend and converge in terms of inflation, budget deficit to GDP and public debt to GDP, and stay that way once they are part of the zone, adjustments between member countries are no longer necessary. There is therefore no need to look for greater federalism.

Shared mistakes In the light of the events of the past few years, both schools of thought were mistaken.

The first, since the increased federalism expected to follow creation of the zone as a matter of course has not occurred and it has proved difficult to conjure international solidarity out of nothing.

The second, since, either for political reasons or because some countries deliberately hid certain aspects of their economies, the countries admitted to the zone were not all chosen based on their strong structural and economic similarities. Mistaken, moreover, because monetary union does not automatically mean convergence will be preserved, even if it existed when the zone was created. On the contrary, it gradually induces structural differences linked to industrial polarisation in some regions corresponding to deindustrialisation of other regions within the zone. A single monetary policy, adapted to the average of the euro zone countries and not to each country’s specific economic conditions, combined with the absence of foreign exchange risk, leads in fact to diverging national economic specialisations, which can result in structural current account deficits in some countries due to insufficient industrialisation.

The financial markets were also mistaken. They kept the interest rates for the public debt of the different euro zone countries at very similar levels, even though significant differences were gradually emerging in both public debt ratios and current account deficits.

These policy and market mistakes resulted in a major crisis specific to the euro zone, caused, not by bad results and ratios at consolidated level, but by increasingly major differences between countries within the zone, without any mechanism for regulating such phenomena having been put in place, or even provided for.

How can the vicious circles be broken? Resolving the zone’s intrinsic problems has so far proved extremely difficult, painful and confused.

Two vicious circles have emerged that have accelerated the crisis. The first is that formed by the economic growth rate, the interest rate on public debt and the public deficits of the countries in difficulty. To restore its public finances and competitiveness, a country must drastically reduce public spending and increase taxes while reducing labour costs – even when several countries within the same zone are doing so at the same time. The impact on economic conditions is in this case very negative. The fiscal multiplier in such circumstances – with very weak growth – has been calculated, including by the IMF, to be greater than 1. A given reduction in public spending in Europe generates an even greater contraction in economic activity. The resulting slowdown in growth worsens the public deficit, which worries the markets and pushes up interest rates on public debt. This in turn has negative repercussions on the public deficit.

The second vicious circle consists of the feedback loop between the banks and public debt of a same country. European banks hold, as safe investments, bonds issued by their governments, and by the governments of other euro zone countries given the strong financial integration within the monetary union. Fears concerning the solvency of these countries therefore also trigger doubts about these banks which, if these doubts degenerate into a systemic crisis, can only be saved by their governments, thereby immediately exacerbating the fears relating to the public debt.

With a series of tentative initiatives, the euro zone has tried to feel its way out of this severe crisis and break these circles. Once again, two main tendencies arising from the two schools of thought described above have emerged, even though there has been some cross-over and even convergence between them.

The first argues that finding a way out of the crisis depends on Europe’s capacity to move towards greater federalism, a capacity strengthened by the crisis. The second argues that each of the countries in difficulty should itself restore its competitiveness by making sufficient efforts in terms of costs and deficits. Once again, these two tendencies, which are not totally mutually exclusive, have converged toward the European compromises we have already seen.

Thus, after hesitating for rather too long, Europe’s political deciders and the European Central Bank decided to create a European intervention fund, thereby pooling part of the debt of the countries in difficulty, and to create the European banking union. European banking union is an essential component of a monetary zone because banking supervision at the European level is necessary. There is sometimes a suspicion that some national regulators overprotect their country’s banks or do not wish to see the problems and turn a blind eye. A European level of banking supervision is all the more valid in that our banks are also multinationals in Europe, so as to ensure the same quality and efficiency in terms of banking supervision. But the key argument in favour of European supervision is that there can be no solidarity without shared supervision. For this reason the recent agreement is conditional upon putting in place the other essential elements of banking union.

The solidarity aspect worries healthy banks because they are afraid they will suffer from the situation of the weaker banks. The constitution of a European deposit guarantee scheme, at several different levels if necessary, would provide the basis for European interbank solidarity. One possibility would be to have, in addition to the national deposit guarantee funds, a deposit guarantee that would be triggered, at certain times, after the national guarantees had been exhausted, directly at European level, based on the solidarity of the European banks of other countries. This interbank solidarity mechanism would be supported by a solidarity mechanism between the euro zone states. A European crisis resolution mechanism, with in particular a European resolution fund, is expected to be put in place. Such a fund would mean that bank recapitalisation would not necessarily rely solely on the State concerned, which would therefore break the second vicious circle described above.

The ECB has announced that it now has the possibility of purchasing unlimited amounts of the public debt of countries in difficulty if their interest rates exceed a level considered normal, enabling a gradual return to better solvency, providing they implement a structural policy that allows this.

These fundamental decisions – resolution fund, banking union and the ECB’s unlimited, but conditional, intervention policy – have restored confidence and broken these vicious circles, temporarily at least. The issue now being debated in economic circles is whether the efforts made by each country – together with the measures referred to above – can restore the euro zone’s structural situation and save it as it is, by ensuring the lasting convergence of the member states.

The alternatives to austerity

The intense efforts being made by the southern European countries have a huge social cost in terms of living standards and employment. On average, the public debt/GDP ratio of these countries has not improved – it has even worsened in some cases – given the multiplication effect of more than 1 of these budgetary measures. In the case of Greece, the cancellation of a large part of the Greek debt held by the private sector does not appear to have been enough to turn the country around given the considerable social and economic cost of the austerity measures implemented. Italy has decided to implement major structural reforms but is struggling to regain competitiveness and seems to be exhausting itself in uncertain political battles, as can be seen from the recent elections. The improvement in the current account balances of these distressed countries, with the exception of Spain, comes more often than not from a slump in imports due to recession rather than any increase in exports achieved through increased competitiveness. However, Spain is beginning to see some results in the turnaround in its current account balance and the rise in exports.

The question is whether the painful search for competitiveness though austerity in each of the countries concerned, without adjusting exchange rates, can be successful. The lasting recession it provokes undermines potential growth. Even supposing it is successful in the long term, can the turnaround in public finances and exports be achieved before the social cost triggers a political and social crisis that compromises the European equation and the efforts made?

Assuming competitiveness is restored before any crisis breaks, the question is: should the euro zone regulate itself solely by a downward adjustment in living standards in order to bring some countries, through considerable internal efforts, into convergence with more acceptable public deficit and public debt levels and a better balance of payments? If the industrial basis is weak, balance can only be achieved through sluggish growth that does not boost imports, leading inevitably to a lasting slowdown in the euro zone. Or should regulation of this monetary zone by achieved through a mixture of the structural reforms needed to improve public finances and a European policy of supporting potential growth, by truly coordinating economic policies – stimulation here, dampening there – and transfers between the countries so that the least industrialised countries are not permanently obliged to make downward adjustments through austerity?

Such a mixture could help bring about these structural changes without excessive brutality and without triggering a severe recession, thereby making these reforms more acceptable. The structural reforms successfully achieved by Canada and Sweden in the 1990s were greatly facilitated by accommodating economic conditions which made the temporary social cost of these reforms acceptable. This mixture would naturally include better supervision of budgetary policies in particular, because there can be no solidarity without control, in order to avoid moral hazards.

The last question is: can the euro zone develop a greater degree of federalism – supervision, coordinated economic policy and budgetary transfers – that would ensure greater solidarity among its members, without however accepting laxity or “free riders”? This would enable the essential structural reforms to be carried out in a number of countries in an organised and better planned manner over a longer period, and therefore less painfully and with less risk. And to acknowledge and accept the natural diversity of the countries within the zone, including the industrial differences arising from the very existence of the single currency.

This would favour a higher average rate of growth by authorising some countries to have current account deficits while others have surpluses. Or will the euro zone be incapable of carrying out this political change and find itself condemned to requiring, too quickly and for too long, the least industrialised countries to implement austerity policies that bring long-term average growth down to low levels for the whole zone, with all the accompanying political risks. And possibly a risk for the future of the Euro itself.

Download The Future of the euro zone (PDF)

Read in french: L’avenir de la zone euro

First published in french in Nouvelle Revue de Géopolitique, n° 9, Avril-Mai-Juin 2013

Categories
Euro zone Finance Global economy

Necessity and dangers of the Euro

Article published in the newspaper Le Monde in 1997

The merits of the euro have been thoroughly analysed, although inadequately communicated. However, the introduction of the single currency could well be postponed, and even runs the risk of being aborted. And the major reason for this real threat is precisely the fact that the dangers resulting from the euro have been underestimated for too long. No doubt, the remedies to counter these dangers have not been viewed as adequately profitable in elections.

So, what are these dangers?

The exchange rate is a practical and necessary adjustment variable for a country. Certainly, in some conditions, it is one of the least painful adjustment variables. Does one country experience a so-called asymmetrical crisis that its main partners do not? A devaluation can allow it to re-establish itself with less of a setback, authorising it, by a more nature development of its exports and by acting as a monetary brake on imports, to more easily resume the path to growth. Does one country experience greater inflation than its neighbours? Does a lowering of its exchange rate allow it to maintain its outside competitiveness? There is no question here, however, of promoting devaluation as a cardinal point of any economic policy. But well-managed exchange rate adjustments have managed to prove their effectiveness, and the non-inflationary world in which we live today makes it more effective, as were the cases of Italy and Great Britain in 1992-1993.

By nature, the single currency eliminates any possibility of foreign exchange adjustment for a country taken individually, which risks making everything more rigid. Thus, the only way for a country going through an asymmetrical crisis to adjust itself is by lowering prices, increasing unemployment or emigration. These are difficult prognoses to accept!

This difficulty, however, can be remedied in three ways. We are in the heart of the current debate on the euro. The first solution consists of only allowing into the circle of countries with the same currency those that already have a very high level of economic integration, and are thus almost structurally in the same economic cycle, which significantly reduces the risk of uneven impact. This is why, before and after the advent of the single currency, the convergence criteria are important. This is the position of Germany in particular, which strongly holds to these criteria, even after changing over to the euro.

From this point of view, it develops a perfectly logical argument. But the passage is narrow since it only allows few countries (mainly those of the mark zone, including France) to join this circle. This is the origin of the open question about the southern countries, particularly Italy in recent months.

In addition, the Maastricht criteria, as defined for some of them, have not been adapted to cyclical changes. If we wanted to adhere to them at any cost, they would cause the slowdown of the much anticipated boost in growth. Consequently, Germany has thus opted for the following alternative: rigidly doubling down, in accounting terms, on the criteria and taking major risks for growth, or making it a “policy” reading, but no longer having a presentable argument to put before southern Europe to persuade it to wait. This is part of the current pressure in Germany to push back the date of changing over to the euro.

The two other solutions do not eliminate the need for a convergence, a priori and a posteriori, to reduce the risks of uneven impacts, even if it means re-examining the criteria. However they are not happy with that. The second solution is thus based on a stronger idea of what the countries having adopted the euro can share. It consists of coordinating economic policies through appropriate bodies such as a “Council for stability and growth”.

On the one hand, this coordination would enable implementing a stimulus policy in an articulated and complementary manner, and a policy for austerity, according to the cyclical phases, on the other hand, thus playing the “win-win” game and not the game of “every man for himself” which most often makes all players lose.

The third solution is no doubt the best economically, the most logical and the only one to complete the construction of Europe, both monetarily and politically. Let us remember that a centralised monetary power has always been accompanied by a similar movement on a political level. Only greater political integration, leading to a greater degree of federalism, can structurally reduce the dangers of a lack of flexibility engendered by the common currency. Then only, as in the United States of America, for example, an economic crisis in one state can be absorbed without the play of relative price movements and employment adjustments alone. A community-level decision-making centre equipped with some tools and expertise, acting only in the principle of subsidiarity, is necessary to institutionalise the Member States’ obligation to cooperate. Federalism allows the coexistence of decentralised state powers and a regulating and coordinating power in the centre.

A federal budget worthy of this name, that does not add to national budgets, would in fact allow transfers of revenues to the affected State and would thus facilitate the necessary adjustments, making them less dramatic and more tolerable. This would not at all exclude the community rules which aim to make each country adhere to minimum “economic wisdom” criteria. This higher degree of federalism should also allow instituting European tax and social minimums. Let us not be fooled; this risk of a race to the bottom – fiscally or socially, so to speak – is one of the major causes that could hinder the construction of Europe.

As far as the euro is concerned, to continue to think like novices that an economically unified Europe will automatically lead to a politically unified Europe is perhaps already a historical error that risks bringing the construction of Europe to a halt.