Category: Global economy
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/
The post-pandemic period is triggering a strong rebound, and it will take time for supply chains to recover and supply to adjust. As a result, most economists believe that inflation will only be temporary. Moreover, structural reasons for very low inflation persist. In fact, inflation is curbed by globalisation, which keeps the prices of labour, goods and services contained, and the technological revolution, which reduces the bargaining power of low-skilled employees and which, through the dissemination of digital technology and robotisation, allows for productivity gains. It should be noted that since the 1980s, there has been a decorrelation between monetary growth and inflation. And since the 1990s, the Phillips curve has nearly disappeared, as a rise in employment no longer leads to price growth. But what are the reasons that the rise in inflation could be sustainable?
If we look at the long history since the 19th century, we have been experiencing long cycles of inflationary regimes, where the economy is dominated by monetary policy, which fights inflation by dragging down growth when inflation accelerates too much, and vice versa. We also observe alternating long cycles of low inflation, due to the effects of globalisation and technological revolutions. Such a low inflation cycle was in effect at the end of the 19th and start of the 20th centuries, as in the past thirty years. The current cycle has already lasted for a very long time. This is not a sufficient reason to believe that it will end, but this is a cause for reflection. Today, by removing the lid on the economy during the pandemic and with very strong support and then stimulus policies, prices are rising. And the risk of returning to an inflationary cycle re-emerges, a risk that we have not experienced for a long time.
If the pandemic does not lead to “the world after”, it has significantly accelerated the changes that were already under way. In the United States, but also in Europe, there are labour shortages in many sectors, including in low-qualified services, even though overall employment has not returned to its previous trough. As a result, wages are increasing significantly at McDonald’s and in high value-added companies to attract new employees and retain them. Macroeconomic analysis can give false indications if it only focuses on aggregate figures. Let’s add that Biden rightly wants to increase low wages. But the pace and intensity of these increases will be critical. In addition, in most OECD countries over the past few decades, real wages have risen below productivity gains, which is a deformation of the value-added sharing process, to the detriment of employees. Thus contributing to populist reactions and leading to possible future demands, sooner rather than later, for higher wage growth.
With the developments of history in the background and the major economic and employment changes in progress, the sharp rebound in the economy and the resulting significant rise in prices could, if necessary, and if the pandemic does not resurface, trigger a new indexation of wages to prices, and then an indexation loop that could lead the world into a new inflationary cycle. The growing cost of the necessary energy transition may also weigh on a sustained rise in prices. Nothing is certain, far from it, but the scenario should no longer be ruled out.
However, we wager that the central banks, thereby demonstrating their independence vis-à-vis governments and financial markets, would act when growth returns to its medium-term trend to stop such a return to an inflationary cycle. The resulting rises in interest rates would be welcome to curb the speculative bubbles that are currently forming. But governments or companies that are highly indebted should prepare as best as they can by taking structural action on their solvency trajectory.
The longer the pandemic lasts, the more governments need to support the economy, and rightly so, particularly companies in the most affected sectors and the households that depend on them, and the more central banks need to support governments by buying their additional debt. As a consequence of this, debt is strongly increasing. Post-Covid, the question is how this sharp spike in debt will be managed, coming as it does after a period of rising debt globally for at least the last two decades. This is how the ‘debt trap’ is built. Either central banks will gradually exit their quantitative easing policy and long interest rates will rise again, potentially causing the insolvency of a number of companies and States, if they have not returned to a credible debt trajectory before. Or they will not do it and it will exacerbate the financial and real estate bubbles already present with soon or later their bust and their disastrous economic and social consequences. And, ultimately, a possible loss of confidence in money. What policies can we then pursue to best avoid this trap?
There are wrong paths and others to consider, as no solution is obvious or easy.
FIRST WRONG PATH
First wrong pathis the one defended by a number of economists who say that, fundamentally, debt can be limitless because interest rates are close to zero. More specifically, with nominal interest rates below nominal growth rates, debt sustainability would be assured. Thus, de facto, debt levels would ultimately have little importance. But the underlying model, which is well known, is only true under certain conditions.
FOUR REASONS WHY THIS MODEL SHOULD BE CALLED INTO DOUBT:
First, this situation of interest rates persistently lower than growth rates almost inevitably generates financial cycles, that is bubbles on assets (particularly equities and real estate, but also gold, art, etc.), with an excessively strong and under-rewarded trend towards over-indebtedness and risk-taking among investors (households and asset managers). Ultimately, this leads to greater vulnerability in both borrowers’ liabilities and investors’ assets. Major financial crises arise sooner or later, with now well-known economic and social consequences. In addition, these crises reduce potential growth over the long term. These issues are now well documented, so we will not make the case for this point here, as it is clearly explained elsewhere. Finally, we should add that macroprudential policies, however essential they are, remain wholly insufficient to counter financial cycles. On the one hand, because they remain national and it is difficult for authorities to act against the competitiveness of the banks in their own country, on the other, above all because they only affect banks at this time, while the relative weight of financial markets in the national and international financing system has been rising sharply over the last few decades.
Secondly, notwithstanding the financial crises caused, excessively low rates for too long are themselves weighing on growth trends. This is not always well understood. In the usual model, the natural interest rate, calculated on the basis of determinants that are real variables, has been getting ever lower for several decades. It has even been very low in recent years, or even below zero in the eurozone. The extremely low or even negative natural rate could be a sign that savings are above ex-ante investments and inflation is too low, below its target. This would therefore justify taking effective rates ever lower to drive savings down and investment up, and raising the inflation rate at the same time. However, perhaps there is an anomaly in this reasoning. This idea, while partly true, is also partly mistaken, because the monetary regime, that is the monetary policy that unfolds over the long term, also in reality influences the economy and growth over the long term.
Thus, if interest rates are below growth rates for too long, monetary policy affects the real economy by the resulting misallocation of capital. Some companies in fact stay alive, while if interest rates had been close to the growth rate, they would have continually shown a loss and would have actually disappeared (these companies are called “zombies”). They stay alive, distort capital allocation, disrupt the health of healthy and competitive companies, and prevent the natural phenomenon of destruction/creation necessary for any economic dynamism in developed countries. This is one of the reasons behind the decline in productivity gains. Moreover, excessively low interest rates for too long also facilitate debt. It is much easier to borrow when the interest rate is continually below the growth rate. And over-indebtedness inevitably leads to a decline in investment, which again has a negative impact on productivity gains.
To continue our demonstration, consider the traditional model according to which lower interest rates lead to lower savings and higher investment, which holds true in normal times. In reality, if interest rates are below the growth rate for too long and close to zero, this sooner or later leads to an increase in savings. We should accept that money illusion can play a role in this. We have seen this recently (even before the pandemic), with households accumulating much more savings to offset the lack of interest received, in order to reach the capital they deem necessary for their retirement despite everything. We should add that persistently low interest rates for a long time also weigh on company expectations. Under this scenario, we are likely to see very low nominal growth in the future, which does little to encourage an entrepreneurial spirit. Moreover, zero or negative interest rates muddle all economic calculations.
Finally, if interest rates are excessively low for too long, this creates bubbles, leading to wealth inequalities that, in addition to the resulting social consequences, may have a negative impact on consumption. It is not the households with the highest propensity to consume that generate the most wealth.
For all the reasons set out above, there is therefore a clear trap in keeping rates too low for too long. A non-monetary and non-financial model has to be used to believe that finance and money do not have a significant impact on the real economy. Yet, history has proved the contrary.
In order to avoid deflation and allow the economy to rebound, it is clearly necessary to bring interest rates below growth rates during a major crisis, including through quantitative easing policies when interest rates are already very low, particularly during over-indebtedness crises such as that of 2007-2009. But keeping them very low and below the growth rate, when growth has returned, lending is back at its normal levels, etc., leads to a structural weakening in growth, through the mechanisms described above. And then, it leads in turn to ever lower interest rates.
Finally, note that in the usual model, the Phillips curve indicates that the more employment increases, the more inflation rises. Thus, the same model indicates symmetrically that while inflation remains very low, below its target, the economy is still far from full employment. That is, savings are higher than investment, ex ante. This also indicates that the natural interest rate, a modelled and unobservable variable, is below the effective interest rate, thus pointing to the need to push the latter further downwards. But for years, and up to the current period at least, the Phillips curve has not been working any more, with full employment no longer driving the rise in prices.
This means that taking interest rates ever lower during periods of “normal” growth, in search of a lower natural interest rate, may result from a partially erroneous interpretation. An interpretation that could have a negative impact on the economy, given the effects described above. The question, then, of the inflation target, during this inflation regime, at a level below but close to 2%, would become critical.
We believe that too low inflation is dangerous, as it carries with it a significant probability of falling into deflation, due to the impossibility of making flexible adjustments allowing private agents to react to a recession without triggering massive lay-offs or numerous bankruptcies. Excessively low inflation means it is no longer possible to bring down real interest rates or real wages, factors in less economically and socially painful adjustments. But, if structural inflation remains very low, significantly below 2%, for a long period in the economy, due to the effects of globalisation and the technological revolution, does seeking to raise it at all costs, through a permanently ultra-accommodative monetary policy, not lead to all the very negative effects explained above due to interest rates being below growth rates for too long? We believe central banks must maintain an inflation target, that is to say must have a nominal anchor objective, but the chosen targets must be adapted to the long-term economic and financial regime in force. The monetary policy conducted by central banks must in fact make it possible to achieve both monetary and financial stability.
Third reason: the idea that interest rates below growth rates ensure countries’ long-term solvency is based on a series of heroic assumptions. First, the assumption that inflation will not bounce back significantly for a long time. Indeed, inflation is unlikely to pick up in the immediate future, but, in a few years, who knows whether US policy will not revive inflation with a very high budget deficit, wage hikes, etc.? How will a possible very strong recovery after Covid affect prices? With bottleneck effects and a lack of well-trained labor forces adapted to the growing economic sectors. What will be the effect of the reorganisation of certain production and supply chains? Finally, what effect will the cost of the necessary energy transition have on inflation in the middle and long term? A degree of inflation would be valid and useful, as long as it does not turn into an inflationary regime, that is to say generalized indexation. But if inflation were to stay above its target for the long term, either central banks would react, and given the considerable amount of debt, would induce private and public insolvencies that could trigger a catastrophic chain of events, specifically if the announced debt trajectory is not under control or not credible; or central banks would not react, and would therefore expose themselves to a dangerous loss of credibility due to their inability to control inflation. They are indeed guarantors of the nominal anchor, i.e. moderate inflation.
Moreover, even without any significant increase in inflation, if central banks were no longer to buy almost all of the excess public debt, because growth returned to normal for example, there would need to be buyers replacing central banks themselves. The idea that investors would limitlessly be willing to buy debt at zero or negative interest rates seems unrealistic. This is why both retail and institutional investors, as we have seen, take disproportionate risks to obtain small returns.
Finally, it is not only for interest rates to rise for the usual sovereign solvency equation to indicate that conditions have not been met. Indeed, even if interest rates remained at their current levels for a long time, a fairly sustainable and strong shock could lead to a drop in the growth rate itself, thereby jeopardising the expected solvency trajectory. Even a prolonged worsening primary deficit could undermine solvency, even if facilitated in parallel by an interest rate that is lower than the growth rate.
So, there is effectively a debt trap, whether there is a surge in long-lasting and undesired inflation or not. If central banks let rise or raise rates, whether for reasons of a return to normal growth and full employment or to meet their inflation targets if inflation climbs up, the effects on a heavily indebted economy will only be bearable if both governments and private agents have announced and started a credible solvency trajectory. And if central banks do not do this, they are the ones who will lose their credibility, triggering destabilizing monetary and financial, and ultimately economic and social, potentially catastrophic dynamics. Including the destructive dynamic of flight from money, analyzed below.
Fourth reason: if debt increases constantly due to the effect of magic money, the monetary constraint, i.e. the payment constraint, will be increasingly ineffective. However, as Michel Aglietta rightly says, confidence in money is the alpha and omega of society. The monetary system is a debt settlement system. Confidence in money is therefore based on the fact that the debt settlement system gives us confidence by being effective. If households can spend more than they earn over the long term, if companies can finance their losses without limits, if governments do not have any constraints on growth in their debt, it is the monetary system itself that will no longer be effective or credible. The very value of money will thus be questioned, and sooner or later, a flight from the currency, with the appearance of non-bank private currencies, cryptocurrencies, etc. We can easily imagine, and it is already under way, that the GAFAs, more solvent than countries and managing gigantic quantities of trade and settlement, could issue their own currency. Will households ultimately prefer to have this type of currency in this case? It would be very dangerous and destructive for society. Gold, as well as some real assets, could also be lies of escape from money. Think of German hyperinflation, assignats, etc. The payment of compensation required by the winners of the World War I forced the German government to disburse much more than it was capable of. The central bank was forced to finance this. It then ran after hyperinflation, always printing the amount of money necessary to enable spending. This led to the emergence of local private currencies, such as those from large companies, which issued bonds with very small denominations that could serve as currency instead of the mark. This situation proved destructive for society.
SECOND WRONG PATH
Second wrong path: a number of other economists want to cancel partially or totally the debt held by central banks. Note that the idea expressed is uncorrelated to that on which the first path is based. Cancelling debt can only be indispensable if the amount of debt at stake is unsustainable. The two proposals are therefore antinomic.
The idea of debt dumping by central banks does not hold up. On the one hand, governments and central banks must be considered as a consolidated entity in order to have a true vision of the mechanisms at stake. As central banks are mostly owned by governments, what a central bank earns is therefore earned by governments. Cancelling debt, on the other hand, would lead to a serious loss of credibility for both central banks and governments. Experience through history shows that public debt cancellations are only very rarely successful, and that on the contrary they lead to very heavy costs over time. The cancellation of the debt therefore seems outright unthinkable.
THIRD WRONG PATH
Third wrong path: to raise taxes, particularly wealth tax. First, the amounts of these taxes are in no way comparable to the amount of debt. The scales are totally different. In some countries, where taxes are low, we can fully understand that increasing taxes helps towards the solutions to be put in place. In France, taxes over GDP are among the highest among developed countries, including the current capital tax rate, which remains, even after reform, one of the highest among comparable countries. Such an increase would therefore be very dangerous for demand. As it would be very dangerous for supply, as here, once again, it is necessary, during the reconstruction phase, to encourage entrepreneurs to do business and innovate, and to foster competitiveness. This would promote both an increase in production capacity and the country’s appeal. Moreover, the number of start-ups is increasing significantly at the moment. This phase of powerful mutation, which Covid did not create but is accelerating considerably, must be well supported.
FOURTH WRONG PATH
Fourth wrong path: Mandatory Government issued Bonds consist of drawing off a portion of household savings to finance government debt. With savings abundant due to the pandemic, this idea seems to be gaining traction. It is undoubtedly true that savings have increased sharply during the pandemic among households, but also among companies that have been little or unaffected by it. However, there are several possible analysis errors in this idea. First, such a mandatory government issued bond would most likely be perceived as confiscatory, and would significantly reduce trust in governments, which, given the world’s current state, does not seem desirable. Secondly, there would be a subsequent reconstruction of assets, because households would be afraid of not being repaid in the future or seeing the amounts due to them eroded by long-term inflation. This would have an adverse impact on consumption, resulting in an increase in savings. What’s more, the situation is completely different from the immediate post-war era, which saw households hoarding their cash under their bed. The idea was then to mobilise unproductive savings. Today, the European economy is fully banked. 99% of households in France have one or more bank accounts. When they put money aside, it is mostly in bank deposits. Savings are therefore mobilised by banks to lend to the economy. This savings is neither idle nor unproductive. A mandatory government issued bond would move savings that finance the private economy to financing the government.
HOW THEN CAN WE GET OUT OF THE DEBT TRAP?
First of all, corporate debt. In France, we know that the corporate debt-to-GDP ratio has risen significantly in the last decade, faster than the eurozone average, and has now exceeded it. We therefore need to increase companies’ capital in relation to debt. Participation loans are a way forward, but is not the only way of doing this, because they are still debt, even subordinated, and they are relatively expensive. Convertible bonds should undoubtedly also be considered, for example. In any event, households must be encouraged to mobilise part of their savings towards companies’ capital by improving their taxation in such cases or by guaranteeing a portion of the capital thus invested. We should also bear in mind that banks and insurance companies have seen their regulatory capital required on their capital investments in companies increase significantly under Basel 3 and Solvency II. Would it not, at least temporarily, be useful for the European economy and even ultimately favourable to banks’ risk exposure, to reduce the regulatory capital cost of such investments?
For public debt, it would be necessary first to distinguish Covid debt and accept that the excess public debt due to Covid could be refinanced for an extended period of time on a “rolling” basis by the central bank. Like that of companies, government debt is in reality not strictly speaking extinguished. At maturity, they are repaid by issuing new debt, at current market conditions. The important thing for the issuer is therefore not to reduce its debt whatever happens, but to ensure a solvency trajectory that allows subscribers to be found for its new issues at subsequent maturities, and this under “normal” conditions. In order to avoid overly burdening public debt market during future refinancing, in order to avoid compromising government solvency for a sufficiently long period of time, central banks could thus ensure over a sufficiently long period of time the refinancing of the excess public debt due to the pandemic alone. This would not correspond to any cancellation or permanent monetisation of public debt.
Raise the potential growth:
Secondly, it is essential to raise the nominal growth rate in order to make public debt more easily sustainable. Stronger growth generates more income for governments, which has a favourable impact on the balance of public finances, as well as on GDP, and therefore on the numerator and denominator of the public debt ratio. The debt ratio is therefore improved in two ways.
We must not pursue an austerity policy, because we must not enter this vicious circle. In order to increase growth rates, we must pursue policies to support demand, until we see a return to a “normal” growth rate. But structural policies are also essential. Their goal is to increase growth potential. The essential reform of the State in France would improve the efficiency of the money spent and ultimately improve the economy’s competitiveness factors. French public expenditure is higher, in proportion to GDP, than that of most European economies, and its ultimate efficiency is too low. Its comparative performance, measured in terms of PISA and PIAAC scores, or measured by the wage level of nurses, for greater expenses in the sector of education or health, which are just a few examples among many others, clearly shows this. The French poor ranking in terms of equal opportunities (and not equality of income after redistribution, which, conversely, is one of the best among OECD countries) is another example of the way forward to improve the value of the public money spent. But these reforms are difficult to implement during economic crises and do not have a rapid effect. However, they remain essential.
Pension reform, consisting of increasing the number of annuities to take account of demographic change, is highly effective and has faster results. The deficit in the pension system is a major contributor to the public deficit. It is easy to understand that as we are living longer, as examples overseas clearly show, we need to increase the number of annuities we pay in order to be entitled to a full pension. This reform, which is invaluable in controlling public spending, would also be additional proof that France is taking the problem of debt seriously. Finally, pension reform does not undermine growth; on the contrary, it makes it possible to encourage French people to save less by easing or even dispelling their fear of not having a sufficient or predictable pension. And because this reform increases the active population, it increases the growth potential, at a time when we will need everyone in order to produce more.
The reform of unemployment insurance may also be of use to potential growth. Even in this period, the number of jobs that go unfilled remains high. We would seem to need unemployment insurance that does more to encourage people to find a job, while creating a marker of the various allocation criteria according to labour market indicators. At the same time, however, we need to strengthen people’s security and protection, if we are justifiably to make jobs more flexible. Current and future accelerated economic changes will require us to change profession and company even more than before. Better personal protection, particularly through better initial training and more intensive and effective professional training, is therefore an essential corollary.
CONCLUSION
Thus, in order to avoid a step backwards in renewed growth, monetary policy support and fiscal stimulus clearly need to continue until stable growth is restored.
But it will quickly be necessary to give a clear commitment from States, like central banks, to pursue a trajectory over several years making it possible to return to the “normal” and to stick to it in a scrupulous manner, to give confidence in the debt and in fine in the money. Unlimited debt development would cause very serious monetary and financial crises, even if the timing is difficult to predict. Commitment to a medium-term path of sustainability of public finances, in particular by increasing growth potential and without excluding the necessary financing of investments that promote sustainable growth, is essential. Equally necessary is the commitment to a gradual and prudent return of monetary policy to a practice of driving nominal interest rates towards nominal growth rates when growth is satisfactory.”
It has indeed been clearly known since the last great financial crisis that a satisfactory and steady growth rate and a controlled inflation rate and on target are not enough to lead to the absence of bubbles and financial crises. Monetary policy must therefore simultaneously seek economic stability (by closing the “output gap”), monetary stability (by closing the inflation gap between the observed inflation rate and the target pursued) and financial stability (by preventing as much as possible – and not just repairing – bubbles in the financial and real estate markets, as well as abnormal increases in the debt-to-GDP ratio).
In the medium term, this is a narrow way out, but probably the only one feasible.
Biography
Artus Patrick
“Does the ECB’s inflation target need to be revised?”
Natixis Flash Economie, 22 October 2019, no. 1421
Banerjee & Hofmann
“Corporate zombies”
BIS Working Papers 882 – 2 September 2020
https://www.bis.org/publ/work882.htm
Blanchard Olivier & Pisani-Ferry Jean
“Monetisation: Do not panic”
(Vox EU) – 10 April 2020
https://voxeu.org/article/monetisation-do-not-panic
Blinder Alan S.
“Monetary and financial stability in a low interest rate environment: challenges ahead”
BIS Papers No. 98, July 2018
https://www.bis.org/publ/bppdf/bispap98.pdf
Borio Claudio
“Monetary policy and financial stability: what role in prevention and recovery?”
BIS Working Papers no. 440
https://www.bis.org/publ/work440.htm
Borio Claudio
“What anchors for the natural rate of interest?”
BIS Working Papers 777, 26 March 2019 – (page 1 to 16)
https://www.bis.org/publ/work777.htm
Borio Claudio
“The expectations on central banks are simply too great”
Speech, 21 November 2019
https://www.bis.org/speeches/sp191121.htm
Carstens Augustin
“Maintaining sound money compliance and after the pandemic”
Bis speech, 8 October 2020
https://www.bis.org/speeches/sp201008.htm
Couppey-Soubeyran Jézabel, Bridonneau Baptiste, Dufrêne Nicolas, Giraud Gaël, Lalucq Aurore, Scialom Laurence
“Cancel the public debt held by the ECB and ‘take back control’ of our destiny”
Le Monde, 5 February 2021, also published in the following European media: L’Avvenire (Italy), El Pais (Spain), La Libre Belgique (Belgium), Paperjam (Luxembourg), Der Freitag (Germany), Infosperber (Switzerland), Le Temps (Switzerland), Euractiv (EU)
https://cancellation-debt-public-bce.com/
Draghi Mario
“Monetary policy and structural reforms in the euro area”
Speech, Bologna, 14 December 2015
https://www.ecb.europa.eu/press/key/date/2015/html/sp151214.en.html
ECB
“The natural rate of interest”
December 2019
https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op217.en.pdf
de Larosière Jacques
“Breaking the monetary policy deadlock”
Les Echos – 12 September 2019
https://www.lesechos.fr/idees-debats/cercle/sortir-la-politique-monetaire-de-limpasse-1130969
François Villeroy de Galhau: The tale of the three stabilities: price stability, financial stability and economic stability
https://www.bis.org/review/r210304d.htm
Goodhart Charles
“Inflation after the pandemic: Theory and practice”
Vox, June 2020
https://voxeu.org/article/inflation-after-pandemic-theory-and-practice
Goodhart Charles, Schulze Tatjana and Tsomocos Dimitri
“Time inconsistency in recent monetary policy”
Vox, 4 August 2020
https://voxeu.org/article/time-inconsistency-recent-monetary-policy
Klein Olivier
“The Current Financial Crisis : something old, something new”
Article published in Revue Sociétal no. 65 – Q3 2009.
https://www.oklein.fr/en/the-current-financial-crisis/
Klein Olivier / Dubreuil Thibault
“Exiting the ECB’s highly accommodative monetary policy: issues and challenges”
Financial Economy Review – 5 December 2017
https://www.oklein.fr/en/exiting-the-ecbs-highly-accomodating-monetary-policy-stakes-and-challenges-2/
Klein Olivier
“When is the next financial crisis?”
Aix meetings, 6 July 2019
https://www.oklein.fr/en/when-will-the-next-financial-crisis-happen/
Klein Olivier
“Low interest rates: too much of a good thing”
La Tribune, 1 September 2020
https://www.oklein.fr/en/low-interest-rates-too-much-of-a-good-thing/
Klein Olivier
“The debt issue: risk of financial instability and of a loss of trust in money”
EURO 50 Conference, 14 December 2020
https://www.oklein.fr/en/the-debt-issue-risk-of-financial-instability-and-of-a-lost-of-trust-in-money/
Lowe Philip
“Some Echoes of Melville”, Speech, 29 october 2019 https://www.bis.org/review/r191101b.pdf
The members of the round table were:
- Michel Aglietta, Professor Emeritus, Paris X Nanterre University, Advisor to the French Institute for Research into International Economics;
- Agnès Bénassy-Quéré, Chief Economist to the Treasury;
- Anne-Laure Delatte, Head of Research at the French National Centre for Scientific Research;
- Olivier Klein, CEO of BRED and Professor of Financial Macroeconomics and Monetary Policy at HEC Business School.
Here is a transcript of my talk for Printemps de l’Economie.
Not repaying our debt: risk of a loss of trust in money and risks for society
We are in the middle of an unprecedented and potent crisis due to the pandemic. The response from Governments and central banks has so far been strong and appropriate. The budget and monetary policies that have been put in place come down to a temporary lifting of monetary restrictions, in other words, of spending limits. Households were still been paid if employers were no longer able to settle wages, which was crucial to avoid the economy collapsing altogether, thanks to furlough schemes. Funding has been set aside to cover the losses of several companies who, during this time, were quite simply unable to find the money to pay their costs since their fall in turnover. This was entirely necessary to protect not only demand, but also our future supply capacity. However, during normal times monetary restrictions are, strictly speaking, essential for the economy to function.
Governments who have drastically increased their spending and continue to do so, despite a slump in tax revenues, have themselves benefited from a lifting of the monetary restrictions placed on them thanks to the central banks who have been buying up public debt at will.
Central banks have injected a lot of liquidity into the financial markets to help them stay on tracks. They have also been supporting companies by buying their debt. In this way, the central banks have both directly and through the banks helped ensure sufficient funding for the economy.
However, going on the basis that these policies were unavoidable in our attempts to protect the front line, we have to ask what happens next, once we return to normal, and have to deal with the massive debt?
Failure to repay public debt to private creditors would have serious consequences for both the economy and society. Even supposing that the law allowed us to get way with not repaying only the central bank – which is not in fact the case – then given that the Governments are its shareholders, we would in fact be playing a zero-sum game.
The only option would be to set up near-perpetual funding of public debt from the central bank at a rate close to zero.
Even were it possible to repay the additional debt generated by the pandemic in this way, could this solution be extended to all debt, including to future rises in public debt?
Surely this is akin to believing in a magic money tree? Put another way, the question is this: we have found ways to fund things that, yesterday, we thought were impossible to fund; so why can’t we continue doing so forever? Especially since interest rates are very low and below the rate of growth, so the solvency position of private lenders and Governments could, in theory, be protected. However, current interest rates and growth rates are only two contributory factors of solvency – a further crisis could be triggered by a fall in incomes and not only by a rise in interest rates -, of financial stability and, more generally, of confidence.
What is needed is large-scale theoretical analysis to determine whether permanent and increasing degrees of quantitative easing would be possible i.e. keeping interest rates close to zero, allowing the Government to spend more without limits, and private parties to increase their debt without restriction.
However, a policy of endless quantitative easing would not work and should be rejected. Primarily due to the massive repercussions it would have for financial instability. Keeping interest rates too low for too long, whilst the economy returns to normal growth – which we are far from achieving – would ultimately encourage, or even generate and develop financial cycles. In other words, it would encourage larger and larger speculative bubbles which would then pop. We are all too familiar with this phenomenon of financial cycles driven by rapid credit growth combined, in a self-sustaining loop, with a speculative stock or real estate bubble. These phenomena are widely documented and are extremely dangerous because they give rise to major economic and financial crises.
Finally, in the longer term, people could end up shunning the currency altogether. If the spending limits, and therefore monetary restrictions, remain lifted for too long, it is people’s trust in money that will be affected, because the monetary system is essentially a system for the repayment of debts. And as we know, it is the system that gives transactions their coherence and, more importantly, makes the economy work. A crisis of confidence could therefore be triggered by a loss of trust in the validity of receivables and debts, either today or in the future. The whole system is based on that trust. If you buy something, you must pay for it. If you sell something, you are owed for it. And we borrow because we are betting on the future, betting that the investment we make will generate future income, which we can use to repay what we borrowed in order to make the investment in the first place.
A crisis therefore arises when there is mistrust in the payment system, in the debt collection system. Mistrust in financial contracts which are what give us this ability to look ahead to the future. Ultimately, mistrust in money itself.
But what is trust? It’s the ability to rely on someone’s word, or on a signed contract. And this is clearly valuable for an economy; contracts for debts and receivables, which underpin the entire system, must therefore be respected.
Trust in banks is also crucial, because they are the ones that create money ex nihilo by offering credit. The same applies to trust in the central bank. Not only because it is the bank’s bank, but above all because it is in charge of monetary regulation, the linchpin that holds it all together.
If the central bank issues too much central bank money – and without knowing in advance where the cut-off point lies – for too long, and if monetary restrictions are not restored within a foreseeable time period, a serious crisis could occur, on a par with the collapse of France’s assignats during the French revolution, hyperinflation in Germany at the start of the twentieth century, or the recurring monetary crises experienced by certain countries in South America. After that point, there is a risk that the official currency will be spurned. Which could lead to disintegration of the debts and receivables system, in turn triggering disintegration of the monetary system i.e. the potential disintegration of our entire society. In the words of Michel Aglietta, trust in money is the alpha and omega of society.
This trust must under no circumstances be destroyed, otherwise people may decamp to a foreign currency. This is common in less developed countries, but is by no means exclusive to them. That said, if all central banks do the same thing at the same time, it is obviously harder to escape from your own currency by transferring your assets into another currency. Then again, many are able to take refuge in gold. The day could even come when we take refuge in a cryptocurrency issued by GAFA, having become more solvent than the Governments. The cryptocurrency would become a private currency, and a way to circumvent official systems.
In conclusion, money is an institution, and must be managed as an institution, in other words as a whole entity relying on trust and rules. By rules, I mean repayment of debt i.e. monetary restrictions. These rules can be temporarily set aside, but not for long and we must not be fooled into thinking we have found a magic formula for keeping everything working without ever having any restrictions.
Central banks must therefore remain above private interests and the interests of the State, since this is precisely what gives them their legitimacy. There is therefore no room for fiscal dominance i.e. dependence on Governments which would force them to adopt policies resulting in extremely long periods with very low, zero, or even negative interest rates, below the rate of growth, and to inject central bank money into the markets on a continuous basis. At the same time, they must also avoid financial market dominance i.e. the central bank should not be dominated by the financial markets. Central markets must avoid being dictated to by markets clamouring for yet more injections of liquidity under the threat of a stock market crash.
On the contrary, the central bank must defend the public’s interests. It must also protect its credibility. Otherwise in the future it will be powerless, in the event of genuine further need, to use monetary policy effectively and efficiently to support the economy and keep it working, and to keep society itself in check.
Transcription of the video-conference debate organised by ELEC-France on 24 June 2020
Olivier Klein
Executive President of ELEC-France, CEO of BRED and professor of financial macroeconomics and monetary policy at HEC
At this complicated time for everyone, ELEC’s board felt it important to organise a discussion about the pandemic and the financial and economic crisis we are currently experiencing, in order to try to provide some analysis and perspective, insofar as possible at this stage, as we clearly have a long way to go.
- The question of total lockdown
The first question to be addressed – to which obviously no definitive answer exists at this stage, since we don’t yet have sufficient perspective – is whether total lockdown has been positive or negative? While many countries tried to avoid lockdown, before later going back on their decision, in France the question did not arise in the same way, since we did not have either masks or tests. Hence, total lockdown was therefore probably inevitable.
The second question which arises is more “metaphysical” than economic – the price to put on life. This underwent a major revaluation compared with previous major health crises, without necessarily taking into account the potential resulting impacts on poverty, and perhaps even on health.
Despite being a slightly fallacious comparison, it is worth noting that in France we currently have around 30,000 deaths due to coronavirus, while each year 150,000 people die from cancer, and the Spanish flu caused 400,000 deaths in France. But how many deaths would there have been without lockdown?
- Financial consequences of coronavirus
The pandemic and lockdown in the most developed countries caused major disruption on financial markets in the second half of March. In the first fortnight, the financial crisis was more intense than that of 2008-2009. Stock market volatility, for example, was almost double that of 2008-2009. The debt market exploded, with a massive increase in spreads (i.e. risk premiums). Fortunately, central banks immediately took stock of the situation and reacted at once by injecting plenty of liquidity, which may cause problems later on, but without which the financial markets would have triggered a catastrophic crisis.
On this point, I believe that the reason financial markets came close to almost total meltdown was certainly due to the unprecedented and global nature of the crisis, but also because of the advanced stage reached in the financial cycle. Markets had previously seriously underestimated risks, while also seriously overestimating the value of many companies, making the crisis much more severe when it eventually occurred.
Central banks responded very quickly and effectively, by injecting large quantities of liquidity wherever it was needed. Interest rates were cut in the United States, which had a positive effect. The same could not be done in Europe since rates were already negative or zero. Central banks reined in both short-term and long-term rates, as well as many spreads. Bank financing was then very effectively secured by renewing or enhancing a range of special measures. Following a spectacular fall, the stock market eventually rebounded strongly. Governments, supported by their central banks, enabled companies to finance their losses.
- Economic consequences of coronavirus
The pandemic caused extremely violent economic turbulence simultaneously around the world. INSEE estimates that in France, one month’s full lockdown resulted in a 35% decrease in GDP.
For information, a little calculation of my own indicates that the private sector actually saw its GDP slashed by practically 50% during the month of lockdown. This is because the one-third decrease in GDP also takes into account public bodies whose production is measured according to their cost. Yet since their cost did not decrease during lockdown, neither did their production. With 25% of jobs being in the public sector, a simple cross multiplication based on the principle that the number of jobs is proportional to production gives a result of just under 50% – an extraordinarily sharp and violent collapse.
Depending on the number of months of lockdown and the number of months of recovery, this naturally leads to the conclusion that we will not return to the levels of production seen in January and February 2020, but that we will return more gradually to previous levels. The Fed considers that we will not see previous levels of production again before 2022. This has led the OECD to forecast recessions in the UK, Italy, Spain and France of between 11% and 13%. The forecast for France is around 11%. The Netherlands and Germany are set to be between 7% and 8%, which is a big difference, even though the levels remain high. The OECD forecasts just under 3% for China and India, although care should obviously be taken to consider usual growth rates when making comparisons. The recession in the United States is set to see a decline of 7%, while Korea, for example, is set to decline by 1%. Sharp falls compared with previous levels are therefore being seen across the board, although not all countries will be affected in the same way.
- Reactions from governments and central banks
Central banks immediately responded very strongly in terms of supplying liquidity and buying up all kinds of debt, including government bonds, of course, as well as corporate debt. They also bought some speculative-grade debt, which is unusual for banks such as the Fed and the ECB. They purchased all kinds of private and public debt, to maintain rates and spreads at reasonable levels and to avoid a cascade of bankruptcies, as well as financial market contagion.
Governments also immediately responded, although this has led to major public deficits. In the United States, the government deficit for the year compared with GDP is currently estimated at around 20%, which is very high. It is forecast to be around 8% in the eurozone and 11% in France. The estimate for Japan is 8% and an average of 14% in the OECD, bearing in mind the significant weighting of the United States. The effect on public debt will be an increase of between 10 and 20 percentage points compared with GDP. In France, for example, public debt is set to increase from 100% to 120% of GDP by the end of the year.
What did governments and central banks actually do? They temporarily removed the monetary constraint, or payment constraint, which ordinarily means that a loss-making business cannot continue to be financed over the long term or that a household’s outgoings cannot be more than its income over the long term. This monetary constraint, normally a legitimate part of banking operations, was suspended for completely understandable and vital reasons. Faced with this catastrophic situation, if the constraint had not been temporarily suspended, a significant number of companies could or would have gone bust, causing a lasting loss of production capacity in each country. This would be extremely damaging to countries’ wealth.
If governments had not supported households and businesses at the same time, by taking on the salaries that companies were no longer able to pay employees, households would have severely suffered, leading to a social catastrophe, while companies would have suffered even greater losses. It was therefore useful, and even vital, to temporarily suspend the monetary constraint, for both companies and households. Governments did this, with support from central banks in relation to companies, by buying their corporate debt directly on the markets.
Obviously, the success of this measure depended on governments’ own monetary constraint being temporarily suspended. The central banks therefore enabled this by buying up the additional government debt themselves, at least temporarily ignoring what is known as “debt monetisation”, to prevent the markets from panicking in the face of unprecedented levels of public debt and triggering an insolvency crisis.
We therefore saw the suspension of monetary constraints on two levels. Bear in mind that such constraints are necessary in normal times for the proper functioning of the economy, as without them there would be nothing but zombie companies leading healthy companies to become zombies in turn. If a company makes a loss long term on a market and continues to survive, other companies will also start to lose money and all the economic efficiency that minimises human toil would cease to exist. It is therefore essential for this constraint to be re-established at a certain point, to ensure economic efficiency and confidence in the economy as well as the currency.
- The recovery: what reconstruction will be needed?
Markets’ ability to be captivated by the prospect of a rapid recovery is worrying. Countries have suffered severe falls in GDP – almost 50% in the private sector in France. The United States, for example, shed 20 million jobs in a few months. It is therefore no surprise that two million were instantly restored when businesses and restaurants reopened there. It would be more surprising if the country managed to restore the 20 million lost jobs in the next 12 to 18 months. The artificial, sometimes even self-deceptive, enthusiasm shown by markets is therefore of concern.
The relaunch will necessarily be rapid at first, but then gradual. Firstly, since it takes a while for supply and value chains to gradually be rebuilt. Secondly, because of companies’ excessive levels of debt. Depending on the sector and country, they were already heavily indebted previously. With the crisis caused by the pandemic, they have had to finance their losses, leading to an increase in their level of debt, which, without careful supervision, risks hindering employment, investment and growth.
Savings also increased sharply during lockdown, when households consumed significantly less than before. In France, they increased from around 15% to 20%. The question is: are households going to lower their savings rate quickly or will they keep some of the excess as a precaution, due to fears over their future remuneration or future employment?
There is certainly a close and reciprocal relationship between supply and demand. Many companies will wait to see if demand picks up enough to allow them to reinvest and recruit, while many households will wait to see if employment holds up before increasing their consumption again.
Economic policies will therefore play a central role in this interaction between supply and demand. Furthermore, all countries, around the world, are in a bad situation, from China, which is certainly starting to recover, although in a non-linear way, to the United States. This conjunction further adds to the negative effect on the economy, considering that international trade has obviously fallen dramatically during the period.
Economic policies will therefore be necessary following lockdown and will need to be different from those we have seen recently. Firstly, in order to boost supply, which needs to be rebuilt. Measures need to be taken to help increase companies’ capital so that they reduce their debt without slowing down investment and employment. But how? Will the government at least partially guarantee companies’ capital risk-taking? These are topical questions. It will also be necessary to revitalise employment and adopt measures to facilitate investment, on the one hand, and recruitment, on the other, especially among young people entering the job market, for whom the situation will be much more difficult.
Taxes should not be increased in any way, as supply would suffer. Now more than ever, we need entrepreneurs and innovators, as well as savers open to taking capital risks. Anything that might discourage them should therefore be completely avoided.
Certain strategic relocations will be necessary, which will not be easy. Strategically, however, everyone understands that having 90% of penicillin and paracetamol manufactured in China is an issue that needs to be dealt with quickly. And these relocations also present an opportunity to promote a low-carbon economy and thereby meet future climate challenges.
These policies should also make it possible to support demand. We need a policy that facilitates employment. We need to support poorer households while ensuring that they are encouraged to seek employment.
Finally, we will need to strike a careful balance in restoring monetary constraints, vital payment constraints, neither too quickly nor too slowly. Too quickly would be catastrophic, as it would require government austerity policies or budget cuts. At the moment, however, spending and investments are needed to support the lack of private demand. And if interest rates were to rise too quickly, the mountain of debt would become explosive. Steps need to be taken fairly slowly. But not too slowly either. We need a clear and transparent programme for a return to normal. Without this, we could enter a voodoo economy since if, as some continue to argue, we were to do away with all constraints in the future and allow the central bank to swallow any increase in future debts indefinitely without repayment, we would see a catastrophic situation with a series of severe financial crises and, ultimately, a catastrophic loss of confidence in money.
Finally, the whole of economic history demonstrates that whenever monetary constraints have been ignored or disregarded, there has been a flight from money triggering catastrophic financial and economic crises. The value of debts is essential. The debts of households, companies and governments must inspire confidence, and money represents banks’ debt in respect of non-banking agents. So if money lost its value, it would be because debts no longer had any value, since they would no longer be repayable. The fact of not having a monetary constraint would lead to a loss of confidence in money, in other words a massive economic catastrophe. It is therefore vital to find a slow, but nevertheless realistic and credible, way forward to return to a certain normality.
Discussion
Edmond Alphandéry: One subject seems very important to me in our country: the problem of the negligence of the French administration revealed by the pandemic. Until now we have heard absolutely nothing at governmental level about the real reform in France, that of the administration. There are around a million civil servants too many compared with a country like Germany, at an extra cost of between €84 and €100 billion. If we take the most recent example, concerning subsidies for green vehicles, it is clear once again that the administration set up an absurdly complicated system rather than adopting the most elegant solution, chosen by Germany, namely a reduction in VAT, which affects all vehicles without any means testing. Another important point to mention in a comparison with Germany is the experience of the pandemic: how the pandemic was managed and how Germany is emerging from it. Aside from the outbreaks we may see appearing, there are 600,000 people currently in lockdown in Germany, but in the automotive sector and the largest sectors, Germany has still bounced back much more quickly than us.
Olivier Klein: On the first point: yes, for a long time the French government had not prepared for the possibility of a pandemic, since we had neither masks nor tests, which set us back a long way.
Furthermore, I completely agree that this is not the time to slow down or abandon structural reforms. Structural reforms, contrary to what some may think, are not about wanting austerity for a country, but making the economy as a whole more efficient and increasing the potential growth rate. They are about increasing productivity gains by all well-known means and increasing the capacity to mobilise labour. It is therefore vital at this time to implement structural policies. But it is important to choose them well to ensure they do not lead to a worse situation in the short term. And obviously a lot of political courage is required to carry them through.
In Germany, there were around 8,000 deaths for 83 million inhabitants, while in France there were 30,000 deaths for 67 million inhabitants. Growth in France is estimated at -11% for this year, and -7% in Germany. The public deficit will fall to 11 in France and 5.5 in Germany. It is also worth noting there was a decrease in workplace attendance of 43% in France at the end of April and only 18% in Germany. So it is unsurprising that growth has fallen by much less and now the recovery can be much stronger. Finally, the number of short-time workers during lockdown was around 10 million in France out of the 20 million people in work, i.e. around 50%, while in Germany the percentage was only 22%.
Valérie Plagnol: I think we cannot avoid or be afraid of the term austerity, which will clearly be with us after 2022. The question is: how will we organise it in France? Today, the term is taboo. Indeed, in France we have arrived at this point with heavy baggage and baggage that has been packed badly. Today the reforms and the responses are structural in nature and I am worried about the increased government intervention. You mentioned the need for it, but this economic interventionism is accompanied by extremely restrictive directives, including economically. I fear that in the end we will be in a situation of give-and-take. And on the other hand, protectionist behaviour is also emerging. It has been discussed at European level, with predatory behaviour, but it is more a question of protectionism in relation to posted workers, airlines, etc. So the reconstitution or reinforcement of a monopoly which, in the short term, risks leading us into greater inflation. And therefore the accentuation of that famous French drift towards “Club Med”.
Olivier Klein: As I was saying, I believe that structural reform policies are needed, very modestly. If we do not implement them, we will save the short term by considerably worsening our situation in the medium term. So we must implement them. Is the country ready for them? That is another matter. We need to present them properly and explain why they are necessary. Austerity policies, as such, are not the same as structural reforms. In reality, countries that have not adopted structural policies will sooner or later be forced to implement drastic austerity policies. This was the case to some extent in Spain, Portugal, Italy and Greece after 2010, during the eurozone crisis. Countries that had not adopted structural reforms were suddenly forced to implement austerity policies to try to restore their current account balances as quickly as possible, causing considerable social and political harm. Structural policies are therefore not austerity insofar as they increase the potential growth rate, while austerity policies lead directly to lowering the effective growth rate in order to restore balances. I think and I hope that there is a way to create structural policies that do not encourage deflation or austerity, even if there will naturally be difficulties here and there, since certain parts of the population will unavoidably have to make efforts in terms of the quantity of work, level of efficiency, etc. Close attention will therefore need to be paid to the vocabulary used and the use of concepts in order to have a small chance of convincing the population of the need for these reforms, which otherwise will be immediately criticised as contrary to the interests of the population, which is absolutely false.
Patrick Lefas: A question about the role of banks. The situation now is radically different from that of 2008: banks increased their equity and were therefore in a position to finance the economy, obviously with support from government through government-backed loans. My question is: how will the banks manage the increased cost of risk? Because there may be a number of companies unable to continue and which will therefore go out of business. What tools should be developed now? Should we focus on equity loans?
Olivier Klein: As the head of a bank, my impression was that all banks did their job remarkably well during the period, since during the two months of lockdown they provided “essential services”. At BRED, 100% of branches were open and 85% to 90% of employees were physically present. They responded on the basis that they were useful to the nation and that it was absolutely necessary to be present.
To answer the question more precisely, the banks particularly granted government-backed loans, which was vital, but which will inevitably lead to an increase in indebtedness at a time when French companies’ debt level is already fairly high, which will cause problems. I know a lot of business leaders who don’t know how they will repay those loans. Admittedly, they can be spread over five years after the first year, but it will sometimes be very difficult to ensure repayment as it will be necessary to find additional cash flow and margin during the subsequent period, without at the same time hindering investment and jobs. That is really the issue – it is difficult to successfully square the circle. We have therefore all begun to consider, with the public authorities, what solutions could be adopted. There are equity loans. Banks cannot carry out unlimited lending of their deposits as equity loans, as obviously that type of loan is riskier. Fairly substantial guarantees, at least partial, are therefore required from the government.
There is private equity. The difficulty, for insurers as well as for banks, is that since Basel III the capital cost of capital invested in companies is enormous. Three and a half to four times more equity needs to be raised than for a loan to invest in companies’ capital. Reflection is therefore needed at European level: should the cost of capital be considered, for both insurers and banks, when investing in companies’ capital? This is an important debate to have. Should French banks become more business partners to companies, by holding more of their capital, a little like in Germany, with the associated long-term risks and advantages? Advantages for German medium-sized companies: they receive much more support and have more capital. And disadvantages: sometimes too much proximity. And some German banks are not necessarily doing well. Should we create convertible bonds? Many subjects are on the table and will need to be discussed.
Philippe Jurgensen
Honorary President of ELEC-France
I am going to talk to you about how Europe is trying to tackle the economic situation and prepare for recovery, and particularly about the European recovery plan, Next Generation EU, which is a major innovation. A financial innovation, adding to a colossal rescue package including ECB funding (€1 trillion for the PEPP alone, in addition to existing measures and government and corporate bond purchasing), €200 billion from the EIB, with a pan-European guarantee fund, and €100 billion from the SURE instrument for short-time working. The European Next Generation recovery plan is therefore in addition to all of those measures. The Commission’s proposal is very recent, since it was announced on 27 May. France and Germany had proposed €500 billion, the Commission is proposing €750 billion, or 6% of European GDP! If we take into account all the other funding, which is not always clear and is partially duplicated, we arrive at a figure of almost 15% of European GDP, which is considerable.
Today we will try to answer three simple questions: where does the money come from? Who is it going to? And who will pay?
- Where does the money come from?
€500 billion of the recovery plan comes or will come from the EU budget and €250 billion from EU loans. But in reality, the €500 billion is also being borrowed. So €750 billion is being borrowed, €500 billion of which comes from the budget and €250 billion in actual loans. The budget money is being financed by the usual budget keys, including the rebates originally negotiated by Mrs Thatcher, but expanded to many other countries; and naturally the so-called “frugal” countries are keen on this.
The burning question is whether this €500 billion budget is indeed in addition to the 2021-2027 Multiannual Financial Framework. The tendency would be to think so, but it is not so obvious, since that multiannual framework is itself under discussion. As such, there will be possibilities for interference. In the February 2020 council meeting, there were 27 hours of discussion without reaching any agreement on this multi-year financial programme, since the four “frugal” countries – the Netherlands, Austria, Sweden and Denmark – backed by Germany at the time, did not want to exceed the cap of 1% of GDP. No multiannual framework was therefore adopted. The question of whether the €500 billion is actually additional is therefore unclear.
As for the €250 billion in EU loans, on the other hand, this is a real breakthrough since it was an addition adopted by the Commission at a Franco-German level, and it is above all a first, since it represents the creation of a European Treasury.
This innovation was rejected by Germany for a long time and is still challenged by a number of participants. It is true that this EU loan is presented as unique and exceptional, a “one-off”, which may therefore allow those who are against the measure to say that it is not final. It is nevertheless a great innovation and extremely important, I believe, and federal in nature despite everything.
Is there too much debt in Europe? The total debt of eurozone countries is currently equivalent to 86% of GDP. It will reach 103% by the end of 2020 according to European Central Bank forecasts. For France, we were at 98% at the end of last year, 102% last April, and we are set to reach 121% by the end of the year. The fact that there is a European federal community debt alongside national debts is an important innovation.
- Where is all this money going and who are the beneficiaries?
Three pillars will be paid in successive instalments. A main pillar, alone accounting for €655 billion, a second of €56 billion and a third of €38 billion.
- The first pillar is composed mainly of what is called the Recovery and Resilience Facility, equivalent to €560 billion. It is supplemented by REACT-EU, a €56 billion transitional assistance programme for the most affected regions, which strengthens current cohesion policies, and which largely goes to the most backward EU countries, especially in Eastern Europe. Finally, €40 billion goes into funding the Just Transition Mechanism.
- The second pillar is support for companies and private investment. The aim is to provide them with as much capital as possible, in the hope of generating much more private investment. Of that amount, €15 billion is intended for strategic investments.
- The third component mainly concerns research, with a budget of €13.5 billion. It also concerns health systems. Finally, €15 billion in development aid is allocated for non-EU countries, since emerging countries are more affected by the crisis than ours.
Who are the recipients? The biggest beneficiary would be Italy, at almost a quarter of the overall amount – roughly half in subsidies and half in loans: €173 billion in total. Spain takes second place with €140 billion in total, accounting for 18.5% of the total amount, with more subsidies than loans. Then comes France, which has no loans but a significant share of subsidies, with an amount of €38.8 billion or 5% of the total. If we count the sum of subsidies and loans, Poland comes above France, with €64 billion budgeted, or 8.5% of the total amount. Next come Germany, Greece, Romania, etc. The rescue package is obviously intended to be spread between all countries, including those which have suffered the least, which will therefore receive much less than the others.
- Who will repay?
Firstly, out of the €500 billion in budgetary appropriation, only €433 billion is actually in subsidies. The remaining €67 billion corresponds to loan guarantees, a very effective mechanism but not a definitive expense, as normally a high proportion of those loans will be repaid and the guarantees will not have to be invoked. It would be unfortunate if all of the €67 billion was spent, since that would mean that the loans had not been repaid.
As for the €250 billion in loans – EU loans – the question is whether or not they will be repaid:
- According to the budget keys, with the European Commission proposing repayment over 30 years from 2027, extending until 2058;
- Or according to what each country has received;
- Or else according to an ad hoc key: since it is an EU expenditure, it should be financed other than by ordinary budget keys.
This raises two very difficult questions: firstly, the four previously mentioned “frugal” states feel that there are too many subsidies and not enough loans. They therefore want to increase the share of loans in the €750 billion amount. Those same countries, and a few others, also want additional conditionalities, rejected by countries such as Spain, Italy and particularly Eastern European countries. What would these additional conditionalities be? Respect for the main objectives of the plan and the fight against fraud, for example the fight against the black economy in Italy or respect for the rule of law in Eastern European countries. These conditionalities will be managed by an intergovernmental committee, which will have to agree annually to the plan’s expenditure, but which fortunately will decide by qualified majority rather than unanimously.
So could the plan be financed with new own resources as the Commission is proposing? This would be a federal approach which would require increasing the ceiling for own resources, currently at 1.2%, to 2% of European GDP. This is an essential prerequisite for making the loans provided for under the programme. What additional resources could be found? Four are mentioned:
- Extend the ETS (Emissions Trading System) market, the carbon market on which the price per tonne of CO2 is fixed, which could be expanded to maritime and air transport, for example;
- Consider the border carbon tax, which would make it possible to have a sufficiently high carbon price within Europe without damaging our companies’ competitive position;
- Introduce a tax on GAFA, on digital platforms;
- Introduce a tax on European companies.
So what can we conclude from this? Firstly, this is a real rebound for the European Union. The most optimistic are even talking about a “Hamilton moment”, meaning the beginning of debt federalisation, which Hamilton obtained in the United States in 1790. This rebound introduces solidarity, a step towards the transfer union that the Germans dread so much. There is also the creation of a European Treasury. If the Council manages to take the proposed decisions – it will still need to have them approved by the European Parliament and ratified, unanimously – Europe will have made great progress.
Discussion
Laurent Diot: How do we interpret the decision by the Karlsruhe Constitutional Court and the very bad signal it sends out in terms of European construction?
Philippe Jurgensen: This is an obvious legal problem. The Karlsruhe Constitutional Court bases its decisions on rulings by the European Court of Justice, which has said that the ECB’s policy is legitimate. This manner of denying the jurisdiction of the Federal Court is extremely questionable and dangerous for Europe. However, the Bundesverfassungsgericht stated that its position did not apply to the exceptional plan linked to Covid-19 and that furthermore it could be provided with explanations justifying the policy adopted.
Olivier Klein: It would not be impossible, according to my own interpretation, for it to allow part of Germany to set out its future position by saying: “We can have a moment, a one-off, when we will pool debt, but be careful that the ECB does not finance any indefinite increase in debt in the future, because then we would have a means of saying that it has exceeded its mandate.” In a way, there is probably part of Germany, if not all, which is setting out its position or adopting a stance for negotiations.
Valérie Plagnol: Two questions: what are your feelings about the success of this plan and particularly its direct financing component via revenue that would go directly to the European Commission? How can we imagine that we would revise the treaties to move towards the federalism initiated by these first steps?
Olivier Giscard d’Estaing: And have you mentioned the issue of Brexit? Because that is a permanent problem and one which has a major influence on the future of Europe.
Philippe Jurgensen: With regard to Brexit, the problem has moved into the background in recent months, but it is still there and is unresolved. The British strongly refuse to extend the transition period until the end of the year and as negotiations are not progressing, we are heading straight for a no-deal Brexit, which would be considered very bad on both sides.
On the first question, it is really very important to know whether we will be able to free up federal own resources, as the United States did in 1790. Perhaps the fact that four are mentioned proves that none are certain or even very close to succeeding. Each of these options is interesting, however, particularly the border carbon tax, which it is difficult to do without, but there are obstacles and objections for each of these four possible sources.
Olivier Klein: From a general perspective, is losing the UK from Europe such a very bad sign? At times like these when we are discussing a possible step towards slightly more federalism and the construction of an additional budget, wouldn’t London’s presence hinder the possibility of reaching agreements?
Olivier Giscard d’Estaing: In fact, I think it would actually be a relief if the problem were resolved, as it would enable us to consolidate our federalist efforts on the continent. What I deplore is this indefinite postponement of the solution, with England playing its hand and then the European Union playing its own.
Philippe Creppy: On the other hand, we may see a harder stance adopted by Northern countries, which feel that they have a different position to take following the UK’s departure.
Philippe Jurgensen: If England were still here, those countries would obviously have relied on its support and it would have been among the frugal countries. Unfortunately for them, they are now all alone and abandoned by Germany.
Jacques Lebhar: We have not discussed the international trade dimension, and particularly trade between the European Union and the rest of the world. Firstly, because it is an important aspect of the economic recovery and growth. Secondly, because when it is addressed, it is via taxation, even if that is justified from a protectionist perspective. And finally because all the discussions about economic sovereignty and relocations tend towards a renunciation of traditional EU policies, of its trade policy, and could lead to a lower proportion of international trade in economic activity within the EU. So how do you see this dimension being taken into account within the Commission or the Council? What do we do about international treaties? We are seeing changes to the policy towards China. This is an element that is fairly central to EU countries’ macroeconomic outlook and which is directly or indirectly linked to the search for own resources.
Philippe Jurgensen: I think that we need to continue to have an active foreign trade policy and to conclude agreements like the CETA agreement, even if it is strongly contested by certain parts of European opinion. And moreover the European Union has also continued to negotiate and conclude trade agreements in the midst of the coronavirus crisis. The environmental dimension needs to be included, in accordance with public opinion. And in this respect, I do not agree with the idea that the border carbon tax is a protectionist measure. It is a vital measure if we want to meet ambitious targets such as achieving carbon neutrality by 2050. It will be impossible to achieve this if we have an economy in which European companies pay a heavy price to emit less carbon, but we continue to import products duty-free that have been manufactured without any respect for the environment. Either we abandon environmental objectives – despite increasingly public support for them – or we implement this carbon tax.
Patrick Lefas: I completely agree, especially since when we look at the situation in France, the carbon footprint is greater than the carbon costs of French production. So we face a real question: how do we reduce the carbon footprint of the imported portion? This is an especially important issue since it involves very considerable sums.
Olivier Klein: Furthermore, we are going to need a fairly strong trade policy towards the outside world, because the United States is starting to announce surcharges on exports of European products. We will therefore need a fairly consistent, well-established and well-negotiated position.