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“The situation in Europe in the era of coronavirus” : the speechs of Olivier Klein and Philippe Jurgensen at the conference of the European League for Economic Cooperation on June 24, 2020

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.

Categories
Economical and financial crisis Global economy

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

OPINION. When a very serious economic and financial crisis occurs in a context of near-zero short-term interest rates and prior over-indebtedness, central banks turn to unconventional monetary policies.

Some push interest rates below zero, and all launch a Quantitative Easing (QE) programme to control the long-term rates and risk premiums (spreads) of both public and private debt. This means central banks can use their conventional and unconventional policies to bring short and long interest rates to very low levels and prevent spreads from rising to levels that would trigger a catastrophic chain of bankruptcies due to a sharp rise in insolvency. Very low rates also have a direct positive effect on demand, as well as on the value of capital assets (real estate and equities in particular), which has a positive impact on demand and supports credit.

During these crises, monetary policy – even of the unconventional type – has the de facto objective of lowering nominal interest rates below the nominal growth rate. This clearly helps revive the economy and facilitates deleveraging by making debt easier to repay.

So what could possibly be the danger of such a monetary policy that protects the economy against systemic crisis and a deep recession? The risk lies in adopting a monetary policy which, in fact, is asymmetric. While it is very useful – essential, even – when central banks adopt this type of policy in such situations, in reality we are witnessing a problematic asymmetry: when growth returns with a noticeable recovery in credit, central banks fail to sufficiently reverse their policy, increase their interest rates or scale down their QE – that is, the quantity of central bank money – if they do so at all.

In the eurozone, the official reason has often been that inflation was still too low, meaning the inflation target had not yet been reached, which justified maintaining an ultra-accommodative monetary policy. However, isn’t inflation structurally, and not cyclically, very low, due to the effects of globalisation and technological progress (automation) – which exert downward pressure on wages – combined with the ageing of the world’s population? In this case, is monetary policy capable of increasing it? If monetary policy cannot raise inflation that is fundamentally very low, it obviously becomes dangerous to continue to pursue such a policy for too because it then keeps interest rates below growth rates for too long – “too low for too long”. This causes a financial loop: debt rises faster than economic growth, which leads to over-indebtedness all over again and the return of real-estate or stock bubbles.

It is a vicious cycle, because debt is also used to buy these capital assets, which feeds the bubbles and facilitates more debt. That is how the entire economy becomes more financially vulnerable, with risks embedded in the balance sheets which only grow:

1/ In the assets of financial investors and/or savers

They are looking for even a small return at any cost, since interest rates are too low. So they’re going to take more and more risk in order to get it. The risk premiums are thus compressed in a way that is completely abnormal and obviously dangerous, because when the bubbles burst, the spreads will simply not have covered the cost of the proven risk. The assets of savers and financial investors (who work for the savers: pension funds, insurers, investment funds, etc.), are thus made vulnerable. Pre-pandemic, this led to, among other things, a sharp historical drop in yields on investments in infrastructure, historically low credit spreads, very high valuations for listed and private equity companies, and investment funds holding assets that were more and more illiquid and/or with very long maturities, while ensuring the daily liquidity of these same funds, etc.

2/ In borrowers’ liabilities

Borrowers’ are taking on too much debt under these conditions, which leads to excessive leverage. Among other things, there has been a great deal of share buybacks by companies themselves, notably in the United States. So now it’s the liabilities themselves that are becoming vulnerable. They are vulnerable to a drop in cash flows linked to a slowdown in growth as well as a rise in interest rates. This, in turn, leads to a significantly larger risk of insolvency.

When the above two points combine, there is growth in the number of “zombie companies”, that is to say companies which survive, but which are not structurally profitable and which would go bankrupt at normal interest rates. This phenomenon naturally contributes to a less-efficient economy and lower productivity gains.

Maintaining interest rates that are too low for too long, when they are no longer necessary to fight against insufficient growth of the economy and loans, therefore creates a very risky situation in the long term. An asymmetric monetary policy reaction can thus lead to more financial instability, the progressive loss of economic efficiency with a decline in productivity gains and, ultimately, a succession of financial crises. This was the pre-COVID-19 situation.

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 flow for companies against a prior backdrop of significant financial vulnerability.

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 which shot up, and very problematic liquidity shortages, particularly in investment funds. Fortunately, the central banks responded at lightning speed: they lowered their rates when it was still possible – in the United States in particular – though not on the European side because they had not come back up even after growth returned in previous years. They also began to buy public and private debt, including high-yield debt, and sometimes even equities, by increasing their quantitative easing considerably. They also adopted macroprudential adjustment measures.

Central banks thus quite rightly made it possible to relieve a catastrophic financial situation within a few weeks and have supported the efforts of governments in favour of the economy through the massive use of an unconventional monetary policy. But, very soon, we’ll have to answer the following question: When growth does return to a satisfactory level, how can we exit this monetary policy if governments and companies are even more indebted? Of course, right now the central question is how to get out of an unprecedented economic crisis. And yet, despite everything, we must now think about how we will eventually escape from an exceptional situation where central banks have rightly suspended the logic of the market temporarily, by intervening deliberately and massively to ensure the liquidity of the markets and the solvency of governments and, in conjunction with government action, the solvency of companies by controlling interest rates and spreads.

First of all, the exit will need to be a very gradual one. The situation will indeed be problematic, because at the end of the crisis a number of companies will be over-indebted, especially because they will have had, and fortunately will have been able, to finance their losses, and many governments will be over-indebted, too. In addition, we will have to deal with bubbles on capital assets; prices are already rising sharply, both for residential real estate and equities. If we then raise rates too quickly by a poorly-planned withdrawal of QE, and if we hastily put an end to negative interest rates, it could have a disastrous effect on solvency in the private and public sectors. This, of course, could lead to the risk of a crash in capital-asset markets, which would reinforce widespread insolvency. The exit must, therefore, be very gradual.

Central banks would also be in a bind if inflation recovered in two or three years. If it did, should they maintain the solvency of economic agents at the cost of potentially uncontrollable inflation? Or do the opposite?

But, even if inflation did not recover, should central banks continue their QE ad infinitum if governments and companies – whether by necessity or by choice – did not deleverage? This would result in structurally increased financial instability, both in terms of over-indebtedness and increasingly extreme bubbles, with all the dangers such instability would involve. There would be an increasing moral hazard since borrowers, both private and public, would no longer fear over-indebtedness. Investors would believe that central banks would always rescue them from crashes with no repercussions, and would thus be encouraged to underweight the price of risk in their financial calculations in 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 debts would lead to a catastrophic flight from currency.

First conclusion: to maintain their credibility, and therefore their efficiency, including during systemic crises, central banks must protect themselves, not only against the well-known risk of fiscal dominance, but also against that of financial market dominance to avoid falling into increasingly strong, violent and potentially very dangerous crises. In other words, they must not be dominated either by governments which might want their continuous intervention to “guarantee” their solvency, or by the financial markets. Central banks need to be in a strategic relationship with financial markets. And they should not be afraid to channel collective images and average market opinions into sustainable fluctuation ranges, insofar as possible, or to counter them if need be. Even if the markets today are always asking for more aid to continue their upward momentum. As Fed Chair Jerome Powell said recently, and quite rightly: “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”. 

Second conclusion: alongside the policies implemented by central banks – which need to start thinking about how they will eventually escape their ultra accommodative policies – we need fiscal policies that are sustainable in the medium-term. Not immediately, however, because we need to avoid austerity at all costs in the coming years. Structural reforms will also be necessary to increase the growth potential of each economy. Ultimately, this is the best way to escape over-indebtedness.

That includes policies that aim to increase corporate equity. To reduce excess debt – without hindering growth – we will need much more investment in equity and quasi-equity (equity loans, convertible bonds, etc.). Incentives will therefore be needed to direct household savings towards riskier capital, as well as measures targeting the cost of excess reserves of banks and insurers so as not to make their investments in corporate equity prohibitive. Temporarily, a system where the government partially guarantees the invested capital may prove necessary.

Central Banks cannot do everything on their own. Expecting too much of them can be dangerous, even for their efficiency, when it becomes necessary again.

Categories
Economical and financial crisis Economical policy Global economy

Low interest rates to save an indebted economy?

When a very serious economic and financial crisis occurs in a context of near-zero short-term interest rates and prior over-indebtedness, central banks turn to unconventional monetary policies. Some push interest rates below zero, and all launch a Quantitative Easing (QE) programme to control the long-term rates and risk premiums (spreads) of both public and private debt. This means central banks can use their conventional and unconventional policies to bring short and long interest rates to very low levels and prevent spreads from rising to levels that would trigger a catastrophic chain of bankruptcies due to a sharp rise in insolvency. Very low rates also have a direct positive effect on demand, as well as on the value of capital assets (real estate and equities in particular), which has a positive impact on demand and supports credit.

During these crises, monetary policy – even of the unconventional type – has the de facto objective of lowering nominal interest rates below the nominal growth rate. This clearly helps revive the economy and facilitates deleveraging by making debt easier to repay.

So what could possibly be the danger of such a monetary policy that protects the economy against systemic crisis and a deep recession? The risk lies in adopting a monetary policy which, in fact, is asymmetric. While it is very useful – essential, even – when central banks adopt this type of policy in such situations, in reality we are witnessing a problematic asymmetry. When growth returns with a noticeable recovery in credit, central banks fail to sufficiently reverse their policy, increase their interest rates or scale down their QE – that is, the quantity of central bank money – if they do so at all.

In the eurozone, the official reason has often been that inflation was still too low, meaning the inflation target had not yet been reached, which justified maintaining an ultra-accommodative monetary policy. But isn’t inflation structurally, and not cyclically, very low? In this case, is monetary policy capable of increasing it? If monetary policy cannot raise inflation that is fundamentally very low, it obviously becomes dangerous to continue to pursue such a policy for too long, because it keeps interest rates lower than growth rates, so interest rates remain too low for too long.  This causes a financial loop: debt rises faster than economic growth, which leads to over-indebtedness all over again and the return of real-estate or stock bubbles. It is a vicious cycle, because debt is also used to buy these capital assets, which feeds the bubbles and facilitates more debt.

The entire economy becomes more financially vulnerable, with risks embedded in the balance sheets which only grow:

  • First, in the assets of financial investors and/or savers: they are looking for even a small return at any cost, since interest rates are too low. So they’re going to take more and more risk in order to get that tiny return. The risk premiums are thus compressed in a way that is completely abnormal and obviously dangerous, because when the bubbles burst, the spreads will simply not have covered the cost of the proven risk. The assets of savers and financial investors (who work for the savers: pension funds, insurers, investment funds, etc.), are thus made vulnerable. Pre-pandemic, this led to, among other things, a sharp historical drop in yields on investments in infrastructure, historically low credit spreads, very high valuations for listed and private equity companies, and investment funds holding assets that were more and more illiquid and/or with very long maturities, while ensuring the daily liquidity of these same funds, etc.
  • Second, borrowers’ liabilities: borrowers are taking on too much debt under these conditions, which leads to excessive leverage. Among other things, there have been numerous share buybacks by companies themselves, notably in the United States. So now it’s the liabilities themselves that are becoming vulnerable. They are vulnerable to a drop in cash flows linked to a slowdown in growth or a rise in interest rates. This, in turn, leads to an increased risk of insolvency.
  • When the above two points combine, there is growth in the number of ‘zombie companies’, that is to say companies which survive, but which are not structurally profitable and which would go bankrupt at normal interest rates. This phenomenon naturally contributes to a less-efficient economy and lower productivity gains.

Maintaining interest rates that are too low for too long, when they are no longer necessary to fight against insufficient growth of the economy and loans, therefore creates a very risky situation in the long term. An asymmetric monetary policy reaction can thus lead to more financial instability, the progressive loss of economic efficiency with a decline in productivity gains and, ultimately, a succession of financial crises. This was the situation before COVID.

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 flow for companies against a prior backdrop of significant financial vulnerability.

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 which shot up, and very problematic liquidity shortages, particularly in investment funds. Fortunately, the central banks responded at lightning speed: they lowered their rates when it was still possible – in the United States in particular – though not on the European side because they had not come back up even after growth returned in previous years. They also began to buy public and private debt, including high-yield debt, and sometimes even equities, by increasing their quantitative easing considerably. They also adopted macroprudential adjustment measures.

 Central banks thus quite rightly made it possible to relieve a catastrophic financial situation within a few weeks and have supported the efforts of governments in favour of the economy through the massive use of an unconventional monetary policy. But, very soon, we’ll have to answer the following question: When growth does return to a satisfactory level, how can we exit this monetary policy if governments and companies are even more indebted? Of course, right now the central question is how to get out of an unprecedented economic crisis. And yet, despite everything, we must now think about how we will eventually escape from an exceptional situation where central banks have rightly suspended the logic of the market temporarily, by intervening deliberately and massively to ensure the liquidity of the markets and the solvency of governments and, in conjunction with government action, the solvency of companies by controlling interest rates and spreads.

First of all, the exit will need to be a very gradual one. The situation will indeed be problematic, because at the end of the crisis a number of companies will be over-indebted, especially because they will have had, and fortunately will have been able, to finance their losses, and many governments will be over-indebted, too. In addition, we will have to deal with bubbles on capital assets; prices are already rising sharply, both for residential real estate and equities. If we then raise rates too quickly by poorly calibrated QE’s withdrawal, and if we too rapidly put an end to negative interest rates, it could have a disastrous effect on solvency in the private and public sectors. This, of course, could lead to the risk of a crash in capital-asset markets, which would reinforce widespread insolvency. The exit must, therefore, be very gradual.

Central banks would also be in a bind if inflation recovered in two or three years. If it did, should they maintain the solvency of economic agents at the cost of potentially uncontrollable inflation? Or do the opposite?

But, even if inflation did not recover, should central banks continue their QE ad infinitum if governments and companies – whether by necessity or by choice – did not deleverage? This would result in structurally increased financial instability, both in terms of over-indebtedness and increasingly extreme bubbles, with all the dangers they bring. There would be an increasing moral hazard since borrowers, both private and public, would no longer fear over-indebtedness. Investors would believe that central banks would always rescue them from crashes with no repercussions, and would thus be encouraged to underweight the price of risk in their financial calculations in 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 debts would lead to a catastrophic flight from currency.

First conclusion: to maintain their credibility, and therefore their efficiency, including during systemic crises, central banks must protect themselves against the well-known risks of fiscal dominance and financial market dominance to avoid falling into increasingly strong, violent and potentially very dangerous crises. In other words, they must not be dominated by governments which might want their continuous intervention to ‘guarantee’ their solvency, attempting to resist rate hikes for too long. But central banks should not be dominated by financial markets, either. They need to be in a strategic relationship with financial markets.

 And they should not be afraid to channel collective images and average market opinions into sustainable fluctuation ranges, insofar as possible, or to counter them if need be. Even if the markets today are always asking for more aid to continue their upward momentum. As Fed Chair Jerome Powell said recently, and quite rightly: “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”.

Second conclusion: alongside central bank policies, we need fiscal policies that are sustainable in the medium-term. Not immediately, however, because we need to avoid austerity at all costs in the coming years. Structural reforms will also be necessary to increase the growth potential of each economy. Ultimately, this is the best way to escape over-indebtedness.

That includes policies that aim to increase corporate equity. To reduce excess debt – without hindering growth – we will need much more investment in equity and quasi-equity (equity loans, convertible bonds, etc.). Incentives will therefore be needed to direct household savings more towards capital, i.e. riskier saving, as well as measures targeting the cost of excess reserves of banks and insurers so as not to make their investments in corporate equity prohibitive. Temporarily, a system where the government partially guarantees the invested capital may prove necessary.

Central banks must adopt symmetric monetary policy rules. But they can’t do it all on their own. And asking too much of them can be very dangerous, even for their credibility and efficiency, the next time they are needed.

Categories
Conjoncture Economical and financial crisis Global economy

Post-lockdown: neither austerity nor voodoo economics

The central banks took swift and effective action. States also acted rapidly in an attempt to handle the cost of the unprecedented fall in production as effectively as possible. They did so by enabling the financing of company losses and by taking on the cost of labour, since businesses generating zero revenue cannot continue paying their employees. The aims are to prevent layoffs and bankruptcies, protect production capacity and avoid an appalling rise in poverty.

The set of measures temporarily lifts monetary constraint – vital in normal circumstances to the efficient functioning of the economy – from economic players, businesses and households.

Monetary constraint

But in today’s economic meltdown, the normal exercise of monetary constraint would be catastrophic, leading to bankruptcies and countless irretrievable job losses. For their part, the central banks, while ensuring the liquidity necessary to the financial system, have wisely suspended the monetary constraint of states.

Once the health crisis is over, putting an end to this exceptional suspension will not be an easy task, and it would be dangerous to let people believe that monetary constraint at all levels could be durably lifted simply by central banks buying state and company debt on an ad lib basis.

While monetary constraint should not be abruptly reintroduced, as this could send the economy into a new downward spiral, neither should it be suspended for too long. This is because we must absolutely avoid a flight from currency, the value of which is wholly dependent on the trust placed in the effective exercise of monetary constraint, and hence in banks and central banks, as well as in the quality of debt, including public debt.

Fatal illusion

Central banks should make a part of the additional public debt resulting from the health crisis interest-free on a practically indefinite basis to lighten the load and foster the return of growth. But they must do so in a precise and strictly circumscribed manner. The idea of central banks permanently suspending monetary constraint is a fatal illusion. The major risk involved in acting as if monetary and economic constraints no longer exist is thus not a return of traditional inflation but a loss of confidence in currency. Sooner or later, this would lead to the appearance of a form of hyper-inflation and deep financial instability.

Pressure from public opinion

The reopening could thus entail elevated risks of economic policy mistakes. Under pressure from public opinion, policy may seek to return too swiftly to orthodoxy or assume that we are exempt indefinitely from any and all constraints.

A solid supply policy must be led to rebuild the country’s production capacity and even increase it to reduce its strategic dependence. The process will require all the capacity for work and entrepreneurial spirit of everyone involved. The supply policy must further mobilise labour and include a substantial focus on recapitalising businesses and facilitating investments. Failing this, companies will exit lockdown heavily in debt and may well be unable to invest sufficiently on a lasting basis.

The supply policy must be accompanied by a policy to boost demand, since both have suffered considerably during the crisis. Increasing taxes will not be compatible with either policy. Consequently, we will need to accept budgets with extremely gradual deficit reductions and the fact that monetary policies can only return to their unconventional practices in a cautious fashion. But to salvage trust in state debt and in currency, this should be achieved as part of a highly explicit plan.

Categories
Economical policy Global economy

The pension reform is desirable and credible – Read the full version of my opinion piece in the 02 January 2020 edition of Les Echos

Let’s look at the pension reform as it stands, however well or badly prepared it may be.

Currently, the reform, as presented by the Prime Minister, is both fair – it significantly improves the pensions of many people who receive little or no protection from the law or unions – and fully funded by age-based measures.

The issue of whether the reform should be solely “systemic” (or made universal, meaning a single system for everyone) rather than “parametric” (changing of the parameters to ensure balance) is a very surprising one. French people are much more worried about the amount of their future pensions than about whether the system is made universal, even though a universal system would be fairer.

This is probably where a lot of the mistrust is coming from: a points-based pension system may make people think that the system might be balanced by manipulating the value per point, and therefore the amount of the pensions paid, more particularly downwards. French people therefore needed to feel secure about their future pensions by being shown that the system would be safe-guarded, in other words funded.

The only way of effectively ensuring that pay-as-you-go pension systems are balanced, without lowering pensions, is to adjust the length of people’s working lives, based on demographic changes. Otherwise, they can only be balanced by increasing employee and/or employer social security contributions. This would affect purchasing power and/or make the economy less competitive, immediately or at a later date, and so ultimately reduce the growth rate, employment and purchasing power in both cases. As companies in France already pay 60% higher social security contributions than companies elsewhere in the euro area, any further rise would be unacceptable, both socially and economically, as it would go against the interests of the French economy and of everyone working in it.

This leaves age-based measures as the only way of making the interests of current and future pensioners compatible with aiming for the highest potential growth for the economy. In France, in 1960, there were four taxpayers for every pensioner. In 2010, there were only 1.8 taxpayers per pensioner. At the same time, in 1958, the life expectancy at pension age was 15.6 years for women and 12.5 years for men. In 2020, this has increased to 26.9 and 22.4 years respectively. And the pension age is lower now than in 1958. The healthy life expectancy after retirement has also increased considerably.

Everyone understands this and expects the length of people’s working lives to change. Moreover, all of France’s neighbours have similarly raised their pension ages. We therefore also need to come to terms with reality so that our precious pay-as-you-go pension system is not endangered by an inability to fund it. In France, only around 30% of people aged 60 to 64 work, whereas in the other euro area countries nearly 50% work on average, with 57% in Germany and 68% in Sweden. Of course, work is not only necessary economically, it is also very often a means of integration, socialisation and self-fulfilment. Work also creates work in the dynamics of an economy, something that all the empirical studies have confirmed.

Now it must be considered whether it is better to establish a pivot age or to adjust the number of years worked, as this adjustment would take long careers and the strenuousness of the work more effectively into account, which would be fairer.

A good reform is one that is desirable and credible. This reform is desirable because it is fairer and because it gives French people greater security with regard to the amount of their future pensions. It is credible because it should be funded by adjusting the length of people’s working lives. It is desirable and credible if it does not increase social security contributions in France further, as they are already much higher than in other euro area countries.

For all these reasons, this reform will be positive and helpful for French people and the country’s economy.

Categories
Economical policy Global economy

The issue of inequality: inequality of income – inequality of opportunity

By nature, the topic of inequality covers several aspects. If we look at the global level, levels of inequality between poor and rich countries have decreased considerably since the 1980s. According to the World Bank, 40% of the world’s population in 1981 lived below the extreme poverty line compared with only 11% today. The growth rate of emerging countries has therefore substantially reduced inequalities between the average living standards of the various countries. And if we focus on just China and India, which have experienced and continue to see the strongest economic development since the 1980s, 2 billion people have risen above the poverty line. That’s great progress and one of the obvious benefits of globalisation.

That’s true not only for income, but also for health. My data are less recent, and it has improved even more since then. In 1940, life expectancy in developing countries was 44.5 years. In the 80s, it reached 64.3 years. That’s an increase of 20 years over this 40-year period. Meanwhile, people in developed countries are living nine years longer. Here again, we can see that inequalities in health and life expectancy have decreased.

On the other hand, inequalities within each country, whether developed or emerging, have increased on average with globalisation and growth. That’s because although the growth process allows the greatest number of people to increase their standard of living, some in each country are progressing faster than others, and in some countries, people at the top of the pyramid have access to a larger share of national income. The standard of living has therefore increased for nearly everyone. However, inequality has still managed to grow, simply because certain people’s situations have improved more quickly than others. That’s the nature of happiness, measured by economists in an informative way. All the studies show that happiness is relative. We’re happy when we’re doing better and when our situation improves faster than others. In other words, by comparison. In relative terms. So, even though everyone’s standard of living is rising, the increase in inequality is quickly becoming a social and political topic. We’re therefore seeing a phenomenon needing better clarity: dramatically smaller inequality between countries and growing inequality within countries, even though the level of wealth and well-being has increased overall.

The issue of inequality can therefore be addressed and analysed in various ways.

Income inequality can be measured by looking at the share of the country’s income held by the top 1%. Inequality can also be measured much more precisely and undoubtedly with more relevance with the Gini index. Gini was an economist and statistician who invented the method of studying the distribution of inequality across the entire population. We look at the differences between everyone two by two and average the differences from each to each. If the average of the differences is zero, that means that everyone has exactly the same income. An average of 1 means total inequality. These indices are measured across all OECD countries.

Lastly, a third way doesn’t look at income inequality but at inequality of opportunity. Of course, we’re talking about social mobility and the “poverty traps” that generations can fall into. Equal opportunity is obviously crucial because it relates to the republican pact, the social pact, and the ability to live together and obviously because it is fundamental for the health of a society and its cohesion. When inequality of opportunity is low, more people can be mobilised. That means that no matter where you’re born, if you have talent and equal opportunities, you’ll manage to advance. So, not only is the belief that everyone has the same opportunities an important factor of social cohesion, but it also helps to foster growth because it mobilises all talents wherever they are. The issue of inequality of opportunities is therefore crucial. It means knowing whether they are still the same and their children who all have their opportunities to succeed or if the pathways can be fluid without too much determination for the original social environment. And we’ll see that in France, there is a strong adhesion at both the top and the bottom.

Findings:
I’ll start by presenting a few figures and then some analysis.

In France, compared with neighbouring countries, income inequality after distribution is rather low, whereas income inequality before distribution is rather high. Meanwhile, inequality of opportunities is rather high.

We’ll use these findings to try to come up with some possible conclusions in terms of economic policy and necessary reforms.

First, let’s take a look at the measurement of income inequality before distribution and after distribution. Before allocation, it’s clear, for example, that inequality is greater if wages range from 1 to 1,000 rather than 1 to 100. But we also have to consider people who aren’t working and therefore have very low incomes. The more people there are excluded from employment, the greater income inequality before redistribution is.
And the more powerful the redistribution system is, whether through taxes, support income, and or other ways, the lower income inequality after distribution is.

Before distribution, the GINI index rose from 0.477 in the United States in 1996 to 0.507 in 2016. In the UK, contrary to what one might think, there has been little increase. It increased from 0.473 to 0.504 in the EU and from 0.409 to 0.488 in Japan. So, what do we see? Inequality has actually risen everywhere. And in the US, it hasn’t risen much more than elsewhere, before distribution. Its level of inequality isn’t really much higher than in the eurozone, while in Japan it’s lower.

After distribution, the US fell from 0.507 to 0.391 in 2016. We can therefore see the effect of distribution. It clearly reduces income inequality. There has been a sharp decline in the UK as well. After distribution, the eurozone is a much more egalitarian system than the US since it’s much lower after distribution there. Europe therefore has a system that does more to reduce inequality. And Japan lies between them.

Let’s analyse France. Before redistribution, the Gini index rose from 0.490 in 1998 to 0.516 in 2015. That’s a fairly small upward trend in inequality. Are these inequalities big or small compared with other countries? In 2015, France was a little more unequal before redistribution than the US. Is it because there’s a broader range of wages? Of course not. It’s because there are many more people out of work. That’s an essentially French problem. Other countries very often have an employment rate 10 points higher (75% compared with 65% in France). Germany is almost at the US level. And we know that the unemployment level is very high there. Spain’s level of inequality before redistribution is even greater than France’s. Not surprisingly, Sweden is a more egalitarian country even before distribution. We can therefore see that France had high levels of inequality before redistribution.

But after redistribution, what’s the finding?

In 2015, France was at 0.295, one the lowest indices of all the countries considered. That means it went from having one of the highest indices in terms of inequality before redistribution to one of the lowest after redistribution. We can therefore see that redistribution is very strong in France. In the US, the level of inequality after redistribution is much higher than in France. But in Spain, Italy, and Germany, the level of income inequality after redistribution is about the same as in France. And France’s levels, again after redistribution, are quite comparable to Sweden’s.

France thus has a one of the highest redistribution policies, relative to GDP, of all OECD countries. The advantage is reduced inequalities, but there are also disadvantages. It means much higher taxes and mandatory contributions, which is not without consequences. We can easily see a correlation between the Gini index after redistribution and the burden of social benefits relative to GDP. And, thanks to one of the strongest redistributions among OECD countries, France has one of the lowest income inequalities. Only Denmark, Finland, and Sweden have lower levels.

Now let’s consider the proportion of national income received by the 1% of individuals with the highest national income. In France, they received 9% of national income in 1995. In 2015, they received 10.5%. For the sake of comparison, Sweden had the lowest percentage at 6% of national income versus 9% in France in 1995 and 8% versus 10.5% in 2015. That’s not a huge difference. Let’s look at the United States. In 1995, the richest 1% received 15% of national income. In 2015, this figure was a little over 20%. That’s clearly a striking figure. It’s twice as much as in France. And the increase in the share received by the richest 1% has been much more brutal. In Germany, growth has been a little stronger than in France. While it was also 9% in 1995 like in France, it was 13% in 2015. However, we’re very far from the US. All in all, the richest 1% have received a growing portion of national income. But the phenomenon is much more visible in the US than in Europe.

Another way to analyse inequality is to look at the percentage of individuals at the poverty line.

The customary international way of calculating it can be called into question, but at least it’s an indicator used everywhere. We look at the median income of the French or Americans, for example, as a percentage. Anyone under 50%, or 60% like in our figures on this medium income, is considered poor. It is a relative notion of poverty.

In France, few people are below the poverty line, meaning below 60% of French median income. Meanwhile the percentage is higher in Spain and Italy. It’s also higher in the US. And the percentage of the French population under the poverty line even decreased between 1998 and 2016. It increased in Germany over the same period.
So, again, we can’t say that poverty is high or has increased in France. What we sometimes hear in the media is simply statistically false.

However, in France, inequality of opportunity is rather high compared with similar countries.

According to opinion polls conducted by the OECD, 44% of French respondents believe that education passed down by parents is important for progress through life. In the OECD, which includes Chile, Mexico, all European countries, the United States, etc., the average opinion is at 37%. This reflects a rather high sense of inequality of opportunity in France. Unfortunately, this opinion is correct. In France, socio-economic status is passed on more strongly than elsewhere from one generation to the next. The relative income level is passed on more strongly from one generation to another than in other countries. Lastly, the level of education and diploma is passed on more strongly from parents to children than in other countries. According to these three criteria, inequality of opportunity is greater in France than elsewhere.

Of course, inequality of opportunity exists everywhere, since the socio-cultural environment is very important in the life and development of children. But the way we manage to partially correct the phenomenon can be more or less strong. The OECD calculated this and published a report on this subject, taking intergenerational mobility into account. Then we look at how many generations it takes for a family at the bottom of the ladder to reach the middle range. Clearly, the fewer generations required to reach the average, applying the average mobility of society, the less inequality of opportunity there is. The more generations it takes to achieve this, the more one is confined to the bottom of the ladder or symmetrically protected at the top of the ladder.

In Denmark, it takes 2 generations.
In Norway, 3; in Finland, 3; in Sweden, 3; in Spain, 4.
In New Zealand, Canada, Greece, Belgium, Australia, Japan, and the Netherlands, 4.
In the United States, 5.And in France, 6.

Six generations so that someone at the very bottom of the income ladder has a chance that their great grandchildren will reach the middle income level, given French mobility. Germany doesn’t do better, and neither does Chile! And the average for the OECD is between 4 and 5.

Studies have reached the same conclusions about the inequality of opportunity in France, relative to comparable countries, by calculating the correlations between the income of parents and the income of children once they reach adulthood. The findings regarding correlations of diploma level are similar.

What structural reforms should be done to combat inequality of opportunity?

Of course, the reform of national education must be mentioned. There is currently much less mobility and equality of opportunity in France than many years ago when teachers who supported and pushed their deserving pupils were called “horsemen of the Republic”. This state of mind has not been abandoned, but it is much less widespread, and in reality, national education has declined in overall effectiveness for many reasons that can be explained more or less easily. The effectiveness of education is measured and compared using level tests carried out internationally by the OECD.

Comparative studies show that national education must be able to devote slightly more resources to children in disadvantaged areas or neighbourhoods. It’s also known that a lot comes into place early in life, in kindergarten, and in elementary school. That’s where more resources are needed. But let’s not fool ourselves. It’s a question of efficiency and not global means within national education in France, which has a much higher budget-to-GDP ratio than the other European countries for a disappointing result in the tests.
People also must be supported during their career so that they can progress. Professional training in France is very inefficient and is in the process of being reformed.

Some countries do all this remarkably well, such as South Korea and the Nordic countries. They equip themselves with the means to ensure a good degree of social mobility in their country. Once again, that’s useful, not only for social cohesion, but also for the economy because there will be a search for talent that otherwise wouldn’t be able to express themselves and obviously contribute to the general growth.

In addition, long-term unemployment needs to be reduced, which means more effective support for returning to work and better incentives to take up a job. We also know very well that people in France are entitled to unemployment after four months of work. It’s one of the few countries where it takes so little time to be entitled to unemployment. That should be looked at. And, of course, we contributes to the creation of jobs must be facilitated…

It’s also important to work on territorial inequalities, because they exist.

So, there’s generally less social mobility in France than in other comparable countries, and this is reflected in the evolution between generations through income, degrees, and socio-professional categories.

Plus, we know that low mobility is not only intergenerational, but there is also fewer chances in France than elsewhere for people to be able to evolve during their life.

Two analyses:

From all this, I feel that there are two analyses that need to be given thought.

The first is the link between growth, innovation, and equal opportunities. The second is strong redistribution, which greatly reduces the initial inequalities that lead to a vicious circle.

First angle of analysis is the link between growth, equality, and innovation. For 20 years now, we’ve been living in a context of globalisation and a technological revolution related to digital. These two phenomena are increasingly eliminating repetitive work and the corresponding jobs.

Today, growing in an economy that is no longer a catch-up economy like in the post-war year requires being innovative. Innovation is crucial as the current driving force behind the growth of countries at the “technological frontier” (1). Emerging countries are catching up to developed countries, which must innovate constantly to continue to grow as emerging countries grow very quickly.

That means that we’re in an economy of knowledge and innovation – the only way to create growth and wealth.

As a result, we have to make sure to encourage innovation in our economy and our institutions (for example, organisational methods, labour market, and legislative framework). There’s also a link with equal opportunities because it’s obviously easier to fight poverty when there is growth. And it’s also easier to ensure social promotion to provide social mobility. If we step back and look at ourselves as a company rather than a country, we know that in a company that doesn’t develop, it’s very difficult to develop employees and help them grow. In a growing business, all those who are motivated and talented can be helped to grow.

Growth is therefore needed to reduce the inequality of opportunity and permit social promotion and mobility. If we don’t have enough growth and innovation, we end up with a blocked or jammed society and insufficient social mobility, and this leads to many social cohesion problems. In addition, as I already mentioned, the more we manage to promote equal opportunities, the greater the number of mobilised talents will be, and their energy will contribute to growth. So, we see the virtuous link between these different factors.

Plus, innovations create breakthroughs, which then create new sources of growth and wealth. Innovation therefore calls into question accrued benefits. And that’s also what enables social mobility. In the US, if we suddenly see people appear in the wealth rankings and develop new businesses very quickly, it’s because they seize innovations and can experience some amazing personal developments.

I’m not saying that this is a model in itself, but simply that, even at smaller scales, it’s essential. The more innovation, capacity to invest, and growth there are, the more it is possible to go beyond pensions and promote social mobility.

We therefore have to know how to ensure policies that facilitate innovation and promote this phenomenon. Once again, the innovation economy is the economy of knowledge: it’s education, it’s professional training, and it’s the promotion of all talents. It’s also means eliminating “poverty traps” by, as I already mentioned, better incentives to work, better support in finding a job, and easier abilities to switch jobs in shifting economies.

And that too is part of the necessary structural reforms. To encourage technical progress and innovation, competitiveness must also be encouraged through investment.

The second area of thought is the analysis of income inequalities before distribution and after distribution and the cost of this distribution (2).

The rather high income inequality before distribution is offset in France by redistribution, which is a strong redistribution because inequalities aren’t liked in France. In a way, what’s honourable is a collective choice. But a strong redistribution has a high cost in terms of social benefits and naturally social contributions and taxes. And because this leads to a lot of levies on companies, it spills over onto competitiveness. And lower competitiveness translates into fewer jobs. And the loop goes on. Because if there are fewer jobs, there are much stronger pockets of poverty and therefore large income inequalities before distribution. And then there’s long-term unemployment that must be offset by more redistribution and therefore more business costs. This leads us into a vicious circle.

The goal should therefore probably be to avoid over-repairing. Repairing is certainly normal, but better still is to do better upstream, to reduce income inequality before redistribution and avoid falling into this vicious circle. Prevent rather than repairing a lot of things.

The employment rate in France is 65%. That’s around 10% lower than in comparable countries. This is an unacceptable situation in itself. In France, there aren’t enough working-age people who are working. If we consider the two extremes, between the ages of 60 and 65, there are far fewer people working in France than elsewhere. Much fewer than in Germany, not to mention Sweden, in comparing France to countries with comparable models. Similarly, it’s very difficult for young people to find a job. And we can see the correlation: the lower the employment rate is, the higher the social benefits needed to offset the created inequalities.

Now let’s consider the correlation between employment rates and the size of distribution policies. In other words, employment rates and differences between the GINI indices before and after distribution. France has the strongest redistribution policies and the lowest employment rates.

Again, the correlation is obvious for OECD countries. Because of France’s significant redistribution policy, its social security contributions are roughly 60% higher than the eurozone average and therefore the contributions of neighbouring and comparable countries.

Companies are therefore structurally less competitive. After social contributions, there are left with a considerable disadvantage in terms of the overall cost of labour. This then means a lack of jobs, resulting in large income inequalities before redistribution. Hence the fact that we redistribute strongly… I don’t think redistribution should be stopped. That’s not my point at all. But to do sound, normal redistribution that doesn’t cost in terms of growth and jobs, we must strive to allow many more people to work and therefore allow our businesses to be more competitive. Otherwise, we enter a vicious circle.
Therefore, the challenge is to ensure that, even before redistribution, there are fewer inequalities because many more people are working. Taking action upstream to repair less means entering a virtuous circle, and this obviously means allowing many more people to work, resulting in less income inequality before redistribution and, at the same time, increasing equality opportunities. More working people means more self-sufficient people, far fewer pockets of poverty, and many more socialised people, because work is one of the main forms of socialisation.

Let’s hope that these figures and findings, sometimes unexpected because they are little-known, like these analyses, will be able to contribute to a useful debate about the effective reforms to be conducted, without preconceptions or confusion between the ultimate objective of reducing inequalities, with a primary focus on the high inequality of opportunities in France, and the means to be used to achieve it.
In the words of Bossuet: “God laughs at men who complain of the consequences while cherishing the causes”.

(1) On this topic, see Schumpeterian growth theory by Philippe Aghion.

(2) – The analysis of the cost of redistribution and the vicious circle created between income inequalities before and after redistribution and the lack of competitiveness of French companies was developed by Patrick Artus in several ‘economic flashes’.