Mutualise or Trust the Printing Press

  • Our baseline of a 2 to 3% shock to GDP may be optimistic given the time it takes for lockdowns to curb the epidemic, especially when taking on board the hesitant approach favoured by some key countries such as the US.
  • We need to think about ways to absorb the unavoidable rise in public debt beyond the massive QE response in the short run. Looking ahead, central banks will have to think creatively. Some forms of debt forbearance by “slow monetisation” may be needed – for instance by extinguishing private sector loans vacuumed by the central banks. This could be an alternative to “helicopter money”.
  • In Europe, the “disciplinarian” countries will have to choose between  monetary orthodoxy and debt mutualisation.

How much does a lockdown cost?

Economic forecasting in the current environment is obviously incredibly more difficult than usual and can even be a perfectly superfluous activity in the face of the sanitary emergency. Still, we need to build some reasonable scenarios for the potential size of the macroeconomic shock, because this will of course determine the magnitude and shape of the policy support we need.

For the purpose of our latest forecasting exercise – in which we have GDP declining by 2.1% in 2020 in the Euro area - we tried a different approach from our usual reliance on survey data, to work by “inference” on a bottom-up, sectoral approach. In a very simplified version, a modern, European economy (hence with large public services) can be divided in three blocks. First, the sectors which are going to be directly hit by the administrative lockdown measures (usually about 5% of the total economy). Second, at the other side of the spectrum the industries which will be protected during the lockdowns or could even see a rise in their output (public services, such as healthcare, or telecommunications, financial services), with a weight of about 35%. And in between the majority of the economy, where activity is not directly hampered by the administrative measures, but which will be hit by staff shortages (because of home confinement and transport disruptions), the generic drop in demand driven by uncertainty, or supply lines breaking.

A broad-brush estimate, with an output cut of 100% for the first group, a rise of 10% for the second and activity cut by half in the third would return a weighted decline in production of more than 30% during lockdown. Assuming a lockdown of one month followed by an immediate normalisation, this would be consistent with GDP falling by 10% over one quarter, translating into a cost of 2.5% for annual GDP.

Our level of confidence in those heuristics was very low, but INSEE has produced a very interesting estimate according to which the current level of activity in France stands at 65% of normal, hence a shock of 35%. INSEE is facing its own issues with its sources, and they were careful to be very prudent with their conclusions, but they can still have access to a wealth of data and can rely on their sterling experience in national accounting. We think we can use this as a guide quantifying the shock itself, the major uncertainty remaining of course its duration.

Looking again at the Italian benchmark

How reasonable is it then to posit the most critical phase in terms of economic disruption would last only one month? For this we continue to monitor the developments in Italy very carefully as we have done for the past two weeks. True, Italy presents some specific vulnerabilities in the current configuration, with a higher prevalence of people older than 80 and a level of “acute care” hospital bed supply on the low side. Still, since it is the EU country which went the earliest and the furthest into lockdown (March 9th on a national basis), Italy’s management of the epidemic should provide a lot of information for other democratic, developed nations.

The Italian news flow is tentatively positive.  The national daily growth rate in “current cases” (the Italian authorities prefer to report the number of cases net of the victims and of those who have been cured) fell to 5.4% on 29 March, a similar pace as on 28 March and down from 7.0% on 27 March and 7.8% on 26 March. The contrast between some of the provinces which went into lockdown early in the North and those further South is still there, but the trend is improving in both parts of the country. In Rome the daily growth rate has fallen below 6% on 29 March. In other words, even in Rome, based on the current trend it would take 12 days for the number of cases to double, against less than 4 a week ago.

Still, no full “Hubei-like” situation – a complete stop in the virus propagation after an initial explosion – has yet emerged in Italy. The first lockdown measures were implemented in 11 localities of the province of Lodi on 21 February and even in the town of Codogno – the epicentre -after several days without new cases last week a relapse was observed (6 new cases on March 27th according to ANSA). For the province of Lodi as a whole (in lockdown since 8 March) the daily growth rate has fallen to 1.4% on March 28th  but this would mean that a five-week long lockdown would be barely enough to stop the epidemic. This means our economic forecast probably already is on the optimistic side. 

Dealing with the waves and trade propagation

All the large Euro area economies are now in severe forms of lockdown. But some smaller countries are resisting. The Netherlands and Sweden have taken a less strict approach. Their capacity to soften the economic blow should not be overstated though. Indeed, these two countries – small open economies - are very dependent on external trade (exports stand at 84% of GDP for the former and 46% for the latter, against 30% of GDP for France for instance). Even if they manage to salvage their domestic activity – and even this will be impaired anyway by disruptions in their supply chains from abroad – the damage to their economy via the collapse in foreign demand is going to be significant.

The difference in approaches to lockdowns will become a growing issue “on the way out” of the crisis. Most observers focused in the letter signed last week  by 9 heads of state and governments of the EU on their demand of a joint fiscal response – and we will discuss it in the next section – but they also requested a common approach to the sanitary policy. Indeed, for the most part the EU’s internal borders are still open (the three big exceptions being the Spanish terrestrial border, the one between France and Germany, and Denmark which has in practice “self-isolated”) but it is largely a fiction since internal transport has almost entirely ceased anyway. Tough decisions will be needed when domestic restrictions are relaxed. Indeed, would a country having successfully curbed its “own” epidemic accept to take the risk of “re-importing cases” from member states which have not implemented the same restrictive measures and where the virus could continue to advance? While there may be differences in how cases are counted, in terms of number of victims and when controlling for the size of the population the toll in the Netherlands exceeds by 30% the one observed in France for instance.

Maybe a thornier issue (from a macroeconomic point of view) lies in the current behaviour of the US. Indeed, the propagation of the virus is now very quick there, but the reaction from the US Federal government, when it comes to shutting down the economy to curb the epidemic, is much more hesitant than in Europe. The US economy is already struggling. The unprecedented jump in jobless claims last week is consistent with the unemployment rate rising by 2 percentage points immediately. Our concern is that precisely because of the hesitations, the US will ultimately have to shut down its economy for longer, and later, than in Europe, with a negative spill over effect over the rest of the world.

Now you see the debt, now you don’t

Still, even if the response to the sanitary crisis is hesitant, the US macro response is not. Between a fiscal package of 10% of GDP and a QE now explicitly unlimited – with a lot of “holes” being plugged in the Fed’s arsenal, e.g. extension of the eligible assets to commercial paper and corporate bonds – there is probably enough to deal with the second-round effects of the crisis via household income and corporate defaults. The same is true now of the ECB where QE is implicitly unlimited during the pandemic, helping the emergency fiscal response. But as much as we don’t have doubts as to the capacity of the central banks to deal with the immediate borrowing requirements of 2020 (the ECB has already put on the table enough to absorb a deficit of 7.5% of GDP) we think we also need to start thinking about the medium-term horizon. Indeed, public debt will probably increase by more – and possibly much more - than 10% of GDP. This will leave deep scars. The ECB’s Pandemic Emergency Purchase Programme (PEPP) could be prolonged but for now it is valid until the end of this year only.

We suspect a lot of economists are currently brushing up their history books and looking for clues as to how to mitigate the financial cost of the current crisis. Your humble servant certainly is. Our conclusion so far though is that there is no old “economic catastrophes” which provide perfect guidance in our current predicament, even if discussing them helps shedding light on some of the mechanisms which will be at play this time.

Most European countries managed to bring the public debt they inherited from the Second World War to very manageable levels in just a few years without defaulting nor restructuring. But there was a key difference with the current situation: a large share of production capacity had been destroyed. This meant two things. First, that inflation would be naturally high, because it would take time for supply to catch-up with irrepressible demand. Second, that GDP growth could be massive because the productivity of capital was extremely high. Public debt could thus be kept in check as nominal GDP growth was particularly high.

Moreover, there was another key ingredient which has nothing to do with the usual working of growth theory: financial repression. Indeed, after WW2 cross-border capital controls were tight and governments deployed their creativity to channel existing national private saving towards funding their own borrowing requirements. This often meant that access to capital was an issue for the private sector. The “loop” was often closed by essentially turning the state, or at least the banking sector under strict government control, into the provider of funds to private businesses.

The differences with today are obvious. As we discussed last week, the pandemic does not destroy capacity. It “merely” brings capacity utilisation down, sometimes to zero for the worst-hit sectors. This suggests we cannot count on a mechanical rebound in nominal GDP growth which would magically erode the debt accumulated at the peak of the crisis.

Financial repression is not going to be a possibility either in our view. Preventing cross-border capital controls is at the very heart of the European Single Market. It would take a level of policy coordination far exceeding the current levels seen in the EU to make this work. True, governments are currently taking over funding of businesses – directly so in the US – but this is an emergency solution. Ultimately in the 1950 growth in nominal GDP meant that the competition between private and public funding needs could be managed. In a low inflation/low growth environment a “command economy” would face constant competing demands.

Can we deal with the accumulated debt “the hard way”, i.e. “simply” by raising tax and/or curbing expenditure once the epidemic crisis is over? We suspect this will be the natural slope in some EU member states, but finding the right dosage is going to be difficult on this. Indeed, a quick fiscal roll-back could be very detrimental to the recovery, and we believe that governments have learned from the mistaken coordinated fiscal contraction of 2010 which, coming too soon after the Great Recession, contributed to the weak economic performance of the last decade.

What then? Well, governments could simply decide to take it slow on the fiscal stance for several years and accept to pay the price in terms of additional risk premium on their bonds …but this would mean a rise in funding costs for everyone, including the private sector. For countries whose debt trajectory was already questionable before the pandemic, this is not a workable plan.

We can see two main avenues then. One involves (mainly) the central bank, the other (mainly) the governments, but both options will entail difficult political decisions.

The first way would have the central bank in practice “sterilising” the share of the public debt it will have bought under the pandemic emergency, by pledging to reinvest it continuously for 30 or 50 years. This option was laid out by the European economists of BAML last Thursday. This would create a lasting gap between the nominal debt ratio of governments (total debt issued / GDP) and the quantum of debt relevant for investors assessing the country’s debt sustainability. To work though, this would need to be explicit ex ante. While we see no real difficulty for the Fed or the Bank of England to do something like this, this could prove much more complicated for the European Central Bank as this would be sailing very close to the wind in terms of blurring the lines between fiscal and monetary policy.  Still, we note that the ECB has so far not communicated on the reinvestment of the PEPP).

We think there could be a “sub option” via loans to the private sector. In the “straightforward” version of the circuit the government brings cash to the private sector so that it can survive the crisis and ultimately the government gets its cash from the central bank. It should be possible to by-pass governments. We were intrigued by the Fed’s new “main street lending facility”. A lot of details still need to be hammered out but in our understanding the Fed will provide a backstop to the banks’ lending to small firms. According to Market Watch on 27 March in this facility banks would have the possibility to offload the performing loans to the Fed at par or sell the non-performing loans at a price to be determined to the Fed.

The Fed’s facility is explicitly backed by a government guarantee to protect them against losses but pushing the logic of this approach to this limit, another solution would be to simply accept “voluntary defaults” by firms  - organised and sanctioned by the government, potentially with some conditions to limit free-riding - on these emergency loans which would be borne by the central bank. This means that cash would have been created (via credit origination) without any corresponding claim left on the central bank’s balance sheet. This is the very definition of “helicopter money”, but here via SME loans instead of the usual approach (the central bank writing “checks” to households).

This solution is a tall order of course because it means we would have to accept that central banks could operate in negative equity, but this may be a way, in Europe, to circumvent the Treaty’s provisions against monetary funding of governments, to provide lasting support to the private sector.

This is unlikely to go down well in the most “disciplinarian” countries of the Euro area. But these countries need to balance this – i.e. a threat to monetary orthodoxy – with the other avenue, i.e. going through debt mutualisation.

Indeed, if it is impossible to design a permanent solution via monetary policy, while there is still a consensus on the need to avoid any existential tensions in the Euro area stemming from the specific vulnerability of some member states, then the only route left is debt mutualisation – and this is the approach supported by 9 member states in a letter to the President of the Council, including France, Italy and Spain.

We expressed in Macrocast three weeks ago our support for using the European Stability Mechanism, and more precisely the precautionary credit lines, because we thought at the time it would be a way to incentivise the ECB to ignore its “limits” and engage into a more decisive form of QE. But since the ECB has now explicitly suspended those limits for the duration of the emergency, we think going through the ESM in its present form has become useless and could end up being a net negative. Indeed, a key feature of the ESM loans is that they stay on the requesting country’s balance sheet. While it represents a benefit in terms of funding costs (they are priced below the interest rate a fragile government would have to pay in the market) it does not necessarily change investors’ perception of debt sustainability. It is also politically toxic in the Southern countries since several Northern states insist for tough conditions on such loans.

This means that the optimal solution to what is, ultimately, a symmetric shock affecting all member states – for no fault of them – is “proper” mutualisation, i.e. joint debt issuance whose proceeds can be transferred to the countries in need without appearing in their balance sheet (the cost for national public finances would lie only in the capital guarantee granted to the joint issuance structure).

Given the negative noises around the EU summit last week we are not holding our breath. But in our view, this is the stark choice facing Europe: either finding an unorthodox monetary policy solution or dealing once and for all with the Euro area’s birth defect, i.e. the absence of a permanent, sizeable, “federal” fiscal capacity. The Great Recession of 2008-2009 started in the US, but the US exited faster and in a better shape than Europe. This time Europe was quicker in taking the measure of the crisis, but it may be hampered by its political limits in the design of its response. We suspect the US won’t have those preventions…