More of the sameEconomic outlook & crisis management in Europe

Etienne de Callataÿ

Chief Economist

BECI

May 31, 2013

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Overview

1. The economic outlook

2. Europe : where do we stand ?

3. Europe : where do we go from here ?

4. Structural reforms : we need more

5. Global assessment

Conclusion

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1. The economic outlook

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1. The world outlook

2011 2012 2013 2014

World + 4.0% + 3.2% + 3.3% + 4.0%

Euro area + 1.4% – 0.6% - 0.3% + 1.1%

USA + 1.8% + 2.2% + 1.9% + 3.0%

Emerging + 6.4% + 5.1% + 5.3% + 5.7%

source : IMF [April 2013]

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1. The US economy

Business cycle

- Real estate

- Labor market

- Household debt

- Loan activity

- Business capex

- Policy stance

Structural factors

- Energy production

- New technology

- Demographics + migration

- Economic integration, strong (solidarity & transfers) & credible

- Creative destruction / flexibility

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1. The Euro area economy

Business cycle

- Real estate no bottoming out yet

- Labor market increasing unemployment rate

- Household debt de-leveraging hasn’t started yet

- Loan activity anemic

- Business capex shrinking

- Policy stance ambiguous

Structural factors

- Energy production no shale gas, less nuclear, …

- New technology lagging behind

- Demographics + migration population ageing

- Economic integration no shared vision, no leadership

- Creative destruction / flexibility rigidities / vested interests

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2. Europe : where do we stand ?

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2. Intertwined crises

- Financial sector

- Public finance

- Economic growth

- European integration

→ Intertwined crises

vicious circles … that may become virtuous

BUT there is no such thing as “the” solution to all problems

→ The repair progress has to be slow and patchy

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- Banks were not wise and ethical

- Public sector was not efficiently run, with a long-term view

- European integration was not progressing nicely

- Underlying growth was not that strong

- Wrong policy choices

- Deregulation (f.i., in financial sector, irrespective of high degree of intermediation)

- Monetary union with no transfers, no rescue fund, no Eurobonds, no central bank support, no single supervision, no tazx convergence, …

2. No “good old times”

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- Deregulation

f.i., in financial sector, irrespective of high degree of intermediation

- Monetary union

- Poor crisis prevention mechanisms- Supervision focused on public finance (financial bubbles, wage,

competitiveness, … out of scope)- Wrong indicators, easy to play with- No enforcement- Lack of focus on stabilization mechanism- No single supervision of financial sector- No policy convergence (taxation, social protection, …)

- No crisis resolution mechanism- Very limited budgetary transfers- No rescue fund- No central bank support, and no Eurobonds

2. Wrong policy choices, before the crisis

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- A lot

- Pragmatic, heterodox monetary policy (LTRO, OMT, …)

- Solidarity tools (EFSF, ESM)

- Broadening of minds (competitiveness, …)

- Transfer of competences (SSM, 6-Pack, 2-Pack, Golden rule)

- “Don’t fight the ECB”

- …

- Not enough … and with risks :

- Economic growth

- Social tensions

- Political tensions / loss of support for European integration

- Moral hazard

- Monetary risks

2. What had been achieved ?

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3. Europe : where do we go from here ?

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- To lower the repo rate (currently at 0.5%)

(cheaper financing at ECB = downward pressure on banks lending rates)

- To lower the deposit rate (currently at 0%)

(lower rate for deposit at ECB = greater incentive for banks to lend)

- To extent the 3-year LTRO (long-term refinancing operations)

- To introduce a UK-type “funding for lending scheme” (FLS)

(banks access to cheaper ECB funding in proportion of their new loans activity)

3. What more the ECB can do in 2013 ? (1/2)

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- To activate the OMT (outright monetary transactions)

- To purchase private sector assets

- To purchase sovereign debt

public debt monetization BUT forbidden and raising concerns - Debt from which countries ? - At what price ?

3. What more the ECB can do in 2013 ? (2/2)

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- Fear of terra incognita – uncharted territory

- Fear of long-term consequences (inflation)

- Fear of fuelling a new credit bubble

cf. Jeremy Stein (FED), Feb 2013 : regulation and supervision cannot keep all credit bubble risks under control; higher interest rates would be helpful to alleviate such risks … but it goes against the very lenient current monetary policy

./..

3. Why is the ECB so reluctant to do more ? (1/2)

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- Fear of negative feeling for German voters

- Divergence of interest

Fear of loss of competitive advantage for German corporations

(now that wages in Spain have declined, if the cost of capital was to be the same in Spain as in Germany, production could move to Spain)

- Fear of loss of leverage for structural measures

easy QE solution is a substitute for reforms

3. Why is the ECB so reluctant to do more ? (2/2)

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- Financial crisis Banking Union

- Fiscal crisis Fiscal Union

- Economic crisis Economic Union

- European crisis Political Union

BEWARE :

- Hard to achieve

- Partial answer only

3. 4 Unions for 4 crises

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4. The structural reforms : we need more !

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- Basle III / Solvency II / …

- Scope of activities

- Additional equity requirements for systemic institutions

- Pay package (ratio bonus/fixed)

- Consumer protection

- Rating agencies

- Restructuring of financial institutions

- Banking Union

- Supervision (SSM)

- Deposit guarantees

- Resolution mechanism

→ significant progress … BUT not yet completed

4. Structural reforms – Financial sector (1/3)

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significant progress … BUT not yet completed

Inherent instability of central bank primary objective : price stability, financial stability, State financing

Role of ECB as supervisor

→ conflict of objectives for ECB

SSM = credibility at stake ≈ risk of excess monetary rigor

→ SSM : delegation of powers

≈ risk of regulatory capture not eliminated

→ illusion of risk under control

= bigger bets (“la stabilité rend fou”) (./..)

4. Structural reforms – Financial sector (2/3)

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significant progress … BUT not yet completed

→ financial landscape of the future undetermined

- Splitting commercial banks / investment banks

- Capital & liquidity requirements

(but knowing that ↑ liquidity = ↓ activity = ↓ retained earnings)

- Impact of SSM on mergers (made easier through common regulation)

→ “too big to fail” and moral hazard issues unresolved / “too big money-friendly”

→ towards more de-leveraging BUT need for countercyclical rules

(high buffers are PRO cyclical, not dynamic provisioning)

4. Structural reforms – Financial sector (3/3)

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Declining structural primary imbalances (IMF, April 2013)

2006 2010 2012 2013 2014

US - 0.4 - 6.7 - 4.4 - 2.7 - 1.9

Euro Area 0.5 - 2.4 0.3 1.4 1.5

Belgium 3.9 - 0.4 - 0.5 1.0 1.7

France 0.0 - 2.9 - 0.7 0.3 0.5

Germany 0.3 - 1.4 2.3 2.1 2.0

Greece - 3.7 - 6.1 2.1 4.3 5.3

Italy - 0.2 0.8 4.0 4.9 4.8

Spain 2.5 - 6.9 - 2.6 - 1.2 - 1.8

→ significant progress … BUT much more is required

4. Structural reforms – Public finance (1/2)

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significant progress … BUT debt levels + ageing require more

How ? Only 5 options

- more reforms to boost growth

(retirement age, red tape, tax expenses, tax shift, …)

- more austerity

- low interest rates (financial repression + EA implicit mutualization)

- Inflation

- further debt restructuring

More … and better

• Focus on quality more than on numerical targets

• Focus on long-term

4. Structural reforms – Public finance (2/2)

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- Pension reforms

- Labor market reforms

- Tax reforms (mostly differentiated tax increases)

→ progress … BUT much more is required

4. Structural reforms – Economic growth (1/4)

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Europe’s structural weaknesses

- insufficient investment in human capital and research

- limited ability to transition from an imitation-based economy to an innovation-based economy

- excessive reliance on established firms in traditional industries

- in a number of countries, a growth model based on low-productivity construction and traditional services

- inefficiency of public administrations

- education levels, with “talent gaps” and “excellence vs. democratization” dilemma

- difficulty to combine social protection and economic incentives in a globalized world

- + ageing, openness towards other culture, lack of effective European union, …

See : Breugel, Europe’s Growth Problem (and what to do about it), Bruegel Policy Brief 2013/03, April 2013

4. Structural reforms – Economic growth (2/4)

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The low growth rate means that :

- Private de-leveraging can only be slow

- Fiscal consolidation can only be slow (at best !)

- Banks can only remain weak

- Unemployment can only remain high … and become permanently high

- Convergence of competitiveness within the EA can only be limited

- Investment can only be constrained

- The European social model can only be under pressure

4. Structural reforms – Economic growth (3/4)

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progress … BUT much more is required

→ there is room for improvement

(labor market policies, tax incentives, entrepreneurship, education, …)

→ downward revision of trend output growth

- Ageing

- End of technological catch-up

- Environmental constraints

- Globalization, with rigidities and skill mismatches

- From leverage turbo to private & public de-leveraging

→ insiders will slow down the pace of desirable changes

4. Structural reforms – Economic growth (4/4)

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- Macroeconomic convergence / competitiveness

- Fiscal consolidation

- Financial sector discipline

- Stabilization tools : heterodox ECB, ESM, PSI, …

→ significant progress … including solidarity without the name

BUT much more has to come

4. Structural reforms – European integration (1/2)

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significant progress … including solidarity without the name …

BUT much more has to come

→ no optimal currency area

→ no shared vision, no leadership no willingness to give up sovereignty

→ poor track record of European control (cf. SGP)

→ institutions at EU level, not at EA level, even less at EA+ level

→ poor legitimacy of technocratic agencies & of taxpayer money for banks

2 key concerns

→ trilemma : moral hazard OR EU interference OR exclusion threat

→ impatience / risk of political and social troubles (in “core” as in “periphery”)

4. Structural reforms – European integration (2/2)

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5. Global assessment

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- Fiscal consolidation

- De-leveraging / credit crunch

- Corporate : cost cutting / low capex

- Lack of confidence

- No shared vision (cf. EU Budget 2014-2020)

- No agreed upon strategy (Troïka : stop ou encore)

- Rising unemployment

- No end in sight for recession in periphery

5. Europe – low expectations

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Risks factors

- Loss of political momentum for reforms due to market rally

- Loss of momentum due to political reluctance

- Next crisis trigger :

- Debt unsustainability (Greece, Cyprus, …)

- Political stalemate in Italy

- Banks in Spain, with no access to ESM for past mistakes

- “Brexit”

- Elections in Germany

- social unrest (rising unemployment and no end in sight)

- …

5. Europe – not yet out of the woods

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- Lower inflation = less pressure on real disposable income

- Some support from external growth

- Low level of inventories

- Bottoming out of leading indicators in the periphery

- Less fiscal tightening

- Less fear of extreme risks (post Draghi put, post Cyprus crisis, …)

- Room for

- policy expansion in some countries (fiscal, wage increases)

- credit expansion ( + Basle III relaxation)

- more risk appetite : financial repression means TINA

- Virtuous confidence circle (“Positive contagion”, Mario Draghi)

5. Europe – don’t be too gloomy … again

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Past mistakes = current miseries

First results

- More misery

BUT ALSO

- Declining risk of moral hazard

- Improving competitiveness (unit labor costs)

- Shrinking current accounts imbalances

- Largely adjusted housing prices

- …

5. A new oxymora : painful improvement

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5. Austerity : stop ou encore ?

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Austerity does not seem to work, alternatives well

evolution in Greece, Spain, Portugal, Latvia

vs. Iceland, with no austerity but with devaluation

Take idiosyncratic characteristics into consideration

- High public & current account deficits in some countries

- Resilient exports (commodity-related) in others

No alternative to long-term fiscal & external sustainability

Better to focus on LT sustainability than on ST fiscal balances

… but so far patience has not been rewarded with structural reforms

5. Austerity : stop ou encore ?

See Daniel Gros, CEPS, Feb 2013

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- Financial repression a must for some countries and some banks

- … but risky

- Alternative : more restructuring

- of countries (Greece, Cyprus, …)

- of banks

- … with implications

- official creditors will incur losses

- potential contagion effect (best argument of the financial lobby)

5. Debt restructuring ?

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Conclusion

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The moment of truth ?

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Crisis management = to gain time …

In order to “kick the can down the road”

OR

In order to “kick the can down the cul-de-sac” ?

Procrastination OR gradual, smart repair ?

Thanks to Brian Reading

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US pragmatic political convergence ?

Japan eventually out of deflation ?

China sustainable imbalances ?

+ Geopolitical tensions

+ “Currency war”

+ …

Europe – no monopoly of uncertainties !

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- Black swan : be ready for the unexpected

Does not mean that any crazy scenario will materialize

Major surprises will take place at any time

- From one excess to the opposite

from the great moderation to the Armageddon

- Continuity is more frequent than radical changes !

- Reforms do bear fruit … with delay

Mind the excesses

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More of the same ≠ status quo

More of the same = same slow dynamics

- Suppressed growth

- Healing process : slow and ad hoc

- Learning by doing

- change of focus, from ST fiscal consolidation to reforms

- less “sinners”, more explicit solidarity

- … AND emergence of new dangers

(monetary leniency, social unrest, …)

More of the same

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Fear as only drive for change

«  People only accept change when faced with necessity, and only recognize necessity when crisis is upon them »

Jean Monnet

Conclusion

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