QE and public investment

Since the start of this year the ECB has been applying “quantitative easing” (QE), i.e. a program injecting large amounts of money in the economy. Every month the ECB is buying 60 billion euros of government bonds and in so doing injects the same amount of money in the economy. Up to today the total amount of liquidity injection approaches 700 billion euros.

There can be little doubt that this massive injection of liquidity by the ECB has had a positive effect on exports. It led to a depreciation of the euro vis-à-vis the major currencies (dollar, pound sterling) and boosted competitiveness of Eurozone exporters to the rest of the world.

However, it becomes increasingly clear that QE alone is insufficient to pull the Eurozone economies out of their lethargic growth. In fact, in the second quarter of this year, growth slowed down again. There is a fear that in the next few years economic growth will remain subdued. An expanded version of QE will not solve this problem.

All this should not come as a surprise. Economists have been warning for a long time that when interest rates are close to zero, quantitative easing alone will not be able to stimulate the economy. The reason is that when the interest rates are close to zero the liquidity that the central bank is creating does not easily filter into the real economy. Most of it is hoarded because the opportunities to find attractive rates of return are limited. Many financial institutions then prefer to accumulate the extra liquidity created by the ECB without doing anything productively with it. This is the well-known liquidity trap.

Thus while QE was and is necessary, it is insufficient. It has to be seconded by fiscal policies. Here is the real problem in the Eurozone. Fiscal policies are not helpful. First, too many countries continue to be kept into the austerity straightjacket. Second, and most importantly, public investment continues to decline. But it is public investment that is key to the recovery in the Eurozone.

There are two reasons why public investment is central for promoting economic growth. First, the private sector is still very risk averse and fails to invest enough. This has to do with the lack of confidence in the future. The way to deal with this is for the public authorities to show the way and to kick-start public investments. This will increase economic growth and create more confidence in the future which will stimulate private investment.

Second, public investment is needed to achieve long-term objectives of a green economy. The latter requires investment in alternative energy sources and in public transportation.

Unfortunately, public investment is discouraged by a stupid rule that the members of the Eurozone have imposed on themselves, i.e. that public investment cannot be financed by bond issue. It has to be financed by current tax revenues. This prevents public investment from taking off, from sustaining the recovery and from developing a green economy. 

It is often argued that public authorities should not increase their debt; on the contrary that they should reduce it. Some countries of the Eurozone periphery undoubtedly have limited capacities to add to public debt. But other countries, like Germany, France, Belgium and the Netherlands surely can. The governments of these countries today can borrow at very long maturities almost for free. There are certainly many investment projects that have a rate of return of more than 0%.

A government that issues bonds at close to 0% and channels the money into projects that will have rates of return by far exceeding 0% promotes economic growth and makes the future repayment of the debt easier.

Put differently, what matters in not gross debt, but net debt of governments. Debt issue that makes it possible to invest in assets with a much higher rate of return than the cost of borrowing (now close to 0%) will reduce net debt in the future. Unfortunately, Eurozone countries continue to be mesmerized by gross debt numbers and as a result fail to do the obvious.

It is often said that governments today should not issue more debt because this will place a burden on our grandchildren. The truth is that our grandchildren will ask us why we did not invest in alternative energy and public transportation, and thereby made their lives miserable, when we faced historically favorable financial conditions to do so. 

The Euro and Schengen. Common flaws and common solutions

What do the Euro and Schengen have in common? Both are projects that have the same flaw: they're unfinished business. And therefore they risk falling apart. 

The Eurozone is a monetary union, with one currency, the euro circulating in the Union and managed by one central bank, the European Central Bank. What’s wrong with that? One may ask.

The fundamental problem of the Eurozone is that national governments have their own budgets and issue their own debt. When recession strikes, the system gets into trouble. During a recession government budget deficits automatically increase. Countries that are hit hardest by the recession show larger budget deficits and debt increases. Financial markets that are fully integrated in a monetary union are lurking, ready to strike when observing signs of weakness. Countries hit hardest by the recession experience “sudden stop”: investors massively sell the government bonds, raising the interest rates and pushing these countries into illiquidity. The other countries in the system profit from this, as investors in search of a safe haven buy these countries’ government bonds. Thus during recessions, free capital movements destabilize the Eurozone and plunge the weaker countries into a “bad equilibrium” of ever deeper recession and rising unemployment.

What about Schengen? As the Eurozone, it is an unfinished project. The residents of the Schengen Area move freely within the area. The problem is that the architects of that area forgot to integrate the police and the intelligence services. Moreover, they forgot to transfer the authority to control the external borders to one European body.

As a result a problem arises in the Schengen Area that is similar to what happens in the Eurozone. Criminal gangs move freely within the area. They commit burglaries in one country and flee to another one. In contrast police forces have to stop at borders. Terrorists are planning from Brussels how to attack Paris and escape from the radar of the national police forces and intelligence services. National police forces and intelligence services are not integrated and can no longer guarantee the security of their citizens.

The danger of unions that are unfinished is that they will disintegrate. Without a fiscal union free capital movements will create great instability when the next recession strikes the Eurozone. In the long run, governments that can no longer guarantee a minimum of economic stability to their citizens will be tempted to leave the Eurozone.

In the absence of integrated police and intelligence services, nation states in the Schengen zone can no longer take care of the safety of their citizens. They will be tempted to opt out of the zone. In fact this is already happening today.

The choice we have today is simple. If we want to keep the Euro we will have to create a fiscal union. This implies that a significant proportion of national budgets and national government debts will have to be centralized. A formidable transfer of sovereignty from the nation states to European institutions. If we want to preserve the Schengen area, we will have to integrate police forces and intelligence services while creating a joint control at the external borders. Failure to integrate further dooms both projects, the Eurozone and the Schengen area.

The Eurozone and the Schengen area have fundamentally weakened national governments while nothing has been put into place at the European level to offset this loss of power of nation states. The euro and Schengen can only be saved if we create European institutions that can do what national governments no longer can do, i.e. to ensure economic stability and security for the citizens of Europe.

Low oil prices: good and bad news. And how to deal with the bad news.

Since the start of the summer, crude oil prices have started a steep decline again. From more than $60 a barrel in June the crude oil price has dropped to approximately $42. One year ago the crude oil price exceeded $100 a barrel.  These are fantastic price declines rarely seen in the oil market. They have helped the many European Countries to climb out of the recession. This is not surprising. A price decline of this magnitude means that consumers who spend a significant part of their total budget on gasoline now find out that after filling their cars with fuel they have purchasing power left over to buy other things.

Put differently, the oil price decline is equivalent to a reduction in taxes. As a result, disposable income has increased. This effect has been strong enough to more than offset the austerity policies pursued in many European countries. It is responsible for the economic recovery that we have seen in most of Europe. Thus, it appears that the oil price decline is good news.

While the short-term effects of the oil price decline are positive, the long-term effects are not. One year ago crude oil prices stood above $100 a barrel. This created a powerful incentive to develop and expand the use of alternative sources of energy such a solar and wind energy. The latter had become profitable at such high oil prices. Today with low oil prices this may not be the case anymore in many countries.

In addition, low oil prices also have as a pernicious effect of making transportation by car, trucks and planes much cheaper again. As a result, this will give renewed incentives for excessive worldwide specialization intensifying the massive transportation of goods and commodities from one corner of the world to the other. This will increase the emission of CO2 and will further speed up the global warming.

Our conclusion therefore is that if the low oil prices are maintained the long-term effects for the world are very negative. These long-term negative effects most likely outweigh the positive business cycle effects experienced today.

How can this conflict between the short-term positive and long-term negative effects be solved? The economic answer is easy; the political one is difficult.

It would be easy for governments of the oil importing countries to solve this problem by raising taxes on fuel so as to keep gasoline prices at the level existing one year ago and to use the additional tax revenues to lower other taxes, e.g. personal income taxes. As a result, consumers would continue to enjoy a higher purchasing power. This higher purchasing power would not be the result of lower gasoline prices, but of lower income taxes.

Thus, such a tax shift (more fuel taxes and less income taxes) would make it possible to maintain the positive short-term effects on the business cycle, as consumers would have more money to spend. At the same time, because it keeps the fuel prices high for the users, it avoids all the negative long-term consequences of low oil prices for the environment.  Simple, wouldn’t you think? Yes, but unfortunately the politics is more difficult.

The political problem arises from the fact that the higher fuel taxes that the governments have to introduce create many enemies. These are the car companies and the transportation industry. They all profit from the present low oil prices and are likely to resist any tax increase on fuel. In contrast consumers are mostly indifferent whether the increase in purchasing power comes about by lower gasoline prices or by lower income taxes. The net effect is that it will be difficult for governments to overcome the political resistance that will be organized by the car companies and the transportation industry.

The only way out of this political problem is through an opposing political force. Such an opposing force can come about when large segments of the population recognize that low oil prices increase the risk of global warming and that this can be stopped at little cost in terms of economic growth today.  Such a force can twist the arms of the politicians to act and to safeguard the interests of the general population, today and in the future.

The ECB does not learn from its past mistakes

In 2011 at the height of the sovereign debt crisis when investors panicked, the ECB announced its “Securities Markets  Program” (SMP). This aimed at stabilizing the government bond markets. Unfortunately the SMP program was structured in the worst possible way, i.e. the ECB announced it was ready to buy a limited amount of bonds during a limited time. This backfired immediately for obvious reasons. When hearing this announcement panicky investors decided to sell their Greek, Italian, and Portuguese bonds as quickly as possible to be sure they would beat the other investors before the ECB closed the window.  As a result, the ECB had to buy a couple of hundred billion of government bonds without pacifying the markets. The spreads continued to increase.

It took the ECB a year to learn from this mistake. In September 2012 the ECB started with the OMT program. In contrast with the SMP program the ECB promised to buy unlimited amounts of bonds for an indefinite period. The unlimited nature of the commitment made all the difference. Investors were pacified and expected that bond prices would not drop further. As a result, they started buying government bonds of the periphery country. The beauty of the OMT program is that the ECB pacified the market and did not have to buy one euro of government bonds.

Now fast forward to Greece.  The banking crisis in Greece started when the ECB announced that it would cap the amount of liquidity available to the Greek banks. Customers ran to the bank to withdraw cash from their accounts as quickly as possible before the cap became effective. Today (16^th July) the ECB announced that the cap will be increased by €0.9 billion. This will accelerate the desire of the Greek depositors to withdraw cash from the bank, as they know that the available cash is limited. Instead of reducing the banking crisis, the ECB is in fact intensifying it, pretty much like in 2011 when the SMP program intensified the panic sales of government bonds.

The correct announcement of the ECB should be that it will provide all the necessary liquidity to the Greek banks.  Such an announcement will pacify depositors. Knowing that the banks have sufficient cash to pay them out they will stop running to the bank. Like the OMT, such an announcement will stop the banking crisis without the ECB actually having to provide much liquidity to the Greek banks.

These are first principles of how a central bank should deal with a banking crisis. I would be very surprised if the very intelligent men (and one woman) in Frankfurt did not know these first principles. This leads me to conclude that the ECB has other objectives than stabilizing the Greek banking system. These objectives are political. The ECB continues to put pressure on the Greek government to behave well. The price of this behavior by the ECB is paid by millions of Greeks.

Greece is solvent but illiquid. What should the ECB do?

One feature of the Greek sovereign debt crisis, which is widely misunderstood, is the following. Since the start of the crisis the Greek sovereign debt has been subjected to several restructuring efforts. First, there was an explicit restructuring in 2012 forcing private holders of the debt to accept deep haircuts. This explicit restructuring had the effect of lowering the headline Greek sovereign debt by approximately 30% of GDP. Second, there were a series of implicit restructurings involving both a lengthening of the maturities and a lowering of the effective interest rate burden on the Greek sovereign debt. As a result of these implicit restructurings, the average maturity of the Greek sovereign debt is now approximately 16 years, which is considerably longer than the maturities of the government bonds of the other Eurozone countries. These implicit restructurings have also reduced the interest burden on the Greek debt. The effective interest burden of the Greek government has been estimated by Darvas of Bruegel to be a mere 2.6% of GDP. This is significantly lower than the interest burden of countries such as Belgium, Ireland, Italy, Spain and Portugal.

As a result of these implicit restructurings the headline debt burden of 175% of GDP in 2015 vastly overstates the effective debt burden. The latter can be defined as the net present value of the expected future interest disbursements and debt repayments by the Greek government, taking these implicit restructurings into account. Various estimates suggest that this effective debt burden of the Greek government is less than half of the headline debt burden of 175%.

From the preceding it follows that the effective debt burden of the Greek government is lower than the debt burden faced by not only the other periphery countries of the Eurozone but also by countries like Belgium and France. This leads to the conclusion that the Greek government debt is most probably sustainable provided Greece can start growing again (so that the denominator in the debt to GDP ratio can start increasing instead of shrinking as is the case today). Put differently, provided Greece can grow, its government is solvent.

The logic of the previous conclusion is that Greece is solvent but illiquid.  Today Greece has no access to the capital markets except if it is willing to pay prohibitive interest rates that would call into question its solvency. As a result, it cannot rollover its debt despite the fact that the debt is sustainable.

There is something circular here. If Greece is unable to find the liquidity to roll over its debt it will be forced to default. The expectation that this may happen leads to very high interest rates on the outstanding Greek government bonds reflecting the risk of holding these bonds. As a result, the Greek government cannot rollover its debt except at prohibitive interest rates. The expectation that the Greek government will be faced with a liquidity problem is self-fulfilling. The Greek government cannot find the liquidity because markets believe it cannot find liquidity. The Greek government is trapped in a bad equilibrium.

What is the role of the ECB in all this? More particularly, should the OMT-program be used in the case of Greece? The ECB has announced sensibly that OMT-support will only be provided to countries that are solvent but illiquid. But, as I have argued, that is the case today for Greece. So what prevents the ECB from providing liquidity? There is a second condition: OMT support is only granted to countries that have access to capital markets. This second condition does not make sense at all, because it maintains the circularity mentioned earlier. Greece has no access to capital markets (except at prohibitively high interest rates) because the markets expect Greece to experience liquidity problems and thus not to be able to rollover its debt.  

The explicit aim of the OMT-program was to prevent such self-fulfilling expectations that can push countries into a bad equilibrium. It is appropriate to quote Mario Draghi when he announced the OMT-program on 6^th September 2012: “The assessment of the Governing Council is that we are in a situation now where you have large parts of the euro area in what we call a “bad equilibrium”, namely an equilibrium where you may have self-fulfilling expectations that feed upon themselves and generate very adverse scenarios. So, there is a case for intervening, in a sense, to “break” these expectations”[1] Greece today fulfills the conditions for liquidity support as spelled out by Draghi in 2012. Yet Greece is excluded from this support, and as a result it is kept in a bad equilibrium.

The use of OMT to provide liquidity support to Greece is made difficult by the fact that public authorities hold the largest part of the Greek debt. To solve this problem it would be necessary that these public authorities recognize that the market value of their claims on Greece debt is worth a fraction of the nominal value. These public claims could then be sold in the market at a price that comes close to the net present value of the future disbursements (interest plus capital). At that moment the ECB could extend its OMT-promise to these assets (bonds) thereby creating a market for them.

I am aware that this solution creates a political problem. Governments of the creditor countries will have to recognize the losses they have already made on their claims on Greece. Politicians prefer to live in a fictional world allowing them to pretend no losses have been made so that they can hide the truth to their own taxpayers. The solution proposed here forces these governments to come out with the truth, i.e. the losses have already been incurred. I conclude that providing liquidity to Greece is possible provided governments stop hiding the truth.

All this teaches us two lessons. First, the objectives of the creditor nations, including the ECB, that today add tough conditions for their liquidity support is not to make Greece solvent but to punish it for misbehavior. The punishment is deemed to be necessary to avoid moral hazard risk. It is perfectly understandable that creditor nations are concerned about moral hazard. But it is precisely the desire to punish Greece by imposing additional austerity that makes it so difficult for Greece to start growing again and to extricate itself from the bad equilibrium.

A second lesson concerns the credibility of the future use of OMT.  It clearly appears from the Greek experience that the willingness of the ECB to use the OMT program is very circumscribed. It is circumscribed by the ECB’s desire to solve a moral hazard problem. The ECB seems to be saying that OMT will only be used when it can be certain its liquidity support will not trigger misbehavior. And this can only be achieved by imposing tough conditions. Behind the gloves of OMT is hidden a big stick. It is doubtful that future governments that experience payment difficulties will accept to be beaten up first before they can enjoy the OMT liquidity support.

Now that the European Court of Justice has given the legal clearance for OMT, the question arises whether the moral hazard hurdle to the use of the OMT will easily be overcome. I conclude that the credibility of the OMT-program to be used in times of crises is limited.

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[1] http://www.ecb.europa.eu/press/pressconf/2012/html/is120906.en.html