Tsunami blows away the shibboleths

Action to back up 'do what it takes'

Governments around the globe have shown money can be conjured to virtually any extent possible, if there is an overwhelming need to do so. It is a vindication of what was called the ‘modern money tree’ argument. Monetarism, the old fear that too much money will cause inflation, is dead.

Germany is showing the way. Practically overnight the balanced-budget shibboleth has been dropped. Chancellor Angela Merkel (quarantined herself over Covid-19 fears) on 23 March introduced a €156bn supplementary budget (nearly 5% of GDP), containing €222.5bn of extra spending,  to offset a dramatic fall in output and a slump in tax revenues. On top is a three-pronged  ‘economic stabilisation fund’ made up of  a ‘recapitalisation instrument’  funded by up to €100bn in government debt to invest in hard-pressed companies; guarantees of up to €400bn backing the KfW state development bank covering corporate debt securities; and an authorisation to provide up to €100bn of financing to KfW to fund unlimited loan programmes. In addition comes €50bn of targeted help for 3m small companies.

Across Europe (including the UK), governments are expected to run budget deficits of 8-10% of GDP this year.  A big worry for the euro area is that individual governments’ crisis-fighting efforts have been national in scale. Christine Lagarde, the European Central Bank president, made a welcome announcement last week of a €750bn pandemic emergency ECB bond-purchase programme. Yet there is no accord so far on mobilising large-scale taxpayers’ resources at a euro area level. The European Stability Mechanism bail-out fund has €410bn of unused lending capacity. There has been talk of Merkel overcoming Germany’s long-standing objections to debt mutualisation by agreeing a €1tn corona bond for euro members – supported by an unusual economists’ manifesto in the conservative Frankfurter Allgemeine Zeitung newspaper. But spreading such finance to member states is bound up with tricky questions of moral hazard, conditionality and supranational control over government finances.

A black swan like the coronavirus is by definition impossible to anticipate. But soon after it hits, we should be able to project its likely effects. This black swan is that it is not endogenous, that is, not arising from behaviour within an economic system, as was the case in 2007-08 with securitisation of dubious mortgages. It is truly exogenous, but global in its impact because of the ease of travel that intensified its spread.

The pre-crisis argument was that monetary policy had reached its limits. Now it was the turn of fiscal policy. Bond yields were low to negative and there was scope for borrowing. ‘The burden on future generations’ argument against excess debt was still heard (for example, from Sajid Javid, the short-lived UK chancellor of the exchequer in 2019-20). But the tsunami of economic damage has made the old arguments obsolete.

There are some positive repercussions. Flying has largely ceased and people have stopped travelling, with beneficial effects on countering climate change. But this is swamped by the overwhelming negative effects. Airlines will take many years to recover and will be mopping up huge sums in hardship funds from already overstretched governments.

There were excess savings in the global economy with zero or negative yields. This excess will now be absorbed by governments borrowing to the hilt. Yields will rise to moderate low levels. But this will have highly deleterious effects on countries such as southern euro members reliant on low interest rates to hold down debt-service costs. Charles Goodhart of the London School of Economics has been saying for years that central banks would lose their independence once they allowed interest rates to rise and tightened the debt trap for over-borrowed states.

There will be large-scale changes in trade patterns. Global supply chains will be replaced by domestic ones. This was already looming with US President Donald Trump’s tariff wars with China and Europe. Global supply chains became the norm after the oil shocks of 1973 and 1979. The economics of global supply chains was driven by ease of long-run ocean transport, thanks to container ships and better communications. Now the costs will rise, partly as a result of anti-climate change commitments, as well as realisation that borders can close. We will march back to the 1960s but with much-improved technology such as 3D printing and artificial intelligence – a development that, with luck, could spur a manufacturing renovation.

Working practices will shift with more working from home and fewer offices. Similarly, international travelling for business conferences may be replaced by internet-based technology for better interaction from a domestic base.

In monetary policy, countries such as the US, Japan and the UK are different from the European Union. The Federal Reserve, Bank of Japan and Bank of England can create money to any extent required. The ECB is limited by Maastricht treaty rules which prevents outright monetary financing. Subject to internal limits (being reviewed, in a move viewed sceptically by creditor states such as Germany), it can buy Italian or other government bonds available from commercial banks and other holders, but it cannot inject liquidity without an underling secondary market bond transaction.

Last week Lagarde launched a much bolder philosophy in the direction of ‘whatever it takes’, proclaiming ‘there are no limits to our commitment to the euro.’ As the tsunami moves closer and becomes ever more damaging, collective EU government action is needed to back up the words.

Lord (Meghnad) Desai, a Labour peer, is Emeritus Professor of Economics at the London School of Economics and Political Science, and Chair of the OMFIF Advisers Council. David Marsh is Chairman of OMFIF.

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