The first key message – strong growth in overnight deposits drives the fastest growth in M3 since the GFC (% YoY, breakdown by component of M3) Source: ECB; Haver; CMMP analysis
Summary
March’s monetary development statistics from the ECB provide early insights from the money sector into the impact of the COVID-19 on the EA economy. Broad money (M3) growth jumped to 7.5%, the fastest YoY growth rate since December 2008. The key messages for the real economy here are threefold: (1) households and corporates are maintaining a high preference for holding liquid assets (€9.3tr) in the face of higher uncertainty and the low opportunity cost of holding money; (2) corporate demand for ST emergency liquidity has jumped sharply with government support playing an important role in ensuring future credit supply; (3) the contrasting slowdown in household credit demand so far reflects weaknesses in consumer credit rather than in mortgage demand. The EA Bank Lending Survey results (also published this week) suggest that these trends are likely to continue/accelerate throughout 2Q20.
Messages from the money sector
The ECB’s “Monetary developments in the euro area” statistics for March 2020 released this morning, provide early insights from the monetary sector regarding the impact of the COVID-19 pandemic on the EA economy.
After a period of relatively stability, M3 spiked higher in March 2020 (% YoY) Source: ECB; Haver; CMMP analysis
Growth in broad money supply (M3) jumped to 7.5% YoY in March 2020 from 5.6% in February. This represents the fastest rate of growth in broad money since December 2008. This growth was driven by the rapid growth in narrow money (M1) which grew 10.3% in March and contributed 7.0ppt of the total 7.5% growth in M3. Narrow money growth, in turn, was driven by demand for overnight deposits which grew 10.9% and represented 6.3ppt of the total growth in M3.
EURO 9.3trillion is sitting in cash and overnight deposits despite negative real rates (EUR bn) Source: ECB; Haver; CMMP analysis
At a time of great uncertainty and with the opportunity cost of holding money very low, households (HHs) and corporates (NFCs) have a strong preference for liquidity – €9.3trillion is currently sitting in (cash) and overnight deposits with March seeing the highest monthly inflows YTD. In December 2008, overnight deposits accounted for 35% of total broad money. Today, they account for 60%. This is despite the fact that overnight rates are only 0.2% for HHs and 0.0% for NFCs compared with inflation of 0.7% (March 2020). As described in “Brutally exposed” and “Are we there yet?”, persistent HH net financial savings at a time of low/negative rates is a clear symptom of the enduring debt overhang on the EA.
Counterparts of M3 – credit to the private sector an important counterpart (% YoY, breakdown by counterpart) Source: ECB; Haver; CMMP analysis
From a counterparts perspective, credit to the private sector contributed 4.5ppt of the total 7.5% in broad money albeit with different dynamics between the HH and NFC sectors. On an adjusted basis, credit to the private sector grew 5.0% in March versus 3.7% in February. This is the fastest rate of growth since February 2009 (albeit, still lagging the supply of money, see “Are we there yet?” for why this matters).
What is driving the spike in PSC growth? (% YoY) Source: ECB; Haver; CMMP analysis
NFC lending, which had been slowing since April 2019, rebounded to 5.4% YoY in March 2020 from the recent low of 3.0% in February 2020. The monthly flow of adjusted loans to NFC rose to €118bn compared with monthly flows of only €6bn and €11bn in February and January respectively.
Divergent trends in NFC and HH sectors in March (loan growth,% YoY) Source: ECB; Haver; CMMP analysis
Of this €118bn, the largest segment was ST loans with a maturity of up to 1 year which grew €46bn having fallen in the previous two months. This data is consistent with the results of the EA Bank Lending Survey (April 2020) which noted the “clear upward impact of Covid-19 pandemic on firms’ loan demand, largely driven by emergency liquidity needs.” These trends are expected to continue through 2Q20. Banks indicated that they expect credit standards from NFC lending to ease considerably on “account of the support measures introduced by governments.”
The second key message – 1Q20 monthly NFC flows broken down by maturity (EUR bn) Source: ECB; Haver; CMMP analysis
In contrast, HH credit growth slowed to 3.4% from 3.7% in January and February 2020. Mortgages, which account for over three-quarters of EA household lending, grew 4.0% from 4.3% in February and 4.1% in January. However, there was a more noticeable slowdown in consumer credit. This slowed to 3.9% in March from 6.2% in February and is now growing at the slowest rate since November 2016. The bank lending survey noted that, “A continued net tightening of credit standards and a strongly negative net balance for household loan demand are expected by banks in the second quarter of 2020”.
The third key message – 1Q20 monthly HH flows broken down by segment (EUR bn) Source: ECB; Haver; CMMP analysisLonger term trends in mortgage and consumer credit growth (% YoY) Source: ECB; Haver; CMMP analysis
Conclusion
While today’s monetary data contains few surprises, it does provide valuable insights into the impact of COVID-19 on the real economy. Uncertainty remains elevated in both the HH and corporate sectors and liquidity preferences support my earlier hypothesis that the EA is still dealing with an enduring debt overhang – a topic that I will be returning to in an update of sector balances in the EA.
There is a positive sign from the NFC sector. The increase demand for ST emergency funding is obvious, and indications from banks that government support will facilitate an easing of credit standards in 2Q20 is welcome. The signs from the HH sector are less encouraging. The negative impact on consumption can already be seen and, in contrast to the NFC sector, banks expect credit standards to tighten in the near future. Expect further divergence in NFC and HH credit growth over the next quarters.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
History often rhymes and occassionally repeats itself
In his 1992 analysis “Maastricht and All That”, the late economist Wynne Godley argued that, “the present situation is screaming aloud for co-ordinated reflation, but there exists neither the institutions nor an agreed framework of thought which will bring about this obviously desirable result.” Yesterday, and almost thirty years later, Fabio Panetta, a member of the ECB’s Executive Board, called for a “strong and symmetric fiscal response that offsets the economic damage from the pandemic.” Echoing Godley, Panetta stressed the risks of the current, asymmetric fiscal responses, argued why a new framework was required and made the threat to the future of the single market very clear.
From a corporate, rather than an investment perspective, one of his most interesting observations was that, “uneven fiscal support implies that a firm’s location, rather than its business model, will be the decisive factor in determining whether it survives the crisis.” A new angle?
What links Godley and Panetta’s observations is the fact that by design, the nation states of the euro area (EA) have given up sovereignty of their national currencies – they have become users rather than issuers of currency – and have, in effect, limited policy options to controlling money supply and balancing budgets. Why does this matter? In previous posts, I have argued that: (1) monetary policy has been only partially successful, at best, but also carries hidden risks; (2) asymmetric rules that are tough on deficits but weak on surpluses are inappropriate in the current situation; and (3) this is the time for co-ordinated, counter-cyclical fiscal policy across the EA.
One of Godley’s criticisms of the Maastricht Treaty was that it created no new institutions other than the ECB and yet, somewhat ironically, it is the ECB that is now leading the arguments for a new and more appropriate policy framework (see also “Fiscal, first and foremost“). Panetta concluded that, “Acting now to create the conditions for a symmetric fiscal response will help all member countries to shorten the duration of the crisis period, protect the economic base on which their future production structures and exports rely, and – perhaps most importantly – uphold the premise of a shared and indivisible European destiny.”
I would concur up until the final point – most importantly acting now will minimise the appalling human costs not only of the pandemic itself but also of the subsequent economic downturn. This should be the top priority for all. EU leaders meet tomorrow (23 April 2020) to debate their response and to consider possible funding models. Their responsibilty is immense.
Please note that summary comments above are extracts from more detailed analysis (including extended links to Modern Monetary Theory and Balance Sheet Theory) that is available separately.
EA banks’ vulnerability to rising provisions in the wake of the Covid-19 pandemic. Pre-provision profits were only 2.4x provisions in 4Q19 Source: ECB; CMMP analysis
Summary
In previous posts, I have highlighted how the basic macro building blocks that are required for a sustained recovery in European bank sector profitability are missing. In this post, I use recently published ECB supervisory bank statistics, to illustrate why the sector also remains poorly positioned to absord the impacts of the Covid-19 pandemic at the micro level.
On the bright side, the capital ratios of “significant institutions” (ie, banks supervised by the ECB) rose to 18.4% at the end of 4Q18, the highest level since the ECB began publishing their supervisory bank statistics in 2Q15. The CET 1 ratio was 14.8% (ranging from 12.2% in Spain to 18.8% in Belgium). Non-performing loans also hit a new low of 3.2% at the end of 4Q19 compared with 7.5% at the end of 2Q15 (but remain relatively high in Italy, Portugal, Cyprus and Greece).
However, profitability remains very weak. The aggregate ROE fell to only 5.2% in 4Q19 compared with 6.2% a year earlier. Banks in Slovenia were the only banks in the ECB sample that delivered aggregate ROEs in excess of 10%. Elsewhere ROEs ranged from lows of 0.1% and 0.9% in Germany and Portugal respectively to 7.6% and 8.6% in the Netherlands and Austria respectively. Above average ROEs in Austria, Spain and Belgium reflect higher underlying profitability and lower leverage whereas ROEs in the Netherlands and France also reflect higher levels of leverage.
In a week, when large US banks have announced weaker profits driven to a large extent by higher provisioning levels, the low “pre-provision” profit cover of only 2.4x in the EA is concerning. Pre-provision profits were less than 2x provision charges in 4Q19 in Portugal (1.5x), Germany (1.8x), Italy (1.8x) and Spain (1.9x).
As the old joke goes, “If you want to go there, I wouldn’t be starting here.” Sadly, in this case, there is no humour, as weak profitability threatens the supply of credit at a time when it is needed most.
Please note that these brief summary comments are extracts from more detailed analysis that is available separately
Six charts that matter
First the good news
On a positive note, the aggregate capital ratio of EA banks is at a new high of 18.4% (% RWAs) Source: ECB; CMMP analysisBanks in the Netherlands, Belgium, Ireland, Germany and France have higher-than-average levels of capital adequacy (% RWAs, 4Q19) Source: ECB; CMMP analysisAggregate NPLs also hit a new low of 3.2% at the end of 4Q19 Source: ECB; CMMP analysis
Now the bad news
Profitability levels remain weak and well below costs of equity (and operating costs remain too high) – Slovenian banks are the only banks delivering aggregate ROEs >10% Source: ECB; CMMP analysisAbove average ROEs in Austria, Spain and Belgium reflect higher underlying profability and lower leverage, whereas French and Dutch ROEs also reflect higher leverage Source: ECB; CMMP analysisPre-provision profits were only 2.4x aggregate provisions in 4Q19 (when NPLs were at new lows) Source: ECB; CMMP analysis
At the time of writing (3 April 2020), more than one million people have been infected and more than 53 thousand have lost their lives in the Covid-19 pandemic. The euro area (EA) is one of the epicentres of this global crisis and faces huge human and economic costs.
Introduction
CMMP analysis can add little value to the debate over the human costs and the appropriate medical and social responses to the pandemic. It can add value to the economic and political debate, however, by applying its three core analytical frameworks – global debt dynamics; money credit and business cycles; and financial sector balances.
I begin by challenging three myths from the past two decades that: (1) painful structural reforms post-2000 were the main driver of Germany’s recovery and resurgent competitiveness; (2) existing fiscal frameworks (including the Stability and Growth Pact) are still relevant in 2020; and (3) “this crisis is primarily the hour of national economic policy” (Issing 2020).
Instead, I argue that: (1) the main reason why Germany’s fiscal deficits did not widen substantially after the collapse of the 2000 IT bubble was that ECB policy led to other countries experiencing asset bubbles, lost competitiveness (and a build-up of unsustainable debt); (2) asymmetric fiscal rules that are tough on deficits but weak on surpluses are inappropriate in the current situation; and (3) this is the time to re-establish coordinated, counter-cyclical fiscal policy across the EA.
EA governments have the opportunity to show that it’s not just the ECB that “will do whatever is needed”. More importantly, failure to acknowledge and debunk the myths of the past and to respond to this opportunity appropriately, risks immeasurable harm to the future of the European project.
Myth #1: The role of structural reforms
In 2000, the EA and Germany were hit hard by the collapse of the IT bubble (real GDP, YoY, country contribution to total growth) Source: ECB; Haver; CMMP analysis
Twenty years ago, the euro area (EA) experienced a sharp economic slowdown following the collapse of the IT bubble. The Germany economy was hit hard in the process, experiencing three consecutive quarters of negative growth (3Q01-1Q02). The domestic fiscal response was insufficient to counter the massive increase in savings by both the NFC and HH sectors.
Germany’s fiscal response was insufficient to counter the massive increase in private sector savings after the IT bubble burst (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
In short, Germany had become the second developed economy (after Japan) to experience a balance sheet recession in the post-war period (Koo, 2015). In response, important “Agenda 2010” structural reforms (pensions, labour market) were introduced between 1999 and 2005. This (painful) experience has shaped the enduring narrative about the requirement for similar reforms across Southern Europe.
Germany becomes the second developed market (after Japan) to experience a balance sheet recession with the private sector deleveraging despite lower rates (HH and NFC credit as % GDP, dotted lines indicate period of ECB rate cuts) Source: ECB; Haver; CMMP analysisIn response to weakness in the German economy, the ECB cut rates to a post-war low of 2% (lower than rates had been under the Bundesbank) Source: ECB; Haver; CMMP analysis
Unfortunately this narrative is incomplete and underplays the role of ECB policy at the time. In the face of German economic weakness, the ECB cut ST interest rates to 2% in 2003 – lower that they had ever been under the Bundesbank.
M3 growth expanded much faster in the EA (ex Germany) and led to corresponding increases in wages and prices. In contrast relative subdued M3 growth in Germany subdued wage and price inflation (nominal growth in M3 rebased to December 2000) Source: ECB; Haver; CMMP analysis
This had little impact on Germany where money supply, prices and wages continued to stagnate, as balance sheet recessions theorists predict.
Trends in unit labour costs show how other major EA economies lost competitiveness against Germany Source: ECB; Haver; CMMP analysis
The story was very different elsewhere in Europe. Other countries in the EA lost competitiveness against Germany, experienced unsustainable asset bubbles, and built up unsustainable levels of debt.
The cost of borrowing for Spanish HHs fell quickly in response to cuts in policy rates (% YoY) Source: ECB; Haver; CMMP analysisBut led to an unsustainable housing boom, collapse and balance sheet recession in Spain (residential property price rises, % YoY) Source: ECB; Haver; CMMP analysis
This brief historical summary is important because it falsifies the idea that recessions and the lack of competitiveness in Europe’s periphery are the results of “national idleness”. Instead, they occurred because Germany was unable to use fiscal stimulus to address its own severe balance sheet recession and ECB monetary policy was forced to pick up the slack, leading to asset bubbles across the EA and, when these bubbles burst in 2007, balance sheet recessions in periphery countries and ultimately the euro crisis.
Myth #2: Fiscal frameworks are still relevant
Too little, too late? Private sector deleveraging in the EA began later and has been more gradual than in the UK and the US (private sector debt as % GDP, dotted lines indicate timing of peak levels) Source: BIS; Haver; CMMP analysis
In February, before the full impact of the pandemic was becoming understood, I was arguing that the EA was still dealing with the legacy of these debt overhangs. Private sector debt levels were still high too high, money, credit and business cycles were significantly weaker than in past cycles and inflation remained well below target.
Collective fiscal policy “was” about as tight as at any poing in the past twenty years (4Q sum, % GDP) Source: ECB; Haver; CMMP analysis
In spite of this, the nations of the EA were collectively running a fiscal policy that was about as tight as at any period in the past twenty years. They were doing this at a time when the private sector was running persistent net financial surpluses. This policy mix failed a basic “common sense test” even before the wider impacts of the pandemic were emerging.
Failing the “common sense test”. What was the point of running a tight fiscal policy when the private sectors was running persistent financial surpluses above 3% of GDP (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
A key lesson from the German (and Japanese) experience is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. Balance sheet recession theorists argue that these “unborrowed savings (at a time of zero interest rates) are responsible for the weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary” (Koo, 2015).
Relating the same argument to inflation targets, when inflation and inflation expectations are below target and rates are zero or negative, fiscal policy should lead with an expansionary stance and monetary policy should cooperate by focusing on guaranteeing low interest rates for as long as needed.
Since, I wrote these comments, EA governments have responded with a series of emergency fiscal measures including immediate stimulus via spending and foregone revenues, deferrals of some revenue sources, and other liquidity provisions and guarantees. However, the scale of the responses varies widely and, most importantly, there has been a lack of common fiscal responses, even in the EA.
Before, turning to this issue in myth #3, I will highlight an important argument from my preferred sector balances approach and Wynne Godley’s core identity that states:
Domestic private balance + domestic government balance + foreign balance = zero
Germany was able to emerge from recession partly by boosting exports to EA countries who were growing more rapidly in the wake of the ECB rate cuts described earlier (total current account and current account with the rest of the EA, EUR billions) Source: Haver; CMMP analysis
Governments in low-debt countries often overlook that they have benefitted massively from membership of the single market and the ability to run large current account surpluses. Germany was able to emerge from its earlier recession by boosting exports to the rest of the EA where economies were responding (too quickly) to ECB rate cuts. Today, Dutch private and public sector deficits are offset by financial deficits run by the RoW.
Dutch private and public sector surpluses are offset by widening RoW financial deficits (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
Put simply, “asymmetric fiscal rules – tough on deficits, weak on surpluses – are quite inappropriate to the [current] macroeconomic situation” (Gentiloni, 2020).
Myth #3: This is the hour of national economic policy
The EA is one of the epicentres of the Covid-19 pandemic and faces huge human and economic costs. Non-essential services in major economies that account for one third of total output have been closed and the IMF estimates that each month’s closure equates to a 3% drop in annual GDP. The IMF concludes that, “a deep European recession this year is a foregone conclusion” and today’s PMI releases support that conclusion.
Policy makers have responded quickly with large monetary and fiscal expansions (including suspensions of previous fiscal rules and limits). Through its Pandemic Emergency Purchase Programme (PEPP) the ECB plans to buy €750 billion in addition bonds (on top of the previously announced €120bn purchases) and has removed country limits.
After the “lo spread” false start, the ECB announced bold PEPP action putting the onus on politicians to respend approrpriately (Italy 10Y bond yield minus German 10y bond yield, ppt) Source: Haver; CMMP analysis
Debate now centres on whether a further common and significant response is needed. Options under consideration include ESM credit lines (combined with OMT); so-called “corona bonds”, a EA Treasury, and one-off joint expenditures.
Once again, this debate has exposed divisions between “defensive hawks” and more “ambitious integrators”. The French, Italian and six other EA governments are proposing combining using the ESM with the issuance of corona bonds. The German government has a preference for exhausting other options first, while the Dutch government has not only stated that use of the ESM should be considered only as a last resort, it has also ruled out the option of issuing corona bonds.
The IMF argues that, “the determination of EA leaders to do what it takes to stabilise the Euro should not be understated.” The EU’s economic chief, Paolo Gentiloni, believes that “consensus is growing day by day that we need to face an extraordinary crisis with extraordinary tools.” Nonetheless the corona bond debate threatens to deepen the rift between EA capitals over how far and how fast the EA should harness common fiscal solutions to tackle the pending economic damage.
The future of the European project may rest on how this debate is resolved.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
Household net worth is at a new high driven by persisent financial surpluses post GFC combined with positive revaluation effects from housing and financial assets (multiple of disposable income) Source: ECB; Haver; CMMP analysis
Examining wealth effects
Households (HH) in the euro area (EA) have been running persistent financial surpluses of between 2-3% GDP since the GFC. I considered the implications of these trends for the choice of policy mix in previous posts (see “Policy reboot 2020”). In this post, I examine the implications for the resilience of HH consumption in the face of the Covid-19 crisis.
HHs have run persistent financial surpluses since the GFC leading to a build up of financial assets (% GDP, 4Q sum) Source: ECB; Haver; CMMP analysis
HH net wealth (HNW), the difference between the value of HH assets and liabilities, is an important determinant of private sector consumption. Given that HH consumption accounts for 54 cents in every EURO of GDP, it is also an important determinant of overall GDP growth in the EA.
Changes in wealth affect consumption in the short run as HH feel richer or poorer and become more or less confident. The level of HNW is also an important driver of long term consumption since, along with income from employment, it determines the amount of economic resources available to HHs.
Trend and breakdown (NFAs, FAs, FLs,) of HNW over the past twenty years (EURO trillion) Source: ECB; Haver; CMMP analysis
HNW hit a new high in absolute terms (€52trillion) and as a multiple of disposable income (7.2x) at the end of 3Q19. This included non-financial assets (NFAs) of €34trillion, largely in the form of housing, and financial assets (FAs) of €26trillion, netted off against financial liabilities (FLs) of €8trillion.
Breakdown of changes to HNW highlights the importance of revaluation gains in NFAs (change in Euro per capita) Source: ECB, Haver, CMMP analysis
The growth in HNW reflects not only the build-up of FAs, but also revaluation gains in these and other NFAs. As discussed in “Fuelling the Fire”, Quantitative Easing has stimulated asset prices and led to increased housing and financial wealth (see graphs above and below).
QE has stimulated asset prices and increased housing and financial wealth (changes in per capita terms by quarter and as rolling 4Q sums) Source: ECB; Haver, CMMP analysis
Revaluation gains of NFAs have been particularly important in Portugal, Greece, Spain, Germany and Austria. However, ECB estimates suggest that while residential property prices remain undervalued in Greece, they were overvalued by 12%, 16% and 18% in Portugal, Germany and Austria respectively even before the impact of Covid-19 as felt.
Property prices were over-valued even before the impact of Covid-19 (3Q19) Source: ECB; Haver; CMMP analysis
Potential revaluation losses on NFA will have a negative impact on HNW for obvious reasons, but their impact on future consumption (marginal propensity to consume) is more challenging to determine (and varies between micro and macro levels).
To summarise the very extensive economic analysis in this area, the long-term housing effects on consumption are consistently weaker than those of financial wealth. Indeed, in a recent analysis of larger EA economies, the ECB concluded that, “Spain is the only large EA country for which consistently positive housing wealth effects have been estimated.”
HHs in the Netherlands, Belgium, Italy and France have higher gearing to changes in FA values Source: ECB; Haver; CMMP analysis
Significant heterogeneity exists in terms of the size and structure of HH financial assets. FAs are 2.2x the size of EA GDP on average, but above average in the Netherlands (3.6x), Belgium (3.0x), Italy (2.5x) and France (2.4x). Higher gearing to the value of financial assets in these economies is offset by the “absolute cushion” of higher per capita FA holdings in the Netherlands (€167k), Belgium (€121k) and France (€86k). However, in aggregate, Italian HHs have higher gearing than average but lower than average holdings of FAs per capita (€72k versus the EA average of €75k). Other Southern European economies also have smaller cushions in terms of FAs per capita – Greece (€25k), Portugal (€42k) and Spain (€50k).
Liquid assets are an important part of HH total FAs especially in Greece, Portugal, Austria, Germany and Spain. Source: ECB; Haver, CMMP analysis
FAs consist mainly of liquid assets (currency and deposits) and pension and life insurance-related assets. These assets account for 70% of total HH FAs with the remainder held in higher risk products including equity, debt and shares in investment funds. The share of higher risk assets has fallen from 40% pre-GFC to 30% currently suggesting that the negative impact of recent market falls may be less than after the GFC. In addition, HHs in Greece (59%), Portugal (44%), Austria (40%), Germany (40%) and Spain (39%) hold higher amount of their financial assets is liquid assets. However, on a per capita basis, the largest liquid holdings are in Belgium (€38k), Austria (€33k), Germany (€31k) and Ireland (€31k).
Conclusion
The stock of HH wealth in the EA has risen to new highs in absolute terms and as a multiple of disposable income and represents an important economic resource in the face of the Covid-19 crisis.
Revaluation gains of both NFA and FA assets have been important drivers of recent HNW growth, but both will turn sharply negative in the current environment. At the macro-level, long term housing effects on consumption difficult to measure but are consistently weaker than those of financial wealth (with the exception of Spain).
HHs in the Netherlands, Belgium, Italy and France have relatively high gearing to changes in the value of FAs, although with the exception of Italy this is offset by relatively high per capita holdings on FAs. HHs in Southern European economies typically have lower “cushions” in terms of per capital holdings of financial assets.
Since the GFC, there has been a de-risking of HNW holdings away from debt, equity and shares in investment funds in favour of liquid assets and pension and life insurance related assets. Lower risk assets now account for 70% of HH FAs. In addition, HHs in Greece, Portugal, Austria, Germany and Spain hold relatively high amounts of FAs in liquid assets. This suggests that the MPC from financial effects may be lower than after the GFC.
These conclusions come with the obvious caveat that the impact of changes in wealth on HH consumption differs substantially between countries, between NFAs and FAs and between HHs within the same country.
Please note that the summary comments above are extracts from more detailed analysis that is available separately
The ECB revised down its outlook for growth and called for “an ambitious and collective fiscal response”(December 2019 forecasts (o); March 2020 forecasts (n)) Source: ECB; CMMP analysis
A crucial week – part 2
On Thursday 12 March 2020, the President of the ECB, Christine Lagarde made a clear call for a policy reboot in the euro area. Unsurprisingly, Madame Lagarde presented a downbeat assessment for economic activity in the region. GDP forecasts were revised down to 0.8% (from 1.1%) for 2020 and to 1.3% (from 1.4%) for 2021 and left unchanged at 1.4%. Inflation forecasts were unchanged at 1.1% for 2020, 1.4% for 2021 and 1.6% for 2022 although downside risks were acknowledged notably from lower oil prices. (These new forecasts do not reflect the potential impact of the Coronavirus fully, due to their timing.)
Prior to the meeting, expectations had included a -0.1% cut in the deposit facility rate to -0.6%, a lending facility and a boost to QE (FT, 2020). The ECB did not deliver on the former. Instead, they announced a package of measures including a further €120bn of bond purchases and more cheap loans for banks. But, and more importantly, the key message was extremely clear – Madame Lagarde highlighted that the appropriate and required response to the current growth shock “should be fiscal, first and foremost.” In the Q&A session, she also noted that the fiscal measures already announced totalled only €27bn ie, a quarter of 1% of the GDP for the EA…adding:
“…hence, we are calling for an ambitious and collective fiscal response.”
Christine Lagarde, President of the ECB. 12 March 2020
The UK delivered in the first half
The UK delivered in the first half – a sustained fiscal loosening combined and coordinated with a package of Bank of England measures (OBR forecasts for public sector deficit as % GDP) Source: OBR; CMMP analysis
This was a crucial week for policy makers in Europe. The UK delivered with the “largest sustained fiscal loosening since the pre-election budget of March 1992” combined with a coordinated package of measures from the Bank of England.
“Mais, en attendant…”
To repeat – does it make sense to run tight fiscal policy (1) at this point in the cycle and in the face of weakening global growth and (2) when the private sector is running persistent financial surpluses?(4Q sum of financial balances, % GDP) Source: ECB; Haver; CMMP analysis
As feared, the European response has been more limited and insufficient. Madame Lagarde was correct in her assessment of the required response, but the second half of this crucial week ends ultimately in disappointment. Extra time is required…
Please note that the summary comments above are extracts from more detailed analysis that is available separately
“A major policy shift to sustained fiscal loosening” – current OBR forecasts for the UK budget (solid line) compared with March 2019 forecasts (dotted line) as % GDP Source: OBR; CMMP analysis
A crucial week – part 1
On Wednesday 11 March 2020, the new UK Chancellor, Rishi Sunak announced the “largest sustained fiscal loosening since the pre-election Budget of March 1992” (OBR, 2020). Prior to the budget statement, the Bank of England also announced a package of measures – an unscheduled rate cut (to a historic low of 0.25%), the offer of cheap funding to banks, lowering banks’ capital buffers and expectations for banks to not increase dividends – in manner neatly described by the Chancellor as, “carefully designed to be complementary and to have maximum impact, consistent with our independent responsibilities.”
Government spending (% GDP) rising to late 1970s levels – a major shift Source: OBR; CMMP analysis
Viewed through my preferred financial sector balances approach (summarised in Wynne Godley’s identity below), the new budget addresses last year’s (partially) flawed assumptions behind the policy of fiscal tightening ie, that a move towards a public sector surplus would be accompanied by a narrowing of the RoW’s net financial surplus and a widening of the private sector’s net financial deficit including higher level of borrowing. Instead it incorporates a widening in the net financial surplus of the household sector – appropriate given the high level of UK HH debt and low level of UK HH savings – offset by a widening in the public sector deficit. The assumptions regarding the balances of the NFC and RoW sectors remain largely unchanged.
Domestic private balance + domestic government balance + foreign balance = zero
Wynne Godley
On a positive note, this appears a more balanced policy including an appropriate shift in responsibility away from the HH sector to the UK government. The co-ordination between fiscal and monetary policy is also a positive sign. Nonetheless, the Government’s gross financing requirement averages around £150 billion a year over the next five years, around half as much again as a share of GDP as in the five years prior to the financial crisis. Hence, the OBR concludes that, “public finances are more vulnerable to adverse inflation and interest rate surprises than they were.” On top of this, the reliance on the RoW as a net lender to the UK economy remains an additional and obvious risk.
Attention now turns to the ECB. As noted in “Are we there yet?” the EA is positioned better to ease fiscal policy than the UK but immediate risks remain that policy response may be limited. Watch this space, we are half way though a crucial week for UK and European policy makers.
The charts that matter
Last year’s (partially flawed) assumptions
Last year’s partially flawed assumptions expressed within the sector balances framework (% GDP) Source: OBR; CMMP analysis
“We expect the public sector deficit to narrow slightly, offset by a small narrowing in the rest of the world surplus. The corporate and household sector deficits are expected to remain broadly stable. The general profile of sector net lending is little changed from previous forecasts, although the size of the household sector deficit is slightly smaller than in our October forecast, consistent with an upward revision to our forecast for household saving. The size of the rest of the world surplus is slightly larger, reflecting the upward revision to our forecast of the current account deficit.” (OBR, 2019)
New versus old – the HH sector
HH sector is now expected to run wider net financial surpluses of between 1.3% and 1.6% of GDP Source: OBR; CMMP analysis
New versus old – the public sector (and the policy shift)
The end of austerity and a shift to sustained fiscal loosening (public sector net financial deficit as % GDP) Souce: OBR; CMMP analysis
New versus old – little change to NFC sector forecasts
NFC deficits are forecast to offset HH surpluses meaning that the private sector remains in deficit in aggregate (% GDP) Source: OBR; CMMP analysis
New versus old – still reliant on the RoW as a net lender
“Still very dependent” – the OBR assumes that the RoW will continue to run net financial surpluses of c.4% GDP over the forecast period (% GDP) Source: OBR, CMMP analysis
March 2020 forecasts expressed through sector balances
Widening HH surpluses offset by looser fiscal policy and widening NFC deficits (% GDP) Source: OBR; CMMP analysis
Conclusion
We are half way through a crucial week for UK and European policy makers. The first half saw a sustained loosening of fiscal policy by the new UK Chancellor, co-ordinated neatly with a package of measures from the Bank of England. This leaves a more balanced and appropriate policy mix.
In the second half, attention now focuses on the ECB and EA governments. The euro area is better placed than the UK to relax fiscal policy but the immediate risk remains that the policy response may be more limited. Watch this space.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
Sharp falls in large European banks’ share prices reflect dramatic weakening in macro foundations – “macro building blocks matter” (% change YTD to 9 March 2020, SX7E index heavyweights) Source: FT; CMMP analysis
A crucial week
This is a crucial week for European policy makers. The coronavirus has weakened the European banking sector’s macro foundations in a dramatic fashion and has exposed wider policy weaknesses. The SX7E index of European banks has fallen 32% YTD and underperformed the wider SXXE index by 16%. This performance is consistent with my CMMP narrative that (1) macro building blocks matter, and (2) that last year’s bounce was a relief rally rather than the start of a period of sustained recovery.
GDP growth expectations, that are stable and subdued at best, now face obvious downside risks, credit growth is showing early signs of peaking, ST and LT rates are at new lows and the yield curve is inverted. In this adverse environment for European banks, attention now switches to policy makers. They are equally exposed.
QE has already shifted the balance of power from lenders to borrowers and carries hidden risks in terms of future growth, leverage, financial stability and income inequality. In recent posts, I have argued that the EA remains trapped by its debt overhang and outdated policy rules, and that a major policy reboot is long overdue. It makes little sense for collective fiscal policy to be about as tight now as any period in the past twenty years at a time when the private sector is running persistent net financial surpluses.
The immediate risk is that this week’s policy responses remain limited. The ECB meets on Thursday with expectations of GDP downgrades, a cut in rates (to -0.6%), liquidity measures (and a possible adjustment to macroprudential tools) potentially discounted already. Far more helpful, indeed necessary, is clear co-ordination between political leaders and central bankers globally. A policy reboot would be a silver lining to the current storm gripping financial markets and global economies.
Watch this space, this is a crucial week.
The charts that matter
Mind the gap
SX7E “heavyweights” have fallen sharply from their 2020 highs – Soc Gen, Credit Agricole, Deutsche, ING, UCI, BNP Paribas are all more than 35% below peaks (% change from 2020 high to close on 9 March 2020) Source: FT, CMMP analysis
MBB#1: Subdued GDP forecasts likely to be revised down
The ECB is likely to revise down its forecasts for GDP growth this week – current forecasts are based on global growth forecasts that have already been downgraded by the OECD, who have also downgraded EA GDP to 0.8% (2020e) and 1.2% (2021e) Source: OECD; ECB; EC; Haver; CMMP analysis
MBB#2: Credit growth remains a “relative” bright spot
HH (3.7% YoY) and NFC (3.2% YoY) credit growth is subdued in relation to past cycles but well above the levels associated with recession in the EA Source: ECB; Haver; CMMP analysis
MBB#3: ST rates locked at the base of the ECB corridor
A further cut in the deposit facility rate (t0 -0.6%) this week will be negative for NIMs in those countries (Austria, Italy, Portugal and Spain) and market segments (NFC lending) that are characterised by floating rate lending Source: ECB; Haver; CMMP analysis
MBB#4: LT rates at new lows and firmly in negative territory
10Y bond yields have returned to August 2019 lows of -0.71% Source: Haver; CMMP analysis
MBB#5: EA yield curve inverted again
The inversion of the yield curve has negative consequences for NIMs in countries (Belgium, France, Germany and the Netherlands) and market segments (HH lending) that are more exposed to fixed-rate lending Source: Haver; CMMP analysis
Current policy has “hidden risks”
QE risks fuelling the growth in less productive FIRE-based lending with negative implications for leverage, growth, stability and income inequality Source: ECB; Haver; CMMP analysis
Policy needs to match context #1 – a favourite graph again!
The gap between the supply of money (M3) and the demand for credit has started to widen again, indicating an on-going deficiency in credit demand (and debt overhang) Source: ECB; Haver; CMMP analysis
Policy needs to match context #2 – what are balances saying?
The private sector continues to run financial surpluses in spite of negative/low rates (4Q sums, % GDP)a clear message that the debt overhang remains Source: ECB; Haver; CMMP analysis
Finally, does this make sense?
Does it make sense to run tight fiscal policy (1) at this point in the cycle, and (2) when the private sector is running persistent financial surpluses? Source: ECB; Haver; CMMP analysis
Conclusion
This remains a crucial week for European (and global) policy makers. The ECB is widely expected to downgrade its GDP growth forecasts and to cut the deposit facility rate to -0.6% (from -0.5%). Further liquidity support and adjustments to macroprudential tools are also probable. Unfortunately, this is unlikely to be sufficient to address market concerns, the impact of the debt overhang and slowing global growth. Far more hopeful, indeed necessary, is clear co-ordination between political leaders and central bankers globally. If there is to be a silver lining to the current storm, this would be it.
As noted in “Are we there yet?”, the EA is positioned better to ease fiscal policy than the UK (where both the private and public sectors are running simultaneous financial deficits) but we are more likely to see fiscal stimulus in tomorrow’s UK budget than in the former this week. Watch this space, this is a crucial week.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
Leading, coincident and lagging indicators have peaked
The key chart
Watch this space – leading (real M1), coincident (real HH) and lagging (real NFC) indicators have all peaked, but remain well above the levels associated with recessions risks (% YoY, real terms). Source: ECB; Haver; CMMP analysis
The key message
January’s monetary developments data for the euro area (EA) presented no surprises. Monetary aggregates are still growing well above the levels associated with heightened recession risks.
Broad money (M3) growth increased to 5.2% from 4.9% in December 2019. Narrow money (M1) remains the main component, contributing 5.3% to this growth (other ST deposits being the negative balancing item) and accounting for 69% of the outstanding stock of M3. There is now just under €9trillion residing in (cash and) overnight deposits despite negative real rates, indicating an enduring debt overhang in the region.
Private sector credit grew 3.8% YoY, a new high in nominal terms in the current credit cycle, but lags the growth in the supply of money, reflecting the on-going deficiency in credit demand.
However, an early warning sign is flashing within the context of my money, credit and business cycle framework. Growth rates in real M1 (a leading indicator), real HH credit (a coincident indicator) and real NFC credit (normally a lagging indicator) have all peaked at the aggregate level and in Germany and France, the two markets that have driven loan growth in the region. None of these indicators imply recession risks, but they do point to a slowdown in economic activity across the euro area. Watch this space…
The charts that matter
No headline surprises – broad money (M3) grew 5.2% in January versus 4.9% in December (% YoY, nominal terms) Source: ECB; Haver; CMMP analysisGrowth trends and breakdown of M3 by component – overnight deposits (red bars) remain the key driver of money supply growth. M1 contributed 5.3% of the total 5.2% M3 growth, other ST deposits were the negative balancing item(% YoY, nominal terms) Source: ECB; Haver; CMMP analysis Confirmation of the enduring debt overhang – c Euro 9 trillion sitting in (cash and) overnight deposits despite negative real returns (Euro billions) Source: ECB; Haver; CMMP analysis
M3 = credit to EA residents + net external assets – LT financial liabilities + other counterparts
From a counterparts perspective, and on a positive note, credit to other EA residents (the purple bars) has replaced credit to central government (the green bars, QE impact) as the main driver of M3 (%YoY, nominal terms) Source: ECB; Haver; CMMP analysisEarly warnings #1 – real growth in M1 (leading indicator) has fallen from recent peak of 7.3% in November 2019 to 6.8% in January (% YoY, 3m MVA) Source: ECB; Haver; CMMP analysisEarly warnings #2 – real growth in HH credit (co-incident indicator) has also fallen from recent peak of 2.6% in November 2019 to 2.3% in January (% YoY, 3m MVA) Source: ECB; Haver; CMMP analysis Early warnings #3 – real growth in NFC credit (typically a lagging indicator) peaked at 3.0% in October 2019 and has fallen to 2.0% in January (% YoY, 3m MVA) Source: ECB; Haver; CMMP analysisGermany is the second largest contributor to EA HH credit growth after France – growth hit a new peak of 4.5% in January in nominal terms, but has fallen from 3.4% in October 2019 to 2.9% in January in real terms(% YoY) Source: ECB; Haver; CMMP analysisGermany is the largest contributor to EA NFC credit growth. Nominal growth rates peaked at 7.0% in June 2019 and have fallen to 5.0% in January. Real growth rates peaked at 5.6% in August 2019 and have fallen to 3.3% in January (% YoY) Source: ECB; Haver; CMMP analysisFrance is the largest contributor to EA HH credit growth – in nominal terms, growth hit a new high of 6.5% in January, but peaked in real terms at 5.4% in October 2019 and has fallen to 4.7% in January Source: ECB; Haver; CMMP analysisFrance is the second largest contributor to EA NFC credit growth after Germany – nominal growth rates have fallen from 8.3% in August 2019 to 5.7% in January and real rates have fallen from 6.9% to 3.9% over the same period Source: ECB; Haver; CMMP analysis
Please note that the summary comments above are extracts from more detailed analysis that is available separately
Time for a policy reboot – does it make sense to run tight fiscal policy (1) at this point in the cycle, and (2) when the private sector is running persistent financial surpluses? (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
Introduction
In my previous post, “Policy reboot 2020?” I suggested that, “progress towards dealing with the debt overhang in Europe remains gradual and incomplete”. This prompted two follow-up questions:
How do I monitor this progress within the Macro Perspectives framework?
Why does it matter?
In this post, I present eight graphs that are key to monitoring this progress:
Private sector debt ratios (PSDRs)
Costs of borrowing
Lending spreads versus policy rates
Growth in broad money (M3)
Growth in private sector credit
Money supply vs demand for credit dynamic
Inflation
Private sector net financial balances
Summary and implications
The eight graphs confirm that the EA is still dealing with the legacy of a debt overhang. Private sector debt levels are still too high, money, credit and business cycles are significantly weaker than in past cycles and inflation remains well below target.
In spite of this, the collective fiscal policy of EA nations is (1) about as tight as any period in the past twenty years and (2) is so at a time when the private sector is running persistent net financial surpluses (largely above 3% GDP since the GFC).
An important lesson from Japan’s experience of a balance sheet recession is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. These savings (at a time of zero rates) are responsible for weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary (Koo, R. 2019).
Ironically, the EA is positioned better to ease fiscal policy than the UK (where both the private and public sector are running simultaneous financial deficits) but we are more likely to see fiscal stimulus in the latter (March 2020) than in the former.
It’s time for a policy reboot in the EA for 2020 and beyond.
Eight key charts
Key chart 1: Private sector debt ratios
Too little, too late? Private sector deleveraging in the EA began later and has been more gradual than in the UK and the US (private sector debt as % GDP) Source: BIS; Haver; CMMP analysis
The first chart illustrates twenty-year trends in private sector debt ratios (PSDR) – private sector debt as a percentage of GDP – for the UK, EA and US. The three vertical, dotted lines mark the point of peak PSDR for each economy. This is the standard starting point for analysing debt overhangs.
Private sector deleveraging began much later and has been more gradual in the EA than in both the US and the UK. The PSDR in the EA is now the highest among these three economies.
The US PSDR peaked first at 170% GDP in 3Q08, fell to a post-GFC low of 147% GDP in 3Q15 (co-incidentally the point when the EA PSDR peaked) and is currently 150% GDP
The UK PSDR peaked one quarter later (4Q08) at 194% GDP, fell to 160% GDP in 2Q15 and is currently 163%
The EA PSDR continued to rise after the GFC before peaking at 172% in 2Q15 and declining slightly to 166% currently
For reference, but not shown here, household (HH) and corporate (NFC) debt ratios (the two sub-sets behind these totals) differ across the three economies. In the EA, the NFC PSDR is 108% (above the BIS’ maximum threshold of 90%) but the HH PSDR is only 58%. In the UK and US these splits are 79%:84% (see “Poised to disappoint”) and 75%:75% respectively. In other words, the risks lie in different places in each economy.
Key chart 2: Cost of borrowing
The cost of borrowing for HH and NFCs has fallen sharply, reflecting relatively weak credit demand (composite costs %, nominal terms) Source: ECB; Haver; CMMP analysis
The second chart illustrates the ECB’s composite measures for HH and NFC cost of borrowing (in nominal terms). The cost of borrowing typically falls in periods of debt overhang, reflecting weak demand for credit.
Weak credit demand is reflected in the cost of borrowing for EA HHs and
NFCs falling sharply.
HH and NFC costs of borrowing both peaked in
3Q08 at 5.6% and 6.0% respectively
The HH cost of borrowing hit a new low in
December 2019 of 1.41%
The NFC cost of borrowing hit a low of 1.52% in
August 2019 and is currently 1.55%
For reference, costs of borrowing in real terms (shown here) remain low at 0.11% for HH and 0.25% for NFCs but above their October 2018 lows of -0.49% and -0.65% respectively.
Key chart 3: Spreads vs policy rates
Lending spreads at, or close to, post-GFC lows (composite cost minus MRR, ppt) Source: ECB, Haver, CMMP analysis
The third chart illustrates the spread between composite borrowing
rates and the ECB’s main refinancing rate (MRR). These spreads typically narrow
during periods of debt overhang.
Spreads between borrowing costs and the ECB’s main policy rate are at,
or slightly above, post-GFC lows.
HH spreads have declined from 2.97% in May 2009 to a new post-GFC low of 1.41%
NFC spreads have declined from 2.76% in May 2014 to 1.55% currently, slightly above their post-GFC low of 1.55%
Key chart 4: Growth in broad money (M3)
Growth in M3 has been steady since 2014 easing, but subdued in relation to past trends (% YoY) Source: ECB; Haver; CMMP analysis
The fourth chart illustrates the twenty-year trend in the growth of
broad money (M3). Broad money reflects the interaction between the banking
sector and the money-holding/real sector.
Growth rates in broad money have been stable since ECB easing in 2014
but subdued in comparison with previous cycles.
In December 2019, M3 grew by 5.0% YoY
Narrow money (M1) contributed growth of 5.3% which was offset by negative growth in short term marketable securities
For reference, the share of M1 within M3 has risen from 42% in December 2008 to a new high of 68%, despite the fact that HH overnight deposit rates are -1.25% in real terms.
Key chart 5: Private sector loan growth
Private sector credit growing at the fastest rate in the current cycle, but growth is subdued in relation to past cycles (% YoY) Source: ECB; Haver; CMMP analysis
The fifth chart illustrates YoY growth in private sector credit, the main counterpart to M3.
Private sector credit is growing at the fastest rate in the current
cycle but also remains subdued in relation to past cycles and highly
concentrated geographically (Germany and France).
Private sector credit grew 3.7% YoY in December
2019 (3m MVA) above the average growth rate of 3.5%
Germany and France together contributed 2.8% of
the 3.7% growth in HH credit and 2.6% of the 3.2% growth in NFC credit in 2019
Key chart 6: Money supply vs credit demand
The gap between the supply of money and the demand for credit has started to widen again, indicating an on-going deficiency in credit demand Source: ECB; Haver; CMMP analysis
The sixth chart – one of my favourite charts – illustrates the gap between the supply of money (M3) and the demand for credit by the private sector. In typical cycles, monetary aggregates and their counterparts move together. Money supply indicates how much money is available for use by the private sector. Private sector credit indicates how much the private sector is borrowing.
The gap between the growth in the supply of money and the demand for
credit indicates on-going deficiency in credit demand in the EA.
Since 4Q11, broad money and private sector credit trends have diverged with gaps peaking in 3Q12 and 1Q15
The gap narrowed up to September 2018 but has widened out again recently
Key chart 7: Inflation
Inflation persistently below the ECB 2% target during 2019 (% YoY) Source: ECB; Haver; CMMP analysis
The seventh chart ilustrates the twenty-year trend in inflation (HICP) plotted against the ECB’s current inflation target. Again, inflation rates tend to much lower in periods of debt overhang.
Inflation remained below the ECB’s target throughout 2019 and finished
the year at 1.3%
Inflation ended 2019 at 1.3%, below the ECB’s target of 2%
Key chart 8: Private sector financial balance
The private sector is running a net financial surplus in spite of negative/low rates (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
The eighth, and final chart, illustrates trends in the private sector’s net financial surplus. In this analysis, 4Q sums are compared with GDP.
Finally, the private sector (in aggregate) is running a financial surplus in spite of negative/very low policy rates – a very strong indication that the economy is still suffering from a debt overhang
In aggregate, the EA private sector is running a
net financial surplus equivalent to 3.1% of GDP (3Q19) at a time when deposit
rates are negative (average -0.9% during 3Q19)
Why does this matter?
…Fiscal rules should be designed to favor counter-cyclical fiscal policies. Nevertheless, despite various amendments to strengthen the counter-cyclical features of the [EA] rules, the outcomes have been mainly pro-cyclical.
IMF, Fiscal rules in the euro area and lessons from other monetary unions, 2019
The EA is still dealing with the legacy of a debt overhang. Private sector debt levels are still too high, money, credit and business cycles are significantly weaker than in past cycles and inflation remains well below target.
Does this make sense #1? Collective fiscal policy is about as tight as at any point in past twenty years (Government net financial deficit, 4Q sum, % GDP) Source: ECB; Haver; CMMP analysis
In spite of all of this, the nations of the EA are collectively running a fiscal policy that is about as tight as at any period in the past twenty years. They are also doing this at a time when the private sector is running persistent net financial surpluses. Clearly, these developments fail a basic “common sense test”.
Does this make sense #2. The key chart again – what is the logic of running a tight policy when the private sector is running persistent surpluses (largely above 3% GDP) Source: ECB; Haver; CMMP analysis
Its worth noting that fiscal policy rules in the EA, including the Stability and Growth Pact, were created without reference to the private saving and for an economic environment that no longer exists (eg, positive rates, high inflation, government mismanagement etc.).
Are current rules still fit for purpose – government deficit/surplus as % GDP (y axis) plotted against government debt as % GDP (x axis)? Red lines indicate current SGP rules, green line indicates a balanced budget. These rules were designed for a different type of recession and constrain appropriate policy responses today Source: ECB; Haver; CMMP analysis
Leaving aside, the weak track record of adherence to these rules by member states, the obvious question is whether these rules remain relevant and whether the current policy mix is appropriate?
An important lesson from the experience of Japan’s balance sheet recession is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. Balance sheet recession theorists, such as Richard Koo, argue that these, “unborrowed savings (at a time of zero interest rates) are responsible for the weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary”.
Relating the same argument to inflation targets, when inflation and inflation expectations are below target and rates are zero or negative, fiscal policy should lead with an expansionary stance and monetary policy should cooperate by focusing on guaranteeing low interest rates for as long as needed.
The UK is not as well positioned as the EA to relax fiscal policy – the UK private and public sectors are running simultanous deficits – but we are more likely to see UK fiscal easing first, in the March 2020 budget (4Q sums, % GDP) Source: ONS; Haver; CMMP analysis
Ironically, the EU is positioned better to relax fiscal policy than the UK (where both the private and public sector are running simultaneous deficits) but we are more likely to see fiscal easing in the latter (March 20202 budget) before the former.
In short, it is time for a policy reboot in the EA for 2020 and beyond.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
