The Great Repression

Economic policy is about to take a turn for the weird. UK government borrowing in April 2020 was as high as in the whole of fiscal year 2019-20, at over £62bn, whilst the Bank of England is now seriously considering reducing interest rates into negative territory. Such is the precarious state of the economy as measures to combat Covid-19 take effect that all of the things we previously took for granted are about to be turned upside down.

The fiscal position

Dealing first with fiscal issues, the Office for Budget Responsibility reckons that UK public borrowing will reach 15% of GDP in fiscal 2020-21 which would represent the biggest peacetime deficit on record (chart below). Governments have no choice but to pull out all the stops given that they have imposed measures which impact on people’s livelihoods. With governments having shut down large parts of the economy, those affected by the measures need some form of support as a quid pro quo. The question remains as to how we will pay for it. In the short-term governments have no choice but to borrow more. Although the UK did not enter this crisis with a great deal of fiscal headroom, it does have some. The ratio of net debt to GDP ended fiscal year 2019-20 at 93.3% but as a result of the surge in borrowing in the first month of the fiscal year it jumped to 97.7% in April – the highest since 1963 - and it seems only a matter of time before it exceeds 100%. 

A decade ago, Carmen Reinhart and Ken Rogoff, in their famous 2010 paper, Growth in a Time of Debt, argued that a debt ratio in excess of 90% has major adverse consequences for economic growth since an increasing amount of resources is then devoted to debt servicing. The low level of interest rates today means that debt servicing costs are at their lowest in history so the 90% threshold may be less binding than in the past (if indeed it ever was, as there remains a lot of controversy regarding this figure). Ironically, on data back to 1700 the UK’s average debt ratio is 99% (chart below). Evidently imperial expansion and the financing of wars did not come cheap. But at the beginning of this century, the debt ratio was around 30% of GDP and whilst the financial crisis of 2008 did a lot of damage, it is notable that the debt ratio has continued to climb during the Conservative government’s term of office. Having spent the past decade telling the electorate that the deterioration in public finances was all the fault of the previous Labour government, even before the Covid crisis, the Tories have not exactly had a great record on managing public finances.

That said, even a net debt ratio of 100% is likely to be easily fundable. Despite what the ratings agencies may say, the UK has a long track record of not defaulting on its debt and it issues in its own currency. Nonetheless, no government will be comfortable with debt ratios at current levels and this partly explains why many policy makers want to reopen the economy as soon as possible in order to get some tax revenues flowing into the Treasury’s coffers.

The monetary response

Whilst I have long been an advocate of a more activist fiscal policy, it is equally clear that fiscal policy alone cannot do everything and needs to be backed up by monetary policy. It is presumably for this reason that the BoE is discussing the merits of cutting policy rates into negative territory. Although there are some circumstances in which they might be useful, I have never been persuaded of the merits of negative rates (a view summarised here).  In very simple terms, they are designed to persuade households and firms to bring forward activity and represent an attempt by central banks to alter the time preferences of economic agents. For those with an eye on their retirement funds, the idea of negative rates is anathema and the impact on savers is one of the reasons why a case has been brought before the German Constitutional Court.

As I have mentioned numerous times before, one of the problems with the negative interest rate policy is that it operates only on the supply side of the credit equation. Reluctant borrowers cannot be forced to take out loans and in the current environment, where uncertainty is at a maximum, households and corporates will not borrow under any circumstances. A bigger concern is that once rates fall into negative territory, they will stay there for a long time. That has certainly been the experience in Japan and the euro zone. Indeed, the experience of the last decade has been that central banks never seem to believe that the economy is strong enough to support monetary tightening. Consequently if interest rates do fall into negative territory, I fear they would not quickly rebound. As the respected head of the BIS research department, Claudio Borio, noted last year, “A growing number of investors are paying for the privilege of parting with their money. Even at the height of the Great Financial Crisis (GFC) of 2007-09, this would have been unthinkable. There is something vaguely troubling when the unthinkable becomes routine.”

As to whether a policy of negative interest rates has much economic effect, the jury is still out. Evidence from ECB researchers suggests that negative rates have boosted economic growth in the euro zone, although Italy might beg to differ. But no central bank is ever going to produce evidence that says its signature policy is not having the desired effect so we should treat the results with some caution. However, it does have a real impact on the banking sector. I do not expect the vast majority of the public to shed any tears for banks, which emerged from the 2008 crisis in better shape than they dared hope, but negative rates will squeeze margins. At a time when the BoE is exhorting banks to continue lending because “it is in their interest to do so”,  a policy which makes banks think more carefully about who they lend to is inconsistent with this strategy. Evidence from Sweden suggests that initial moves into negative territory do get transmitted to lending rates but subsequent moves do not. In other words, the monetary transmission mechanism can break down quite quickly. 

We should be under no illusions that policymakers will have to take all available measures to get the economy back on its feet. Given the huge surge in sovereign debt, governments and central banks are about to embark on a prolonged period of financial repression in order to reduce the cost of debt servicing. By doing so, governments will be able to reduce the extent of fiscal austerity required to control public finances when the economy finally recovers. If this means a period of negative interest rates, so be it. However, there is nothing to be gained from doing so for a prolonged period although if asset bubbles, screwing future generations of pensioners and failure to use the market mechanism to discipline risk taking are your thing, be my guest.

Everything in proportion

A couple of weeks ago I wrote a piece looking at the ruling by the German Constitutional Court (GCC) which suggested that the ECB should demonstrate proportionality in the conduct of its asset purchases. It is worth revisiting the question to focus on the legal issue of proportionality, which is not well understood by non-lawyers in the Anglo Saxon world (including me). The reason for doing so is that the objections raised can be applied to the conduct of monetary policy around the world, not just in the euro zone, and goes to the heart of my criticisms about the overly lax monetary policy followed by central banks over the past decade.

Proportionality is not a concept which is enshrined directly into English law, which instead leans more heavily on the principle of (un)reasonableness. English law uses a standard known as Wednesbury unreasonableness to determine whether an action is such that “no reasonable person acting reasonably could have made it.” In case you are wondering, it gets its name from a 1948 legal ruling on a case between Associated Provincial Picture Houses and Wednesbury Corporation. Proportionality, on the other hand, is designed to check the infringement of citizens rights by legislative, administrative or judicial authorities and is enshrined in German law as far back as the 1880s. Without being an expert on law, my understanding is that reasonableness is concerned with the process by which outcomes are derived whereas proportionality is concerned with the outcome itself.

The GCC made the point in its ruling that the ECB’s Public Sector Purchase Programme (PSPP) has a number of economic side effects to which the ECB has not apparently given sufficient consideration. Asset purchases result in low interest rates which produce “considerable losses for private savings” and allow “economically unviable companies to stay on the market.” I would not contest these views but the complainants who brought the case argue that the ECB has not provided evidence to suggest that these costs are outweighed by the benefits of its actions. With the ECB having held policy rates in negative territory since 2014 and buying assets since 2015 in a bid to hold down bond yields, the extent and duration of monetary easing is increasingly a cause for concern because it magnifies the adverse consequences of the policy.

This goes to the heart of my own criticisms of central bank actions over the past decade. Indeed, I have made the point repeatedly that once the economy started its recovery from the 2008-09 recession, there was a case for central banks to take back some of the emergency monetary easing, if for no other reason that they would have more scope for policy easing when the next downturn hit. I have also argued that low interest rates have side effects which central banks have studiously ignored, particularly when it comes to their impact on future pension income. I once raised this question directly with the central bank governor of one of the smaller European nations, who admitted that he was aware of the problem but had come to the conclusion that the short-term considerations were more important. Arguably, the current generation of central bankers has displayed a lack of proportionality in their approach to monetary policy and we may only be aware of the impact of recent actions in the long-term. Admittedly, the Covid-19 outbreak has changed the calculus as central bankers are forced to take unprecedented action but it does not excuse their actions over the past decade.

The complacency in this regard was highlighted in Mark Carney’s last speech as BoE Governor when he suggested that society as a whole has not lost out from low interest rates because “the vast majority of savers who might lose some interest income from lower policy rates stand to gain from increases in asset prices that result from monetary policy stimulus, since only 2% of UK households have material deposit holdings without material financial assets or property wealth.” As I have pointed out before, a large part of society may indeed have seen an increase in the value of their wealth holdings, but since a significant part of it accrues in the form of housing, it is not easily realisable. Nor does it benefit those at the lower end of the income scale who are unlikely to have a large stock of assets. Carney’s post-hoc justification for the actions taken during his time as Governor would fail the GCC’s proportionality text.

When it comes to central bank decisions to ramp up asset purchases, it is not just the ECB which shows a lack of proportionality. Central banks argue that their inflation mandate gives them scope to boost asset purchases in a bid to return inflation to the target. But the evidence suggests that the policy has not worked because the likes of the ECB and the BoJ, which pioneered the policy almost 20 years ago, have singularly failed to boost inflation back towards 2%. Monetary theories of inflation have simply not worked over the last two decades – there has been no evidence that increasing the volume of liquidity in the economy has boosted prices (other than for financial assets), as the chart below indicates for the euro zone. If that remains the case, the good news is that central banks can continue creating liquidity without any adverse consequences for their inflation mandate. The bad news is that it undermines the case for the policy.

Nor should we necessarily buy the argument that central bank actions do not represent deficit financing simply because asset purchases are not taking place at the behest of the government. It would be naïve in the extreme to think that central banks and finance ministries do not coordinate their policies, particularly when in the UK the Treasury indemnifies the BoE’s bond purchases. None of this is to say that central banks should not buy bonds. However, the excuse that this being conducted for inflationary purposes is starting to wear a bit thin. It is really about creating space in the bond market to allow them to digest the huge flow of debt issuance which, as I argued here, does not have to constitute monetary deficit financing.

But if you believe that central banks have no other mandate than controlling inflation, this is a difficult case to make. Indeed, in the euro zone it is legally impossible. However, if central banks can argue that their actions are designed to prevent a breakdown of the sovereign debt market, which would have significant implications for the operation of economic policy, this would be a more proportionate response than hiding behind the inflation smokescreen. It would also be more honest.

The limits of modelling

The British government has made it clear throughout the Covid 19 crisis that it has been “following the science.” But at this relatively early stage of our understanding of the disease there is no single body of knowledge to draw on. There is a lot that epidemiologists agree on but there are also areas where they do not. Moreover, the science upon which the UK lockdown is based is derived from a paper published almost two months ago when our understanding of Covid was rather different to what we know now. I was thus fascinated by this BBC report by medical editor Deborah Cohen, who posed questions of the current strategy and interviewed experts in the field who expressed some reservations about how the facts are reported. Whilst the report gave an interesting insight into epidemiology, it also reminded me of the criticism directed at economic forecasting.

One of the most interesting issues to arise out of the discussion was the use of models to track the progression of disease. The epidemiologists quoted were unanimous in their view that models were only useful if backed up by data. As Dame Deirdre Hine, the author of a report on the 2009 H1N1 pandemic pointed out, models are not always useful in the early stages of a pandemic given the lack of data upon which they are based. She further noted that “politicians and the public are often dazzled by the possibilities that modelling affords” and that models often “overstate the possibilities of deaths in the early stages” of a pandemic due to a lack of data. As Hine pointed out, epidemiological models only start to become useful once we implement a thorough programme of tracing and tracking people’s contacts, for only then can we start to get a decent handle on the spread of any disease.

This approach has great parallels with empirical macroeconomics where many of the mainstream models used for analytical purposes are not necessarily congruent with the data. Former member of the Bank of England Monetary Policy Committee Danny Blanchflower gave a speech on precisely this topic back in 2007 with the striking title The Economics of Walking About. The objective of Blanchflower’s speech was to encourage policymakers to look at what is going on around them rather than uncritically accept the outcomes derived from a predetermined set of ideas, and to put “the data before the theory where this seems warranted.”

I have always thought this to be very sensible advice, particularly in the case where DSGE models are used for forecasting purposes. These models are theoretical constructs based on a particular economic structure which use a number of assumptions whose existence in the real world are subject to question (Calvo pricing and rational expectations to name but two). Just as in epidemiology, models which are not consistent with the data do not have a good forecasting record. In fact, economic models do not have a great track record, full stop. But we are still forced to rely on them because the alternative is either not to provide a forecast at all, or simply make a guess. As the statistician George Box once famously said, “all models are wrong, but some are useful.”

Epidemiologists make the point that models can be a blunt instrument which give a false sense of security. The researchers at Imperial College whose paper formed the basis of the government’s strategy might well come up with different estimates if, instead of basing their analysis on data derived from China and Italy, they updated their results on the basis of latest UK data. They may indeed have already done so (though I have not seen it) but this does not change the fact that the government appears to have accepted the original paper at face value. Of course, we cannot blame the researchers for the way in which the government interpreted the results. But having experienced the uncritical media acceptance of economic forecasts produced by the likes of the IMF, it is important to be aware of the limitations of model-driven results.

Another related issue pointed out by the epidemiologists is the way in which the results are communicated. For example, the government’s strategy is based on the modelled worst case outcomes for Covid 19 but this has been criticised for being misleading because it implies an event which is unlikely rather than one which close to the centre of the distribution. The implication is that the government based its strategy on a worst case outcome rather than on a more likely outcome with the result that the damage to the economy is far greater than it needed to be. That is a highly contentious suggestion and is not one I would necessarily buy into. After all, a government has a duty of care to all its citizens and if the lives of more vulnerable members of society are saved by imposing a lockdown then it may be a price worth paying.

But it nonetheless raises a question of the way in which potential outcomes are reported. I have made the point (here) in an economics context that whilst we need to focus on the most likely outcomes (e.g. for GDP growth projections), there are a wide range of possibilities around the central case which we also need to account for. Institutions that prepare forecast fan charts recognise that there are alternatives around the central case to which we can ascribe a lower probability. Whilst the likes of the Bank of England have in the past expressed frustration that too much emphasis is placed on the central case, they would be far more concerned if the worst case outcomes grabbed all the attention. The role of the media in reporting economic or financial outcomes does not always help. How often do we see headlines reporting that markets could fall 20% (to pick an arbitrary figure) without any discussion of the conditions necessary to produce such an outcome? The lesson is that we need to be aware of the whole range of outcomes but apply the appropriate weighting structure when reporting possible outcomes.

None of this is to criticise the efforts of epidemiologists in their efforts to model the spread of Covid 19. Nor is it to necessarily criticise the government’s interpretation of it. But it does highlight the difficulties inherent in forecasting outcomes based on models using incomplete information. As Nils Bohr reputedly once said, “forecasting is hard, especially when it’s about the future.” He might have added, “but it’s impossible without accurate inputs.”

More courtroom drama

As central banks and governments around the world battle to put in place measures to mitigate the worst of the Covid-19 economic fallout, the euro zone once again finds itself in an extremely difficult position. Whilst EU governments have done much to provide a range of packages to support workers who would otherwise lose their jobs, the only pan-Emu institution capable of looking at the regional picture is the ECB which is, to use the English cricketing parlance, batting on a sticky wicket.

Yesterday’s ruling by the German Constitutional Court (GCC) ordering the German government to ensure the ECB carries out a “proportionality assessment” of its debt purchases threatens to open a new front in the dispute between northern and southern members of Emu. The GCC is concerned that the “economic and fiscal policy effects” of the bond purchases should not impinge upon the ECB’s policy objectives and it has threatened to block Bundesbank purchases unless the ECB completes a review within three months. Having watched the UK Supreme Court intervene in Brexit-related issues, rightly in my view, it is difficult for me to say that the GCC is wrong. It is, after all, merely acting in what it perceives to be Germany’s national interest according to domestic law.

But this is not the first time that the GCC has become embroiled in the euro zone debate, having generally taken a dim view of Mario Draghi’s “whatever it takes” policy to keep the euro zone together. A case was first brought to the GCC in 2015 when a group of concerned citizens claimed that the ECB was engaged in monetary deficit financing which runs contrary to the Maastricht Treaty. This was subsequently referred to the European Court of Justice in 2018 which ruled in favour of the ECB. However, the GCC has now ruled that the ECJ’s earlier ruling is “untenable from a methodological perspective” which is a much stronger tone than anything it has delivered previously.

Had the ECB not recently ramped up asset purchases, the GCC would not have had to reopen the debate. But it did, and we could now be looking at a major constitutional problem. In effect the GCC has questioned the primacy of EU law, which takes precedence over national law and was such a bone of contention for Brexit supporters in the UK. Panos Koutrakos, professor of European law at City University in London is quoted in the FT as suggesting this represents “the first case where a German court says the European court has no jurisdiction.” One does not have to be a lawyer to realise that if the court has no jurisdiction, the legal basis of the single currency is under threat. It could get a lot worse for the EU if this encourages other governments to ignore ECJ rulings. For example, it has raised fears that the Polish government, which is engaged in a dispute with Brussels over the independence of the judiciary, could continue to defy the ECJ which would undermine the basis of the EU itself.

The GCC’s actions serve further to underscore the notion that there is one law for the prosperous north and another for the highly indebted southern Emu economies. If Germany is going to chafe at the actions of the ECB, the likes of Italy are less likely to accept lectures from other Emu members regarding fiscal policy. German politicians are likely to argue that both the actions of the ECB and the Italian government are in breach of the legal foundations of the euro zone. They may even be right. But that is not how the episode will be seen in Rome which is already disgruntled by the apparent lack of solidarity regarding support for those economies hardest hit by Covid-19.

As it happens, I find it hard to believe that the GCC really wants to cause the single currency project to unravel. Consequently I expect that the ECB will come back with a justification for its actions which satisfies all parties and the single currency will remain intact. But this is perhaps the most serious illustration yet of the flaws of the project. There are no instances of a single currency project holding together in the long run without some form of fiscal union. It is precisely because no such fiscal body exists within Emu that the ECB has to act as it does. History records that the Gold Standard lasted for almost a century whilst the Latin Monetary Union endured for 50 years. But the Bretton Woods System fell apart after 26 years. The common factor in the demise of each of these systems were the strains inherent in maintaining fixed exchange rate parities without any instruments other than monetary policy. Moreover, Bretton Woods fell apart because the US, as the biggest economy, was no longer prepared to subordinate its domestic policy to maintain the international order. The lesson from history is that the longer term future of the European single currency remains in doubt unless reforms are made to the institutional architecture.

But are the German critics right in their view that the buying of assets represents monetary deficit financing? The ECB has always been careful to emphasise that its balance sheet expansion has been driven by the need to raise inflation to meet the 2% target. If we accept this as true, then it is acting in accordance with its monetary mandate and not out of any fiscal concerns. Furthermore, the ECB buys in accordance with the capital key which means that it has bought more German Bunds than corresponding securities from other Emu members.

However, the lingering suspicion remains that there is a gulf between what the central bank says in public and the underlying motivation for its actions. But as Gertjan Vlieghe of the Bank of England pointed out recently, looking merely at the balance sheet transactions is not a good guide as to what a central bank is doing because “when a central bank issues reserves, the main counterpart asset on the central bank balance sheet is generally some form of government financing … in a strict sense some part of government spending is always financed with central bank money.”  The crucial determinant of the action is “who makes the decision and with what objective.” Given the separation of powers between Emu governments and the central bank, it is hard to make the case that the ECB is directly engaged in monetary financing. However much the judges sitting on the GCC may know about the law and however much they may suspect the actions of the ECB, they cannot prove anything beyond reasonable doubt. This may be an instance where the court has bitten off more than it can chew.