Combining Fiscal Policy and Monetary Policy (w/ Lucrezia Reichlin)
ED HARRISON: Lucrezia Reichlan, it's very good to talk to you here on Real Vision. We are, I think, at a critical moment in Europe right now in terms of policy. I want to talk to you about what's going on in Europe but also about what you've been doing in terms of forecasting policy or actually the economy in general, and then what that means in terms of what you see going forward in Europe. LUCREZIA REICHLAN: Okay, Europe. You say we are at a critical point in Europe but I would say we are at a critical point, not all in Europe, but also in the US. If I have to look at the broad picture, I would say that actually, Europe, relatively speaking, looks quite good. If I have to see the rest of the world, it doesn't look as bad. I'm a little bit more optimistic on the broad picture on Europe. Now, if I have to look at the economic data there, I'm a little bit more pessimistic. My business, which is called Now-Casting, it's about reading the pulse of the economy on a real time basis. We analyze through the lenses of a model the data flow, through the publications of different data every day, something gets published, the model eats it up and produces a series of updates on the economy. We do that for all the main economy in the world. If I look at the European data, in what the data flow has been telling us, is that basically since the end of 2017, we have seen a very persistent softening of the data of the real economy. ED HARRISON: That precedes the whole China-US trade war. LUCREZIA REICHLAN: It does, it does. I think it's not just related to that. In fact, there are different views in Europe about especially on the German economy, which is the main economy, the engine of the European economy, and we have seen this slowdown, particularly in Germany. If you talk to the Germans, a lot of them say this is temporary, it depends on the trade uncertainty and so on. I just don't believe that story. I think this has been too persistent to make the stories believable. There is something else going on, which is probably related to structural crisis of the automobile sector. The general slowdown of the economy that you see that the IMF has review, also the forecasts downward for all the economies. Now, we have the lowest growth since the great crisis. Now, Now-Casting had detected that at an early stage. Actually, I remember talking in a big meeting here in New York, the beginning of 2018 and the market just didn't believe us, but we turned out to be, I think. Now, is this a catastrophic event? I don't think so. We are not necessarily seeing like a deep recession. I think this quarter, the German economy will be more or less a zero. There is a difference between a recession, consecutive quarters of negative growth and just very, very low growth in a persistent way for a protracted period of time. I think we are more in the latter category. That, I think is trend growth that has slowed down, and this has to be understood. I can't give you a number of conjectures, but I think it's more like we're becoming like Japan. This is what we have to worry about also from the policy perspective. ED HARRISON: There are two ways I could pivot off of that. One is go deeper into that, but actually, before I do, I want to go back to-- because you talked about 2018 the beginning and Now-Casting, it makes me think about tell us what is Now-Casting exactly? How can you use it for an economy? How far out can you go in terms of your projections? LUCREZIA REICHLAN: Well, the philosophy of Now-Casting it is that we are forecasting a present and a very, very short future, short-term future. ED HARRISON: In the short term future is? LUCREZIA REICHLAN: One, two quarters ahead. The present is already a big deal, because GDP is published only one month and a half after the end of the quarter, one month of data depending on the country, it gets very much revised and so you need to have a tool for forecasting the present. Well, I designed these tools like years ago, so that was a very natural academic research, building up models that could be appropriate for that problem. ED HARRISON: I heard that you are a pioneer in Now-Casting, that's right? LUCREZIA REICHLAN: That's right. Yeah. Basically, I did it. At the beginning, well, that was the product of academic research, but was also trying to adapt the academic research to the problem of central bankers where facing-- not facing, which is you see all these data, you're bombarded by data, but then at the end of the story, you have to form a view about where are we now. This is very important to set interest rate. Of course, you have to set a view about where the economy is going in the next couple of years. If you don't know where you are now, your forecast for the longer horizon are about to be wrong. ED HARRISON: It's not just for central banks. My understanding is you have a client base that is in the markets in particular who also think understanding that is important. LUCREZIA REICHLAN: That's right. Well, that was my background, I was more academic then, and then I was a central banker for a while and then I was a consultant for many central banks. Now actually, I am not doing this for central banks anymore, I have my own company and we sell the Now-Casting for basically all the economies of the G20 for investors. Our clients are basically hedge funds or sovereign funds or pension funds. A lot of our clients are actually systematic traders. They use our input. At the end, what we are selling is a string of data. It's a Now-Cast that we move all the time. Now-Casting the same thing, but we update our view in relation to the data flows. If you want, you can say that this is a signal about the pulse of the economy, a signal about the macro economy and we know the macro, the macro signal is very important also for financial markets, more than maybe what was taught in the past. That's what we're doing. Now, we are also trying to combine this with financial information to try to see whether the disconnect between risk appetite and the macro signals provides a signal that can be exploited in investing. ED HARRISON: Now, it sounds like trend data or the data and the trend of that data is very important in terms of what your assessment was from the beginning of 2018 to now, meaning that the ECB as an example was saying, actually, things are going to be fine. You were saying at the beginning of 2018, the trend is not in that direction. The trend is going slowly down. LUCREZIA REICHLAN: Well, more than the trend. Okay, I also use other models, but the Now-Casting model was saying that there was a-- the time, at the beginning of 2018, the we signal that the fact that the data were signaling negative seen. Now, two years later, I can see that the revisions were always in one direction. I think you can learn a lot from how you revise. We kept revising downwards. We do that on almost on a continuous time. That's a very interesting signal, I think, for investors. Now, institutions like Central Bank, the EMF, the ECB, they revise whenever they produce their forecast for the market and then if you look at it, a lot of their revisions have always been downer rubbish. Now, I also use other model, especially for forecasting inflation which look more at the underlying trend like you were saying and if you use those tools then you can see and that actually, you just observe GDP employment but you could actually also try to decompose the observations into some movements which are more high frequency, something like goes up and now and something which is more low frequency that move very, very slowly, that's what I would call the trend. Now, if you extract that trend, so of course, it's controversial how you're going to do it but if you do it and that you have a number of ways to verify your techniques for doing this, then you can say that in Europe, we have had a slowdown of trend growth, what the economies called potential growth at least since the great crisis. The scar that the great crisis put in, in our economy has been quite severe. In Europe, like the US, we had two crises [indiscernible], 2008 plus 2011, related to the debt crisis. We had like, two recessions so the legacy is quite heavy. I don't know, I don't think that it has been digested yet but this has affected the long term trend and this is what we're seeing now that we are-- the recovery has never really been very decisive. ED HARRISON: Going back to what you were talking about at the outset then, you're relatively optimistic about Europe at this particular juncture, that is relative to other economies. When you talk about the trend being down, how do you reconcile those two? LUCREZIA REICHLAN: No. Okay, in terms of economic number, the trend growth in the US is slightly higher. There are different reasons for that, including demographic. In terms of what that means for the European citizens, GDP is not the only metric for [indiscernible]. We have less skewed income distribution, a much more balanced society, much more protection for people in terms of social security and some. No matter how much our divisions of course, also in Europe, we have lots of issues, but I think that our society is more cohesive. ED HARRISON: That is interesting, because now, we're moving into the political economy realm because that is big topic here in terms of when I said that Europe is facing a crossroad so to speak, it does seem like the very recent period has seen a coming together on a political economy front within the Eurozone. If you look at, for instance, data on the citizens of Europe and what they think about the Euro since the crisis, the sovereign debt crisis, people are much more positive about the euro. It seems like there is that cohesiveness, and the question is, is how does that play out in terms of likely Eurozone reformation that's necessary to help the economy going forward? LUCREZIA REICHLAN: Yeah, you're right. Definitely, there is much more trust now in the common currency than there used to be a while ago. Of course, we need to reform the economic governance of the monetary union. I think that is difficult for Americans maybe to understand what are the issues, what are the problems of having a common currency but not having a common federal state, so that all the fiscal decisions are decentralized at the level of the national state. ED HARRISON: What are those problems? What is it that are the most salient problems in the way that the Euro architecture is now? LUCREZIA REICHLAN: Well, let me just give you some example. Central banks during the crisis, and they have expanded a lot their scope of action, everywhere in all jurisdiction, the balance sheet have expanded, they have implemented policies, which were quite innovative and I think that was the right thing to do. They have a very important function in avoiding a total meltdown of the Economy, especially in 2009, but also going later on. The more they expanded their scope of their action, the more they had an effect on distributions and this distribution effect in Europe means that some countries gain more than others and some sectors of society gains more than others. This has created some tensions and we have-- because there are national interests that are not-- there are still different national interests even if we have the same money, of course there is a big divide between the debtors and the creditors for example. We now have negative interest rate and the bankers are not happy with negative interest rate, insurance companies are not happy with negative interest rate, but where there is debt, those guys are happy. This creates tension. Countries are divided among countries which are creditors and countries which are debtors, it's not a very clean division because there are also division within countries, but clearly, Italy for example, my country, has a public debt which is above 130% GDP. Clearly, the low interest rate policy of the ECB is giving it a big boost, and the Germans are worried that this will create moral hazard which means incentives for the Italians to misbehave and to overspend and so on. Then if these would lead to a debt crisis in Italy, this will have consequences also for the Germans and the rest of the Europeans. This is the discussion that has paralyzed in the past. Now, the German economy is also slowing down, and everybody's pushing the Germans to expand their fiscal policy because monetary policy cannot be the only game in town. They have the so-called fiscal space to do it because their debt level is very low, but they don't want to do it because the Germans don't like that. ED HARRISON: If they don't do it, then who will? Because we were talking about this in the telephone earlier, I think that the German point of view-- and I'm dialed into the German point of view, is that look, 60% debt to GDP and 3% deficit. Those are the numbers that are enshrined in the treaty. If we're not the ones who are saying these numbers matter, then who else will? It was terrible when we-- under Schroeder and the French under Chirac, violated the deficit hurdles, now, we're not going to do that again. We're going to stick to it and therefore, act as an example for everyone else. LUCREZIA REICHLAN: Yeah. I have a lot of sympathy for the attitude that the Germans have with respect to rules. You have treaties, you have rules so either you change the rules, or you follow the rules. If I had to look at the situation today, I would say let's change the rules, because those rules were designed in the '90s, where the problems were very different. We were, like Europe, like other economies, we're coming out from the experience of high inflation and so design-- the way in which we designed the mandate of the European Central Bank was very much with that problem in mind. The fiscal rules were designed because the big problem at the time was feared was debt sustainability. Today, we're facing very different problems. We have a very low inflation. People don't want to spend, they prefer fair to keep their money at negative interest rate rather than invest. The externality is quite different, so we need to spend, we need to put money on the table, we need to sustain aggregate demand. Also maybe we need more public intervention in a number of areas. I think the deep the cause of why companies do not want to invest in private investment is very low in Germany and in Europe in general, is that there is a lot of uncertainty about all the big transformation technology. We talked before about the car industry, but also climate change, which is a huge concern and maybe in Europe, we are much more sensitive to that problem than in the US since you worked out on the Paris Agreement. Well, I don't know about the population, but definitely our administration is less sensitive than the Europeans in general are to this problem. We know that something will have to be done on climate change so that will mean a lot of transformation, painful transitions for a lot of sectors and so on. If we want to push the economy, then we need more public guarantees. We need the public sector to say we will be there as an insurance to make sure that-- we are facing big externalities and when we have these externalities, there is a case for more public intervention. ED HARRISON: Do you think that public intervention, if and when it comes, will come before a recessionary crisis or something, a debt crisis, whatever it might be, is on the doorstep or do you think that European policymakers would be proactive in creating the rules that allow that physical space to be utilized? LUCREZIA REICHLAN: Well, I don't believe there will be ever an agreement, not in the next few years, an agreement to have an instrument to do common stabilization policy at the physical level. However, because there is too much fear that this will mean too much risk sharing between countries, there is no enough democratic accountability for that differently. We cannot have a super national instrument of that kind without having the vote of the taxpayers that will legitimize something like that. On the other hand, I think that, and the president, new president of the commission has been very clear on that, that we will have a big investment program related to climate change. I think that there are lots of issues of the size of the program, how it's going to be finance and so on. I think there will be an effort in that direction. I think climate change maybe will be the vehicle for some fiscal push. ED HARRISON: Interesting. There's also on the banking side, a problems. I think I would look at it from a twofold perspective. One is about capital. The second is about the structure of the banking sector. That is, is that as compared to the United States, the banking sector within a common currency is balkanized. The question becomes, how much of an impediment is that to growth in Europe? What are the solutions to that problem that is on the one side, capital and the second, the balkanization? LUCREZIA REICHLAN: Yes, that's a very important point because if you think of risk sharing across different areas, there is fiscal but there is also the financial. Europe is overbanked. Our financial sector is based more on banks than on the capital market and that's a big difference with respect to the US. We have to-- and banks, there are issues about having too much banking because that correlate banks are also-- they hold sovereign debt. When we have fragile state that makes banks fragile and when we have fragile banks that make states fragile, so there is that correlation that we have to break. To break that means that we need to have more cross border banks, we have to hold diversified portfolios and not just the national banks holding their own sovereign bonds and being exposed excessively to the local economy. We need to break the balkanization. To break the balkanization, we introduce a number of reforms since 2014, the banking union. We now have a common supervisor which has been a huge step forward. There are some tools which are still lacking, for example, we do not have a common deposit insurance like in the US. We have some rules for banking resolutions but they are not working very well. We don't have a common backstop which is large enough to face a possible crisis of a big bank. We need to complete the banking union and there is some willingness to go in that direction and we need also to develop the capital market. Now, to develop the capital market, I think one issue is that there is no euro bond, there's not a common safe asset in Europe. This is something that is really not going-- there is no political willingness to make a big step forward in that direction. ED HARRISON: And the Germans will call it debt mutualization? LUCREZIA REICHLAN: They will call that debt mutualization and there have been a number of proposals to create some synthetic asset which would combine the different sovereigns and then with some trenching but this is a lot of financial engineering at the end of the story. If there is no political willingness to share risk across countries, I think it would be very difficult to go in that direction. I'm not particularly optimistic about capital markets. ED HARRISON: Can we use Deutsche Bank as an example here, because that's an institution actually I used to work for a long time ago and the interesting bit is it's within Germany, which is considered one of the countries that's most aggressively negative on debt mutualization, common deposit backstop, etc. Germany, Deutsche Bank could benefit from cross border action increasing capital at the institutional level. They're emblematic of what the problem is within Europe relative to the United States. How do you solve a problem like Deutsche Bank? LUCREZIA REICHLAN: Well, Deutsche Bank has a lot of problems, which are also specific to Deutsche Bank. In fact, if we think you asked before, what is the problem of-- it used to be that the Italians had the most fragile banking sector. Now, I'm not sure this is the case. The big elephant in the room is Deutsche Bank. They will have to end the ER in the process of changing the business model quite radically. In general beside the-- the question is do we want more cross border banks, or do we want national banks? Now if you have a unified financial market, ideally you would want to have more cross border banks. It's not entirely uncontroversial though because you know that the big banks are also too big to fail and then there is those other issues. Let's assume that big banks are more efficient to be demonstrated, but we want cross border banks for risk sharing its own then we really need to have some tools so that it would be clear what happens if there is a crisis. Then the answer to-- in here, there is a conflict between the home and the host. The countries where there is the subsidiaries and the countries where the holding. This contrast between the home and the host, that is what made it difficult during the crisis, for example, for a big bank to optimize liquidity and capital. I was a board member of UniCredit for nine years. UniCredit is a cross border bank and during the crisis, the Italian bank which is where the holding is could not benefit from the cheap liquidity of Germany because even the regulators would not allow this optimization within the group. This is understandable because they host and the home, they would have different interest in case of a big bad event. What is the answer to that problem? Well, to hold more capital at the holding the level of for example. These are the things that we are discussing. I think they're entirely solvable issues. There is also the issue of, of course, of the common deposit guarantee. I think more than that is the question of where do you want to put the capital and how, if we are going to go in the direction of more cross border, you need to have more tools to make sure that all the incentives are aligned. ED HARRISON: Let's move to a third topic that's somewhat related to the banking sector. I think maybe the vehicle to do that is through a recent paper that you had with regard to banks and interest rates, that what's happening with regard to interest rate spreads and the effectiveness of monetary policy in Europe is different than it used to be or than it is in the United States. That was my read of what you had to say that you did an analysis that showed that there were still some problems with regard to the effectiveness of monetary policy transmission. Can you talk a little bit about that? LUCREZIA REICHLAN: Yeah. Well, we are now experimenting with a negative interest rate, which is something that the US didn't do or haven't done yet. Then this is controversial. Is it working or not? Now, I think it's probably too early to say. Now, the European Central Bank has done very interesting studies looking at the data on each single institutions to see what do banks do when they're faced with negative interest rate? What they show is that the strong banks, they are able to pass it on to corporate and while it's the weak banks are the ones which are hit. There is a really big difference on-- so then you could argue, okay, that's fine because we are overbanked so maybe, the weak banks are not sufficiently efficient and so, we shouldn't worry too much about those banks. Now, having said that, it is not clear what is the magnitude of that effect? Also, of course, there are many issues to avoid and that there would be a big preference for cash for example. Then the other issue is that our banks or bank be able to-- the banks which are stronger will be able to exploit arbitrage opportunities through lending and borrowing, big banks of different jurisdictions. Of course, there, yes. In principle, yes. This is how the mechanism should work that even if the markets are balkanized, this is actually impaired. This is all very recent. It needs careful understanding of the numbers but what we should not do is just listen to the European banks and the insurance companies that they are very powerful lobbies and they say no way, this is destroying us and so on. The answer to that is okay, try to be more efficient. Actually, I was very impressed by the fact that the head of the Banking Association was Jean, who is the CEO of UniCredit said no, low interest rate is good for us because there are generally an equilibrium effect. If it helps the economy, it helps the banks, so the question is does it help the economy? ED HARRISON: That is the question because now that we are faced with zero percent growth in Germany and lower trend growth and Europe overall, the question then becomes, what if fiscal policy, if the hands are tied on fiscal and you're not getting a supranational infrastructure program in the near term, who steps into that void? What tools do they use to step into that void? LUCREZIA REICHLAN: Well, fiscal policy, we already commented on, I'm not particularly optimistic. The countries which have more fiscal space have to go for it. We'll have to see what Germany will end up doing. There is also all the new projects on climate change as I commented, but the monetary policy can probably do more and the problem is that political limit is not a technical limit. Central banks could increase the monetary base permanently, could take the money and put it in the hands of the people. They could buy green bonds, they can do all things, but we are reaching a political limit in which a lot of the governors especially who're known in Europe, they don't want it anymore. More than him this time, I think the last set of measures that the ECB implemented, they passed with nine votes against so this has been a peek in the position to the president. Christine Lagarde, the new president, who is going to start the basically next week, she will have to confront a very divided governing council and she will have to solve mostly, basically a political problem. I think her program will have to basically construct a new consensus and also, she will have to review the strategy so that this is one of the things that everybody wants at this point. I think that Mario Draghi was very effective in a constructive ambiguity type of situation in which basically, as long as inflation is below 2%, then we can do whatever we want, because our mandate is to have inflation close to 2%. Now, inflation has been below 2% for a long period of time. That communication is not that persuasive anymore, convincing anymore, because it's not possible that since we are below 2%, then we can finance whatever. We will have to put some other pieces of some added constraints or some other ideas into this strategy, into the mandate or the ECB. Just to have an inflation, [indiscernible] probably is not enough. I think that around the revision of the strategy, probably there will be an important discussion, which will also be politically colored. ED HARRISON: Yeah. I saw that even the French Central Bank head was arguing with some of the Northern European heads that yes, we need to rely more on fiscal policy a.k.a. go away from Draghi's policy. They were saying to Christina Lagarde, we know that you're coming in, and we want to just prime you that we're not in line with where Draghi was going. This is the time for change. In terms of that change, what do you think that she would had? What's going to happen? How is Christine Lagarde going to change the ECB, if you could predict? LUCREZIA REICHLAN: I think that she's a good politician, she has a lot of experience in politics more than in monetary policy, so probably this is the skills we need now. She will continue to say we need to have more fiscal policy, but of course, you can say that as long as-- at least, Draghi has said that for a long time but if they don't do it, they don't do it, then what? I think she will have to work closely to the European institution if we have on the line that the president of the commission to make sure that some fiscal capacity is produced at the level of the commission and with the governments or the union. In terms of monetary policy, she will have to start derivation of a strategy and around that, to construct some new consensus. ED HARRISON: Could she go more negative? LUCREZIA REICHLAN: I think she could. I think she could. It's difficult to forecast. I don't know her enough in terms to understand what she would do, but probably she will be less daring, and then she will be more conservative I was saying. More conservative, if I can see how the IMF operated during the debt crisis, after all, we have that points of observations from her leadership in that episode. I would say that she would go a little bit more with the mainstream than Draghi has done. ED HARRISON: Well, it's been a very good discussion. I want to thank you for coming on. I think that we definitely still are at a crossroads, but you seem very optimistic about, at a minimum, the political economy parts for -- LUCREZIA REICHLAN: Relatively speaking. ED HARRISON: Relatively speaking. Thank you. LUCREZIA REICHLAN: Thank you. Thank you.