THE FINANCIAL FALLOUT
Covid-19 has left the financial system in a state of shock and the European Central Bank faces a prospective crisis, writes Colm McCarthy
Dan O’Brien and Colm McCarthy on an economy in freefall
FACEBOOK founder Mark Zuckerberg gave the world the motto ‘‘Move Fast and Break Things’’, celebrating the disruption culture of the Silicon Valley innovators. The things Zuckerberg proposed to break were the out-dated business models of stuffy old offline competitors, not the architecture of the international trade and finance system. If there can be a motto to guide Europe through the Covid-19 epidemic, it should be ‘‘Move Fast, and Break as Little as Possible’’. Don’t damage the channels of international commerce, and don’t place strains on government funding and the banking system, inflicting on the shrunken economies a financial crisis to accompany the unfolding public health tragedy.
Whether European governments have obeyed the injunction to move fast on fighting the virus remains to be seen. Some have moved faster than others but at EU level they may be breaking things, intent on risking an avoidable financial crisis in the Eurozone. In the aftermath of the post-2008 crash, the European Central Bank under Jean-Claude Trichet moved slow, and broke the sovereign bond market. Last week, his successor Mario Draghi, he of the ‘‘whatever it takes’’ speech in July 2012 which saved the Eurozone from break-up, likened the current emergency to a war. Central banks have always financed governments without hesitation in wartime and Draghi knows his economic history.
Following the Glorious Revolution of 1688, William III arranged to sell debt (the royal origin is why it is called ‘‘sovereign’’ debt to this day) through a syndicate of London merchants, many of them members of parliament. The syndicate morphed into the Bank of England, and the outstanding securities came to be known as the national debt. The best measure is the net financial obligation of the state, including the central bank, to non-state debt holders domestic or foreign.
The first run-up in Britain’s national debt financed the War of the Spanish Succession, pitting Britain and its allies against France. The resulting Treaty of Utrecht in 1715 gave large parts of French North
America to Britain, along with Gibraltar, all that remains.
Assorted military adventures through the 18th Century, including the 1756 to 1763 replay against France, the American War of Independence and the Napoleonic wars brought Britain’s debt to an estimated 240pc of national income immediately after the victory at Waterloo in 1815. This is almost double the current debt ratio in Italy, Europe’s likely epicentre for financial contagion. Britain’s debt was reduced gradually over a full century in time for World War I, which added over 100 GDP points in just five years. By the end of World War II in the late 1940s the figure was back to well over 200pc.
At the onset of the financial crisis in 2008 the number had again been reduced to a safe level around 40pc, has since risen to about 80pc and will exceed 100pc, perhaps by quite a distance, once the coronavirus recession has been contained. It has finally begun to dawn on people that a V-shaped recession is not happening — the decline has been almost vertical — and a nice symmetric U-shape with just a few months on the bottom is another delusion. In Ireland the fall in employment in a few weeks exceeds what took almost three years in the post-2008 crash. The most likely outcome is something like Nike’s swoosh logo, a calamitous drop followed by a slow and drawn-out recovery.
Every European country faces a large increase in the budget deficit, adding to debt ratios already stretched in many cases. The 19 countries in the Eurozone face an extra problem. Since they have no currency, they have no central bank, at least not in the sense that the central bank can do what the Bank of England did to finance wars. It bought government debt, in domestic currency, and financed others to do so, until the war was over. Whatever it takes.
Britain won its wars (bar an away defeat against the USA), managed to run balanced budgets or surpluses, grew GDP and got post-war debt slowly under control without default or hyperinflation. The other tactic, if you lose the war, is to default, inflate the debt away, or both. Mario Draghi is correct to use the analogy of war to characterise the economics of the coronavirus recession in Europe. A war is a sudden supply shock as real productive resources are commandeered for non-market purposes (killing foreigners). On this occasion real productive resources, on a colossal scale, have been idled deliberately by governments to save lives, including foreigners.
There is no unwelcome deficiency of demand that could be remedied through a conventional relaxation of fiscal policy. Demand is constrained by supply, not the other way around, and the interesting question is whether supply capabilities can be preserved through what could be a prolonged downturn.
The Central Bank report last Friday suggests that the Irish Government could be adding €20bn or more to the debt mountain this year and it is difficult to see how further additions can be avoided. Every other country in Europe will be doing the same thing. This is not an asymmetric shock, affecting one or a small number of Eurozone members, it is a common shock affecting all, but potentially terminal for the common currency if the ECB fails to do what needs to be done. What is needed is not a Eurobond, call it a Coronabond if you like, issued by the European Stability Mechanism, an institution designed for yesterday’s problem, targeted interventions in problem countries. These bonds would require guarantees from weak as well as strong members, ranking ahead of normal bondholder claims and damaging the credit profile of Italy and other weak issuers.
Route one is for the ECB to emulate what central banks will do in Japan, the USA, the United Kingdom and elsewhere, fund the government, all 19 governments in the ECB’s case, through capping the interest rate that the weakest will have to pay.
That means a willingness to support the sovereign bond markets without limit and without conditions. The ECB’s chief economist, Philip Lane, put it like this on March 13: “We will not tolerate any risks to the smooth transmission of our monetary policy in all jurisdictions of the euro area. We clearly stand ready to do more and adjust all of our instruments, if needed, to ensure that the elevated spreads that we see in response to the acceleration of the spreading of the coronavirus do not undermine transmission.”
The ECB could usefully relax its inflation target too. After wars there has often been a burst of inflation as pent-up demand is released into an economy whose productive capacity takes time to recover.
This could happen again but the persistent failure of the European Central Bank to hit the 2pc inflation number has seen the Eurozone price level fall well short. The price level, taking 2013 as the starting point, is eight or nine per cent lower than it was supposed to be, increasing the real burden of debt in the countries with heavy borrowings.
The ECB is overdrawn on the inflation account, and a few years at 4pc or 5pc would repair the damage.