The guest commentary below was written by written by Daniel Lacalle. This piece does not necessarily reflect the opinions of Hedgeye.
In an article published in the Frankfurter Allgemeine Zeitung, Isabel Schnabel, Member of the Executive Board of the ECB states that governments taking more debt now should not be a concern, and would strengthen the central bank independence in the future.
She claims that “the decisive fiscal policy intervention in the coronavirus (COVID-19) crisis strengthens the effectiveness of monetary policy and mitigates the long-term costs of the pandemic.
With targeted, forward-looking investment, not least under the umbrella of the EU Recovery Fund, governments can foster sustainable growth, increase long-term competitiveness and facilitate the necessary reduction of the debt ratio once the crisis has been overcome”.
The problem of Ms. Schnabel’s article is that it ignores the facts and bets the future of the central bank independence on a rigorous, profitable and successful level of government investment that has never happened and is even more less likely to occur now.
Ms. Schnabel should be, in fact, warning about the enormous risk of malinvestment and excessive debt that may arise from the European Recovery Fund implementation and the massive deficit spending arising throughout the Eurozone.
Why? Because she has the empirical evidence of the failure to achieve the virtuous growth and debt reduction she expects with the examples of the Growth and Jobs Plan of 2009, the Juncker plan and the enormous rise in deficit spending between 2009 and 2011 among many European nations. Once growth recovered, three things were evident:
- Most Eurozone countries maintained a level of deficit spending that elevated the debt to GDP in growth and recession periods because governments get used to spending more in boom times and even more in recession times. Ms. Schnabel expects of the Eurozone governments a level of discipline and fiscal prudence that only Germany and Holland implemented. With the budgets of Spain and Italy soaring without control, the idea that governments will spend money wisely and productively is not just wishful thinking, it is negated by the evidence of the past.
- The debt burden created by the “decisive fiscal policies” in recession times not only stays and grows but leads to rising taxes afterwards to “reduce the deficit” that hinder growth and job creation. The eurozone already suffers from an uncompetitive tax wedge in many countries, and unproductive deficit spending followed by taxes on investment and job creation has become a norm. The eurozone growth has not been slower and with higher unemployment than the United States due to bad luck, but because of the constant crowding out of wealth and productive capacity on the side of many governments.
- Ms. Schnabel should know by now, after years of stimuli, that governments do not “foster sustainable growth and increase long-term competitiveness”. In her article she mentions that productivity growth has been stubbornly weak, yet she does not see any connection between low productivity and the increasing role of government spending and monetary policy in incentivising low productivity via negative rates and public intervention. Government investment cannot boost growth and competitiveness enough to cover the massive debt burden that is being built because governments do not have the incentive to be productive and generate investments with real economic returns. The incentive to malinvest and perpetuate overcapacity is enormous because governments do not suffer the consequences of bad investment decisions, taxpayers do.
Ms. Schnabel knows that the experience of previous crises shows us that no, in times of weakness governments should not decide to supplant the private sector.
Governments do not have better or more information than the private sector on where and how to invest and have all the incentives to malinvest and overspend, because the ECB continues to support by buying sovereign bonds and cutting rates. The evidence of rising debt, poor productivity and higher unemployment than its peers of the eurozone should be enough of a warning sign, and the example of Japan should serve as a red flag as well.
Ms. Schnable knows that the elevated levels of debt to GDP incurred by most eurozone countries will not be reduced to pre-pandemic levels, even less to sustainable levels, with constant public deficit spending promoted by monetary policy and with calls to questionable “investments”. Ms. Schnable may ask herself one question: If all those massive “investments” that some eurozone governments are announcing are profitable, productive and will promote long-term growth and jobs, why none of them had been implemented in the 2014-2019 period despite low rates, high liquidity and the Juncker plan to support?
Because the vast majority of what most eurozone countries will include in the “investment” recovery plan are not productive, profitable or growth-oriented projects.
Ms. Schnable should know that many eurozone countries like Spain have relied on monetary policy to disguise structural challenges, and that monetary policy has gone from being a tool to buy time to implement structural reforms to a tool to avoid them. Ms. Schnable should also know that the euro is not the world reserve currency and that replicating the Federal Reserve’s policy does not make governments spend wisely and productively. The ECB balance sheet is now 57% of GDP and negative rates have been there for years, and the result has been disappointing growth in the good times and a larger crisis in the bad times.
The rising role of governments in the economy is not a coincidence. It is one of the leading causes of the eurozone’s weakness, when governments already consume more than 40% of annual GDP.
The evidence of the past shows us that governments do not create jobs, growth or competitiveness. An IMF paper analyzing government spending plans concluded that “the effect of government consumption is very small on impact, with estimates clustered close to zero… which raises questions as to the usefulness of discretionary fiscal policy for short-run stabilization purposes” (Ilzetki et al, 2011). The eurozone has showed that negligible positive impact for years.
Unconventional monetary policy was not implemented because governments spent too little, but because governments spent too much, and could not finance themselves without central bank quantitative easing and asset purchases.
The ECB will not strengthen its independence with large deficit spending and massive debt from member states. It will be even more dependent on disguising the insolvency of countries once, when Covid-19 stops being an excuse, debt and government spending will continue to rise.
This is a Hedgeye Guest Contributor note by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the most recent Escape from the Central Bank Trap. This piece does not necessarily reflect the opinions of Hedgeye.