Striking contrast between US and Euro Policy response

The consensus view on the economic impact of the Covid pandemic envisages a plunge in economic activity across the global economy in the second quarter of the year, followed by a recovery in the latter part of 2020, with no significant damage to potential growth. This may prove optimistic but also appears  the prevalent view in equity markets, with investors ignoring  data which does point to a very severe hit to output and employment, believing  that short lived. Policy makers have reacted, of course, and we have seen a significant fiscal and monetary response, although that has varied across the globe and the contrast between the US and the Euro area (EA) in that regard is particularly  striking.

On the monetary side the Fed  initially reacted to a scramble for dollar liquidity by pumping trillions of dollars into markets that were effectively seizing up, including the provision of dollars to other central banks across the globe. It then embarked on a broad purchase of assets, ranging far beyond government bonds  and mortgage backed securities,  to include bank loans and even junk rated corporate bonds,  taking the extraordinary step of buying the latter through ETF’s. As a reult the Fed’s balance sheet has grown by over 50% since the turn of the year, currently standing at $6.6 trillion from $4.2 trillion. As a result excess reserves held by commercial banks have doubled in just two months, to $3 trillion, while the money supply (M2) has grown at an annualised 16% pace over the past three months. Monetarists might worry about the implications  for inflation down the line but markets certainly feel it is supportive of asset prices.

Monetary policy has also been supportive in the EA , but the scale of the response is quite different; the ECB’s balance shee has increased too but by only 12%, to €5.3 trillion from €4.7, and the amount of exces liquidity in the system has not greatly changed.  It is also worth noting that interbank rates  have actually risen (3-month euribor rose to -0.16% last week before falling back to -0.22%) implying that all  EA banks are not deemed equal, while it is reported that US banks are pulling back their EA lending.  Of course the ECB is constrained in its response relative to the Fed in that it can provide  short and now longer term loans to banks  but cannot buy unlimited amounts of assets, as its public sector purchases are contrained by the capital key  and issuer limits. It has sought to circumvent the latter with its PEPP scheme, but that is limited to €750bn , at least for now.

On the fiscal side the EU has struggled to find a mechanism to provide support across member states, with the result that each county has sought its own solutions, although the degree of fiscal space available varies greatly. A €540bn package was produced to great fanfare by euro governments, but as with many such announcements the devil is in the detail- in this case €100bn was in the form of employment grants from the European Commission, with the rest in the form of EIB loans and  ESM loans, with the latter unlikely to be taken up. Grants rather than loans became the big issue at the recent EU summit, with headlines emerging about a package amounting to ‘trillions’ but nothing was agreed and it seems that  funds will eventually come out of the EU budget, with the issue of loans versus grants kicked down the road.

In the US the  Federal fiscal response has been quicker and substantially larger, with a series of packages emerging, the largest being €2 trillion. Again one should note that some of this is in the form of loans, albeit guaranteed by the government on attractive terms. That said , the IMF expects the US fiscal deficit to exceed 15% of GDP this year, which is more than double that forecast for the EA. . In any downturn automatic  stabilisers kick in ( tax receipts fall and government transfers rise) so fiscal deficits will increase  anyway in the absence of any discretionary policy action but the difference between the respective US and EA deficits is clearly not just cyclical.

 

Fiscal support is from taxpayers, not helicopters

The economic impact from  Covid-19 has already been unprecedented in its severity and speed, prompting governments across the globe to offer  extraordinary levels of fiscal support to ameliorate the impact on households and businesses. As a consequence budget deficits will soar, raising the question of how they will be funded. The fact that some of the additional government spending has come in the form of cash payments to households or direct wage support has prompted references to ‘Helicopter money’, although that is to misunderstand the concept and indeed how these deficits will be funded,which as it stands will be from existing and future tax payers  albeit with the caveat that central bank actions can reduce the interest bill.

The term ‘Helicopter money’ was coined in 1969 by Milton Friedman, musing on the impact of  a one-off increase in the money supply, in this case via the drop of €1,000 dollar bills from the sky (it would simpy raise prices he thought). More recently the idea re-emerged  in the noughties as central banks started to worry about deflation and  has also become associated with Modern Monetary Theory or as some call it, the ‘Magic Money Tree’. This contends that money is essentially a fiscal creation and that a government with monetary sovereignty, such as the US or UK,  can fund additional spending by printing money rather than through taxes, albeit in the modern world through the central bank simply crediting a balance in the State’s account at the bank. Note that euro member states do not have monetary sovereignty and the ECB is prohibited from monetary financing.

What is striking  though is that,to date at least, the huge sums that governments have committed to spend are seen to be funded by borrowing. The partial payment of wages by the State, for example, is no different from the payment to recipients of unemployment or other social welfare i.e. it is  a transfer from tax payers, paid out of current tax receipts or from future tax receipts by borrowing.

Consequently, Government debt levels will rise steeply, as in many cases deficit ratios  will balloon to double digit levels, although that depends on the duration and  severity of the recession unfolding before us.  In Ireland’s case the Central Bank (CB) has  recently projected an Exchequer  deficit around €20bn this year, which if broadly right implies a major increase in debt issuance. That had been put at up to €14bn, against €19bn due for redemption because  the NTMA had intended to run down some of its cash balances which amounted to €15bn at the beginning of the year. The implication now  is that a €10bn reduction in cash balances would still require around €30bn in issuance of new debt.

The NTMA have already issued €11bn to date and of course the interest rate on the debt is very low, albeit higher than it was a few months ago, so debt is being redeemed and replaced at a much lower cost, reducing the average interest rate on the outstanding debt, which is now down around 2%. QE is helping of course, which allows the ECB and the (CB) to buy up to a third of any issuance and hold up to a third of debt issued. That means that most of the interest on that QE debt is paid to the CB , boosting its income and hence largely returned to the Exchequer as CB profit.

This is not helicopter money as the bonds at issue will have to be repaid, most likley by  issuing new debt on redemption, which implies QE will be never ending unless economies are strong enough for private investors to buy all of the new debt issued. There is also an additional contraint on QE in the euro area  in that bond buying is broadly proportionate to each member’s population and GDP, which determines the ‘Capital Key’ ( share of the ECB’s capital subscription). In Ireland’s case it is around 1.5%, so Irish government bonds held under QE amount to €34bn out of a total of €2261bn .

The Covid pandemic and resulting economic crisis has prompted the ECB’s new Pandemic Emergency Purchase Programme  (PEPP)  which does  appear to include the capital key constraint but not the issue limit. It is designed to run this year with a size of €750bn  and therefore in theory could buy most or all of a new bond. Ireland might  issue €15bn in a  30 year pandemic bond, for example,   and the ECB could buy say €12bn, with most of the interest therefore paid to the CB. All this helps to reduce interest costs but is not the same as printing money to give to individuals, via bank transfer or from a helicopter.