The Irish economy grew by 3.4% in 2020, outpacing China.

Ireland appears to have been the only country in the Euro Area to record economic growth last year, with real GDP rising by 3.4%., which also means it outpaced China (2.3%). Nominal GDP is now €366bn, and it has actually doubled in seven years. The 35% rise recorded in 2015 plays a significant part of course but excluding that year the average rise in nominal GDP since 2013 is 7.2% and 6.2% in real terms, a remarkable performance.

Growth in 2020 was achieved despite big Lockdown related falls in domestic demand, including a 9% decline in consumer spending and a 10% fall in building and construction. The contraction in investment spending on machinery and equipment was larger, at 25%, while the decline in Intangibles (R&D and Intellectual Property ) was 35%, bringing the total fall in investment spending to 32%.

Government spending rose substantially, including large transfers to support household and businesses, and the increase in Government consumption in the national accounts was 10%. However, the Government component in GDP is so small now that the net impact on growth in 2020 was less than 1%. The main reason the Irish economy grew last year was the performance of the export sector, which due to its composition (chemicals, pharma, and ICT) performed very well despite the pandemic, rising by 6.2% in volume terms , with all of the growth coming in terms of merchandise exports.The corollary to that export gain was higher multinational profits but overall factor outflows actually fell, albeit offset by a larger fall in investment income inflows , leading to a big rise in net outflows. Consequently GNP growth was much weaker than GDP, at 0.6%.

The 2020 growth figure was achieved despite a large seasonally adjusted 5.1% fall in GDP in the final quarter, although the component breakdown is a little odd, in that exports grew by over 4%, but that was outstripped by a 24% increase in imports. The latter is subtracted from the GDP measure but looks high relative to the consumption and capital formation figures and we would not be surprised if the Q4 figure is not revised upward.

Absent that revision the big fall in the final quarter left the annual change in GDP in q4 at just 1.5%, a much lower carryover effect than we anticipated. Growth in GDP over the first half of 2021 will be flattered by positive base effects but the economy is now entering the year with far less momentum which allied to the Lockdown over q1 has negative implications for the 2021 growth figure as a whole..

Wealth ,Debt and Snowballs

In the past week the Central Bank published its latest figures on the balance sheet of Irish households, covering the third quarter of last year, while the Department of Finance produced its annual thoughts on Government debt. The latter tends to generate more column inches, raising the question of whether the level of debt owed by the State is too high or in some way represents a major problem, while the ongoing extraordinary shift in household debt and wealth receives less attention.

On the latter Irish households are continuing the process of deleveraging which started in 2009 with debt of just over €200bn, equivalent to 210% of disposable income at the time. Since then the economy has recovered and then boomed, moving to full employment in 2019, while interest rates have fallen sharply , including mortgage rates which are currently at all-time lows, yet household debt has continued to fall in cash terms, declining to €130bn on the latest figures. The change in term of disposable income is more pronounced still, with the ratio at 107%, back to the range last seen twenty years ago.

Housing is the main asset on the other side of the balance sheet, and the property crash was the main driver of a collapse in net household wealth (i.e, assets minus debt); from 2008 to 2012 if fell from over €700bn to a low of €430bn. Since then the recovery in the housing market has been a big driver of the rise in household net wealth, which reached a new high of €831bn in q3. The long rally in equity markets has also helped boost pension assets while the past year has also seen a significant increase in holdings of liquid assets in the form of cash and bank deposits. This had started before Lockdowns but in effect households have become forced savers given the reduced options to spend.

As a result households now hold €163bn in cash and deposits which exceeds debt owed by €33bn, a far cry from 2008 when debt exceed deposits by €85bn. Of course these are aggregate figures and some households have few or no assets and a lot of debt while the reverse is also true. The change has been bad news for Irish banks, which have seen assets fall and deposits surge in relation to shrinking loan books.

The path of Government debt has been very different. Gross debt soared in response to the financial crash, reaching €215bn or 120% of GDP in 2015. From there it fell a little in cash terms but very significantly relative to GDP given the growth of the Irish economy, declining to 57.2% in 2019, one of the lowest ratios in the EA and below the 60% figure required under the Stability and Growth pact. The Irish Government responded to the Covid pandemic by significantly increasing transfer payments to households and firms, as elsewhere, and the debt figure ended last year at some €220bn, albeit still with a low debt ratio of around 61% given that Irish GDP probably grew.

Government Debt is potential problematical for two reasons. One is the annual cost of servicing it, which means Government spending diverted from other areas. That cost will in turn depend upon the debt stock and the average interest rate on that debt and thanks to the ECB the latter has tumbled; the average cost of Irish debt is now under 2% , less than half the rate in 2013, because Ireland can refinance maturing debt at a rate close to zero and even below for shorter dated borrowing. As a result debt payments costs the Government under 5% of total revenue, versus 17% five years ago.

Governments rarely run large budget surpluses for any period of time so debt is generally simply rolled over rather than repaid out of revenue i.e. if €15bn is due to mature in a given year the authorities will issue €15bn to fund it, plus any additional borrowing if there is a fiscal deficit. That raises the second issue for Debt- can the Government readily refinance maturing bonds. That depends on investor appetite and in general is affected by who owns the debt and expectations about repayment, with the debt ratio playing a key role in that expectation.

Japan has a debt ratio of 240% but few expect a default, in large part because most of the debt is held internally, by banks, the Central Bank, insurance companies and pension funds. So Japan owes the debt to itself and these holders are also far less likely to sell it before maturity. That example also highlights that expressing the debt relative to the population is not meaningful, as it ignores the ownership issue. In Ireland’s case domestic ownership is actually not high but over €40bn of the total is owed to the EU on very long maturities and of the €140bn of bonds at issue over €50bn is held by the Central Bank and the ECB .These bonds have to be repaid of course but the interest is largely recycled back to the Exchequer and the large holdings under QE and PEPP means less bonds available to investors who might sell before maturity, perhaps precipitating a spike in bond yields and hence raising issues about refinancing, as happened in 2010.

On the debt ratio itself, its evolution over time depends largely on two factors ( ignoring one-off impacts like asset sales) – the fiscal balance excluding debt interest (the primary balance ) and the difference between the rate of interest on the debt and the growth rate of GDP. In Ireland’s case, and indeed in many developed economies in recent years, the interest rate (r) is now well below the growth rate (g) and this ‘snowball effect, as it is known, has been a big factor in the fall in the debt ratio. So, let’s say,. Irish GDP grew at 5% a year over the next five years with the interest rate at 2%, the debt ratio would fall by around 3% a year, assuming a primary budget balance, down to 53% from the current 61%. By extension, given that snowball effect the Irish Government could actually run a primary fiscal deficit of around 3% per annum and maintain the existing debt ratio.

The fact r<g in many economies has been a big factor in changing attitudes to debt, with the IMF, for one, completely changing tack from its pro-austerity stance of recent years, now arguing for large fiscal stimulus. Of course rates may rise in the future and QE may one day end but that is likely to be some way off. So as it stands Ireland does not have a debt problem given the debt ratio , the interest rate and the ownership of that debt. Why then are some concerned? One answer is that it is argued GDP is not a good measure of Irish income and as such a better denominator to use is modified national income, a specifically Irish concept which adjusts GDP for various multinational related flows. On that metric the ratio is thought to be around 107% in 2020, a lot higher than 61% but still not excessive by EU standards. In this writer’s view the concept is not useful anyway and was an overreaction by the CSO to the 2016 GDP figures (the release precipitating the ‘leprechaun’ saga). No other statistical agency recognises the concept, it is impossible to forecast and in any event appears to have a very similar tax elasticity to GDP anyway (indeed Corporation tax is more closely related to GDP).

Irish economy again confounds, up 11.1% in q3

We have noted on other occasions that the Irish economy, as measured by GDP, behaves more like a secular growth stock than the cyclical entity forecasters generally assume, reflecting the strength and composition of the multinational export sector , driven as it is by ICT, Pharma and medical devices. The widely expected external trade downturn never materialised, which also raises questions about the forecast impact of Brexit on the export sector and hence the broader economy.

Exports rose by 5.7% in volume terms in the third quarter, which alone would have boosted GDP by 7.4%. Growth wa stronger still, however, as domestic spending benefitted from the re-opening of the service sector over the summer months. Consumer spending had fallen by 19% in q2 but jumped by 21% in q3, adding over 5 percentage points to overall GDP, while building and construction also soared, by 40%, although Government consumption was flat after rising by over 9% during the Lockdown in q2.

Spending on machinery and equipment also rebounded strongly in the quarter although multinational investment in R&D, by far the largest component of investment, rose only modestly, so reducing the growth in total capital formation to 4%. That also dampened imports, which rose by 1.5%.

The reported decline in GDP in the second quarter was revised to -3.2% from -6.1%, and the blow-out q3 figures left the annual change in GDP at 8.1%, despite the fact that investment and consumer spending are still down on last year. That’s plus 8.1%, with the average annual growth over the three quarters of 2020 at 3.6%, so absent an enormous fall in the final quarter growth is likely to be positive for the year as a whole. A better gauge of the income of Irish residents is GNP, which adjusts for net profit outflows, and the average annual change over the first three quarters is only marginally positive, albeit still a much better performance that the EU norm.

Inflation: Dodo or Phoenix?

In the late 1970’s and early 80’s annual consumer price inflation in Ireland hovered around 20% and it would have seemed fanciful to anyone living through that period there would come a time when prices would hardly change from one year to the next. Yet, annual Irish inflation since euro membership in 1999 has averaged 1.8% and has been lower still in the last decade , at just 0.5%. Of course Ireland has not been unique in this regard, with inflation in the euro area averaging 1.4% over the past decade or 1.2% excluding food and energy.

The Covid pandemic has added additional disinflationary forces, with the demand shock trumping that on supply, at least to date, and annual inflation is currently negative across the euro area, including Ireland. Some argue , though,that this long period of largely stable prices may be coming to an end, in large part as a consequence of the policy measures taken to combat the economic dislocation caused by the pandemic.

Inflation, as Friedman noted, is everywhere a monetary phenomenon and the money supply is certainly expanding at a rapid clip in developed economies; in the US broad money supply growth was an annual 23% in August, while the July figure in the euro area was over 10%, including 13.2% in Ireland. In fact most of this is driven by overnight deposits, as households, in particular , are effectively forced savers as a result of economc restrictions, leading to a rapid build up of monies in current accounts that would normally be spent.

How quickly these deposits will be spent on a return to more normal conditions is one question but the broader monetary argument is that banks in Europe and the US now have an unprecedented amount of excess reserves, which can be used to create loans and hence money, so the potential is there for a longer period of excess monetary growth and inevitable inflation.

The Monetarist case is based on the Quantity Theory, which has an identity at its core- the value of national income (PY) equals the money supply (M) times the average number of times that money circulates ( V, the velocity of circulation). The theory assumes that V is pretty stable which if true means that monetary growth above the potential growth of the real economy will push up prices. V can and does fall, however, so ‘excessive’ monetary growth may simply be offset by a fall in Velocity, leaving national income little changed.

It is also the case that bank reserves are a necessary condition for loan growth but not a sufficient one , as the ECB has found in recent years. Firms and households may not be wiling or able to take on fresh debt and banks may also be constrained by low profitability and capital issues, leaving monetary policy essentially pushing on a string..We have also pointed out in previous blogs that the huge fiscal stimulus seen in response to the pandemic is not funded by monetary creation, at least to date, and will ultimately be paid for by taxapayers, albeit at a borrowing cost kept low by central bank purchases of government debt.

In a world of globalisation and largely free trade any excess demand for goods in a given country can anyway be met by higher imports, with little or no impact on the price level. On that view a generalised rise in inflation across the globe requires the elimination of excess supply at a global level and as central banks have discovered this makes it extremely difficult to achieve a desired level of inflation with monetary measures alone. The pandemic has ceratinly impacted supply but it is not clear there will be a significant long term impact on global capacity. Absent that, the structural factors that have kept consumer inflation low may well continue to work. Asset prices are different, though, in that excess demand there can and does lead to inflation, because supply is constrained, such as land and housing in a given country or equities via buybacks. So liquidity can certainly drive asset price inflation , if not consumer prices.

Irish GDP falls 6.1% in q2 but consensus for 2020 will be revised up.

Irish GDP contracted in q2, as universally expected, but the 6.1% quarterly fall was not as severe as many predicted, although the first quarter is now also seen to have contracted, by 2.1%, instead of the initial 1.2% rise. On an annual basis GDP fell by 3.0% in q2 but this followed a 5.7% rise in the first quarter, leaving the average annual change over the first half of the year in positive territory, at 1.4%. The economy probably grew again in q3 and forecasts of contractions in the 8%-10% range over the full year now look far too pessimistic, with the consensus likely to move higher. Indeed our own forecast of -3.5% looks a tad low and we will revisit the forecast again, although with the caveat that the path of the virus remains the key uncertainty.

We have consistently emphasisied that Ireland’s GDP is largely dependent on exports and that the composition of that sector ( heavily weighted to Pharma, medical devices, organic chemicals and ICT) renders it far more resilient than both domestic spending and the export sector in most other developed economies. Consequently , although exports did fall in q2, the decline was modest compared to the trend elsewhere and left the annual change at zero, following a 6.5% rise in q1, which means that the substantial annual fall in exports envisaged by most forecasters is unlikely to materialise.

The Lockdown did have a significant impact on domestic spending of course, with personal consumption plunging by some 20% in the quarter, taking the annual fall to 22%. Spending on Building and Construction also collapsed, by an annual 35%, with a similar fall in residential construction. The other components of investment ( spending on machinery and equipment plus intangibles) also fell precipitously, by 75%, leaving total capital formation 71% below its level a year earlier. The only spending component of domestic demand to grow was government consumption, with an annual increase of 12%, a big acceleration from the 3% recorded in the first quarter.

The plunge in domestic demand was also reflected in Irish imports, with an annual fall of 37% in the second quarter. Imports are strongly affected by the capital spend from multinantionals, with most of the Intangibles component captured as a service import and as such GDP neutral, although adding huge volatility to the investment and domestic demand figures as well as the balance of payments.

The overall picture them is one in which domestic spending plummeted as a result of the pandemic and the lockdown but with an offset fom the export sector. The latter is what differentiates Ireland from its EU peers and is likely to ensure that the GDP fall here is much less severe than elsewhere, if indeed it falls at all.

Negative Rates Forever

The ECB seeks to set short term interest rates in the Euro Area via control over the amount of liquidity it supplies to the banking system, as the latter is required to observe a minimum reserve requirement, in turn related to the amount of customer deposits each bank holds. The current requirement is around €140bn in aggregate and currently banks have €3,000bn deposited with the ECB, implying excess liquidity of some €2,900bn. This will generally put downward presure on money market rates but there is a floor, in theory at least, which is the ECB’s Deposit rate, which has been in negative territory for over six years now . It was cut to -0.5% last September and if money market rates fell below that banks could borrow in the market and deposit back to the ECB at -0.5%, so this potential arbitrage will generally keep rates above the Deposit rate.

The scale of excess liquidity is such that rates are very close to that floor, nonetheless, with 3 -month euribor trading at -0.486% in recent days. Indeed one money market reference rate, the euro short term rate or €STR, is trading below the Deposit rate ( at -0.54%) because it includes non-bank borrowers, unlike the conventional euribor rates.

How long will these rates last? That ultimately depends on the ECB’s perception of the inflation outlook, but judging by expectations in the money market it will be years before we see a return to positive short term rates- the market is currently pricing in a 3 month rate of -0.125% in six years time. That may not transpire of course but as it stands it implies that rates are expected to be in negative territory for well over a decade, and not the short time period envisaged by the ECB when when embarking on that policy.

Does it matter? The standard ECB argument is that negative rates are just an extension of low rates and will eventually boost credit growth, economic activity and inflation. However, negative rates have put pressure on EA bank profitability in that they have indeed helped push down borrowing costs for households and businesses but , to date, at least, most banks have been reluctant to cut deposit rates for households by a similar amount, which would take them below zero. The ECB argues that this hit to bank margins can be offset by loan growth but negative rates send a signal to potential borrowers , implying a pretty dismal economic outlook and one not conducive to productive investment spending by the private sector. Of course if one also factors in the impact of the Covid pandemic it is difficult to see an explosion in credit growth any time soon.Not surprising , then, that EA banks trade well below their equivalents in the US in terms of equity valuation, with Irish banks at around 20% of their net asset value.

There are other issues, which will become increasinly pressing if negative rates are here for the long term. The ECB can provide liquidity but can’t direct where that goes and it may simply be used to bid up existing assets such as equities and real estate. Negative rates are also a massive challenge to the long established investment model of pension funds and wealth managers. That model envisaged say a 60-40 split betwen equities ( deemed higher risk) and bonds and cash but what happens to that model when the yield on the lower risk asset is actually negative ( as is the case with many EA government bonds) and where large deposits with a bank can be charged a negative rate. In other words a fund will lose money by holding cash in a bank or by lending it to the Government. This leads to the TINA (There Is No Alternative) case for taking more investment risk so pushing up equity valuations, real estate prices and lowering the yield on high risk corporate debt.

It is hard to see how the ECB can get out of the current situation, although it does seem reluctant to cut the deposit rate again, and the implicaions of negative rates for savers are not palatable. Commercial banks may well start to cut deposit rates into negative territory for household deposits with significant implications for high savings economies such as Ireland, where household deposits and currency exceeds debt by €21bn, and where deposits in Irish headquartered banks are €37bn higher than loans. The cost of borrowing for households is low, of course, and in Ireland that mainly flows into property but that is constrained by mortgage controls, which do not apply to institutional investors..

Irish Unemployment: 131,000 or over 1 million?

Unemployment in Ireland is officially measured in the quarterly Labour Force Survey(LFS), based on a sample of households, and the numbers in that category have to be both available for work and to be actively seeking it. The Survey also captures total employment, with the sum of those in work and unemployed defined as the labour force.

Prior to the Covid Pandemic and Economic Lockdown the unemployment figure had fallen to a 115,000-120,000 range, with the unemployment rate hitting a cycle low of 4.7% in late 2019. The first quarter of 2020 saw a modest tick up, to 123,000 , and an unemployment rate of 5%, with the universal belief that the following months would see a massive spike , a view reflected in most economic forecasts, which envisaged average unemployment rates of 15%-20% over the year.

The CSO issues a monthly estimate of unemployment, which is often revised based on the LFS when published, and it was a surprise to many that the increase in April and May was very modest ( a rise to 138,000) followed by a fall in June, to 131,000, with the unemployment rate easing back to 5.3% from 5.6%. On the face of it then, these figures are wildly at odds with consensus forecasts.

The CSO does provide an alternative measure, which takes account of those in receipt of the Pandemic Unemployment Payment, and that figure rose to a peak of around 600,000 in early May. However, those recipients do not meet the definition of unemployed as per the LFS so are not captured in the official figure. One option is to assume all are in fact unemployed ( which is unlikely to be the case)and so adding them to the official figure. The CSO use that approach to give an ‘upper bound’ for unemployment , resulting in a total of 695,000 in April and an unemployment rate of 28%.

The numbers in receipt of the PUP have fallen steadily over the past two months, as Lockdown eased, so the upper bound unemployment total in June had fallen to 560,000, with an unemployment rate of 22.5%. Two competing forces will impact that figure from here- the PUP figure will continue to fall as the economy re-opens but some firms wil either not emerge from Lockdown or do so with a reduced workforce, so boosting the official unemployment total.

The Live Register adds an additonal twist . This measures those claiming unemployment Benefit and Assistance and although not the official measure of unemployment ( the cycle low there was 182,000) the trend is used by the CSO to estimate the monthly unemployment figure . Again the Register picked up sharply in April and May ( to 226,000) but fell back again in June, to 221,000. When the PUP figure is added that total rises to 660,000, None of these figures take acount of those on a Wage subsidy scheme , numbering 382,000 in June, so if they are also added we arrrive at a grand total 1,041,822, with a peak of over 1,250,000 in April.

It is highly unlikely that everyone on a wage subsidy and in receipt of the PUP will end up unemployed so the 1 million figure is hopefully not reflective of things to come. At the other end of the scale it is not plausible that all will resume employment as before, so the official unemployment data may well start to tick up over the second half of the year. Nonetheless, estimates of the official unemployment rate for the year now look far too high , and it also may well be the case that unemployment on that definition will keep rising well into 2021, which again is contrary to the consensus .

Ireland only Euro economy to grow in first quarter.

Most developed economies saw contractions in the first quarter, with the Euro Area (EA) decline at 3.8%. A fall in Irish GDP was also widely expected ( the Department of Finance projected -5.0%), reflecting the lockdown which began in March, although the most recent data had shown quarterly  growth in industrial production,  a substantial gain in employment and  very strong performance from merchandise exports, driven by pharmaceuticals and medical devices. In the event Ireland appears unique in  the EA during the early phase of the Covid pandemic as the only country to record GDP growth, with output rsing by 1.2%. This  left the annual change in GDP at 4.6%,  and although it does not mean that the average figure for the year will also be positive ( the q2 decline in domestic demand is likely to be large) , it does reduce the possibility of a double digit decline, as seen by some forecasters.

In truth a wide range of outcomes is possible given that exports account for 130% of GDP, so dwarfing any impact from consumer spending or domestic investment. The type of  exports produced here by multinationals ( chemicals, pharma, business and computer services) does render them more resilient in the type of lockdown seen globally as a result of the pandemic, although contract or offshore manufacturing (largely in China) adds an additional degree of uncertainty to the export outlook. Indeed, the latter fell in the first quarter so reducing mechandise export growth to an annual 4% from the 12% recorded dometically. Service exports grew by over 10% and the volume growth for exports overall was 5.9% in annual terms, which clearly provides a massive boost to total GDP.

Imports must be captured as domestic demand or as an input into exports and so have no net impact on GDP. In the first quarter merchandise imports were flat but service imports rose by 69%,  driven  by  a very large increase in  the import of intellectual property, by a small number of firms. The corollary was a very strong increase in investment in Intangibles, and the CSO did not provide a figure for this or for spending on mechinery and equipment. We know that overall investment spending rose by 197% to €46bn, and that construction increased by over 8% to €5.6bn, leaving a residual of   over €40bn for Machinery, Equipment and Intangibles , and an annual rise of  286%.

Retail spending fell by 5.5% in the quarter, weighed down by a collapse in car sales,  and so a hefty fall in consumer spending was likely and duly emerged, with a 4.7% decline, taking the annual change also into negative territory at -2.5%. Consumption now accounts for less than a third of GDP however, and so even a fall of that magnitude was not sufficient to generate a negative print for GDP, although modified domestic demand, the CSO’s measure of domestic spending excluding the impact of multinationals on investment, did fall by an annual basis. by 1.2%.

The second quarter may well be different in that the fall in consumption and domestic demand is likely to prove strong enough to override  exports  and a double digit decline in GDP is widely expected , both for Ireland and across the EA. That may be the case  but an offseting factor here  may be a recovery in contract manufacturing exports from China. To reiterate; exports are key.

 

Euro Governments can run out of money

The euro zone  economy contracted by 3.8% in the first quarter which was much steeper than either the UK (-2%) or the US (-1.2%). Lockdowns are beginning to ease but the percentage fall in GDP could reach double digits in all three  economies in q2, given the collapse in activity seen in April. Budget deficits will automatically rise in such circumstances (tax receipts fall while transfers to the unemployed rise) but governments have also taken discretionary spending measures in order to support incomes, with the result that fiscal deficts are likely to be extremely large- the IMF forecasts an EA deficit of 7.5% of GDP, with the US at double that figure and the UK at 8.3%. The implication is that the discretionary fiscal effort in the EA  is much lower, in large part because the  EU as a body cannot provide much  budgetary support, leaving it up to individual governments to go it alone. Member states have varying degrees of fiscal space and all lack monetary sovereignty i.e. they cannot create money and so in theory could run out of funds to spend.

A ‘ €540bn stimulus package’ has been agreed by the EU but as is often the case with these initiatives the detail is less encouraging. A €100bn package of loans is on offer to support employment across the EU while €200bn of the package turns out to be EIB loans, with that figure deemed possible from €25bn in additional capital from member states. The final €240bn is again in the form of potential loans, this time from the ESM, although as yet no country has requested funds, with a perceived political stigma apparent given the Fund was set up to bail out countries unable to access the bond market.

The frustration of some EU States  with such ‘smoke and mirrors’ has been apparent, notably from Italy and some of its Southern neighbours, with a call for EU grants rather than loans, given the already high level of debt in many countries. The idea of ‘Corona bonds’ was floated , with the EU as a body guaranteeing repayment, but such debt mutualisation is seen as  anathema in some states, including Germany.

The EU does have a Budget of course but its annual spend is of the order of €160bn  which is just 1% of EU GDP. Moreover, Article 310 of the EU Treaty would seem to rule out running a Budget deficit and to date all spending is funded from current resources.

It was a surprise therefore when Chancellor Merkel and President Macron   unveiled a plan for a €500bn ‘Recovery Fund”, with debt issuance by the EU and the sums then distributed as grants. Some hailed this as a “Hamiltonian moment’ referencing the decision by  US Secretary of State Alexander Hamilton in 1790 to convert individual State debt into Federal Government liabilities. Opposition from other EU states has emerged , however, and it remains to be seen how events unfold.

The borrowing proposed under the Plan is modest enough (3% of EU GDP) and appears to be ‘one-off’, implying that bonds would be repaid from EU resources on maturity, rather than funded by fresh bond issuance, as is the norm for individual governments. In that case it is  bringing forward future EU budgetary spending, so other non-covid related  spending would have to  cut or additional resources raised from member states

The ECB has a role to play in that it could buy some of these EU bonds and is of course  already buying some of the debt of member states, although the German constitutional court challenge to the ‘proportionality’ of that policy has raised issues. Indeed some argue that the German willingness to accept some EU borrowing, however limited, is a realisation that  future ECB asset purchasing is problematical. Again it remains to be seen how the Court challenge will play out but ultimately the pandemic has exposed the fact that the EU, as currently set up, has very limited room to provide centralised fiscal support on the scale required in a crisis. That and the  ban on monetary financing leaves each member State dependent on their respective ability to borrow, so the fiscal support provided  is not unlimited as the money can run out.

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.