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Fiscal policy and monetary policy according to Philip Lane, Chief Economist at the ECB

Jean-Pierre Dumas

January 17, 2023

In this rich interview, I would like to focus on one point, made by P. Lane, related to fiscal policy and its relationship to monetary policy. P. Lane recognizes that debt ratios in some EZ countries have to come down. No need to use the ECB econometric model to know which ones: Greece (public debt ratio 178%, 2022), Italy (147%), Portugal (115%), Spain (114%), and France (112%).

These high debt ratios are due to low growth (Italy) and high fiscal deficit (for too long). When Mr. Lane says that QE was implemented because the inflation rate was too low and the so called “natural” interest rate was negative, I am wondering if he does not forget an important point that cannot be acknowledged by a central banker. In my view, QE was also implemented by central banks (CBs) (the Fed to start with) to finance huge fiscal deficits after the 2008 financial crisis. When these CBs noticed that this huge increase in liquidity (liquidity is not money supply) has no effect on inflation they continued playing the music. They thought that they had found the philosophical stone. It seems that the US has pushed the envelope a bit far. The fiscal deficit for the US was $6500 bn from 2020 to 2022 (9.8% of the US GDP over the three-year period), and $2800 for the EZ (5.3% of the EZ GDP, same period), it is normal that with such deficits you have some inflation.

Therefore P. Lane considers rightly that “In the end, everything has to be anchored on sustainable debt levels”.Unfortunately, all EZ countries are not Ireland which was able to go from a debt ratio of 120% of GDP in 2012 to 47% in 2022 (73-point decline in 10 years).

Source: International Monetary Fund, World Economic Outlook Database, October 2022

If countries like Ireland, Netherlands, Malta, Germany, Lithuania, Latvia, Luxembourg, Estonia, Slovak Republic, Finland, and Austria, “can respond aggressively to large shocks, such as the pandemic or the energy shock”, others cannot (Portugal, Belgium, Greece, Italy, France and Spain) and they implicitly expect the ECB to continue to finance their deficits which is anchored in their economic policy (the pay as you-go pension scheme with an increasing dependency ratio combined with a define-benefit system has the effect of making the system loss making. For example, in France each year, part of the pensions of former civil servants is financed by public debt. This can only increase with the decline of the working population). In addition, population has been accustomed to receiving subsidies for any shocks (covid, inflation, gasoline price increases) this is the “whatever it costs policy”. There are no reasons that we will not face other exogenous shocks (the increase in energy prices is not over if China resumes its normal activity. The coming “economic fragmentation” in the US, Europe and China is a factor of price increase).

So the ECB authorities are well aware that some states (the big ones and the most indebted ones) will not accept the Troika's rule, like Greece and Ireland, if they are in debt distress. The spread of the rates between the southern and northern countries will widen. To avoid this spread, the ECB has invented a "new instrument" called the Transmission Protection Instrument (TPI)”. This instrument allows the ECB to do selective QE in favour of the most indebted countries. It is therefore a strong signal to the governments of large countries that they can continue to run deficits without problems, as they will be "bailed out" by the ECB.

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