Keynote Lecture Juergen B. Donges

This lecture was written on 17 June 2021, but Professor Donges died a few days later without being able to deliver it at the Foundation, as he had done every six months since 2003. May he rest in peace.

Juergen B. Donges

Cologne Institute for Economic Policy

AND AFTER THE PANDEMIC, WHAT ECONOMIC POLICIES?

Forecasts conditioned by pandemic uncertainty

Leading international and national economic forecasting institutions believe they see the light at the end of the tunnel and are betting that economies, after the historic collapse of GDP in 2020 caused by Covid-19, will soon return to the path of economic growth.

• For example, the International Monetary Fund (World Economic Outlook, April 2021) predicts that the global economy could grow by 61 Q3GDP this year and by 4.4 Q3GDP next year. The European Commission (Economic Forecast Spring 2021, May) is along the same lines.
• Among the advanced countries, the United States would lead the way (6.4% and 3.5%, respectively), while the Eurozone would show more moderate records (4.4% and 3.8%).
• Among the emerging countries, China would once again stand out in terms of economic dynamism. China, the source of the pandemic, was the only country that did not fall into recession in 2020 and achieved modest growth of 2.3%. It is now forecast to grow by 8.4% this year and 5.6% next year.

It remains to be seen whether such positive scenarios are inspired more by wishful thinking and pandemic fatigue than by reality. For there is much uncertainty about how the Covid-19 virus will continue to evolve, now with the emergence of new variants (British, South African, Brazilian, Indian strains). That uncertainty is real can be seen in how difficult it is for different countries to predict (i) when economic activity will return to pre-pandemic levels (2021?, 2022?, 2023?), apart from the United States, Germany and China which will achieve this already this year, (ii) to what extent the productive fabric has been damaged and growth potential weakened as a result of business failures, and (iii) how employment will evolve, both for the unskilled and for the skilled and self-employed. Moreover, it remains a big question mark whether governments will succeed in closing the income inequality gap between different groups of the population, which has widened markedly with the pandemic.

Given so much uncertainty, one wonders how useful the economic forecasting exercises we are used to are. What seems likely today may be a dead letter tomorrow. But some quantified guidance is required for important practical tasks. For example (i) the government, to plan its projects (infrastructure, pensions, education, defence and security etc.), (ii) companies, to take decisions on investments and the hiring of personnel in the future, and (iii) the social partners (trade unions and employers), to negotiate wages and other working conditions. But even so, forecasts should be treated with great caution. They are, among the different scenarios that are being considered, the most likely to be realised, but this probability may be very low. Be prepared that the current forecasts may be revised (upwards or downwards) significantly at any time.

This does not preclude addressing a fundamental question: that of future macroeconomic policies, once the pandemic is under control. Specifically, what needs to change in monetary policy and fiscal policy, which are currently fully absorbed with the fight against the adverse impact of Covid-19? Let us take a step-by-step approach and look first at European monetary policy.

 Normalising European monetary policy

For the time being, the ECB will keep its monetary policy on the ultra-accommodative course of recent times (0% interest rates, multi-million dollar purchases of sovereign bonds), just like the Federal Reserve, the Bank of Japan and the Bank of England. The monetary authority's aim is, on the one hand, to keep sovereign debt risk premiums under control and, on the other hand, to keep the sovereign debt risk premiums under control,

ensure that the current liquidity difficulties of many companies as a result of the health measures do not lead to solvency problems that would have a negative impact on banks (non-performing loans) and would abort the recovery of the economy.

But the ECB must also consider when and how to bring monetary policy back to normal. Officially, the turnaround has no date yet. But it is clear that the normalisation of monetary policy cannot be postponed indefinitely. The unintended side-effects are too serious. One need only think of the distortion of the allocation of capital to productive purposes, the penalisation of individual savings, the risks for the banking sector of changes in interest rates, and/or the inflation of financial and real estate assets with the danger for the stability of the financial system that this entails. To ensure that all this does not happen, it is essential to re-establish the driving mechanism of real interest rates, including the 'Taylor rule'.

The risk that the unprecedented injection of liquidity into the monetary system could sooner or later turn into a real threat of inflation is not on the agenda of the European Central Bank's current concerns. But it should be - given the intellectual legacy of the research on the 'quantity theory of money' of illustrious economists such as Irving Fisher and Milton Friedman (Nobel Prize in Economics 1976).

• Much of the expansion of the monetary base (currently about 5 trillion euros) relative to output is not needed for economic transactions. It is simply parked in banks that cannot find sufficient opportunities to lend to businesses and households.
• But when the pandemic is under control and the current health restrictions are lifted, the hitherto suppressed consumer durables spending will increase, which will have an impact on prices. In addition, with the demographic decline in the labour force, there will be significant wage increases in the labour market, which will have an impact on the price level. Nor can it be ruled out that energy prices will tend to rise permanently due to the adoption of regulatory measures against climate change ('Pigou tax' on CO₂) or decisions by OPEC and its allies to cut oil production.

In other words, the recent inflationary upturns we have seen not only in Europe but also (and more intensely) in the United States and China can still be attributed to one-off effects such as the cyclical rise in the price of various raw materials (oil, industrial metals) and the rise in food prices due to an increase in demand as a result of the Covid-19 effect.)

• This need not automatically create a process of sustained inflation, especially when there is still a high level of idle capacity in production. But sooner or later the current inflationary effects could prove to be more permanent and raise the inflation expectations of economic agents, given the excess money created by Central Banks.
• The monetary authority could then be confronted with a serious dilemma: If it tries to suppress inflation, the extensive safety net of attractive financial conditions it has created for the state and businesses would collapse. This would cause major financial difficulties for sovereign and private debtors and endanger the viability of the financial system. If, on the other hand, no action is taken against inflation, it would accelerate, become a serious surreptitious tax on wealth and savings, benefit debtors (especially states) and cause all sorts of distortions in the relative price system, all of which would end up slowing growth and job creation.

Therefore, prevention is better than cure. If, for example, the ECB were to wait to adopt measures until economic agents' inflation expectations rise, it might be too late to avoid inflation. The same applies to the Fed, but not to the People's Bank of China, which has distanced itself from the ultra-expansionary monetary policy of its Western counterparts and is preparing to tighten its own monetary policy.

One aspect of major interest is the new monetary policy strategy that the ECB has been considering since the beginning of 2020 and intends to present in the autumn.

• As will be recalled, the ECB had decided in 2003 to define the inflation target for the Eurozone as a whole as an inflation rate (Harmonised Index of Consumer Prices) 'below, but close to 21 Q3QPT' over the medium term. Former ECB President Mario Draghi interpreted this definition as an inflation rate of 1.91 QE3T. The aim was to avoid both significant inflation and significant deflation. In fact, the inflation rate has been comparatively low over the last few years (in the order of 1% per annum). Dangerous deflation for the pace of economic activity and employment in the form of a recession has never occurred (contrary to constant prophecies that it would).
• The focus is now on the redefinition of the price stability target, following the model set by the US Federal Reserve in August 2020: the target would be pursued 'symmetrically', i.e. the ECB could tolerate, after several years of inflation below (almost) 21Trp3T, inflation above 21Trp3T (i.e. the ECB could tolerate inflation above 21Trp3T after several years of inflation below (almost) 21Trp3T).Average Inflation Targeting). The problem is that what at first sight sounds like a gain in flexibility may at the end of the day result in higher degrees of arbitrariness that reduce the reliability and predictability of monetary policy for economic agents. How long would the inflation rate remain above 2%, how and at what cost would it be reduced, how far would the ECB be able to resist political pressure not to raise interest rates (even if inflation expectations recommend it) and not to end Treasury bond purchases (even if this would be an overstepping of its mandate), and how far would the ECB be able to resist political pressure not to raise interest rates (even if this would be an overstepping of its mandate)?

Another question is whether the European monetary authority should also pursue other EU objectives, such as full employment and ecological sustainability, with a new monetary strategy. In my opinion, no, because it would not be able to do so effectively. Others are responsible for this: The level of employment depends first and foremost on wage policy, which is the responsibility of the trade unions and employers' organisations. Ecological sustainability is primarily determined by the price of CO₂ in combination with environmental regulations, which is in the hands of governments. The ECB should concentrate on what it is mandated to do by the European Treaties and where it has the capacity to manage effectively: to ensure price level stability in the Eurozone.

What would be out of place is to consider the cancellation of public debt that the ECB has been hoarding in recent years through its unconventional policy of quantitative easing (some 2.3 trillion euros) and which has made it the largest creditor of the Eurozone member states. Such debt cancellation has been called for with much media noise by hundreds of left-wing economists, sociologists and political scientists from several countries (including Spain), led by French professor Thomas Piketty (of the Ecole Supérieure des Sciences Sociales, Paris), in a Manifesto entitled 'Cancel the public debt held by the ECB' (5 February 2021). The protesters seem to have been schooled in the simplistic and methodologically fragile so-called Modern Monetary Theory (by Randall Wray, Matthew Forstatar and others) according to which there is no need to worry about high government spending and deficits because they can always be financed by issuing money. Among the Spanish signatories of the Manifesto is the president of the PSOE, Cristina Narbona. Both ECB President Cristine Lagarde and ECB Vice-President Luis de Guindos immediately rejected it, and rightly so: writing off public debt would be illegal because it would amount to financing of state budgets by the ECB, which the EU Treaty and the ECB Statute explicitly prohibit. Moreover, it would be counterproductive because it would weaken the incentives for inexorable structural reforms and raise fears among private financial investors about imposing debt write-downs at their expense (as happened in Greece in 2011/12), which would push up risk premia on new Treasury bond issues to the detriment of highly indebted countries such as Italy and Spain. And of course there is nothing to be gained by calling into question the reputation of the ECB and the euro, as Piketty and his cohorts do. Fiscal policy must at all costs be prevented from dominating monetary policy.

Consolidating public finances

On the fiscal policy side, governments will continue to use the full arsenal of available instruments at their discretion this year to contain the contractionary effects of the pandemic on activity and to sustain employment as much as possible. The European Commission has temporarily suspended (in March 2020) the rules of the Stability and Growth Pact limiting government deficits and public debt (ratios of -31 Q3GDP and 601 Q3GDP respectively) in the Member States.

• As a result, national public accounts are significantly out of balance.
• The Eurozone's common government deficit has increased to -7.2% of GDP in 2020 (2019: -0.6%) and the government debt ratio to 101.7% of GDP (2019: 85.9%). Spain is above the European average, with a government deficit of -11% of GDP (2019: -2.9%) and a government debt of 120% of GDP (2019: 95.5%). Germany showed in 2020 records below the European average: a government deficit of 4.2% (2019: surplus of 1.5%) and a government debt of 71.2% (2019: 59.6%).
• These fiscal indicators will worsen further this year, as governments maintain their extremely expansionary fiscal policy stance. It should be remembered that the Reinhart-Rogoff rule on the sustainability of public debt establishes a ratio of 90% over GDP, beyond which things can get very complicated for governments in terms of fiscal margins for their policies.

The deactivation of the European fiscal rules should not be interpreted as a 'free bar' for unbridled public spending.

• On the contrary, the Commission must press governments to implement strong fiscal consolidation measures once the pandemic is under control and the economic recovery has taken hold.
• Although current fiscal support cannot be withdrawn prematurely, in order not to create deflationary risks, measures should not be allowed to last too long because they could (i) keep non-viable firms in the market because they lack a future business model ('zombie' firms), (ii) distort competition in markets, and (iii) hinder the necessary structural changes in production and employment and the corresponding reallocation of resources towards new and promising productive activities. The same applies to unemployment benefits. If these benefits are repeatedly extended, as has been the case, this reduces incentives to look for work, which not only entails an unsustainable fiscal cost, but also increases long-term unemployment (one year and more) and thus hampers the growth potential of the economy.

With the economic recovery, tax collection will improve, which will make things easier.

• But this does not mean that the challenge of controlling unproductive and structural public expenditure will disappear. In other words, significant primary surpluses will be needed for many years to come. Public spending, if it increases, should only do so at a lower rate than GDP growth.
• Transfers from the post-pandemic European Recovery Fund should be earmarked for projects with significant added value for Europe and a high multiplier effect (say in the areas of digitalisation, environment, health).

While fiscal support cannot be withdrawn prematurely, it is important to avoid that (i) the measures last too long, (ii) keep non-viable firms in the market because they lack a viable business model, (iii) distort competition, and (iv) hinder the necessary structural changes in production and employment. The same applies to unemployment benefits. If these benefits are extended again and again, as has been the case, they reduce incentives to look for work, which not only entails an unsustainable fiscal cost, but also increases long-term unemployment (one year and more) and thus hampers the economy's growth potential.

And it should not be overlooked that continuity sine die and even the extension of public subsidies would be a disguised move towards socialism in the economy (under the popular slogan of the 'supremacy of politics'). Empirical evidence shows that this would be a model of state interventionism in the market that is not conducive to allocative efficiency and is therefore lethal for economic growth and the creation of adequately paid employment. It would create a subsidised society in which incentives for entrepreneurship, self-employment, motivated work, individual savings, people's creativity, and the adaptation of the labour force to changing circumstances resulting from technological progress, economic globalisation and ecological transition would disappear.

A new topic of discussion has recently been launched by US Treasury Secretary Janet Yellen: she proposes the introduction of a global minimum corporate tax rate (multinationals).

• The idea has been welcomed, as might be expected, by the finance ministers of major countries who would see their revenues increase and be better able to finance ambitious public investment projects (such as the one announced by Biden to upgrade and modernise infrastructure in the US economy). The OECD has long called for such a tax regime arguing that tax competition would be 'ruinous', although the empirical evidence does not support this (see tax competition between Swiss cantons, between US federal states and between autonomous communities in Spain with the Basque Country, Navarre and Madrid at the forefront).
• The overall minimum rate sought has not yet been quantified. President Biden advocates 21%. In Europe, the governments of Germany and France have called for a rate of 15%, other countries for 18%. The governments of the smaller countries prefer the tax to be as moderate as possible. In fact, no one knows for sure what the appropriate level of this tax would be.

Finance ministers are interested in abolishing tax competition between countries so that multinational companies, in order to reduce tax burdens, stop moving their tax headquarters from countries with comparatively high taxation (e.g. Germany with a rate of 30%) to countries with low rates, say to Ireland (12.5%) or the UK (19%). And this is the problem with the proposal: Abolishing tax competition is, like any abolition of competition, counterproductive: (i) it leads to more unproductive public spending instead of restricting it, (ii) it promotes less profitable employment instead of fostering it, and (iii) it stifles forward-looking business investment instead of stimulating it.

It remains to be seen whether Yellen's proposal succeeds. I have my doubts. Governments, starting with the G7 and G20, have to agree unanimously on the minimum rate and ultimately consensus would be needed among the 37 OECD countries in order to prevent evasion - a Herculean task.

It becomes more complicated if the US tax authorities insist, as they have been doing since Obama, that large multinational companies such as Mercedes, BMW and Volkswagen should be taxed directly on their profits in the country where they produce and sell (the United States) and not where they are based (Germany); this would mean a significant loss of tax revenue in Germany, which the Federal Government would not be prepared to accept.

Boosting productivity

In order to strengthen the resilience of economies, it is essential to raise total factor productivity and in the medium term to achieve sustainable growth of their potential. The key is technological progress, with innovations in processes and products, as already explained by the great Austrian economist Josef Schumpeter more than a hundred years ago and is today one of the pillars of the 'endogenous growth theory' (pioneered by Professors Philippe Aghion and Peter Howitt in 1998). In addition, venture capital (venture capital) and innovative entrepreneurs (start-ups). In all these respects, Europe lags behind the US, which is also reflected in the fact that productivity gains are slower here (0.5% per year) than in the US (2%). Among EU countries, the strongest R&D performance is recorded in Germany, according to the Bloomberg Innovation Index 2021 (fourth in the ranking Spain ranks 26th (34th in the world); Spain ranks 26th (34th in the world); Spain ranks 26th (34th in the world). ranking world).

The greatest potential for accelerating productivity gains currently lies in the cross-cutting technology offered by digitisation (cloud computing, big data, artificial intelligence). This technology can be applied in many sectors with very low fixed costs and information costs, as demonstrated by countries at the forefront (USA, Sweden, South Korea). Teleworking, which has become widespread in these pandemic times, is part of the digitalisation processes and can be a significant source of productivity improvements due to the gains in effective working time that come with the elimination of commuting and business travel. However, the lack of personal contacts to some extent hampers the dissemination of knowledge.

For digital technology to spread rapidly, it is inexorable to increase public investment in digital infrastructure (including cyber security in 5G networks) and to remove bureaucratic obstacles to its use. In parallel, digitisation in public administration must be promoted (E-Government) and in the health sector (especially in hospitals and primary health care). It goes without saying that it is essential to make the acquisition of digital skills a key subject in schools, universities, dual apprenticeships and further training programmes for workers. In this respect, the recent proposals of the European Commission and the European Parliament under the slogan of Europe's Digital Decade deepening the European single market in the digital dimension. But these proposals should not remain well-intentioned declarations, but should be translated into concrete and far-reaching actions.

In conclusion, the key to returning economies to the desired path of sustainable growth lies in the effectiveness of population vaccination against the coronavirus and the early achievement of 'herd immunity'. Recently we can see an increasing willingness of the population to be vaccinated and significant improvements in cumulative incidence rates. But economies remain fragile due to continuing epidemiological uncertainties. Macroeconomic policies can alleviate the situation to some extent, but there is a limit to everything. We will have to be patient and hope for a strong recovery as soon as the restrictions imposed by Covid-19 are finally lifted, but nobody knows when.