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Positive Momentum Encouraging the Role of the US Dollar

09 May 2013 Patrick Artus, Natixis

There are two issues that the US needs to address in 2013, public spending cuts and the debt ceiling. The US Congress will find a compromise, even if it is somewhat messy, because a fiscal shock would threaten growth.

I foresee a reduction in the public deficit of one point of GDP per year in 2013 and 2014, giving a deficit equivalent to 4,5% of GDP in 2014, which is easily financed in the US. This will cost 0,5% growth over the next two years.

After that, there are other outstanding issues regarding US public finances. The most serious problem, but that will not be discussed at the moment, is the sharp increase in public spending on health care, which will jump from 7% to 14% of GDP over the next twenty years.

The Americans know they have five years to address this issue. Let us not forget that slowly dealing with these questions weighed heavily on growth in late 2012. It will weigh on growth again in early 2013, in particular with the measure that provides for an increase of 2% in the payroll tax paid by employees.

There are, however, some countervailing forces: business investment has begun to surge, and residential real estate is starting to really take off.

The United States can afford to reduce their public deficit relatively slowly because they have no financing problem. For instance, in 2012, non-residents bought US$700-billion in treasuries, which over-funded the trade balance deficit and 60% of the budget deficit.

Q. Do you think the May deadline for raising the debt ceiling will help to finally resolve the problem of the sustainability of medium term US debt?

A. The American problem is well known, it is 2020-2040. If there is no policy change, as from 2013-2014, public debt relative to GDP should begin to decrease and increase again in 2020. There will have to be a real substantive debate on the high levels of Medicaid and Medicare spending.

The Democrats want to increase the tax burden in order to finance these expenditures, while the Republicans are keen to encourage households to seek insurance with private entities. However, policy makers have a number of years ahead of them to have this debate. Today, there is renewed confidence in the United States thanks to the prospect of reduced energy imports because of the shale gas revolution. In short, the dynamic is favourable to maintaining the dollar's role in the future.

Q. Let's talk about the Eurozone. After having presented fiscal austerity as the cure to the sovereign debt crisis, many economists, including within the IMF, are now stressing that the impact of such policies on growth has been underestimated. In 2013, do you think that the Eurozone countries which have already initiated austerity programmes will be able to temper them down?

A. This is an absolutely key issue. With regard to the fiscal multiplier, I think it is risky to work with complex and fragile statistical models. The first question to ask is whether we can have a fiscal multiplier which is higher than it has been in the past.

The answer is yes, for three reasons. Firstly, the countries are implementing their restrictive fiscal policies simultaneously. Secondly, short term interest rates are close to zero, so there is no room for an expansionary monetary policy. Thirdly, Europe is going through a deleveraging period, which prevents having Ricardian neutrality. According to this notion, if public spending goes down today, households will pay less tax tomorrow, and so they will consume more today.

However, to do this, households must have easy access to credit to raise debt, which is not currently the case. In short, the combination of these factors tends to make the fiscal multiplier higher, around 1,2 on average. This explains why Spain has only gained one percentage point of deficit instead of four as anticipated by the budget in 2012.

If there is a consensus on this, the strategy needs to change. I think there are two possible paths ahead. The first one involves taking account of the fact that the fiscal multiplier is greater than 1 and therefore spreading the effort to restore the public finances over time. In this strategy, we would be concerned primarily by the government deficits of the countries in most difficulty (like Spain or Ireland).

Only after that would countries with more moderate deficits implement fiscal adjustment programmes. In the second strategy, we could work on the fiscal multiplier by taking measures to reduce it. Countries could, for example, recapitalise their banks, which would restore investor confidence and therefore lower financing costs.

It is urgent for Europe to start to consider such strategies; otherwise it is heading for disaster. But given the reluctance of the North to relax the pressure on the South, these strategies do not seem to have much of a future.

The former are concerned by the creation of moral hazard, in other words that countries in most difficulty might feel less committed to making the necessary adjustments. There is therefore a considerable risk that the current strategy will not be questioned and therefore that Europe will sink into a deep spiral of depression.

Q. The financial markets seem to have regained confidence in the eurozone, which can be seen through the strong increase in stock prices in Europe. Do you think this trend is sustainable?

A. This confidence may well last because it is based on the certainty of financial markets that the European Central Bank will intervene heavily if prices fall, to avoid a rise in interest rates, what we can call (Draghi pu) in reference to the (Greenspan pu) in the second half of the 90s. Investors, faced with cash piles they hold, are deciding to buy large amounts of European equities and peripheral debts in the euro area, which are deemed safe thanks to the (Draghi pu).

However, this is equivalent to denying the actual development of the economies in the euro area: decline in activity and investment, decline in production capacity of the industry, deterioration of the creditworthiness of banks and political and social risks because of rising unemployment. In sum, we are confronted to of a bubble: there is plenty of liquidity, yields are high and there is movement on a number of assets, risky for the most part.

In this context, no-one can predict when and what event might trigger a return to pessimism on the financial markets in the Eurozone. It could arise, for example, from the Cypriot banking crisis or from an escalation in the political and social tensions in southern Europe.

Q. Against this difficult background, even if there is no break-up of the eurozone caused by the attitude of the countries, as considered and much feared last year, do you think that a break-up driven by the people themselves is possible?

A. What is surprising in this regard is that populist movements are developing in countries which are faring relatively well rather than in those experiencing more difficulties. For example, in Italy, populist movements have lost ground while in the Netherlands and in Austria they have won support. It must also be remembered that in the South, there is a powerful underground economy which coexists with a strong family solidarity that helps people to withstand the crisis.

For example, in Spain, this explains the low default rate on household loans. Consequently, the risk of a social crisis is not necessarily greatest in these countries. On the other hand, there are major political differences between the North and the South of Europe, which I am very concerned about, because it means that an event, even minor, could burst the bubble that has formed on European assets.

Q. Can the banking union be efficient when only the large banks are subject to the common supervisor?

A. It is not only the big banks that will be subject to the common supervisor, but all the banks that the ECB decides to monitor. There are only two exceptions: German savings banks and German public banks. What bothers me about the banking union is not the supervision, it is the fact that old bank losses are not within the remit of the banking union. On top of that, the process is not binding: the European supervisor cannot force a bank to recapitalise and therefore we will not quickly resolve the issue of confidence in banks. We ought to require States to recapitalise the banks that cause problems as soon as possible, and to make progress in the resolution of old arrears.

Q. What should have been the strategy?

A. A complete clean out, like the US banks did. That means provisioning for everything that may, in the future, become dubious and recapitalising or nationalising the banks in order to spread the message. However, the banking system in southern Europe, except for France, is in a difficult situation.

In addition, the example of Cyprus shows that European stakeholders do not necessarily apply the principles that have been up for debate: the principle of not lending to a country with a solvency problem and the crisis resolution principle. Would it not be better just to establish simple rules? For example, you could restructure 30% of all debts that exceed 80% of GDP and nationalise all the banks which do not have enough capital instead of letting them generate new doubtful loans.

Q. How can the fiscal union work when, as things stand, we have been struggling to agree on a budget? What sort of progress can we expect on this subject in 2013?

A. I approve and respect the very clear position that the Germans have adopted, whereby they do not want to pool major public debt without a fiscal union. Progress would require the States agreeing on a number of budgetary principles with a European budgetary authority which would have a veto over national budgets. This would make it possible to pool a large portion of the debts. But this will take years because of fears about loss of sovereignty.

In short, at some unknown date and for some unknown reason, the sovereign debt crisis in the euro area will make its return. We will see then that the institutions we have put in place are not up to the problem. This will in turn cause a very strong impulse to move towards the creation of a European budgetary authority with the power to change countries' budgets.

Q. Some European companies say we should devalue the euro to regain competitiveness: what do you think?

A. If we devalue the euro, all European industries which export outside the euro zone will benefit from it. For a country to benefit overall from a devaluation, the gains made by its industry must not be outweighed by losses related to higher import prices. Italy would be particularly favoured because it has a large industrial sector characterised by a strong sensitivity to prices. The risk would be to create more unemployment, because of the costs of paying for more expensive imports. On top of that, we do not know how to devalue the euro. Because interest rates are close to zero, the only solution would be to buy foreign exchange reserves in dollars, like the Chinese, at the risk of channelling European savings to the US Treasury at the expense of European investment.

Q. If devaluation is not possible, how can we restore the competitiveness and profitability of European companies without worsening the current social situation?

A. First note one thing: German and Spanish companies have no competitiveness problems. Only France and Italy do. In Italy, this is mainly due to productivity gains that have remained around zero for fifteen years. In France, we can see that technological progress comes to a standstill, due to financing problems, ageing of capital, and arrears in payments by the authorities that have pushed companies to stop investing. France has labour costs that would be bearable only if we produced high quality products.

Q. The press has reported widely on the competitiveness of France as compared to Germany. How did it come to this?

A. This is a problem that could be relevant to sociology. French companies have two weaknesses. First, a network of traditional and highly conservative SMEs that invest and export very little: about 80% of SMEs do nothing in terms of economic dynamics and even strong SMEs, instead of developing in size as in Germany, are often sold early by their managers.

Second, when we look at the large groups, growth is almost always realized through acquisitions: when one of them wants to develop a new product, it looks for an SME that has already developed it and buys it. It is therefore easy to understand that without large SMEs, our country cannot go upmarket in terms of quality.

In France, all the SMEs that were created recently and that have been successful have been sold, with the exception of Free. In contrast, in Germany, business practice encourages the reinvestment of profits to develop the firm. We need a real debate: why do French entrepreneurs not want to become leaders of large groups?

You have to remember that only one CAC 40 company started as an innovative SME, Gemalto. Another telling figure: every year, 17% of SMEs with more than 250 employees are taken over by a large group. However, it is precisely the generation of such large groups that creates growth.

Q. Where does the problem come from?

A. The problem is not only political. The administration has a violent anti-industrial and anti-entrepreneurial stance. This is particularly evident when we observe the excessive number of standards. I am not surprised that, in such a hostile environment, some people succumb to the millions being offered by the private equity funds. However, in macroeconomic terms, we have numerous strengths.

We are still at the same level, or above, as our neighbours in many areas: R&D, public infrastructure, educational system, banks. However, France country is still unable to take off, which can only be explained by looking beyond the objectivity of economics. Finally, I observe that there is an increasing trend towards conflict within French companies.

This comes from our corporatist tradition that has nurtured where social dialogue is made difficult because of the structure of our trade unions. Entrepreneurs are forced to build up a heavy bureaucratic apparatus when their business grows. In my opinion, that is the main obstacle to business growth.

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