FINANCIAL DYNAMIC EURO AREA DOUBLE DIP AND SECULAR

FINANCIAL DYNAMIC, EURO AREA DOUBLE DIP AND SECULAR STAGNATION Michel Aglietta Cepii

Changing the model of finance a prerequisite for a sustainable growth regime • Financial capitalism: an unsustainable system – The financial cycle: momentum vs fundamental value – Debt-induced asset price boom and endogenous crisis as “boom gone bust” – Dearth of LT investors • Euro area: inability to date to face the challenge of potential growth recovery – Major errors of economic policy led to double-dip recession – Private sector deleveraging has hardly begun – The trap of secular stagnation is looming • Conclusion; an innovative financial intermediation to revive productive investment 2

Global financial dynamic 3

From the 1980’s on, BIS research showed that financial dynamic has been radically transformed (Drehmann et Juselius) • Before the 1980’s: financial stability. The business cycle (measured by output gap changes) fluctuates around potential growth • After mid-1960’s inflationary drift because real interest rate <growth rate systematically while productivity was slowing down • From 1980’s onwards: financial cycle: long period and large magnitude. Measured by a composite index: private credit /GDP, private credit growth and real estate price variation • The financial cycle is decoupled/ financial cycle →low inflation and stable growth (Great Moderation) while financial disequilibria have accumulated inconspicuously. 4

The financial cycle (17 countries) is driven by private sector credit but impinges heavily upon the public debt • LT <0 correlation between private and public debt, but in 1975 -2000 shifting to >0 • The upward phase of the financial cycle (1996 -2007) has been nurtured by the fastest expansion in Credit/GDP for the last 130 years, while the ratio of public debt /GDP has declined all over the period. • The public debt surged in the financial crisis while it became systemic. Public debt and bank credit to non financial sectors in 17 OECD countries

The financial cycle generates vulnerabilities within the financial system • The debt-induced asset price expansion is a momentum not a mean-reverting process to fundamental value. The diverging momentum stems from conventional behavior due to strong interactive influence under uncertainty. • The price of risk covaries with expectations of the quantity of risk (market vol)→ accumulation of vulnerabilities: – Structural: types of risks exposed to coordination failures which are nests of systemic risk in the intertwined counterparty risk between shadow and regular banking systems – Dynamic: financial intermediary leverage and maturity mismatch ↑ by recourse of shorter and shorter debts to finance asset purchases without organic access to the lender-of-last-resort 6

Fundamental value is a notional price, not a marketdetermined price • How could financial investors embody fundamental values in their strategic asset allocation? – The financial cycle is momentum-driven. Time-series analysis can reveal it over a full cycle (15 to 20 years). It is well beyond of the timeline of political priorities in representative democracies. – Financial reforms worsen the impact of market volatility on the balance sheets of financial institutions→ They make it more difficult the immunization of contractual liabilities. • Extra-financial risks cannot be accounted for in market values: – Risks about intangible capital: demographic, long-run exclusion of labor market, human capital downgrading – Risks about natural capital: risk of breakdowns in ecosystems if unknown tipping points are overstepped. • LT strategic planning with strong democratic backing needed: discount rate set very low to take care of future generations independently of market gyrations and notional price of carbon setting→ sustainable growth. 7

Euro area: unfit to meet the challenge 8

European malfunctioning led to double dip recession • The financial crisis in 2007 -08 impacted the euro zone weakened by economic real divergences between members exacerbated by EMU • In 2009 Europe participated modestly to the global fiscal stimulation drive that was effective to stop the spiraling depression in world trade • In 2010, 3 majors errors of economic policy changed the course of the euro zone: – The cleaning of bank balance sheet was delayed→ credit paralysis – The Greek crisis was allowed to spread to solvent countries → vicious circle public debt/ bank net wealth deterioration + money market fragmentation and freezing – Much too fast restrictive fiscal adjustments→ recession (2011 -13) → high multipliers and ↑ in public debt ratios • In 2014 feeble rebound unable to revive productive investment 9

US/EA: the great divergence 10

Failure to reduce debt and incomplete adjustment in the euro zone National debt variation(% GDP) Private nonfinancial public Δ(2008 -13) US -19 +22 EA 0 +13 -7 +6 -11 UK Japan France Germany Italy Spain GDP growth (% average) Current account balance (%GDP) 2012 -14 US 2, 4 -2, 3 +26 +24 +13 +21 +54 EA 0, 0 0, 5 1, 1 -1, 2 -0, 6 +2, 0 -1, 6 +7, 4 +0, 6 +0, 3 -16 +34 UK 1, 6 -3, 9 -3 +46 Japan 1, 4 +0, 3 France Germany Italy Spain 11

The low-growth trap Fiscal austerity Nominal rate at ZLB Investment ↓ Real income stagnation Thwarted private deleveraging Credit demand decreases Inflation ↓ Real interest Rate ↑ Consumer demand feeble exchange rate ↑ LT unemployment Human capital deteriorates Persistent Weak demand Potential Growth ↓ Capital Renewal ↓ TFP growth↓ 12

Need of a new financial intermediation • A sustainable growth regime requires : – Capital and technology transfers to finance the catching-up of EMEs – Strategic asset allocation to finance ageing in advanced countries – Financial mechanisms for investments in mitigation and adaptation to climate change • Stricter prudential ratios and mark-to-market accounting impede banks and institutional investors to take risks if robust risk sharing devices are not at hands • Because of externalities, irreversibility and non-linear dynamics, market accounting cannot be economically efficient for LT investment: – It overvalues market risks in injecting ST market fluctuations into LT assets – It biases internal rate of returns of investment projects in ignoring >0 and<0 externality • Counting on market finance leads to conservative strategies→ new investment channels and new financing instruments needed to share the risks: – Carbon asset as legal reserve in the monetary system – Carbon asset as collateral of new brand of Green Bonds of the highest rating issued by a public financial intermediary (“Ecological Fund”) backed by public capital. 13