Odd Lots - Former ECB Chief Economist Peter Praet on What's Next For Central Banks

Episode Date: December 3, 2020

With developed economies still operating well below pre-crisis levels, central banks face substantial pressure to pursue stimulative policies on an ongoing basis. But what more can they do with the tools at hand? And how much do political fights get in the way? On the latest Odd Lots, we speak with Peter Praet, the former Chief Economist at the ECB, who served under Mario Draghi for almost a decade, about the lessons learned during that experience, and how they apply going forward.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthall. And I'm Tracy Allaway. So Tracy, we talk a lot about monetary policy on the podcast. We talk a lot about central banking, what the future of central banking looks like in the post-crisis era. For all we talk about it, it's like we probably keep, we never talk about it enough. There's always more to discuss. Well, I feel like this is one of the big themes of 2020, right? So we've had this economic crisis and we've seen various responses to it from central banks.

And we've seen various government responses to it as well. And now we're sort of waiting to see what the combination of those two things actually looks like and how monetary policy interacts with fiscal policy. I feel like that's that's the thing we're all watching, right? Yeah, I think that's fair to say. And I think, you know, and again, this is sort of for people who have listened to several episodes. It's at this point as a retread. But I always think it's important that a lot of these debates were happening already going into this crisis about the sort of limits to monetary policy, even in recent years, whether central bankers needed new tools, whether there needs to be a greater emphasis on fiscal policy and so forth to accelerate growth. These were already being. debates that were happening pre-crisis, and like many other things, this crisis has really accelerated them. Yeah, absolutely. It's funny how the crisis is doing that really accelerating trends that were already in play. But I feel like the other big question around central banking has to be the continued misses on inflation targets as well. So we've now had many, many years

of central banks around the world missing their inflation target. No one quite knows why. And that's why even before 2020, we were starting to see that discussion about whether or not something else was needed besides pure monetary policy. Yeah, exactly right. And, you know, this is a pretty profound issue for central banks because I think, you know, everyone agrees it's a little more complicated, but on some level, the premise of a lot of monetary policy, at least traditionally, or sort of interest rate policy, is that there is this sort of a give and take or balance between inflation and full employment or inflation and robust growth. And so I think if there is some question about what it takes to hit the inflation target

or why inflation doesn't pick up even when the unemployment rate drops to historically low levels, I do think to some extent that really calls into question a lot of the traditional model. Yeah, absolutely. And I feel like this has been a long-running theme on all thoughts now. Absolutely. So I'm very excited. Today we're going to to be speaking to a huge, important guest in the world of central banking, monetary policy, economics, someone who's really just a big name, someone very excited to talk to. We're going to be speaking with Peter Pratt. He is the former chief economist of the European Central Bank. He was on the executive committee of the bank, crucial decision maker for eight years from

2011 through June 2019. So has been right in the middle of things up until very recently, sort of almost right up against the current era. And currently, he's a senior fellow at the University of Brussels. And we're going to be digging into these topics, the ECB, the future of central banking, macro policy overall. Very excited about this conversation. Peter, thank you very much for joining us. Yes, hi. So, Peter, thank you so much for coming on. I mean, you know, Tracy and I introed. We've been really picking apart these topics for a long time. Before we dive into the sort of bigger theoretical questions facing central banks, I'm just curious your perspective right now on the recovery in Europe. Are the existing set of policies enough to make the recovery from the crisis self-sustaining? Can you get back? Can Europe get back? Can Europe get back? to pre-crisis levels, or does there need to be something further yet, either from fiscal

authorities or the European Central Bank to return to trend? I think you have to distinguish a little bit the short term and the medium term here. I think it's always the case, but I mean, it's particular that case in the situation because you have the second wave, which has been very strong, actually, and has led to lockdowns, you know, in different countries at different degrees. And for that sort of situation here, I think it's absolutely clear that you need more policy stimulus and basically from the fiscal authorities.

So I think that's accepted by most economists, I think that's to me very clear. The role of the central bank here, as has been communicated recently, which is relatively new, actually, is basically that the central bank wants to preserve the easy financial conditions that you have and not to try to end accommodation.

Basically, the message you get from the central bank is to say financial conditions are okay, you know, that easy across countries also, not only on average, but across countries. And so it's important to preserve these conditions in a situation where the expectation is that governments are going to come with new stimulus measures. I think that's fair enough.

I think that's fine. I don't see why, you know, by adding accommodation, trying to bring the curve, you know, the yield curve lower than what it is today would stimulate, you know, domestic demands. So I don't think it will. So basically, some economists have even alluded to the fact that to some extent it resembles a yield curve control. You know, you want to keep the curve, the interest rate curve, you know, more or less

as it is today. But to do that, to do that, you may need, of course, to buy more bonds, given the huge issuance of government bonds. So just to stabilize the conditions, you may need to add, you know, another round of QE, basically on what is called the Telcho, the pandemic emergency purchase program of the ECB. That's the short term. And you want to bridge what?

Well, I mean, it's a vaccine story. The vaccine is for the time being not taking, you know, as an upside, a very big upside in the projections of central bankers in general. They just say, well, it was more or less, more or less already in our scenario before the announcement, you know, the two announcements. you know, the two announcements we had in recent weeks. But personally, I think the vaccine now has a much higher probability. So the variance, actually, the uncertainty around the vaccine, the spreading of the vaccine,

I think this has reduced the uncertainty. That would be a positive factor. So for the time being the central bank and the ECB, I think in particular, they just want to bridge it to that situation in the second half of next year. So you don't need to do much necessarily, but you want to ensure that the financial conditions, the easy conditions that you have today are maintained in a situation when governments are going to spend, you know, more. What comes after, well, we can discuss that later because that will not be easy. Yeah, we're definitely going to get into that.

But before we do, I mean, just looking forward to next year, there are a few people who, despite everything that's happened, are pretty optimistic about the future. of Europe. So, you know, we now have the common debt issuance. We have the fiscal transfer that we've been talking about for many, many years. Brexit might finally be over. Do you buy into the idea of things looking up for Europe as a whole? You know, there was this famous quote, you know, from Jean Monnet by saying Europe will be forged in crisis. I always said, you know, prevention is better than, you know, reacting to crisis. Of course. you have to react to crisis. It's better than the opposite. But I think that's a little bit risky

strategy. I mean, because Europe in the past, you know, events that we had with the global financial crisis, the sovereign debt crisis, and now the pandemic, well, Europe was not really prepared for that sort of situation. And so the good news, of course, is that in crisis, Europe reacts very strongly, and that's the positive news. But on the other hand, very often, they are caught, you know, by the events. And the events go faster. and the capacity, you know, to reform the institutions. Now they came, as you rightly mentioned, with extremely important decisions in the middle of the crisis,

the pandemic crisis, coming with transfers, issuance of common debt, but they always say, you know, the communication is that this is a one-off, you should not prejudge that you're going to do that for the future. These will be discussions for after, and we will see it's, we cannot prejudge, you know, that there will be, you know,

sort of more permanent transfers. But I think it's important what happened. I wouldn't call it, as many people say, you know, Hamiltonian moment, you know, referring to the US history. I wouldn't call it that way. But I would certainly recognize that this is a very important thing. Hadn't this happened, the union would have collapsed. I think this is, you know, the head of states

were so, you know, worried about the potential consequences on the union of the COVID crisis and the economic effects of the crisis, that they, as they did in previous events, you know, came with this huge, you know, stimulus program at the European level. So I think it's positive, but it doesn't guarantee you that you have the right institutions now. Europe puts in place institutions like, you know, banking supervision, for example, at the global financial crisis. But, you know, then they tend to go backwards, you know, to finalize what they've started with, you know, and come with new problems. So I think there is always an element of ambiguity in institutional reforms in Europe that puts risk, you know, to the, to the Union.

Can you explain that further? I mean, you had a front row seat to all of this for several years. And from the outside looking in, that's certainly the appearance, that there will be some big shock and awe announcement. We're going to spend all this money. We're going to launch some new vehicle. And then it feels like there's like this inertia or centrifugal force and things start to slow down and things start to look less impressive than they appeared. What are the forces that cause what you just described where things, the sort of, the ambition seems to slow over time? Well, here, you know, the final approval from the recovery plan, you know, is not done because you know that there are basically two countries, Hungary and Poland, threatening to veto the whole project.

And so, I mean, there is today, today, uncertainty about that. On that point, just because this is news today, I mean, I would not be too worried because in Europe, you know, when you cannot agree with 27 countries, you can have, if there are a coalition of willing, you know, at least with nine countries, you can still within the European treaties, you can still do the things they want to do now. So I think they will finalize, at least for most countries, what they decided to do. That means a big expansion plan. They will do that. The question now, which is new, I mean, this is real money for a big part of that. The main concern, actually, that most analysts would have is how do you spend that money?

I think money would be spent, but how do you spend that money? Because, I mean, at some point you have to reimburse that money. And the impact of the COVID crisis, usually, is to lower your GDP potential growth. And it weakens the economy, you know, for a while. So the whole plan, that's why it's called recovery plan, it's basically directed for investment. And investment are supposed to increase potential growth. And that would mean the reimbursement of debt, common debt also, easier in the future. But that's the biggest challenge now in Europe.

If it's a success, that means that the real money, there will be real money. When the real money is spent, if it's spent correctly across the jurisdictions in the different countries, I think that could serve, you know, very positively the union in the future. Now, if it's the other case, there will be, you know, the political reaction in many countries will be totally the opposite. I mean, you can imagine, you know, you give grants to one country that has been hit more. Part of that money is paid by richer countries. And then that money is unwisely spent, you know, in consumption, well, maybe income support.

That's not the objective now. And there will be a surveillance process, how the money is being spent. If that process is well done, I think then we can start talking about the game change about all this. I would say for today, this is one shot. It's extremely important, I think, and certainly for the business cycle. But for the longer run, I think we have to see how this money is being used. And you cannot tell today because, you know, it's complex also. So that last point actually relates to a question that I wanted to ask you.

which is there does seem to be a consensus developing that monetary policy is going to be used to augment fiscal policy or whatever the government does. But for the ECB and for the European Union, I mean, clearly they have a different setup than, say, the Bank of Japan or the Fed. Is the ECB going to be able to be as effective when it comes to using monetary policy to augment fiscal policy as other central banks? Or what are the unique challenges they're going to face in doing that? No, you're right. I mean, there are unique challenges because you have one central bank and then you have different ministers of finance, different countries. So you don't have a single fiscal policy. But many of the problems we have in Europe are the same as in Japan or the US in the

UK. So they are not, they're common to all central banks. Let me just remind you that, you know, In the 80s, the world of central bank can change very fundamentally. There was sort of general consensus that, you know, business cycle policy, you know, smootening the business cycle would be delegated to the central bank. Governments, basically, the Ministry of Finance, would basically, of course, let their fiscal policy, you know, react automatically, you know, to business cycles. But discretionary policies would not really be trusted, you know, from Ministry of Finance. Basically, because Minister of Finance, they look at the political business cycle, and so when they spend the money, it's linked to a political cycle, which is not necessarily the business cycle.

So basically, the consensus was, you know, business cycle policy, basically, you know, when the economy goes down, you lower the rates, and then the economy goes up. If you have inflation, you're tightened. I mean, that model a la Taylor rule, if you see the simple rule, was a consensus. And government basically would look at three things, basically. They would look at the allocation of resources, you know, how taxation influences their allocation of resources, for example. They would look at redistribution of income and wealth, these sort of issues, and then they would ensure the sustainability of public debt.

And so the central banks were kind of independent agencies with a very clear mandate. It could be prime stability in Europe as a primary mandate, but basically all the central banks following more or less the same model, you know, business cycle responsibility is you and you have the tools to do that. And that was the environment in which I was supposed to work. I work and I was supposed to work efficiently during this eight years. And what happened is that, you know, different things. I mean, one of the things which is common to many central banks is that we reached the lower

bonds. So the interest rates went to zero. And so you have a mandate, it's just price stability. But in terms of toolbox, you know, you hit something, can you enter new territories? So we tried a number of innovative instruments, quantitative, as you know, negative rates also. We went into all this. And as was said in your introduction, well, the results, I think, can be debated at least, but for the general public and analysts in general.

Well, the conclusion is that you didn't reach the 2% that you were targeted. And so one is the issue of instruments that is, you know, still debated today. I think the instruments have been efficient, but the question is still open. The second reason why central banks didn't succeed, and this is one of the points I personally mentioned very often in my communication, is that we had a succession of shocks, you see. You can say, fine, your monetary policy, including QE, would be efficient, but then you get a new shock. and putting the economy down again. And then you try again with your monetary policy.

Then you get again a new shock. I can refer one of the last shock we had before the COVID. It was what we call the geopolitical shock, which hit animal spirits in the manufacturing industry. Basically, let's say, the protectionist pressures coming from the United States. And the eroding trust in multilateral institutions, the Brexit, et cetera.

So you can see the issue not from an instrument point of view, like, you know, what is the room of maneuver when race are zero, but you can also see it as a succession of deflationary shock in the economy that complicates very much the central bank action. I think there's these two explanations. And then you have a third explanation, which is the one you just mentioned, is some people refer that to the flatness of the Phillips curve. That means that you need a hell lot of monetary stimulus to get inflation because the reaction of market participants in general, labor markets, capital markets, but especially or product markets, is very slow compared to your monetary policy action.

So basically saying the world has changed. There's a lot of inter-reconnections across economies. And so there is competition of China. There is a digitalization of the economy. Unions are not as strong as before. So the relationship has changed. Now, if you combine the three elements, the lower bound, that means your rates go to zero, and then what do you do?

You try other instruments. Suddenly you have a succession of shocks, negative shocks in the economy. And third, you have changes in the relationships because, you know, the world has changed because of digitalization, globalization, lack of union power and all these things. Then you get a little bit the story in which we had. In Europe, it was even worse because in the global financial crisis. in which we were not very well prepared as the U.S. and many other countries in the world. We had also a sovereign debt crisis, which stressed, you know, the fact that the monetary

union in Europe was not very resilient because you have to prepare for the worst. If you are in a country, well, in a country, you have a lot of institutions, you know, that can be activated very quickly in case of crisis. We didn't have that in Europe. And there was, I would say, you know, with the sovereign debt crisis, and we paid a very high price in Europe because of that. We had a very big shock, you know, following the global financial crisis because of institutional weaknesses, what we call the incompleteness of the monetary union. Now, as I said before, there have been very strong political reactions, institutional improvements in Europe, which is very positive. I think, you know, we have banking supervision.

we have, I think, a better capital market union, etc, etc. But these institutions, I stop with that. But these institutions today are not yet, you know, very strong, sufficiently strong to face the challenges that we have. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra.

Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini. will bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off. And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays, we speak with journalists, columnists, and key political figures to prepare you for the week ahead.

Join us as soon as you wake up and bring us with you wherever you're willing. weekend plans take you. Watch us on Bloomberg television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. I want to focus on something you just said. This might be getting into some controversial territory, but I think it's important, interesting stuff. So you talk about these sort of geopolitical shocks or various setbacks. There's also internal politics. And again, speaking as someone

who just observes from the outside, and again, you had a front row seat to this, but, you know, we saw this sort of pretty, the extraordinary lengths that druggie underwent, especially over the course of the sovereign debt crisis to, you know, expand the ECB toolkit or at least fit the toolkit for the the time needed. And that's provoked, that provoked some pretty, you know, loud backlash. And we always heard it particularly from German media in particular, and German central bankers who seem to have a very different view on the proper conduct of monetary policy than sort of the mainstream views that sort of exist in Europe and the U.S. And it even culminated into a situation right after you left in the fall of 2019 in which there was criticism of the Draghi era for their views stoking inflation.

And you pushed back on it publicly and you said it wasn't helpful. How much of an impediment was this or is this to the evolution of the ECB and monetary policy to address the various crises of the times, this sort of very sharp break that there is with the sort of core European or sort of the German view of monetary policy. How difficult of a challenge was that in your eight years on the executive board? No, you're right. I mean, I was very often surprised that in spite of all what you say, that it worked. We always in the governing council could decide. And of course, there were some different views in the governing council, which is not the case today with the COVID shock, which is a bit of a different situation.

But in these years, you had, of course, a lot of differences across countries, you know, some like Germany recovered very quickly after the sovereign debt crisis in the global financial crisis. It's not the case, of course, of countries like Italy and others. I think the main problem we had in the ECB, and I think, especially with Mario Draghi, I think, you know, we were at some point the only game in town, you know, because the political institutions, the institutional settings, you know, supporting these sort of situations were extremely weak in you. And so I think that the ECB had to take this leadership.

And I think a little bit contrary to what you said, at the political level, it was accepted, you know, that whatever it takes was very much endorsed and accepted, you know, including in Germany at the highest level, political level. In the population, of course, one of the issues is that the situation, you know, about negative rates, of course, we had to have negative rates. If you look at the curve in Germany, for example, today, you have minus 50 basis points for the short-term rates, minus 0.5. And then when you go to the long end to the 10-year curve, you get minus 55 today. If you look at a country like Japan, for example, where you say Japan is not a particularly growing country, you know, with inflation, well, their curve is minus 10 to zero.

And the U.S. it goes, you know, it goes up to 0.9%. So the country doing the best, you know, being a sort of safe asset, gets extremely low rates. And countries, you know, where the risk a bit higher, get higher rates. And during the COVID crisis, we lived again, you know, that situation when markets, you know, get nervous. You have an increase of the spreads, you know, across the countries. And all the idiosyncrasies that you find within the union, you know, as, you know, emerging, you know, in financial asset prices tremendously. And at that time, Mario had to intervene and say, you know, we do whatever it takes.

You took that initiative. In the COVID crisis, it was a different situation where there was a full consensus, including to intervene, you know, sometimes more in particular markets than other markets because of that particular situation. That's a revolution, actually. But you're right. I mean, it has been in the Governing Council not too difficult to get, you know,

a very strong consensus, all the measures with it, but not always unanimity. But it's the length, you know, of this period, you know. And I explained that by the succession of shocks that we had. I thought in 2018 that this time, you know, that's it. We're going to be able to exit, you know, from QE progressively. And we announced that, you know, I was there when,

You know, I proposed, you know, that at the Guaradalini Council at that time. But then we had, again, the new shock that came, and then now we have the COVID shock that came. So this normalization never happened, actually. Since we were talking about the whatever it takes moment from Mario Draghi, I kind of wanted to ask you about that, actually. So when Draghi made that famous speech, he was basically calling the markets bluff, right? Was there ever any doubt within the ECB that just uttering those words would be enough to stop contagion? What was the debate like before he went out and actually made that statement? I think we can say that the president of the central bank took his responsibility by making that announcement.

So that is a sort of announcement that is not without risk, I think, so that I gave him really the credit by taking this risk, as a president, because that's, as you say, something, you know, it may not work. And no, it worked pretty well. And then you have to ask yourself, why did it work really? First, I mean, you have to be a good communicator. I think that he was. He knew that he would be backed, you know, by the governing council, even if there would be, you know, some problems potentially,

but he would be backed by the governing council. Certainly a strong majority of the governing council. And maybe more importantly to all this, is that before the announcement of Mario in July 2012, before that, you had the head of state and governments that decided to improve the institutional setting of Europe by putting in place a single supervisory mechanism, the supervision of bank, looking at crisis management.

So there was an institutional change which was accepted by government, by the politicians, before the announcement of Mario. And I know some politicians at the time, they thought that the ECB was not reacting sufficiently fast to the innovations that were decided by the government. And so there was a little bit for the president also the timing of the announcement

that the ECB had to do. I think he had to do that. And certainly the ECB would not, I don't think the ECB would not have made that sort of commitment without the institutional improvements that were the science. at the political level.

And the markets understood, I think, pretty well that the politicians would back the central bank and they would also improve the institutional environment of the monetary union, which caused all the problems we saw. And so the fundamentals, the institutional fundamentals, would improve and the central bank would support that by its commitment. And then, you know, the ECB came, you know,

then of course I was very much involved in the design of what we call the OMT, which was basically that ECB would do whatever it takes, but it would not be a blank check. It would be subject to a conditionality framework where European institutions would be, and political institutions would be involved. So I think the framework, severe stress, but it came, and that's why I say Europe would be forged in crisis, fine, we survived,

but it was very close, I must say. And so it worked. The COVID is a new situation indeed. So you mentioned that back in 2018, you had some hope that perhaps the era of extraordinary monetary policy might come to an end and that we might return to just ordinary monetary policy. But of course, that didn't happen. And we don't even seem like, you know, it's anywhere close these days. The European Central Bank in many ways has been far more innovative than. and say the Fed and trying multiple tools.

So you mentioned negative rates. We've also seen dual rates. We've seen not only quantitative easing, but also easing through the credit channels in a way that the Fed hasn't done, essentially all different kinds of efforts to get around the lower bound, the fact that rates are more or less at zero

and don't have much further to go. In your view, what are the most promising tools for central banks? what actually works at the lower bound? That's a very good question. I would say yes, in particular, I give credit to very brilliant people in the staff of the ECB, and they are still there, very creative people. And it is true that ECB has very often been very innovative.

I would caution you that when you look at the toolbox, you have to look at the combination of the toolbox. It's very difficult to say, I pick up one instrument and what is the most efficient one. It depends on the context. It depends a little bit the circumstances in which you are. One question today is to say things that have worked in the past, would they still work today? So you always continuously have to revisit your toolbox and the way they interrelate. I think that's now communicated by Christine Lagarde very clearly that maybe in December,

they will take more or less the same decisions, you know, about the PEP, you know, the pandemic, you know, emergency purchase program. And the, you know, cheap lending for banks, they may do that again. And that looks quite, you know, quite, not a very big innovation. They may limit. But they will always look at all the instruments and the relationship between the instruments. So you do always this sort of exercise. I think when you ask the question, what is the most efficient? I would say today, today, because as I say, it's context-related.

Today, I think there is a big issue. You have a COVID shock which hits a lot the SMEs, small and medium-sized firms, not a very big one that can have access to the capital markets, but a lot of SMEs. SMEs depend very much of bank lending, and the situation of banks is not brilliant before the shock. The rate of return was a miserable 2% return on equity, and they are well capitalized. There are plenty of liquidity, which is good. that makes them resilient, but they're not very profitable.

And so the biggest risk in Europe when the COVID came was that you got a credit crunch immediately. And so there was a combination of government reactions, you know, to give government guarantees. And there was on the side of the ECB, cheap lending, funding for lending, and all the measures that the ECB and supervisors took, you know, to make life a bit easier for banks

so that they're able to lend to the sector that has been hit. So I think the most important instruments for today It was because you have a key issue with that sort of shock with lending to SMEs. And SMEs depend off bank. So you cannot just say, as some economists, they've written, this may be wasted money because a lot of SMEs, you know, are, you know, cinemas, you know, restaurants, bars, tourist industry, et cetera. There are a big other in services.

You cannot just reason like this. I think you have to support because there are some very good enterprises. And of course, you know, when you close the business, what can you do even if you're a good enterprise? And if you let some of these firms go down, it's very difficult to recreate the relationship that you had before. And that's a classical problem. So I think here, I would say number one, it's the how will the bank react? Will they continue to lend? And what are the policy tools that you need to ensure that?

And it's a combination of government intervention and central bank, you know, I would call it even subsidize. for the banks. I don't like so much the word, but, you know, when you lend, you know, at minus 1% to banks on the conditions that they keep their loan book, you know, basically to SMEs constant, you know, that they don't reduce it. Well, it's a form of subsidy, of course, because that comes away from the P&L of the central bank. But I think the ECB has been quite innovative, you know, in lending at negative rates and below, you know, the money market rates. So it doesn't, it's not the guarantee, of course, of success, but I think it's because the banks could decide not to lend, you know,

even with these incentives. But that's why the government interventions have been absolutely key as well. So that's an important thing. The other instruments that we have is what we call the PEP, you know, the pandemic emergency purchase program, which is just like QE. But it's more than the traditional QE because here you have an envelope. That's the ID.

and you can use this envelope extremely flexible. So there were a number of constraints on QE before, across countries, for example. In this case, you say, well, if I see that the transmission of monetary policy doesn't work well in a particular country, because interest rates go up, you know, in that country, and that's not what I want, I will buy more of these bonds, let's say Italy, Spain, some of the countries which have been hit more by the shock, I will buy more. And markets will know that, of course, and there will be some, you know, I will normalize.

I will facilitate the transmission of my monetary policy by specific targeted intervention in some countries. This is a revolution because we never did that, actually. In the OMT, we had a promise that we would do that under conditionality. In the case of COVID, the ECB has an envelope, a big envelope, and says, I'm going to use my firepower. powder to ensure that the transmission of monetary policy corresponds to what I want. And it was very successful because the spreads went down immediately.

But I immediately say that it was successful also because a little bit later you had the recovery fund that came from the European side. So in this crisis, and I think it should have been in the previous crisis as well, when you have a sort of good coordination between the fiscal authorities, the political institutions and the central bank, I think the impact can be quite good. And that's not what we had in the global financial crisis and certainly not in the sovereign debt crisis in the beginning. And then it came. And unfortunately, it cost a lot in terms of wealth in Europe. Now we have a good cooperation between the two. When will it end? Because that's the next question, of course.

For the time being, you know, there is no inflation. There are some deflationary risk. in the economy. And so the cooperation between the two is pretty good because there is no diverging, you know, interests are aligned on both sides. And inflation is low. That's the mandate of the ECB. And supporting the economy for that sort of shock,

you know, is also the priority of government. So, I mean, it works pretty well. The question, of course, which is not yet discussed in the markets, of course, because I think it's too early, is that suppose a vaccine, you know, gets very good results in the second half of 21 and that, you know, the animal spirits changes, changed totally because people start getting optimistic, you know, and there's all this, you know, pent up demand, you know,

that's going to be materialized. People start buying, they start going in restaurant, they want to have fun. And then suddenly the cycle turns very much. Then, of course, you have to see what will be the reaction of the central bank at what point. I don't think the central bank has to rush because the damage to the economy is so big, you know, that I think inflation forces will come much later. But, I mean, you know, markets like to anticipate all situations. And I think that's a situation that, you know, needs a little bit more work from the side of the ECB, more communication.

It's probably too early to do that because that's not a priority to think, you know, about phasing out. You may send ambiguous messages if you do that. But at some point, they will have to start, you know, in speeches, maybe communicating about, you know, how do we see a situation where, in, you know, inflation starts to go up a bit too fast, maybe. You know, the aligned interest that you see today between Treasury and the Central Bank would not be there anymore at some point.

I don't think it's for the time being a situation, which is realistic, but it may happen at some point. And as you know, markets always have to be ready for any situation. You know, we always have seen surprises in the past, so you can always have surprises. So that's the strategy of phasing out and the relationship with governments with the Treasury. I think that would be a key debate for in the coming years.

I mean, as you said in your introduction, rightly. I wanted to go back to what you were saying about the banking system, because, of course, one of the criticisms of unconventional monetary policy is that it damages banks, it potentially pushes risk outside of the banking system onto shadow financial institutions that we don't really have very good data or insight into what they're doing. and, you know, we're now into at least our 10th year of unconventional monetary policy. How confident can central bankers be that they're going to be able to offset the longer-term risks,

the longer-term financial risks, this reach for yield, things like that, of their unconventional monetary policies? Yes, I think that's an excellent question. for the time being, it's a question around financial stability and financial stability risks moving from the banking sector to the non-bank, you know, the other financial institutions. And we don't have that to the same degree as in the United States. So I think it's still in Europe. I would say it's unfortunate.

In Europe, you still have a highly bank-intermediated environment. And as I said, you have a shock in SMEs, which really depend on banks. it's very simple. So that's the priority. On the other hand, you're right. I mean, when you look at the instruments like Huey, and when the central banks, for example,

also in Europe, I said that also, we want to ensure that financial conditions remain very accommodative. Well, financial conditions are equity prices, you know, bond prices, everything, credit spreads and all that, when you say financial conditions. So it's a sort of compact, you know, a sort of average of all asset prices.

And if you say you want to keep them accommodative, I think it's fine. That's your objective. But of course, at some point, you know, it gives the impression among market participants that is a sort of backstop or a sort of put, cheap put option, which is put in place by central banks, basically saying, well, look, if there is an event somewhere and financial conditions deteriorate, because equity prices suddenly fall very much. And what would be the reaction of central banks? So markets start to internalize the reaction function of the central bank,

saying this is a quasi-objective of the central bank is to keep financial conditions, you know, as they are accommodative. And then the market people would then say, well, look, there is a backstop. You know, if asset prices fall, you know, anyway, the central banks would intervene. And that may lead, of course, to excesses in the market, people don't perceive the tail risk on the left side, and they basically say there is a backstop on the central bank. So I think central banks have to be very cautious.

And I personally, when I was there, always avoided to say things that I read sometimes in communication of central banks, for example, to say, we want to ensure that financial conditions are going to remain accommodated. I think that's fine, that's what they want to do. But you want to ensure something is, well, you know, it's, you have to be careful about that. What do you do about this? I mean, the answer, the classical answer is to say, well, you have to monitor this sort of risk, you know. So you have macroprudential framework.

You have regulation and supervision. And that's basically what you have to do. And but we know, for example, in the United States, the toolbox in terms of macroprudential instruments is not very, is not very impressive. I mean, if you look at the U.S. And I know that in several speeches, some governors in the U.S. have complained about this. So that's an issue. In Europe, I think we have a little bit more in the toolbox

at the national level and also the European level, but essentially the national level. But I would agree also that the toolbox in macroprudential is not impressive for the time being to deal with the problems you mentioned. I think the central banks in their monetary policy deliberations, you know, when you decide about QI, or if you do more QE, I think in the future they will need to put in the discussions,

in the monetary policy discussions to give a more prominent role, you know, to financial stability consideration. Usually, you know, the monetary policy decisions are not very focused on financial stability in general. If you're a big shock, of course, there will be. But there will not be a systematic discussion about financial stability risk and a sort of, you know, what are the tradeoffs, you know, between, the different risks. I think this has started in recent years, and I think it will continue.

As Christine Lagarde, I think as rightly said, you know, in response to the German Constitutional Court issue, by saying, you know, we look at, you know, the pros and cons of our measures, including, you know, the side effects on financial stability. But I think this will have to be done in a more systematic way in the deliberation of monetary policy. It's not easy to do, you know, this sort of arbitrage. I think if that had been done in recent time with the COVID shock, for example, I don't think it would have changed anything in monetary policy because the reaction of the central bank to the sort of shock that we saw was very clear.

So I think it wouldn't have changed. But in the future, it may be when you think about the length of your interventions in the markets or the way you intervene in specific markets like with a pandemic purchase program, I think there you need that sort of discussion about, you know, are the market prices, right? Do you see movements which you think are exuberance? You know, the ECB, for example, has said, you know, when, you know, we want to go against non-fundamental volatility in the spreads, you know, that sort of message, the non-fundamental volatility in spreads of some countries, for example.

I mean, when you go into that sort of reasoning, it's very delicate. to do. I think in crisis, you can say that because, you know, there was so much, you know, excess volatility. But when you go into more normal time, you know, you may have more minor shock. And what are you going to qualify as, you know, non-fundamental volatility? What is more close to the fundamentals? And this is a tricky issue. So in acute phase, you don't ask yourself this sort of question because you have to act and very quickly and front load your interventions. And I think this he beat pretty well with a COVID shock. I was very impressed, I'm a say, by what they did.

I'm Francine Lacquois, an award-winning journalist. And I've got a new podcast, leaders with Francine Lacqua from Bloomberg Podcasts. I've interviewed everyone from Heads of State to fashion icons about the news of the moment. But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision. Listen to new episodes every other Monday. Follow leaders with Francine Lacroix wherever you get your podcasts.

I want to ask another question about a sort of post-crisis risk. Obviously, Tracy, talk about financial risk. There's also, you know, you mentioned all of these SMEs, many of which could end up going out of business, whether it's movie theaters, restaurants, bars, some will be saved, some may not be saved. And the thing I'm interested in is hysteresis and the idea that. that if we have a, you know, the longer this goes on, the more the economy suffers a sustained degradation of productive capacity. That even after the vaccine, I'd say we get a vaccine in the spring or early summer, that there's because of this sustained shutdown, because of loss of businesses that can't easily be reversed, we're just in the U.S. or Europe or anywhere,

there's not as we don't have what it takes productively to come back. How big of a risk is that, in your view, in terms of growth potential post-crisis, and how much does, say, aggressive fiscal policy now help mitigate that risk? You know, Joe, this is my main concern, what you say now, because when you look at major shock like the global financial crisis, but also other shocks, you know, the old shock in the 70s, what you always saw is that the potential growth went down, so the long-term growth went down, so it hit very much.

the supply side of the economy. And so, you know, when you talk about, for example, the fiscal policy and the sustainability of debt, people will tell you, good news, you know, interest rates are very low and the growth rate is higher. So, you know, you can have sustainable debt at much higher ratios. The problem, of course, is that, Jay, you know, the growth rate, the long term has also fallen. So interest rates go down, but the long-term race also go down.

And the extent to which this happened is not sufficiently factored in in the long-term debt sustainability analysis that you see among many market participants. So I think this is a real issue. Now, European politicians, I mean, have understood that, actually. And the recovery plan is precisely to try to answer to your question by saying, look, we don't talk about support measures for the economy as it is, but we want to invest, you know, in technologies of the future digitalization. Now, the question, can they realize that? Because, as you know, before the crisis, you know, potential growth was trending down in most economies, was trending down.

It was not trending up. And so these problems of the past are still there. So the optimistic view, which I must say I don't share really. I think it's going to be very challenging. But the optimistic view is to say, well, there's a big shock. People have understood, you know, that your future depends, you know, of innovation and all these things. Europe is going to make a lot of efforts to improve the economy, et cetera, et cetera. They're going to invest in digitalization.

But at the same time, if you look at climate, take climate, for example. A lot of the investments will be in climate. And one of the questions is, all these investments in climate, which I think are necessary, are these investments going to increase the potential growth rate? This is not obvious, of course, because you could say, you know, the pollution is lower, and in the long run it's better for a society, it's even in the short term, but it's better. And maybe you have lesser tail risk, you know, and shocks, climate shocks than before. But in between, you know, your potential growth is maybe not stimulated by that.

This is a key question. That's why the European Commission came with a combination of climate change investment and digitalization. That was the, I wouldn't call it the trick, but that was the beauty of their plan is to say, look, I have something that would improve the supply side, and I will make an effort in innovation and all these things, and at the same time, it will be climate friendly. Now, as we said before, there are many other reforms that you have to do, you know, to get, you know, to increase your potential growth rates. So this is the right question. And I think that question about sustainability of public finance is addressed by many economies today in a way, you know, which politicians very much like, of course, because they say, well, R is lower, you know, for almost forever before the growth, below the growth rates. So you can increase your public that much further, you know, than what you thought before. And of course, politicians like that.

No, there's just one qualification to that. So I'm worried about this, but there's one qualification. I think in the short end, you have no choice. So I still believe that fiscal policies, the way they are conducted, are absolutely necessary in spite of what I say. But when things will normalize, it will be quite complicated. And that's why, you see, I say, you know, there may be political tensions in different countries.

There will be probably more asymmetries. You know, some countries will do better. and times will be extremely challenging. So you will go with the vaccine and the improvements with the phase of euphoria, and then suddenly the problems of the past, magnified by what you just said, will come back, you know, in force.

And there will be a lot of claims, you know, to say, look, you know, look, I need, for example, you need to put more money in healthcare, you need to go in climate, you know, you go into education. And so the politics, you know, of the post-COVID shock will be quite complicated.

That's not the priority today. The priority today is to get out of this situation, but after it will not be easy. And between the central bank and the minister of finance, it can be fine as long as inflation is well behaved. And I think that's probably part of the good scenario, which has a high probability, and the central bank would then.

But imagine, for example, imagine, for example, things go much better. And in the markets, market people start to say, look, plenty of people, plenty of investors have bought, you know, boons and other, you know, long-term bonds at negative rates for a very long period of long maturity. At some points, as you know, markets function, at some points when you will see, you know, things improving, there will be a lot of people selling their positions and go to shorter-term maturities. And when you see that, long-term rates will increase. You have seen that in the U.S. following modestly, you know, 10 to 15 basis points, you know, after the announcement on the vaccine.

But imagine you go to a situation when the vaccine, it works. It's being, you know, it's being given to a big part of the population and faster than what you expect. So in the second half of next year, then there will be a lot of selling of government bonds because who wants to keep, you know, a boon at minus 50. 60 basis points. And so that means that long-term rates, as we have seen in this little episode in the US will go up. And then you will have to see, you know, at what point the central banks will intervene or not intervene in this normalization phase. I think it's a little bit too early to think too much about this. But the episode in the US, you know, two weeks ago with the vaccine, I think was precisely the sort of scenario I have in mind, you know, but at a bigger scale. And that the central

banks should be prepared for that. A steepening of the yield curve, I think, when you have good news, is absolutely not a problem. But as you see, markets tend to overshoot, usually. And a strong increase of rates, you know, in a normalization period would not be welcome. As long as you don't have inflation, the central banks may intervene, but they have already, they will have already 25, 30 percent of public debt in their books. Are they going to buy another 10 percent in their books just to make the point. And I think this, this, nobody wants really to talk too much about this because, you know, the priority is not yet to think about this. But at some point, we have to be prepared because, you know, there is light at the end of the tunnel, as we say, and

the train, it may be faster than some people think. So we have to be prepared for all scenarios. And I confess with you, I'm worried about the normalization phase, but also more fundamentally about the potential growth in Europe, because normally it should go down and not up. Now, there is a little bit hope that, you know, people get wiser, they will invest wise and all this thing. But that's not so much the lessons of the past, what we have seen in the past. But let's hope for that. Well, just as a quick follow-up to that point, I mean, one of the ideas that you hear,

and you certainly hear it in the U.S. and maybe implicitly through the Fed's new framework is that there are benefits to running at And that, okay, we've, the Fed sort of implicitly has admitted that in the past, it's hiked rates prematurely, that it sort of was too aggressive to normalize rates and then had to reverse the rate hikes of 2018 and come to mind. And then the reversal in 2019, are there benefits to running at hot? And what do you feel about this debate that it's like, okay, let's let the economy grow. Let's tolerate some more inflation. And that could in general. the sort of investment that we need to see so that these declining trend growth rates. And as you pointed out, even going into COVID, growth potential growth rates were going down, that we might actually get a meaningful, sustained reversal of these trends as opposed to just a temporary growth boom that then reverses again. That's an excellent point.

I mean, the intuition is rather than simple that if you try to stimulate and support demand and even create excess demand, firms are going to invest, you see, and that would have an impact on supply side, and you can have a sort of virtuous circle. Support of aggregate demand will be followed by, you know, good supply side reaction. So there is probably some point with this.

I mean, there is always some truth into that. But I would warn generally that the supply side depends on many other things like taxation, regulation, the business environment. And if you support, I mean, that's the more classical view of that. And I think, you know, in Europe, if you take the periods before, we saw declining productivity.

Just before the financial crisis, you saw declining productivity growth in spite of high aggregate demand, you know, very strong aggregate demand. So I think it did work. I mean, you need to have structural reforms, you know, to increase your potential growth. So I think there is some point, you know, to that, but I would certainly not say that this is a sufficient condition. A necessary condition is that you improve your regulatory, your taxation, your business environment if you really want to change the potential growth.

When I say the business environment, it doesn't exclude necessarily the state. We know that public infrastructure can play an important role if it's well done, of course, and it's a question of governments. What we mean we say, it's not supporting aggregate demand that's going to make the trick. I think that would be an illusion again. And we have seen that in the past. I don't see reasons why that should be different in the future. So you need reforms again.

That's why I say in the normalization phase, don't forget, we are going to get back to the level of pre-COVID shock, to the level, not before, well, at best, early 22. Before we get to the level, that means there is a huge importance. meant compared to expectations of people. And that means that, you know, at some point, people were already complaining before in different countries about, you know, their status, you know, their wealth evolution, the income evolution.

These things will come back. This is not a priority today, but these things will come back. So I think when we talk about institutions in Europe, it's absolutely essential, including the transfer we talk about, that you have a mechanism of surveillance of the money which is being given, that it's efficiently used because if that is in place and things go down later on,

you know, you better have tested your new institutions on that. And there, you know, you cannot be optimistic on that, naively optimistic, because the banking union is not even achieved today. I think we don't have much time

to do these reforms and they have to be done in crisis, actually. And I think it's understood for the banking union, certainly by the ECB, pleading for the capital market union and the banking union, but you need regulatory changes to do that, you need legal changes to do that,

solvency loan, and there are many things you have to do. And when you see Minnesota Finance, for example, their priority today is not really to do that because they have to deal the shock now. And coming with new regulatory changes, tax changes for the future, completing the capital market union, the banking union, it's not the top priority, you know, in the day-to-day,

life of politicians. They say, well, we'll see that a bit later because now I have to manage the crisis. But when the crisis is finished, you will lack, of course, of renewed institutions. So I think this message is very well understood by the Central Bank, by the European Commission. By a number of ministers of finance, if you look at Germany, they would absolutely approve I think that sort of reasoning that it's now that you have to change and improve, you know, institutions, the internal market, especially with the Brexit, you know, you have to do all this thing. You have to increase the political cohesion, you know, to deal with China. You know, the U.S. will be a bit better, you know, in the international relations.

But I think what we have seen in the U.S. is a warning for the future. I mean, you know, it will not be as before, even with the new administration. It will not be as before. So Europe has to organize itself, doesn't have much time, and they have to do it now. But it's not easy. I mean, for ministers of finance, because they have their short-term priorities, which is normal. Peter, that was fantastic. That really appreciate you taking a time.

It was a real treat to get your perspective. And thank you for coming out. Thanks, Peter. That was great. Bye. Bye. Good. Okay.

Bye-bye. That was a real treat, Tracy. Peter sounded. I don't know if pessimistic was the right word, but at no point did he seem like particularly optimistic, did he? No, I think even in his sort of, I mean, I think even in like what meant. many people would say is the best case scenario where we do get a vaccine and things change very

quickly. He seemed to lay out a very uncertain policy path in that case. The idea of a potential inflation overshoot or maybe markets get enroiled along the lines of what we saw a couple weeks ago when we have this big rotation from growth into value and it was supposed to have broken a lot of quant models and things like that. It's not what most people would focus. on when we're talking about the economic implications of a vaccine. But I do think he has a point. No, I mean, I guess on the one hand, I think it's good for public officials, central bankers to sort of maybe they should have a sort of slightly skeptical or pessimistic outlook because they should be guarding against downsides. But, you know, just thinking about the issues he identified and

his sort of skepticism that demand side policies would work, that there's much. appetite to engage in reform outside of a crisis, which is another sort of recurring theme that we've talked about a few times. It's not great, but I mean, I love this perspective, obviously. I love hearing. Yeah, absolutely. And it was interesting to hear him reminisce a little bit about what was going on at the ECB during some pretty famous times, like during Mario Jockey's, whatever it takes moment. Yeah, I mean, he's sort of, it's interesting. It's fairly, yeah. diplomatic and obviously most central bankers are pretty good at diplomacy, but one has to imagine. Avoiding questions about how annoying the Germans were when it came to fiscal transfer?

I'd just say he, there must have been some pretty tense moments in the behind closed doors between sort of a, the Germanic view of central banking versus everyone else who wanted to get things moving along. That's also a diplomatic way of putting it. Yeah, exactly. This is my audition to be a central banker one day that I can describe things like that and a polite word. On that note, shall we leave it there? Sure, let's leave it there. All right. This has been another episode of the Oddlots podcast.

I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at The Stallword. Follow our producer, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts under the handle at podcasts.

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