Odd Lots - The ECB’s Former Vice-President Explains The Historic Step That Europe Just Took

Episode Date: August 10, 2020

For years, people have identified the lack of fiscal transfers and fiscal burden sharing as one of the glaring architectural flaws of the European economy (particularly within the eurozone). One positive that may result from this crisis is the potential for that to change. Last month, EU governments made an agreement to establish a recovery fund that would see wealthy, thriving countries (like Germany) directly aid in the economic recovery of countries that are struggling (such as Italy). It’s something people hoped to see during the eurozone crisis of nearly a decade ago, but which never quite panned out. On this episode, we speak with former ECB Vice-President Vítor Constâncio about the historic step, and the future for central banking at a time when fiscal firepower is becoming even more important.See omnystudio.com/listener for privacy information.

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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. Hello and welcome to another episode of the Oddlots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. Tracy, I was thinking, we don't really talk that much about Europe these days. I mean, I guess not in relation to the heady days of the Eurozone debt crisis. No, we don't. But also I feel like in this particular crisis, at least from some of our episodes, you know, obviously we talk a lot. in the Fed context, the U.S. context. And of course, you know, I've talked plenty about Hong Kong and

Asia and Asian supply chains and China and so forth. It feels like we focus a little bit less on how this current crisis is playing out in the European context. Yeah, I think that's right. I guess the implication is that maybe this has been unfair in some respects because there has actually been something very, very interesting going on in Europe at the moment. Yeah, I mean, for one thing, you know, there's a good argument to be made that Europe, at least relative to the U.S., if not necessarily Asian countries, has done a pretty decent job overall of suppressing the virus itself. And, you know, for years during the euro area crisis, there are always people like fiscal policy, fiscal policy, that's what's missing. You've got to spend more, got to get the Germans to spend more. And, you know, maybe this time it looks like they're actually doing. Yeah, that's exactly what I was thinking. So we had the announcement of a big deal, 750 billion euros worth by the EU to fund a sort of long-term recovery fund for the Eurozone. And that's a big deal because as you point out, everyone's been talking about fiscal stimulus, but it looks like the Eurozone is finally going ahead and doing it. Right. And so this, of course, raises questions. And it's a theme that we've definitely had a lot on our podcast. which is, does this augur something bigger for the post-crisis period?

So, of course, it's well known that, you know, there's a lot of money being spent by governments all around the world, including the U.S., but the question mark is, okay, when the acute crisis phase is over, do governments just retrench, or does this become a sort of new macroeconomic stabilization model? That's a theme that we've hit dozens of times. But it's particularly important in the European context, I think, because people have sort of of identified the lack of fiscal burden sharing as sort of a basic architectural tension or flaw within the euro system. Yeah, I think that's exactly right. How does the, I don't want to say

the intrusion of fiscal stimulus, but how does the arrival of fiscal stimulus on the scene actually reshape the way that monetary policy works? And I guess we should also mention that the ECB is also in the midst of another really important project, which is rethinking how it targets inflation. So we have all of this going on simultaneously, real existential questions for the role of the European Central Bank. Absolutely. Well, I'm very excited. We have a fantastic guest to talk about all of this.

We are going to be talking with Victor Constantio. He is the former vice president of the European Central Bank from 2010. 10 through May 2018. He's now a professor at Navarra University in Madrid. The perfect guest to discuss all this. So without further ado, let's bring him in. Vitor, thank you very much for joining us. So are you happy to not being a policymaker in this time, or do you miss being at the ECB during such an extraordinary moment? Well, it's always difficult to get out of executive responsibilities. And I miss them, of course. I could not say that I am happy to be out.

For unfortunate circumstances of the COVID shock, we are again in a very important period of policymaking. But fortunately, Europe has been doing well, I think, in this episode, better than in the previous episode of 2010 to 2012. Just to start out with, walk us through the significance of the deal that was agreed, the 700 billion euros. You tweeted about it. Clearly, you think it's important. What's the significance? Well, it establishes four precedents that are very meaningful. In the first place, it involves a decision to issue common European debt.

Commission will issue 750 billion of debt to fund these programs. And that's a first. The second point is that this is going to be distributed in the form of budget transfers and not loans to the countries. Third, it's a big program to implement what it is a European fiscal policy stimulus to address a recessionary phase in the European economy, and that's also the first time that this happens at this level. And fourth, the distribution of the public transfers, which corresponds to. to a little more than half of the 750 billion is done in a way that it is not proportional

to the size of each country, but indeed benefits more the countries that have lower level of living and higher unemployment. So there is a convergence play. There is a solidarity aspect of this, that it's also quite new in terms of transfers To give you two examples, on a proportional basis, Italy would be entitled to 50 billion, but they are getting 80 billion, whereas Germany would be entitled to 96 billion in proportional terms, but is getting only 27. So these four points put together constitute indeed very important precedence, and perhaps,

and we all hope so, that it will be a, sign of things to happen if, again, there will be a stressful situation in the European economy. And that's a very important element for everyone, the notion that when there is a very stressful social economic situation, Europe steps up and takes decisions to fight the recession and does not leave behind. any of the member countries. It's a big message for the future.

And I think markets are really beginning to interiorize what this means. And we see that already, but it will take time, of course, perhaps for the markets, particularly Anglo-Saxon markets, to overcome the lingering doubts about the European project. So you mentioned some really important things. For the first time, sort of joint debt issuance is happening. Also, the fact that Germany is going to bear more of the burden or the idea that their

economy is more robust. There will be these transfers. But people are calling this for years. Like 10 years now, people have to say, Germany needs to spend more, Eurobonds, Germany needs to spend more. It never happens. Talk to us from your perspective, having been an ECB policymaker. about the pace that Europe operate.

Why does it sort of, from the outside, it's like, oh, this took so long, 10 years. Everyone knew this needed to happen. What is it about Europe that these things tend to unfold seemingly quite slowly over a long period of time? Well, you know, the initial design of our monetary union was under the influence of what was the macroeconomic thinking of the time and particularly central European economic thinking

that maintain that it would be enough to have monetary policy as a macro-stabilization tool. And that second, it would be enough for monetary policy to cater for price stability in order for the economy to work smoothly and progress. A great belief in the private sector and the market economy. And so no one was aware that facing big economic shocks, as the one in 2008 and 9, more would be needed.

Initially, of course, because there was a big pressure on the banks, and the banks had to be helped by the public sector, there was indeed some increase in deficits. for that purpose. But very quickly, since the G20 meeting in Toronto, there was fiscal retrenchment. And as a result, we had in Europe in 2011 and 12, we had a double deep, a second recession that no other advanced economy or region had. And that was the result of this thinking and also the fear of Central Europeans that if more lax fiscal policy in member countries would be allowed, that could result in the future to more need of assistance, and they didn't want it. So everyone was a little blocked by the initial rules.

And it took time then even for us at the ECB to be able to start QE, which we did only in January, 2015, as you know, much later than other major central banks. But lessons were learned from that episode, I believe, especially that the double-deep, the second recession, was the result of too much fiscal consolidation in all member countries at the same time. So this time, the reaction was different, which was, of course, also helped total only by lessons learned, but also by the fact that this was a symmetric shock. It was an act of nature, which was eating all countries in the same way,

and no country could be blamed for this shock. So that helped also the response to be quite different. And third point, which I think is also very important, we are in a very different geopolitical situation. And so in Europe, starting with Germany, but not only Germany, we are now more aware of the need of Europe acting together to protect and expand its sovereignty, to be able indeed to stay on its own feet, as Chancellor Merkel said some time ago. And this awareness increases the sense of collective responsibility for the whole. And that also it's a big driver behind what is happening, this new awareness that Europe has indeed to deepen its integration

in order to survive better and prosper in a new international situation where the pressures coming from Russia, from China, and unfortunately now also from the U.S. have to be considered as real and serious. Since we're talking about that shift in mindset, if we zoom in on Germany in particular, I'm just curious, why do you think, or what is it about either the German economy, the structure of the economy, or the German mindset that made them so resistant to fiscal spending or, you know, establishing some sort of Eurozone-wide federal-type deficit for so long? Well, it was indeed their own domestic approach for four years, which it's called order liberalism,

in the sense indeed that the central bank and monetary policy taking care of price stability would be enough because the rest of the economy would work well on its own. And it has worked well for them for quite some time. But they reacted to the shock, to the crisis, to the banking crisis, very fearful of what could happen. And we saw that at the time, because think, for instance, Since 1969 until 2009, Germany had in its periconstitutional law the principle of the golden rule for fiscal policy, meaning basically that investment expenditure would not count for the fiscal rule. They changed it in 2009, introducing an overall debt break, as it is called, on the overall structural deficit and no specific treatment of investment whatsoever. So they tightened the fiscal rule precisely at the peak of the crisis of 08 or 9 for them. And then, of course, this was exported three years later to the European fiscal rule under their influence, of course, in a softer way than the rule they have.

But it shows that they reacted very fearful to the shock at the time. Lessons were learned, I think, because they themselves last year, or rather this year, had to break in a way that rule in order to expand their own. fiscal policy in the response to the COVID shock. This takes time, but lessons have been learned, and we see everywhere, for many reasons, a return of fiscal policy, not only because of short-term reaction to conjunctural shocks, but also that in the context of the secular stagnation phase that advanced economies are going through fiscal policy as a unsubstitutable role to play. And finally, there is a recognition of that even in Germany. So do you feel this is a never going back moment as in now we have

established or now Europe has established this fiscal policy mechanism, some precedent for burden sharing that you feel confident, at least for the time being and for years? to come? This is going to be a part of the toolkit? Well, no one can predict the future, of course. These will be operational for a number of years because it will take time to implement and then the economy will improve and so on. But indeed, these shows that there is a new awareness about the importance of keeping Europe really cohesive, which is even more important.

in terms of having a monetary union. Now, the big cement that we have in the European project is indeed the monetary union and the euro, because it's objectively, I would say, practically unbreakable experience, and then it means that if there are stresses, if there are shocks, they have to be coped with. This precedent shows that there is these collective,

sense of responsibility that I am sure will happen again if there is a major crisis. This does not mean that, you know, we are going to have a fiscal union around the corner. It's not the case. It does not mean that other institutional reforms are going to happen in the visible horizon, but indeed is a game changer. the result of the new situation and of the lessons learned from the previous crisis, and that will not, of course, go away. I'm Francine Lacqua, 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. So we have this new or growing recognition of the importance of fiscal stimulus,

not just in Europe, of course, but in a lot of other places, specifically the U.S. I feel like we talk a lot about the need for fiscal stimulus, but we don't talk as much about what that fiscal stimulus should actually look like. So when it comes to the European deal, what is the best way to spend that 750 billion euros and what kind of spending, I guess, would promote long-term economic recovery the best? Well, it will be spent mostly on public investment by the member states. And there is already a rule, a principle in the decision of the European Council that says that 30% has to be used for the purpose of greening of our economies to fight climate change. So it's already a chunk of the overall amount that has to be dedicated to investment.

that will help this fight and this objective that Europe has defined to reach a situation of being carbon neutral. And so there are targets, there are milestones, there is a timetable, all that is going to be very present in the national plans that now the member states will have to develop to use these money. And then there are, of course, other types of infrastructure needs in all countries that will benefit from this plan. And in itself, it's an element of stimulating aggregate demand. So it will be really going mostly to investment. I hope also that it will help some countries with a lower level of living to have the resources to support. some segments of the population that are not so well protected by the programs that already have been put in place. I'm thinking about gig workers, precarious workers, say, in performing arts and other types of things that do not have regular employment

and were not the object of the panoply of measures that were put in place to help everyone, in these initial stages of the prices. And that, of course, also is important for stimulating aggregate demand. So it's basically the eighth anniversary. I guess we just passed it of when Mario Draghi, who is the president of the ECB when you were the vice president, he had his famous whatever it takes speech, establishing that the ECB would theoretically, if needed, backstop government debt. And we saw spreads on peripheral debt. I closed very sharply. And that was sort of the beginning of the end of the euro area crisis.

Are we ever going to get back in your view to the sort of boring old central banking of how we used to think about it? It's like occasionally high grades, occasionally cut rates. No one never talks about balance sheets or anything like that. Or is that gone for good? And if we do have this world, fiscal plays a much more active and aggressive role. What is the future of central banking even outside of a crisis? Well, I would say that it is normal that in certain situations of recession, or in the case of a monetary union of fragmentation, beyond what would be justified by the situation of fundamental values,

that in those cases, there is an implicit collaboration between monetary policy and fiscal policy because the stance of both policies converge in those situations, like the one we had before, and particularly like the one we have now, because, of course, this time, the fiscal policy was more important to respond to this type of shock in order to maintain income of people suddenly unemployed or locked down, and only fiscal policy could do that, and also to help firms to survive this period. And monetary policy took care both of normalizing financial markets, avoiding a financial crisis, and helping credit supply by the banking sector. So the division of labor was easy to define and the stance was convergent.

But let's not extrapolate that for every situation because the test of this sort of new relationship that people talk about, the test will come one day when inflation may increase. And then, of course, the central bank has to respond. to that. And that's the crunch moment when we will see how these go, but we are ears from that challenge to happen. And the degrees of collaboration have varied among countries. I would say that it's important to underline the following. Neither in the euro area or in the US, there was any degree of full-fledged properly named monetary financing. What the central banks are doing is not monetary financing.

The Bank of England did a little bit of monetary financing by giving a bridge credit to the Treasury. But neither the ECB or the Fed really did monetary financing. So when I also to take that into consideration. Although loosely, of course, the media are calling what the central banks are doing as monetary financing, but it is not. Okay. I wanted to pick up on that inflation point because, as we mentioned in the intro, the ECB is currently thinking very hard about how it approaches its own inflation target, which I think the exact. language is below, but close to 2%. Do you think, I mean, there seems to be lots of confusion about why central banks around the world haven't been able to hit those inflation targets in recent

years. Do you think that central bankers understand how inflation works? Yeah, good question, of course, and it would be a very long answer to address all aspects. Go for it. But, yes. Now, the question starts with the following thing. You know, Milton Friedman instilled in the minds of many economists and many central banks at the time when he was writing that inflation is always and everywhere a monetary phenomenon. That's what he said.

And by that he meant that inflation was determined by the, development of monetary aggregates, M2 in the case of US, say M3 in the case of Europe. And so the idea that the central banks could fine tune the inflation rate, not immediately, not in very short-term horizons, but, you know, within two, three, four years, could indeed put inflation at whatever level they would wish. Well, things proved to be much more complex than that, because inflation depends on the overall relationship between aggregate demand and supply. And that is influenced by many other factors, including, of course, fiscal policy, but also including external shocks. that macroeconomics, particularly in the U.S., which has dominated the field, of course, for all the reasons we know, tended to be thinking mostly in terms of closed economies, because the U.S. being so big, you know, the external sector was not so important or seen as so important.

But the point is that inflation depends for long periods of time on many other things. Friedman himself was interviewed in the year 2000 about Japan, where there was the beginning of the deflation, as you know, and he answered, well, it's very simple to solve it. You just have to have the central bank buying sovereign bonds. That will expand money and money aggregates and the problem will be solved. Well, it was not followed at the time, but some years later it was followed. Now, the Bank of Japan has bought a little more than 100% of GDP of Japanese public debt, and inflation has not responded.

So it was wrong, clearly. And we do have now, you know, many reduced. form regressions to forecast inflation that take into account the import prices, which includes, of course, the exchange rate, that include also possibly other cost shocks that may occur, and that include expectations and inertia, that indeed, the economic agents, both households and firms, when they decide prices, tend to have certain inertia. in taking those decisions by thinking about what has been the progression of inflation in previous years. And if you put all these elements in a way to forecast inflation, you can have relatively reliable ways of forecasting inflation,

where the slack of the economy is also there, of the domestic economy, it's also there. It's still meaningful, but of course, during certain periods, is overwhelmed by, the effect of the other drivers of inflation. It does not disappear. What has disappeared, and it's also in all the media, is that the initial Phillips curve was just a relation between, in this case, wages and unemployment. That simple, bivariate relation has indeed collapsed. and a more complex way of forecasting inflation, which the economists also call Philip Curbs, adding to the confusion of all this discussion,

the slack is still there. But it's also a factor, and as you see, monetary aggregates are not there anymore. So it has been difficult then, just by monetary policy to change inflation to the level in a period where globalization, And the entry of more than one billion Asian workers with low wages in the world economy put a lot of pressure on declining prices of many industrial products.

And that was a major shock that affected the overall economy of inflation in all our countries so much that the pure domestic slack was not so much in command of, of inflation as it was in the past. And that is, of course, is still true. And that's why central banks indeed have not the easiness, the discretion to put inflation at whatever level they want within a period of, say, five years. But that is not imply that monetary policy

had a big contribution to avoid even a worse scenario of deflation. And that was avoided in all advanced economies, with the exception of Japan. And that, indeed, the role of the central banks has been very important. Sometimes, however, not helped, particularly in Europe, by what fiscal policy was doing. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report,

delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and data to keep you informed. Yes, there are other products like this from a variety of news organizations, but they usually rerun their radio newscasts throughout the day. That's not what we do. We create customized episodes that can only be heard on Bloomberg News Now. And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes.

So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts. We're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen. I want to expand more about inflation and the role of central banks. And thinking back to, I mentioned Mario Draghi is whatever it takes. And part of the innovation in the logic of that speech was that sovereign government bomb spreads should be considered part of the ECB's mandate to narrow because the widening of them impeded

monetary transmission. So even if there was some technical rule that said the ECB can't buy government debt, you could get around it by saying it fits into the monetary policy transmission. Now we're seeing a potential sort of more things falling under. the mandate or the goals of the central bank, including perhaps thinking about climate and inequality and other sort of economic concerns that in the past may not have been as strictly narrow as just keeping inflation targeted. Do you see any risk with this? Do you worry about the ECB specifically or other central banks taking on too much potentially? Well, yes, those are, say,

subordinated targets to the role that the central bank must perform in our economies. They are always there. They are also in the treaty, in our case, that says that without prejudice to price stability, then monetary policy should help all those other policies that you mentioned in general, and that are listed, of course, in the treaty itself. But they are subordinated goals and cannot be the dominant goals because it would make really no sense. Because in a way, what central banks can do, for instance, in what regards climate change, is not very much. Of course, central banks have a portfolio of securities, particularly nowadays when they buy,

and that can become and should become greener and certainly avoiding the more brown sort of securities. But if you look to the numbers after that effort to make the portfolios greener, you see immediately that the overall effect on what is at stake with climate change is indeed, perhaps unfortunately, but it's indeed small. Regarding inequality, well, it's a mixed thing, because if one end, it is true that the purchases increase the price of risky assets, which are mostly held by income segments of the population, they also have increased the price of housing, particularly in Europe. And housing is the element of overall wealth in our economies that is bigger than financial wealth, and particularly stocks. And that stock of housing is held mostly by the middle class. And the price of those assets has increased as I made a speech about that.

And there are two papers published by the ECB later that also point to those factors. And also there is, of course, the effect of expansionary monetary policy on employment, on reducing unemployment, and that is a very powerful way of also of taking care of inequality. But monetary policy, by definition, cannot do everything. There are trade-offs. And so monetary policy has to have priorities, and it has priorities defined by the law. And so what it can take in from those other secondary objectives, important as they are for the society at large, there are other public authorities that are more responsible for that. Take, for instance, climate change. It's certainly for the governments to step up their initiatives to take care of that big objective.

So I see these as indeed a consideration which is there and should be there, but cannot be predominant. The same, for instance, regarding the so-called zombie firms. Again, it's a potential problem. But it's not for monetary policy to have as a priority to think about the fate of weak companies. Monetary policy targets price stability, economic growth, the slack in the economy, and not other things. And there are trade-offs. Zombie firms are more the purview of the way banks manage their credit risk by not ever-greening and not continuing to land to problematic firms than to monetary policy. Particularly at this moment, also the amounts of liquidity and capital in the banks imply that the keeping some weaker firms during this period is not crowding out the possibility of banks giving credit to all the good firms that have good projects and intentions to invest and to expand.

So just to give you three examples of some subordinated concerns that the central banks should not ignore but cannot become a priority. I have a related question on the sort of muddling of monetary policy with politics. One of the options when it comes to reviewing the ECB's inflation target is to create a flexible target, which would allow the central bank to either undershoot. or overshoot inflation as needed. And I'm curious to get your views on if the ECB did adopt that kind of flexible target and the target therefore becomes discretionary, then doesn't that sort of make it a political choice to either undershoot or overshoot inflation at a particular time? And does that endanger the independence of the central bank?

I think that the target for inflation adopted by central banks should be indeed symmetric, because, as we all know, when there is a supply shock to the economy that in some cases may lead to an increase in inflation, like a big oil price increase, say, monetary policy should not respond to that immediately because it cannot change. that situation and would only aggravate the recessionary effect on the domestic economy of that olive price increase. That is well known, which means that in those periods of supply shocks, inflation could be accepted to be above target and should be accepted to be above target.

So it should be symmetric. And in my view, the best way to have it is what, say, the fact of the fact that the fact Fed has now, which is to say, well, we have this objective one number. It's 2% in the definition of the Fed, which is not the headline inflation, as you know, but okay, it's 2%. And then it's symmetrically interpreted. It can be slightly below, it can be slightly above, according to the types of shocks that the economy suffers. And of course, it cannot be kept exactly at 2% all the time. So some economists and central bankers argue that more explicit flexibility would be helpful, for instance, by adopting a well-defined range around two and put the numbers of the

range. I am against that because that creates uncertainty and also opens the door to the possibility in, for instance, situations that are clearly recessionary and inflation is weak. If it is within the band, within the range, then it would consider to be all right, and the central bank would not move policy, which is wrong. So I am against ranges. A way of also then justifying more flexibility is to go for the so-called averaging inflation targeting. That there is a number, there is a target, but it has to be attained over a number of years. to allow precisely years where inflation is below and then years where it is above. Well, it's enticing, but again, I also do not agree too much to that because it's too precise

and will tie the ends of central banks perhaps too much when, say, the six years of the averaging would come and what to do and then possibly fail and changing into averaging inflation rates, inflation target would not by itself move expectations of inflation. It's just not because central banks would go for this, that now everyone would start to take decisions in the economy, as if inflation is indeed going to increase according to the new averaging target. It's not going to happen that way. So I am against, but I see that it may happen in the US.

At least, you know, it was very much on the cards before these crisis and may come again. If it comes and if the US would adopt that explicitly, that would have a big impact on other central banks. And then perhaps the ECB would have also to adopt that. But it's not something that I favor to start with, but I, of course, could accept for the reasons I mentioned. It's better to have one number and the notion that it is symmetric target to manage monetary policy. I think it's something really fascinating there about how if the U.S. were to adopt this overshoot or catch-up strategy, that might have an influence on other central banks.

And I'd just love to, like, as someone who's attended all these ECB meetings, starting from when you were the governor, the Bank of Portugal, so 18 years worth of meetings. How does change happen over time? Do people think new ideas, do discussions, push people into new areas, or is it about simply the composition of the ECB changing over time as people swap in, swap out roles? Talks us a little bit more about how sort of evolution of thinking works at the ECB. opinions move starting in academia, for instance, and events also determine change of mind in people, certainly. And for instance, talking about averaging inflation targeting, there is one thing that is now

in the mind of every central banker in advanced economies, which is that after this big shock, of the virus, there will be scars in our economies and unemployment that will take time to be reduced to previous levels, which justifies that our economies from a macroeconomic policy perspective should be run as high-pressure economies, allowing a little bit of overeating in order to correct quicker, the scars in unemployment and in productive capacity that will be destroyed during this period of the virus crisis. And this idea of allowing that a period after this crisis of, you know, high pressure of potentially a little bit of overeating, is well justified by adopting averaging inflation

targeting, which provides then a more explicit intellectual rationale for that way of managing and accepting this development of inflation. And so it may happen. And that, of course, then may be shared more widely than just, say, in the Fed, if indeed the Fed moves that way. But it is, in my view, true and it will happen that major central banks will allow some degree of accommodation of high pressure economy and potentially a little bit of inflation during the immediate period following this COVID crisis. I have a slightly weird question, but in the current environment, environment, it does feel like there's a lot of outrage directed at central banks for a variety of

reasons. But I think one of those reasons is people feel that the central bank is sort of forcing rates ever lower, eroding people's savings, possibly inflating bubbles in the stock market, things like that. Do you, what's your response to people who criticize the central bank for doing that kind of thing. And also, this is the weird question, but do central banks actually have the power to set interest rates wherever they like? Well, central banks, of course, influence very much short-term rates, but now via purchases also have a degree of effect over medium and long-term rates, particularly because markets are afraid of central banks, and move in the direction of those purchases more so than what the amounts that the central banks are indeed buying would objectively justify.

But then there is then an influence also on medium-immian rates. But it's not true that the central banks totally determine. interest rates throughout the spectrum of maturities, because many other factors enter the behavior of investors, and they know that in the end, the amounts that the central banks could mobilize have limits in relation to the size of those markets. And let's recall that what counts for this purpose in asset markets, is the total stock of the assets that potentially can be moved. As James Tobin always said, it's the stock that counts for the development of pricing

and not just the flows of what the central banks are buying and so on. Because at any moment, investors can take views about the future that will move a big chunk of the stock that is there. So there is no full control of medium and long-term rates that are then driven by other factors. But there is certainly an influence, of course, that's now become an instrument because we reached short-term policy rates that are very close to zero. And then there is this limit and the need then to intervene more along the maturity spectrum. And that's what QE in part is doing, is doing other things, but it's also doing that. We've been talking about these sort of big picture questions about Europe, the future of central banking, etc. Just to bring it back to the current moment, when you look at Europe, do you feel confident that the existing fiscal package and the existing stance of monetary policy are appropriate to get the economy roughly back to where it was?

pre-crisis in a decent period of time, or do you think ultimately there will have to be yet furthermore done on the fiscal or monetary front? Well, we are all dependent on the virus and on the possibility of a second wave. That would then require bigger stimulus, both monetary and fiscal. But forgetting that for the moment, I would say that perhaps next year there will be will be needed a little bit more of monetary policy. Fiscal is already very much committed, and deficits will continue to be high next year, not as high as this year, but still high as the IMF has forecasted, the amazing 23.8% deficit for the U.S. this year and minus 12.4 for next year.

And that's before the new package being discussed right now. And in Europe, the deficit this year of 11% and 5.3 next year. It can be a little higher next year because one thing is that governments gave a lot of guarantees to bank loans. And there will be defaults, NPLs in many loans. And some of those guarantees will be activated. next year, and that will increase the deficits next year. So the stimulus will continue, the deficit will continue. There is the new package, and that should be indeed enough for the recovery, which nevertheless

will be, in my view, sluggish. I don't anticipate that we will reach the same level of GDP of 2019 before 2023, meaning the end of 22, perhaps, but certainly not before, and perhaps even the end of 23. So it's a sluggish recovery because there has been a structural decrease of demand for many sectors of our economy. And the levels of demand for those sectors are not going to come back anytime soon to the same levels as before. and that will affect, of course, growth because creation of new productive capacity in other sectors will not be as quick as to offset that shock to the supply side of our economies, including international supply chains and all that.

And also because consumers will be increasing their saving rates for a number of years. It happened in 2008, after the shock of 2008, it will happen this time, perhaps even more after the experience they had this time. So that altogether creates the conditions for a sluggish recovery. We have to be aware of these limitations, but certainly this recovery is going to happen. but it will take, you know, at least a couple of years, if not a little more, to come back to the levels of 2019. And of course, we will never come back to what would be the trend of growth of our economies if it had continued without this big shock, the same as it happened with the shock of 2008. Vitor, that was a fantastic. Really appreciate you joining us. Really enjoy getting to hear from someone of your perspective. Thank you. It was a pleasure, too. That was really great. Thank you.

Tracy, that was a real treat getting to talk to someone who has been so involved with policymaking and some of the biggest issues of the economy, basically two decades. Yeah, absolutely. You know that saying to be a fly on the wall of, you know, room of the ECB meeting and he's sort of been in, well, a lot of them, hasn't he? Yeah. According to our colleague Lorkin, who knows the ECB better than basically anyone else I know, he never missed a meeting in 18 years. Wow. That's quite a record. But I do think it's interesting to talk to him at this particular juncture because, of course, as we've been discussing, it does feel like the very nature of central banking and monetary policy is beginning to change. It feels like there's sort of a handoff from monetary policy to fiscal stimulus, but at the same time,

there's the question of how monetary policy is going to interact with that stimulus. Yeah, I think what's interesting, too, about this moment is that, so obviously the COVID crisis comes along and throws everything into disarray and policymakers have to scramble to new tools. But I think what's really striking is that the sort of intellectual, um, ground, work for a change was in the works pre-COVID. You know, this idea of, okay, more aggressive, consistent, active role for fiscal policy, people have been talking about this for a while, and that's been a theme of some of our conversations.

So it's kind of like the intellectual, you know, terrain was shifting. And then we got the moment with the COVID crisis where suddenly it's like, okay, we have, this has to go beyond papers, tweets, and talks, and to actually start thinking about how we're going to put this into practice. And so, you know, that's sort of, it's a moment for multiple reasons. Yeah, that's true. Although one thing that strikes me whenever we have these conversations with economists is just how much of economics is still uncertain. So, for instance, why is inflation not necessarily behaving the way a lot of people expect it to? Or why is the Phillips curve flat? Where should the natural rate of interest be? Is there such a thing?

as the natural rate of interest. I feel like these are all really big questions that listening to Vitor, you can tell that they govern a lot of his thinking and presumably a lot of other central bankers thinking, but there are so many uncertainties swirling around them. Yeah, I was really glad that you asked that question about a sort of theory of inflation, so to speak, because it's such a profound question, because if you have all these central banks and they're like targeting, you know, the U.S. is a dual mandate, but technically the ECB just has one mandate, the inflation mandate. But if you set out this mandate, okay, you have to hit this, and yet no one can really articulate what drives inflation. That just to me gets to like such a

core question about like what are central banks even doing if the thing they have to target, they don't know how to get there. Oh yeah, absolutely. I find inflation as a subject just really fascinating. Also, how they measure it. I think a lot of people in Europe right now, especially would argue that living costs are going up, even though inflation is still persistently under target. But, okay, getting slightly off track, that is a topic for another odd thoughts episode. It could be a series, actually. Oh, yeah, let's do an inflation series. Yes. Yeah, that'd be a good one. Okay. But just, you know, like just what Vitor said about, oh, Milton Friedman, who is sort of the godfather of how modern economists thought about inflation for years. And he's like, oh, if Japan doesn't

have inflation, file the government debt. It really sort of shows how much work there is to be done still on this topic. Yeah, that was a good anecdote. Okay, shall we leave it there? All right, let's leave it there. This has been another episode of the Odd Thoughts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. You can follow me on Twitter at the stalwart, and you should follow our guest, Vitor Constancio. He's on Twitter at VMR Constancio. And follow our producer, Laura Carlson, at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today.

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