Draghis Jackson Hole Speech Has Been Misunderstood

Draghi's Jackson Hole Speech Has Been Misunderstood

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Mario Draghi's speech at Jackson Hole on August 22nd caused a considerable stir. For the first time, he admitted that the absence of a central bank backstop for government borrowing means both higher borrowing costs for governments and a greater likelihood of market punishment for profligate governments (my emphasis):

Since 2010 the euro area has suffered from fiscal policy being less available and effective, especially compared with other large advanced economies. This is not so much a consequence of high initial debt ratios – public debt is in aggregate not higher in the euro area than in the US or Japan. It reflects the fact that the central bank in those countries could act and has acted as a backstop for government funding. This is an important reason why markets spared their fiscal authorities the loss of confidence that constrained many euro area governments’ market access. This has in turn allowed fiscal consolidation in the US and Japan to be more backloaded.”

QE is indeed fiscal policy

Some have hailed this speech as indicating that the ECB is about to embark on a major QE program. But I fear they are mistaken. Although Draghi expresses concern that inflation expectations may be becoming unanchored on the downside, he also admits that transmission of monetary policy is hampered by continuing rate fragmentation in the periphery:

Sovereign pressures also interrupted the homogenous transmission of monetary policy across the euro area. Despite very low policy rates, the cost of capital actually rose in stressed countries in this period, meaning monetary and fiscal policy effectively tightened in tandem. Hence, an important focus of our monetary policy in this period was – and still is – to repair the monetary transmission mechanism.”

A major QE programme in the Eurozone would be counterproductive while credit channels in the bank-dependent periphery remain blocked. This is why the ECB's attention is on relieving funding pressures on banks rather than direct reflation via QE. The latest scheme is a Targeted Long-Term Repo Operation (TLTRO) to provide cheap funds to banks for lending to SMEs. This would help to drive recovery for the whole Eurozone by increasing activity and demand in the core. (It's worth remembering that corporate investment is currently very low in Germany and there have been calls for major expansion of investment there in order to raise domestic demand and reduce the bloated trade surplus.) Purchases of ABS by the ECB are also planned, and since these would provide a central bank guarantee for SME lending across the entire Eurozone they would be far more effective at ending rate fragmentation and supporting SME lending in the periphery. However, they are a long way off. The ECB has only just appointed Blackrock to advise it on the design of such a program.

Some analysts have claimed that this speech was Draghi's “Abenomics” moment. Nouriel Roubini argues that Draghi has outlined a similar “three arrows” approach:

  • structural reforms in periphery countries

  • fiscal easing focused on investment and on demand stimulus in the core

  • quantitative and credit easing

But Roubini, like others, ignores the context of this speech. It is not fundamentally about restoring growth in the short term. Nor is it about the balance of monetary and fiscal policy, or about the responsibilities of core versus periphery. In fact it is not about short-run economic policy at all. It is about unemployment.

Specifically, it is about the growing tragedy of unemployment in periphery countries, particularly among the young. Unemployment across the Eurozone is currently at 11.5%, with unemployment among 15-24 year olds about twice that. But these figures, bad though they are, disguise the true horror of unemployment in some periphery countries: Spain, for example, where adult unemployment is at the same level as the US at the height of the Great Depression, and half of all young people are unemployed.

Draghi rightly notes that this is partly cyclical. He shows that the Eurozone's labour market has actually suffered two shocks, the first being the financial crisis of 2008 and the second – and far worse – being the sovereign debt crisis of 2011:

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But the concern is the length of time that unemployment has been elevated, and the fact that it disproportionately affects the lower-skilled and the young (since the young lack the skills and experience of working adults):

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There is evidence that employers discriminate against the long-term unemployed, particularly if they are low-skilled or their skills have atrophied because of disuse (hysteresis). But for the young it is even worse: young people who leave school or college only to spend years unemployed are scarred for life, their earnings potential seriously diminished. Many never achieve their full potential.

And the consequences of this shocking waste of human capital could be serious. Highly-indebted governments in the Eurozone depend on high tax revenues in the future to reduce their debt burdens: while even less heavily indebted governments such as Germany will also need high tax revenues in the future to support their increasing proportion of elderly. The future fiscal sustainability of the Eurozone depends on the young people whose futures are currently being systematically destroyed by unemployment. THIS is what Draghi's speech is about.

Draghi's concern is that the unemployment that was originally cyclical is becoming structural, as the low-skilled leave the workforce and the young fail to enter it. The result would be a permanently elevated unemployment rate and/or reduced labour force participation rate, a higher NAIRU and lower trend path for growth. But in the Eurozone, unemployment is primarily a fiscal concern: unlike the Fed, the ECB does not have a mandate to maintain full employment. That is why this speech focuses so much on fiscal policy. Draghi is not suggesting a Shinzo Abe-style “shock and awe” combined fiscal and monetary stimulus package. Rather, he is discussing long-term adjustments to both monetary and fiscal policy to combat the twin scourges of unemployment and hysteresis.

And his suggestions are extremely interesting. He rightly observes that the structural rigidities in many Eurozone labour markets must be addressed. Spain's unemployment, for example, is primarily due to the collapse of its construction industry, as is Ireland's: but Ireland's flexible labour market was better able to adjust than Spain's dual market (protection for older established workers at the expense of younger ones):

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But structural rigidities are not the only problem. As Draghi explains, the Eurozone cannot compete with emerging and frontier markets on costs, so must develop skills and expertise in high value-added industries. This requires substantial investment in education and training across the entire Eurozone, not just for those currently at school and college but importantly also for adults whose skills are inadequate and/or atrophied. Draghi's call for a “discussion” about the overall fiscal stance of the Eurozone should be seen in this context. Although he clearly thinks there is room for core countries to ease their fiscal stance, he is not fundamentally in favour of short-term fiscal stimulus to kickstart growth. What he wants is long-term investment in both physical and human capital.

This investment could come from two sources. Firstly, it could come from those countries that still have the capacity to borrow. However, the most financially stressed sovereigns are also those with the highest unemployment:

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Clearly, investment in education and training that depended entirely on sovereign funding would primarily benefit people in core countries, widening the gap between them and people in distressed periphery countries and making it even harder for those countries to restore competitiveness.

So the really radical part of Draghi's speech was his call for an investment programme led by the EU itself.

The EU's budget is currently too small to support an extensive all-age skills development programme across the entire Eurozone. It would have to be leveraged to enable such a programme – and this means Eurobonds. Not Eurobonds as we have previously thought of them: pooling of existing and future sovereign debt remains anathema. No, these would be Eurobonds issued by a federal authority. And potentially they, unlike Eurozone sovereign debt, could be backstopped by the ECB, making them attractive to investors and keeping borrowing costs low.

Such a programme would imply harmonisation of education and training opportunities across the whole Eurozone. Draghi explicitly debunks the notion – endorsed particularly by Germany – that people within the Eurozone can simply migrate to where the work is:

Cross-country migration flows are relatively small and are unlikely to ever become a key driver of labour market adjustment after large shocks.......the long-term cohesion of the euro area depends on each country in the union achieving a sustainably high level of employment.”

Clearly, if the road to long-term recovery in the Eurozone is to give people in Greece the same employment opportunities as people in Germany, their education and training must be of a similar standard.

So Draghi is actually calling for establishment of federal institutions with independent fundraising powers. And he ends with a warning.

We should not forget that the stakes for our monetary union are high. It is not unusual to have regional disparities in unemployment within countries, but the euro area is not a formal political union and hence does not have permanent mechanisms to share risk, namely through fiscal transfers.....Given the very high costs if the cohesion of the union is threatened, all countries should have an interest in achieving this.”

Remaining an incomplete union is not an option. Either the Eurozone becomes a fully-fledged federation, or it will eventually fall apart.

Related reading:

Draghi looks ahead to a turbulent time - Simon Nixon, WSJ (paywall)

Europe according to Draghi - Jean Pisani-Ferry, ProSyn

A worse crime? - Coppola Comment


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