François Villeroy de Galhau: Central banks' response to the
"tragedy on the horizon"
Speech by Mr François Villeroy de Galhau, Governor of the Bank of France, at the SUERF -
Online Conference, 14 October 2020.
* * *
Ladies and Gentlemen,
I am very happy to join you today for this discussion that, although virtual, will be very real in
terms of the strength of the ideas put forward. I am grateful to Michala Marcussen for offering me
the opportunity to give this speech on such a dense topic: central banks' response to the
"tragedy on the horizon".
Faced with an unpredictable shock, the past eight months have driven the global economy into
uncharted territory. However, one danger is certainly looming larger at the moment : our lasting
addiction to public debt. Let me be clear: in the face of the unprecedented covid-shock, a
massive and one-off recourse to public debt financing was both inevitable and desirable.
However, we have entered this crisis with public debt levels, which were already very high in
most countries, with few notable exceptions. The continuous rise of public debt, along with
climate change, represent two of the main long-run challenges that we face today. In his famous
2015 speech, Mark Carney spoke of climate change as the "tragedy the horizon". With this, he
of
meant that this tragedy is inevitable if we do not act, but it is in the long term, possibly leading to a
"status quo bias". Public debt is of a somewhat different nature: we do not know if nor when the
tragedy - a major confidence shock, for instance - may happen. But we know for sure that rising
public debt is a growing risk hanging over us, and still more over our children and grandchildren.
Let us therefore call it a "tragedy on the horizon": a moving horizon - indeed nobody knows
precisely where geographically the horizon lies -, but it will not be any less threatening. So what
would our best response to this possible tragedy on the horizon be ? And what can we do to
avoid it? Let me elaborate somewhat on a simple triptych (i) Monetary Policy (ii) Fiscal Policy and
(iii) their renewed interactions.
I. Monetary policy and the ECB mandate
In order to address this unprecedented Covid crisis, the ECB acted boldly and rapidly, using all
the tools at our disposal and inventing new ones such as the PEPP. By doing so, we
successfully avoided both fragmentation and deflation.
We rightly decided to keep a steady hand in the last Governing Council meeting, and I still think
today that our present very accommodative monetary stance is appropriate. But steady hands
are not tied hands: we have free hands for the future, and will be ready to act further if needed.
Let me now turn to the ECB's strategic review, on which work has restarted. It is more extensive
than the FOMC's as it will cover, among many things, structural changes: climate change,
financial stability; and the effects of digitalisation. The Eurosystem will take its time, as the Fed
did, to consider the different alternatives. But we can already today shed some light on three key
points, especially after the excellent "ECB Watchers" conference in Frankfurt on 30 September:
1. A dual mandate like the Fed's and the ECB's two-tiered mandate are actually more similar
than they look.
2. There is some room for clarification in our inflation objective.
3. We should look again at the "second pillar" of the ECB and its possible link with the so-called
"secondary" objectives.
1/ Our mandate puts a clear priority on price stability, and is not a dual mandate. But neither is it
merely a single one: I would characterise it as a two-tiered mandate that includes at least two
other objectives without prejudice to price stability: on the one hand "to support the general
economic policies in the Union" contributing among other aims to a "social market economy,
1
aiming at full employment and social progress" ; and on the other hand "to safeguard the stability
2
of the financial system"
Furthermore, I would argue that there is still less of a difference between a dual mandate and
flexible inflation targeting in the present economic context : notably, the measures we have taken
to offset the effects on inflation of negative shocks such as the global financial crisis or the health
crisis have a direct effect on growth and employment.
2/ Average inflation targeting is a flexible tactic, possibly temporary, within a wider strategy of
keeping inflation sustainably where expected. But still more importantly, our inflation objective has
to be symmetric and medium-term.
As regards symmetry, I cannot do better than quoting Christine Lagarde in her impressive
speech of September 30th: "In the current environment of lower inflation [compared to 2003
and our previous strategic review] (...) to underpin inflation expectations, we need to ensure
3
that our aim is perceived to be symmetric by the public" . I personally add that we might
therefore be willing to accept inflation higher than 2% for some time, without mechanically
triggering a tightening of our monetary stance.
Medium-term means that we should judge our inflation performance over a long enough
4
period. As I said on previous occasions , our medium-term target needs to be viewed in two
ways: it has to be forward-looking to guide inflation expectations, but it cannot ignore the past
either.
If credibly symmetric and medium-term, our inflation objective would probably achieve similar
outcomes ex post than explicit average inflation targeting.
3/ Finally, we need to rethink our "second pillar" - the present monetary analysis - notably in light
of financial stability concerns. To do so, we could track a broader set of nominal aggregates:
Financial aggregates, from the perspective of financial stability, and potentially look more
closely at the assets of financial institutions including non-banks (such as their provision of
credit in the broadest sense) rather than at their liabilities only (including money, as in the
past).
Other starting with nominal GDP growth, which is a key metric in
economic aggregates,
the assessment of private and public debt sustainability. But also employment and income
distribution, which respond to the demands of the Treaties as well as to the expectations of
the public.
II. The three cornerstones to restore fiscal sustainability
Of course we should not repeat the mistakes of the last crisis, and tighten, the fiscal taps too
quickly. But in the longer term, fiscal discipline is also needed. In the current context of an
unprecedented rise in public debt, some tempting illusions have arisen. We must not give into
them. We cannot, for instance, allow ourselves to believe that cancelling the public debt held by
the central bank is a viable solution. Nor is the softer version of this idea - converting this debt
into perpetual bonds.
Let us be clear on this: the public debt pile - which has risen sharply - will need to be paid back
eventually... To do so, three combined levers will have to support the necessary debt
reduction strategy:
1 / We will first need time in order not to phase out fiscal accommodation too early, and create
cliff effects like in 2011-12. We should resume the debt-ratio reduction after growth returns to its
pre-crisis level probably around 2022. But fiscal policy cannot simply be countercyclical in bad
times; the same thinking needs to be applied in better times as well.
2/ Growth is indeed a key determinant in financing the debt inherited from the crisis. This leads
me to the debate initiated early last year by O. Blanchard. First, the best way to ensure that the
differential between the interest rate and the growth rate (r-g) remains negative - which is not
granted forever, nor everywhere - is to increase g. And hence, let us listen to the balanced
message of Blanchard: "public debt is bad, but not catastrophic. It can be used, but it should be
used right." Unfortunately, the quality and the content of public spending is too often the "blind
spot" in the fiscal debate. In August, M. Draghi quietly coined the telling expression of "good debt".
Expenditure should be used for productive purposes and for young people: education and
training, and research, which have a strong impact on long-term growth. On the contrary, fiscal
transfers have a much weaker multiplier in the long run.
3/ Better control of public spending: unfortunately, in many countries including the one I know
best, we have not managed to keep spending under control. Covid-19 related public spending is
clearly the buffer mechanism that the economy needs in the current circumstances. But there
are also less warranted expenditures and this is precisely what we must focus on since the pace
of extra-covid spending seems in several countries to be accelerating even more quickly than
before the virus crisis.
Broadly speaking, the recipe for debt reduction depends on each country's "own speciality":
some countries need above all to boost productivity growth; others need to control their public
spending but they have one ingredient in common: efficient reforms. Let us not forget this
imperative of reforms in the short-term urgency of the covid-crisis.
III. How to revisit the interaction between Monetary Policy and Fiscal Policy?
In the current context, both monetary and fiscal expansions are indispensable to sustain demand
and inflation and to mitigate the costs of the current crisis. However, given the unprecedented
rise in public debt and extremely low or negative interest rates, some are tempted by the
seductive lure of "fiscal dominance", a situation in which the central bank would have to follow
another objective: the financing of public debt. This paradigm shift could jeopardize our
independence and our mandate. Ultimately, it could lead to a loss of confidence in the value of
the money, as observed in the past.
In revisiting the interaction between monetary and fiscal policies, there is a need to make a clear
distinction between short-run opportunities, corresponding to the current crisis period, and
medium-term challenges, which will arise when the economy has fully recovered. In addition, in
the euro area, having a single monetary authority and 19 national fiscal authorities creates further
challenges in the absence of coordination among Member States on their budgets and of a
permanent euro area fiscal capacity. This is why risk-sharing across the euro area should not
rely only on fiscal mechanisms but also on private markets by completing the Capital Markets
Union.
In the short term, the risk of fiscal dominance is not an issue. Today, monetary and fiscal
objectives are fully aligned and require expansionary policies from both sides. Fiscal policy can
help monetary policy to achieve its inflation objective by boosting demand. Firms and households
are encouraged to borrow in such an environment, which allows them to benefit fully from the
monetary stimulus. Monetary policy can also render fiscal policy more effective. The dominant
view is indeed that fiscal policy becomes more effective at the Effective Lower Bound (ELB)
because monetary policy is less likely to react to offset its effects. This is because either the
desired policy rate is sufficiently below the ELB or the central bank has committed to keep
interest rates unchanged through forward guidance.
However, conflicts of objectives between fiscal and monetary policies may arise in the
future. The ongoing accumulation of public debt and the large expansion of central banks'
balance sheets increase the likelihood of such conflicts. On the one hand, large fiscal stimuli for
too long may lead to concerns about debt sustainability and, via the expectation of future fiscal
tightening, offsetting the favorable effects on output and inflation. On the other hand, central
banks should keep the risks taken in their balance sheets under control to avoid threatening their
own independence. Indeed, low inflation today is not a guarantee that it will remain low forever.
They must keep a sound balance sheet with adequate capital in order to keep full control of their
monetary stance all along the road.
The key question is then how to reconcile the benefits of a mutual reinforcement of monetary
policy and fiscal policy in the short-term with the challenges of keeping inflation under control and
public debt to sustainable levels in the long-term. There is no magic answer to this question but I
will try to sketch here some basic principles that are in my opinion ingredients of a sound
policymix recipe:
1. We should not forget the
Each authority should be guided by and stick to its mandate.
lessons from the past and the reasons that led to the construction of our current European
architecture. The Maastricht treaty includes strong safeguards against 'fiscal dominance', by
granting independence to the ECB, introducing the monetary-financing prohibition and
designing fiscal rules. These are not negotiable principles. Inflation should remain under the
control of an independent monetary authority while fiscal authorities are in charge of the
provision of public goods and income distribution, under the condition of debt sustainability.
For this, it is necessary to preserve the credibility of the fiscal rules' framework. In other
words, I would not jump to a hasty revision of the Stability and Growth Pact.
2. Monetary and fiscal authorities should take into account the intertemporal
consequences of each other's actions. This means, as said before, that the central bank
should only adopt measures that can be unfolded if inflation pressures or the risk of a
deanchoring of inflation expectations materialize. Fiscal authorities instead must ensure that
public debt will converge to a sustainable path in the long term even if interest rates return to
higher equilibrium levels in the future. And they must - hopefully - improve the quality of
fiscal expansions by favoring spending that enhance future long-term growth. This is
especially true at present for the European and national recovery funds.
3. The rules on the exit from exceptional measures must be clear ex ante to avoid
The exit from exceptional monetary measures should
things going wrong in the future.
be fully in the hands of the central bank and guided by its mandate of price stability. Fiscal
authorities must also be credible and give guidance on their future actions, by committing to
tightening the stance when the economy has recovered. They should follow a stronger
countercyclical fiscal policy in good times, to create the space that is necessary in bad
5
times. What Blanchard and Summers call "semiautomatic stabilizers" - stabilising fiscal
policies that operate according to predefined triggers - could be an avenue worth exploring.
Let me add as a conclusion that, against this backdrop, the Next Generation EU package
constitutes a new and innovative element of the European fiscal framework, which contributes to
a sounder policy-mix. Beyond the most recent political and institutional discussions, which
belong to elected leaders, a quick implementation of this European Recovery Fund is an
economic must.
This innovation, while still a one-off, could also imply lessons for the Economic and Monetary
Union, which from the start has lacked a permanent fiscal capacity at supranational level for
macroeconomic stabilisation in deep crises. Either we succeed in designing - at end - credible
and coordinated countercyclical rules for national fiscal policies, or we should think about some
central fiscal capacity, reversible in its use, controllable in its size, but effective through the cycle.
This should be one area of discussion in the "European momentum" which the crisis has
initiated. Thank you for your attention.
1
Article 3.3 of the Treaty on the European Union.
2
Article 127.5 of the Treaty on the Functioning of the European Union.
3
The monetary policy strategy review: some preliminary considerations, Speech by Christine Lagarde, President
of the ECB, at the "ECB and Its Watchers XXI"conference, 30 September 2020
4
www.banque-france.fr/sites/default/files/medias/documents/2020.05.25_sep_en_cl.pdf
5
See Blanchard & Summers (2020), Automatic Stabilizers in a Low-Rate Environment, AEA Papers and
Proceedings, vol 110, May.