Jérôme Creel and Fabien Labondance

The collapse of Silicon Valley Bank (SVB) has rekindled concern about the solidity of the US banking system and, via the danger of contagion, the European banking system. It offers a kind of case study of the complex relationship between banks and the economy.

SVB’s collapse came a few months after the Committee for the Alfred Nobel Memorial Prize in Economics, funded by the Royal Swedish Bank, awarded the 2022 prize to Ben Bernanke, Douglas Diamond and Philip Dybvig for their contributions to banking economics. In particular, Diamond and Dybvig explained the mechanisms by which a banking panic can occur (word of mouth is enough – economists speak of self-fulfilling prophecies), the difficulty of separating a solvency crisis from a liquidity crisis, and the measures to be implemented to stop it, i.e. by insuring deposits[1]. Bernanke showed the way that a banking panic can be transmitted to the real economy, thereby justifying the central bank’s implementation of a bank bailout. Their work undoubtedly helps to better understand the recent decisions of the US monetary authorities to contain the crisis triggered by SVB, such as the extension of deposit insurance.

In addition to this work, an empirical consensus had emerged that economic growth, as measured by the change in GDP per capita, could be explained by the development of bank credit and the financial markets. The international financial crisis of 2007-2009 reshuffled the deck. The work of Gourinchas and Obstfeld (2012) and Schularick and Taylor (2012) (and much subsequent work) showed that the expansion of bank credit was a leading indicator of banking crises. However, the link between bank credit, bank fragility and prosperity remained to be established.

This is the link that we explore with Paul Hubert in a paper entitled “Credit, bank fragility and economic performance”, to be published in the Oxford Economic Papers. This paper examines the role of bank fragility in the relationship between private bank credit and economic growth in the European Union. We consider two types of bank fragility, one in terms of bank assets, and the other in terms of liability: the share of non-performing loans on the balance sheet and, in addition, the ratio of capital to assets, i.e. the inverse of leverage.

Our results are as follows. First, bank fragility, represented by non-performing loans, has a negative effect on economic growth: the higher their share of the balance sheet, the lower the growth of GDP per capita. Second, if bank fragility is included in the estimated model, in most specifications, bank credit has no effect on economic growth. The impact of credit on per capita economic growth seems to depend on the degree of bank fragility. Credit only has a positive and significant effect on per capita economic growth in a sub-sample ending before 2008 – which is in line with previous literature – and when non-performing loans are relatively low, i.e. when bank fragility is limited. Conversely, when bank fragility is high, credit has no impact on growth, whereas non-performing loans have a significant negative effect[2].

Omitting a bank fragility variable in the relationship between bank credit and economic growth may therefore lead to erroneous conclusions about the economic impact of financial development.

The main implication of these empirical results is that closely monitoring and limiting non-performing loans – ex ante through prudent credit supply policies, or ex post through incentives to build up loan loss provisions – not only plays a prudential role at the bank level but also has an impact at the macroeconomic level. This monitoring of non-performing loans is critical for bank credit policy to have a positive impact on economic activity.

[1] See the critical summary of their work in the article by Hubert Kempf, “Diamond et Dybvig et la fragilité bancaire” [Diamond and Dybvig and Bank Fragility], forthcoming in the Revue d’économie politique.

[2] On the liability side, leverage has no impact on economic performance.

by Christine Rifflart

Spain has been hit hard in 2020 by the Covid-19 health
crisis, which the authorities are struggling to control, accompanied by an
economic recession that is one of the most violent in the world (GDP fell by
11% over the year according to the INE)[1]. The country’s unemployment rate reached 16.1% at
the end of last year, a rise of 2.3 points over the year despite the
implementation of short-time work measures. The public deficit could exceed 10%
of GDP in 2020, and the public debt could approach 120% according to the Bank
of Spain’s January 2021 forecasts. Europe has enacted large-scale support programmes
for affected countries, and as one of these Spain will be the country receiving
the most EU-level aid. It will benefit from at least 140 billion euros, with 80 billion
of that (i.e. 6.4% of 2019 GDP) taking the form of direct transfers through the
NextGenerationEU programme.

This aid is arriving in a very particular political
context, marked by the progressive aspirations of a coalition government
(PSOE-Unidas / Podemos) that has governed for just over a year, and which still
appears to be solid. The commitments made in December 2019 between the two
parties in a joint Pact entitled ”Coalicion Progresista –
Un nuevo acuerdo para Espana” [Progressive
Coalition – A New Agenda for Spain] have now been included in the recovery plan
sent to the EU Commission, and the first measures of the planned reforms have
been included in the 2021 budget. In this difficult health and economic
situation, the Spanish government could seize the opportunity provided by this
crisis to carry out a thorough restructuring of the country with the help of
European funds and push through some of the social reforms announced in the
PSOE-UP Pact. The needs, it must be said, are great. In 2018, the poverty rate
was 19.3% among young people and 10.2% among those over 65 (compared with 11.7%
and 4.2% respectively in France). Even though annual growth averaged close to
3% over the period 2015-2019, Spain’s unemployment rate has remained at a very
high level (14.1% in 2019), and labour productivity is still almost 25% lower
than in France. There are significant regional disparities and insufficient investment,
particularly public investment. But Spain could turn the corner over the next
few years. The measures announced are commensurate with the government’s
ambitious aspirations for growth, employment, and social equity. The greater risk
is probably to the government’s solidity and its political capacity to
implement it.

The 2021 budget, the first since July 2018!

Spain has gone two years without a budget vote, as
the 2018 budget was extended twice after being amended by government decrees. But
the government has finally managed to provide itself with a 2021 budget while
impeccably respecting the timetable it had set out. The budget was sent to Brussels
on 10 October 2020, approved on 3 December by the Congress of Deputies (Spain’s
lower chamber), and on 22 December by the Senate, and so was adopted in less
than three months. However, nothing can be taken for granted. The latest legislative
elections in November 2019 (the fourth in four years) failed to give an
absolute majority in Parliament to the socialist party PSOE, or even to the leading
two parties combined (i.e. PSOE-UP, 155 deputies out of 350). So Pedro
Sanchez’s coalition government was compelled to seek the support of the small
pro-independence and regionalist parties for the adoption of its budget. After
three months of negotiations and several thousand amendments, a large majority
was obtained. Of the 350 deputies in Congress, 188 from 11 different political
formations voted in favour (155 from PSOE-UP, 13 from the ERC and 6 from the
PNV). It must be said that a political failure would have been very unwelcome
given the great needs and expectations and the favourable opportunities.

European funding to carry out the modernization of Spain’s
production infrastructure, as set out in the PSOE-UP Pact of December 2019

According to Spain’s Finance Minister [2], the country is expected to receive 79.8 billion
euros in European subsidies over the period 2021-2023 under the NextGenerationEU programme. This is over 10 billion
more than the amount announced by the Commission in the spring of 2020 (69.4
billion, a revision of +14.9%), as the 2020 growth forecasts made last autumn were
more pessimistic than those made six months earlier, and due to converting the initial
funding from 2018 prices to current prices. The revision concerns the
allocation of the Recovery and Resilience Facility (RRF), which has increased
from 59.2 billion euros to 69.5 billion, with the grant under the REACT EUprogramme remaining at 10.3 billion. Spain is
thus now the largest recipient of EU funds, ahead of Italy, which is to receive
79.6 billion (up from 76.1 billion initially announced), i.e. 4.4% of its 2019
GDP, 2 points less than Spain. Seventy percent of this allocation is guaranteed
for 2021-2022 (46.6 billion) [3]. The balance over 2023 will have to be reassessed
in June 2022, depending on the economic situation and the state of public
finances in the light of the Stability and Growth Pact rules, which are likely
to be restored by that date.

In order to benefit from European funds, Spain,
like all its partners, has to present its National Plan for Recovery,
Transformation and Resilience, which aims to stimulate short-term growth
through investment and consumption [4],
and to promote a “more sustainable, more resilient economy that
is prepared for the challenges ahead”,in thewords
of the Commission. Ultimately, the government’s objective is to raise potential
growth by 0.4-0.5 percentage points to over 2% per year by 2030.

While Spain traditionally has a low rate of
absorption of European funds, this time the government wishes to speed up the
process greatly. So on 20 January (with a deadline set for 30 April), the
government submitted to Brussels the 30 files in its Recovery plan presenting
the investment projects and the guidelines for the reforms envisaged in the
areas of taxation, the labour market, and pensions, which are intended to
ensure the country’s transition. It even foresees anticipating the release of
the RRF funds (scheduled after the Commission examines the Recovery plan for two
months) by financing the investments with debt. It must be acknowledged that
the needs are immense in Spain’s production system, which is marked by the
importance of SMEs. At the end of 2019, 53.5% of businesses were made up of the
self-employed, 40% had between 1 and 9 employees, and 5.5% had between 10
and 49 employees, in total accounting for half of all jobs. According to the
government’s intentions:

• 37% of the funds are earmarked for the ecological transition
  (250,000 new vehicles purchased by 2023, installation of 100,000 charging
  stations, transformation of the electrical system to 100% renewable energy
  by 2050, and the renovation of more than 500,000 homes for improved energy
  efficiency);
• 34% are for the digital transformation (with a coverage rate of 80%
  of the population, including 75% by 5G; development of teleworking for
  more than 150,000 public jobs; training for more than 2.5 million SMEs;
  etc.);
• And 30% for Research and Development, education and training, and social
  and territorial inclusion.

The broad outlines of the reforms have also been
drawn up. The new orientation of the tax reform aims at greater progressiveness
and more redistribution [5], and is already included in the 2021 budget (see
below). The reforms concerning the labour market, which is still very dual, and
pensions have not yet been discussed in Parliament or with the social partners,
so they are still at the stage of principles, which should, nevertheless,
satisfy Brussels. As regards labour market reform, the main measures presented
aim at generalizing the use of open-ended contracts and tightening up on the
use of fixed-term contracts; strengthening the use of flexible working time as
an alternative to fixed-term contracts and redundancies; the modification of active
employment policies; calling into question the 2012 reform on collective
bargaining; an employment programme targeted at young people (2021-2027); and modernizing
the public employment service (SEPE). The pension reform is less advanced and
is giving rise to greater tension between the partners. For example, in the
plan sent to Brussels the government did not include its proposal to increase
the contribution period for calculating pensions from 25 to 35 years.

Above all, however, Spain’s National
Plan for Recovery, Transformation and Resiliencepresented to the
European Commission, which should lead to the disbursement of European funds,
is fully in line with the Coalicion  Progresista – Un nuevo acuerdo para Espana Pact signed in December 2019 between the two ruling
coalition parties PSOE and UP-Podemos. The document’s initial sections stress
the importance of investing in the digital transformation, the ecological
transition, and R&D and training to modernize Spain’s economy and create
quality jobs. The European grants provide the left-wing government with a giant
opportunity to finance this project to transform Spain’s productive infrastructure.

Higher taxation to finance the social measures
included in the Pact

In addition to the investment projects included in
the recovery plan and financed by European funds, in its 2021 budget the
government launched the tax reform presented in the Pact, which is intended to
finance the social measures planned or already taken. As mentioned above, the
absence of a majority in the Congress of Deputies and the Senate has opened the
way for negotiations with the small pro-independence and regionalist parties,
and thus for concessions to obtain support. Not all the measures were approved [6]. Ultimately, the reform should bring in 7.7
billion euros [7], 1.4 billion less than what was set out in the budget
bill sent to Brussels. If we add the cost of maintaining VAT on surgical masks
at 0%, the shortfall to meet the deficit commitment comes to 3 billion euros.

The 2021 tax reform mainly focuses on large corporations
and high income earners. It includes:

• Reducing
  the corporate tax exemption on dividends and capital gains received from foreign
  subsidiaries from 100% to 95%. So
  now the 5% not exempted is taxed at the general rate of 25% (30% in the
  case of banks and oil companies). This measure excludes SMEs (companies
  with a turnover of less than 40 million) for three years (expected gain of
  1,520 million euros). In addition, the State has introduced a minimum tax
  on listed real estate investment companies (SOCIMIs) of 15% (+25 million
  euros);
• A
  2-point increase in personal income tax (IRPP) on income over €300,000 and 3 points on
  savings income over €200,000 (raising the rate from 23% to 26%) (a total gain
  of €490 million). This measure affects the 36,200 individuals with the
  highest incomes (i.e. according to the Ministry, 0.07% of contributors) [8];
• A reduction from 8,000 to 2,000 euros in the IRPP exemption
  threshold for individual investments in private pension funds (+580
  million) and an increase from 8,000 to 10,000 euros in the incentive
  threshold for companies;
• The tax on insurance premiums has been increased from 6% to 8%
  (+507 million);
• An increase in VAT on sugary and
  sweetened drinks, excluding dairy products, from 10 to 21%
  (expected gain of 360 million);
• The introduction of a 0.2% financial transaction tax for
  corporations with a capital of more than €1 billion (Tobin tax) anda 3% tax
  on the digital economy (GAFA tax).
  These taxes should bring in €850 million and €968 million respectively.
  Adopted in 2020, they came into force on 16 January;
• A green tax is being introduced with the creation of
  a tax on single-use plastics (+491 million) along with other measures (tax
  on waste, etc.) (+861 million);
• Lastly, measures to combat tax fraud are being
  taken, with an expected gain of 828 million.

This additional tax revenue is intended to cover
social expenditure, in particular the Minimum Living Income introduced
in June 2020 to reduce poverty and promote labour market integration. This will
affect around 850,000 families (2.3 million people, 17% of the population). The
amount of support ranges from 462 euros per month for a person living alone to
1,015 for a family. The pensions and salaries of civil servants will be increased
by 0.9%, non-contributory benefits by 1.8%, and the reference indicator used to
determine eligibility for many social benefits (IPREM) by 5% (it has been
frozen since 2017). The other flagship measure concerns dependency support, with anadditional
600 million, and education. On the other hand, the goal
of raising the minimum wage (SMI) to 60% of the average wage by the end of the
legislature (to between €1100 and €1200 per month in 2023) has been temporarily
suspended. After a 20% increase in 2020, the SMI therefore remains at €950 per
month for 14 months. The salaries of members of the executive have been frozen
this year.

After long years of political instability, it is to
be hoped that, despite the difficult context, the current coalition government
will be able to continue to find a basis for agreement within the different
Spanish political formations in order to take advantage of the favourable
opportunities and open up new and constructive perspectives.

---

[1]  For a more detailed analysis of the crisis, please
refer to the OFCE Policy Brief by Hervé Péléraux and Sabine Le
Bayon: “Croissance mondiale confinée en 2020”, no. 82 of 14 January
2021.

[2] The
information must be approved by the European Parliament in the coming weeks.

[3] The distribution of these new amounts over
2021 and 2022 is not available. We do know, however, that of the 69.437 billion
initially planned for the period 2021-2023, the State was to receive 26.634
billion in 2021, including 2.436 billion from the REACT EUfund for
the purchase of vaccines. Out of the 26.634 billion received, the State is to disburse
10.8 billion to the regions, which are also to receive 8 billion REACT EU funds to strengthen their health and education systems.

[4] On the basis of an average multiplier of 1.2,
in the budget bill sent to Brussels the government estimated the impact of the
recovery plan on growth at 2.5 points in 2021. Under less favourable hypotheses
(the rather slow rate of absorption of past European funds, complexity in
management at the regional level, etc.), in January 2021 the Bank of Spain
estimated the impact at between 1 and 1.6 points.

[5] According to the OECD, in 2018, the ratio
between the average income of the richest 20% and the poorest 20% was 5.9 in
Spain, compared to 4.6 in France.

[6] Thus, the tax increase on private educational
and health institutions was rejected before it was even presented to the
Congress of Deputies, and the tax increase on diesel (+3.8 cents per litre to
34.5 cents, compared to 40.07 on petrol) had to be abandoned. These measures
were expected to bring in 967 and 500 million euros respectively.

[7] Using the cash concept, the revenue changes from
6.847 billion to 5.635 billion in 2021 and from 2.323 billion to 2.135 billion
in 2022.

[8] This measure reflects a fairly marked retreat
from the Pact’s commitments. Indeed, the IRPP was expected to increase by 2
points on income > €130,000, by 4 points on income > €300,000, and by 4
points on savings income > €140,000. An increase of 1 point in the wealth
tax was included for assets over €10 million.

By Christophe Blot

As with the economic performance of all the industrialized
countries, economic activity fell off sharply in the second quarter of 2020
across the Atlantic before rebounding just as sharply the following quarter. The
management of the crisis in the US is largely in the hands of the different States,
and the election of Joe Biden should not change this framework since he
declared on November 19 that he would not order a national lockdown. However,
the health situation is continuing to deteriorate, with more than 200,000 new Covid-19
cases per day on average since the beginning of December. As a result, many
States are adopting more restrictive prophylactic measures, although without returning
to a lockdown like the one in the Spring. This situation could dampen economic prospects
for the end of the year and also for the start of the mandate of the new
President elected in November. Above all, it makes it even more necessary to
implement a new recovery plan, which was delayed by the election.

As in the euro zone, recovery in the US kicked off as
soon as the lockdown was lifted. GDP grew by 7.4% in the third quarter after
falling by 9% in the previous quarter. Compared with the level of activity at
the end of 2019, the economic downturn amounted to 3.5 points, versus 4.4
points in the euro zone. The labour market situation also improved rapidly,
with the unemployment rate falling by 8 points, according to data from the Bureau
of Labor Statistics for November, from its April peak of 14.7%. These results
are the logical consequence of the lifting of restrictions but also of the large-scale
stimulus plans approved in March and April, which have massively absorbed the
loss of income for households and to a lesser extent for US companies (see here).
However, the upturn in consumption is still being dampened by some ongoing restrictions,
particularly in sectors with strong social interactions, where spending is
still nearly 25% lower than it was in the fourth quarter of 2019 (Figure 1).
As for the consumption of goods, it has been much less
affected by the crisis and is down only 12% from its pre-crisis level for
durable goods and 4.4% for non-durable goods. Nevertheless, most of these
support measures have come to an end, and as of this writing the discussions
that began in late summer in Congress have not yet led to an agreement between
Republicans and Democrats. Despite the rebound, the health impact of the pandemic
and the economic consequences of the lockdown on the labour market require a discretionary
policy in a country where the automatic stabilizers are generally considered to
be weaker[1]. New support measures will be all the more
necessary as a further tightening of restrictions is looming and the recovery
seem to be running out of steam. The initial consumption figures for the month
of October point to a fall in the consumption of services, and employment also
stabilized in November, remaining well below its level at the end of 2019.

However, after the setback of the discussions in
Congress, it will now be necessary to wait until the first quarter of 2021 for
a new support plan to be approved and for a possible reorientation of US fiscal
policy after Joe Biden’s victory. In the Autumn, the Democrats proposed a 2
trillion dollar (9.5 GDP points) package, almost as much as the 2.4 trillion dollar
(10.6 GDP points) package adopted in March-April 2020[2]. The aid would, among other things, support the
purchasing power of the unemployed through an additional federal payment.
Although unemployment is much lower than in the second quarter, it remains
above its pre-crisis level and is now characterized by an increase in long-term
unemployment for which there is generally no compensation. In November, the
share of those who had been unemployed for at least 27 weeks was 37 per cent
(or 3.9 million people, Figure 2), and the median duration of unemployment
had risen from 9 weeks at the end of 2019 to almost 19 weeks in November 2020.
In addition, States whose tax revenues have decreased with the crisis could
benefit from a federal transfer, thereby avoiding spending cuts[3].

However, despite the end of the suspense over the
outcome of the presidential elections, the political and economic uncertainty
has not been completely resolved. Indeed, it will not be known until early
January whether the Democrats will also have a majority in Congress. They have
certainly kept the House of Representatives, but it will be necessary to wait
until the beginning of January for the Senate, with a ballot planned in Georgia
that will determine the political colour of the last two seats [4]. Both seats are now held by Republican senators.
However, Joe Biden won Georgia by 0.2 points against Donald Trump, the first
victory in the State for a Democratic candidate since 1992. With both State-wide
senatorial elections to be contested directly, the results are likely to be
close.  If one of the Democratic
candidates is defeated, Joe Biden will be forced to contend with the
opposition. But, as Paul Krugman
points out, the Republicans are generally more inclined, once in opposition, to
promote austerity. This is reflected in the uncertainty indicators of Bloom,
Baker and Davies, whose economic policy uncertainty rose in November (Figure 3).
This uncertainty is certainly lower than in the Spring but remains higher than
that observed between 2016 and 2019. During this period, growth could weaken,
and then a strong recovery is likely to be followed by more subdued growth,
which will have repercussions on the labour market. Regardless of the outcome,
a plan will likely be approved in the first quarter of 2021, but its adoption
could take longer if it is conditional on an agreement between Republicans and
Democrats in Congress. However, this could be lengthy given the urgency of the
health and social crisis, and could plunge a significant proportion of the most
vulnerable into poverty.

Source : Baker, Bloom & Davis. https://www.policyuncertainty.com/index.html

---

[1] See for example Dolls, M., Fuest, C. &
Peichl, A., 2012, “Automatic stabilizers and economic crisis: US vs. Europe”, Journal of Public Economics,
96(3-4), pp. 279-294.

[2] By comparison, the
European programmes are weaker, ranging from 2.6 GDP points for France to 7.2
points for the UK.

[3] Note that the States generally have fiscal
rules limiting their capacity to run a deficit.

[4] Of the 100 seats in the Senate, the
Republicans already hold 50. In the event of a tie between the two parties, it
is the voice of the Vice-President-elect Kamala Harris that will decide between
them. A single victory in Georgia would therefore allow the Republicans to
retain the majority.

By Magali Dauvin and Raul Sampognaro, DAP OFCE

Since the Covid-19 pandemic’s
arrival on the old continent, a number of countries have taken strict measures
to limit outbreaks of contamination. Italy, Spain, France and the United
Kingdom belatedly stood out with especially strict measures, including lockdowns
of the population not working in key sectors. Sweden, in contrast, has
distinguished itself by the absence of any lockdown. While public events have
been banned, as in the other major European countries, there were no
administrative orders to close shops or to impose legal constraints on domestic
travel[1].

Given the
multiplicity of measures and their qualitative nature, it is difficult to break
down all the decisions taken, and in particular to express their intensity.
Researchers at the University of Oxford and the Blavatnik School of Government
have nevertheless built an indicator to measure the severity of government
responses[2]. This indicator clearly shows Sweden’s specific
situation with respect to the rest of Europe (Figure 1).

The mobility data supplied
by Apple Mobility provides a complementary picture of the severity of
containment measures across countries. At the time of the toughest lockdowns, automobile
mobility was down by 89% in Spain, 87% in Italy, 85% in France and 76% in the
United Kingdom. The decline was less severe in Germany and the United States
(about 60% in both countries). Sweden ultimately saw its traffic reduced by
“only” 23%. While these data should be taken with a grain of salt,
they also give a clear signal about the timing and scale of the lockdowns in
different countries, once again pointing to a Swedish exception.

During the first half
of May, the various European countries began to gradually ease the measures
taken to combat the spread of the Covid-19 epidemic.

Sweden’s
GDP resists in Q1

In our assessment of
the impact of lockdowns on the global economy, we highlighted the correlation between the fall in
GDP observed in the first quarter and the severity of the measures put in place
to combat Covid-19. In this context, Sweden (in red in Figure 2) fares
significantly better than the OECD member countries (green bar), and especially
the rest of the European Union (purple bar). Although this is a first estimate,
GDP has not only held up better than elsewhere, but has even stabilized (‑0.1%).
Only a few emerging economies, which were not affected by the pandemic at the
beginning of the year (Chile, India, Turkey and Russia), and Ireland, which
benefited from exceptional factors, performed better in the first quarter [3].

The relative
resilience of Sweden’s GDP in the first quarter seems to suggest that the
country might have found a different trade-off between epidemiological and
economic objectives compared to other countries[4]. However, this aggregate figure masks important
developments that need to be kept in mind. In the first quarter,
the stabilisation of Swedish GDP was due to the positive contribution made by foreign
trade (up 1.7 GDP points) to a rise in exports (up 3.4% in volume terms),
particularly in January, before any health measures were taken.

In the first quarter,
Swedish domestic demand pulled activity downwards (by ‑0.8 GDP points due to household
consumption and -0.2 GDP points due to investment), as in the rest of the EU. The
shock to domestic demand was of course more moderate than in the euro area,
where consumption contributed negatively to GDP by 2.5 points and investment by
0.9 points. Nevertheless, the physical distancing guidelines issued in Sweden must
have had a significant impact during the first quarter.

In a
troubled global context, Sweden will not be able to escape a recession

If we assume that the
avoidance of a lockdown and the relatively limited administrative closures (confined
to public events) did not give rise to any significant shock to domestic demand
– which seems optimistic in view of the first quarter data – Sweden will
nevertheless be hit hard by the shock to international trade[5].

According
to our calculations, based on the entry-exit tables from the World Input-Output
Database (WIOD)^[6] and our estimates related to the
lockdown shocks in Policy Brief 69, value added is expected to fall by
8.5 points in Sweden in April due to the containment measures taken in the rest
of the world. The shock will hit its industry especially hard, more or less in
line with what we estimate globally (-19% and 21%, respectively).
Unsurprisingly, the refining industry (-32%), the manufacture of
transport equipment (-30%) and capital goods (-20%), and the other
manufacturing industries sector (-20%) will be hit hardest by the collapse
of global activity. Since a significant share of output is intended for use by
foreign industry, the worldwide containment measures will lead to a reduction
of almost 15 points in Swedish output in April (Figure 3). The same holds for commercial
services: exposure to global production chains is hurting transport and warehousing
(-15%) and the business services sector (-11%). Ultimately, the containment
measures will have an impact mainly through their effect on intra-branch trade.

The
weakness of Swedish manufacturing, weighed down by international trade, seems
to be confirmed by the first hard data available. According to the Swedish Statistical Office, exports fell by 17% year-on-year, a
figure comparable to the decline in world trade as measured by the CPB for the
same month (-16% by volume). Given this situation, manufacturing output will be
17% lower in April than a year earlier.

What
could be said about domestic demand in Q2?

In
a context of widespread uncertainty, domestic demand may continue to suffer.
Indeed, Swedish households can legitimately question the consequences of the
shock for jobs – mainly in industry – described above. On the other hand, fear
of the epidemic could deter consumers from making certain purchases involving
strong social interactions, even in the absence of legal constraints. What do
Swedish data from the beginning of Q2 tell us about Swedish domestic demand?

In
Sweden, consumer spending fell in March (-5% year-on-year). Note that the
country’s precautionary guidelines and physical distancing measures were
introduced on 10 March. The fall steepened in April, after the measures had in
force for a full month (-10% year-on-year). The measures in place hit purchases
of clothing (-37%), transport (-29%), hotels and catering (-29%) and leisure
(-11%). While the data remain patchy, May’s retail sales, an indicator that
does not cover the entire consumer sector, suggest that sales were still in a
dire state in clothing stores (-32%). In addition, new vehicle registrations
continued to fall in May (-15% month-on-month and -50% year-on-year). Pending
more recent data on activity in the rest of the economy, the volume of hours
worked[7] in May remains very low in hotels and
catering (-50%), and in household services and culture (-18%), suggesting that
significant and long-lasting losses to business can be expected.

On
the positive side, the data show a trend towards the normalization of household
purchases in May for certain consumer items. As in other European countries,
the recovery was particularly strong in household goods, where retail sales
returned to their pre-Covid level, and in sporting goods, while food
consumption remained buoyant.

Ultimately,
the health precautions taken by Sweden since the onset of containment measures are
akin to those implemented in the rest of Europe since the gradual easing of the
lockdowns. While the shocks to the consumption of certain items are less severe
than those observed in France, it is noticeable that, in the context of the
epidemic, some consumer goods could be severely affected even in the absence of
administrative closures. In addition to the recessionary impact imported from
the rest of the world, Sweden will also suffer due to domestic demand, which is
expected to remain limited particularly in certain sectors. The Swedish case
suggests that clothing, automobile, hotel and catering, and household services
and culture could suffer a lasting shock even in the absence of compulsory measures.
According to data available in May, this shock could reduce household
consumption by 8 percentage points, which represents 3 GDP points. How lasting the
shock is will depend on the way the epidemic develops in Sweden and in the rest
of the world.

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[1] The Swedish institutional framework
helps to explain in part this differentiated response, which focuses more on
individual responsibility than on coercion (see https://voxeu.org/article/sweden-s-constitution-decides-its-exceptional-covid-19-policy). The country’s low population density
could also help explain the difference in behaviour vis-à-vis the rest of
Europe but not in relation to its Scandinavian neighbours.

[2] This indicator attempts to synthesize
the containment measures adopted according to two types of criteria: first, the
severity of the restriction for each measure taken (closure of schools and of businesses,
limitation of gatherings, cancellation of public events, confinement to the
home, closure of public transport, restrictions on domestic and international
travel) and second, whether a country’s measures are local or more generalized.
For a discussion of the indicator see Policy brief 69.

[3] Booming exports in March 2020 (up 39% in value) driven by strong
demand for pharmaceuticals and IT offset the fall in Ireland’s domestic demand during
the first quarter.

[4] This post on the OFCE blog does not
focus on the effectiveness of Swedish measures with regard to containing the
epidemic. Mortality from Covid-19 is higher in Sweden than in its neighbours (Norway,
Finland, Denmark), suggesting that it has run more epidemiological risks. This is
provoking a debate that goes well beyond the purpose of this post, but which does
deserve to be raised.

[5] International trade may actually impact
growth more than expected due to constraints on international tourism. In 2018,
Sweden actually ran a negative tourism deficit of 0.6% of GDP (source: OECD
Tourism Statistics Database), which could have an effect on domestic
activity if travel remains limited, especially during the summer.

[6] Timmer, M. P., Dietzenbacher, E., Los, B.,
Stehrer, R. and de Vries, G. J. (2015), “An Illustrated User Guide to the World
Input–Output Database: The Case of Global Automotive Production”, Review of International Economics., 23: 575–605

[7] In May, the volume of hours worked was
down 8% year-on-year (after -15%). The recovery in hours worked in May was due mainly
to manufacturing and construction. The recovery was less pronounced or even non-existent
in business services.

Jérôme Creel, Xavier Ragot, and Francesco Saraceno

The second meeting of
the Eurogroup did the trick. The Ministers of Finance, after having once again laid
out their divisions on the issue of solidarity between euro area Member States on
Tuesday 7 April 2020, reached an agreement two days later on a fiscal support plan
that can be put in place fairly quickly. The health measures taken by the Member
States to limit the spread of the Covid-19 pandemic will enjoy better
short-term financing, which is good news. The additions to Europe’s tools for
dealing with the crisis will be on the order of 500 billion euros – this is
certainly not negligible, and note that this comes on top of the efforts
already put in place by governments – but this corresponds mainly to a new
accumulation of debt by the Member States. The net gain for each of them, as we
shall see, is actually quite marginal.

The Eurogroup will
propose the creation of a credit line (Pandemic Crisis Support) specifically
dedicated to the management of the Covid-19 crisis within the framework of the
European Stability Mechanism (ESM), without strict conditionality (meaning that
recourse to the credit line will not imply any control on the part of the EMS
over the future management of the Member State’s public finances). The creation
of the credit line was inspired by the proposal by Bénassy-Quéré et al. (2020), the advantages and disadvantages of which we presented to the Eurogroup meeting on
9 April 2020. The amount allocated to this credit line represents around 2% of
the GDP of each euro area Member State, or nearly 240 billion euros (in 2019
GDP).

The lending mechanism
proposed by the European Commission to supplement the partial unemployment
programmes of the Member States – it goes under the name of SURE – will clearly see the light of day and will be
endowed with 100 billion euros. For the record, the three main beneficiaries of
SURE cannot receive a combined total of more than 60 billion euros in loans.

Finally, the European
Investment Bank (EIB) will grant an additional 200 billion euros, mainly to
small and medium-sized enterprises in the EU Member States. In total, the euro area
countries will have 480 billion euros in additional financing capacity.

Table 1 below
presents a breakdown by country of the amounts in play. As part of the 240
billion euros of Pandemic Crisis Support, Germany will be able to benefit from
a borrowing capacity of nearly 70 billion euros, France nearly 50 billion
euros, and Italy and Spain 35 and 25 billion euros respectively. These amounts
correspond to 2% of the 2019 GDP of each country. At this point, there is no
indication of whether the Member States will draw on this capacity. The
advantage in doing so depends crucially on the difference between the interest
rate at which they can finance their health and economic expenses without using
the EMS and the interest rate on loans made by the EMS. The financing cost without
going through the EMS is the interest rate on the country’s public debt. The
cost of financing through Pandemic Crisis Support is the interest rate at which
this credit line is itself financed, that is to say, at the lowest rate on the
market, i.e. the German rate. So it is obvious that Germany has no interest in
using this credit line. Of the 240 billion euros allocated to Pandemic Crisis
Support, the 70 billion euros for Germany is thus useless. For countries other
than Germany, the use of Pandemic Crisis Support depends on the difference between
their interest rate and Germany’s rate, the infamous spread. If the spread is
positive, using the EMS effectively reduces the cost of borrowing. But as shown
in Table 1, the gain enabled by Pandemic Crisis Support is rather low. For
Greece, whose spread vis-à-vis Germany is the highest in the euro zone, the
gain would come to around 0.04% of GDP in 2019, i.e. a 215 basis point spread
multiplied by the amount allocated to Greece for Pandemic Crisis Support (3.8
billion euros, which corresponds to 2% of its GDP of 2019), all relative to its
2019 GDP. For Italy, the gain is on the same order: 0.04% of its GDP. Expressed
in euros, Italy stands to gain 700 million euros. For France, whose spread
vis-à-vis Germany is much lower than that of Italy, the gain could be 200
million euros, or 0.01% of its GDP in 2019.

Assuming that the amounts allocated by the EIB are prorated to the country’s size (measured by its GDP in 2019), and that Spain, Italy and France benefit from 20 billion euros each under SURE, the total interest rate savings would reach, respectively, 680 million, 1.5 billion and 430 million euros (0.05%, 0.08% and 0.02% of GDP). At a time when it seems to be raining billions, these are not big savings. Unless you think of it as a metaphor. Like rain before it falls, the billions of euros are not really euros before they fall.

By Christophe Blot and Paul Hubert

The Covid-19 crisis
will inevitably plunge the global economy into recession in 2020. The first
available indicators – an increase in the unemployment rolls and in partial
unemployment – already reveal an unprecedented collapse
in activity. In France, the OFCE’s assessment
suggests a 32% cut in GDP during the lockdown. This fall is due mainly to stopping
non-essential activities and to lower consumption. The shock could, however, be
amplified by other factors (including rises in some sovereign rates, falling oil
prices, and capital and foreign exchange movements) and in particular by the
financial panic that has spread to the world’s stock exchanges since the end of
February.

Since 24 February
2020, the first precipitous one-day fall, the main stock indexes have begun a
decline that accentuated markedly in the weeks of March 9 and 16, despite
announcements from the Federal Reserve
and then the European Central Bank (Figure 1). As of 25 April, France’s CAC-40 index had
fallen by 28% (with a low of -38% in mid-March), -25% for the German index and nearly
-27% for the European Eurostoxx index. This stock market crash could revive
fears of a new financial crisis, only a few years after the subprime crisis. The
fall in the CAC-40 in the first few weeks was in fact steeper than that
observed in the months following the collapse of Lehman Brothers in September
2008 (Figure 2).

While the short-term impact
of the Covid-19 crisis could prove to be more severe than that of the 2008
financial crisis, the origin of the crisis is very different – hence the need
to reconsider the impact of the stock market panic. In the financial crisis,
the origin was in fact a banking crisis, fuelled by a specific segment of the
US real estate market, the subprime market. This financial crisis then caused a
drop-off in demand and a recession through a variety of channels: higher risk
premiums, credit rationing, financial and real estate wealth effects,
uncertainty, and so on. While some of these elements can be found today, they
are now being interpreted as the consequence of a health crisis. But if there
is no doubt that this is at the outset a health and economic crisis, can it
trigger a stock market crash?

Another way of posing
the question is to ask ourselves whether the current stock market fall is due entirely
to the economic crisis. Share prices are in fact supposed to reflect future changes
in a company’s profits. Therefore, expectations of a recession, as demand –
consumption and investment – and supply are constrained, must result in a reduction
in turnover and future profits, and therefore a fall in share prices.

However, the financial
shock could be magnified if the fall in stock prices is greater than that
caused by the decline in corporate profits. This is a thorny issue, but it is
possible to make an assessment of a possible over-adjustment of the stock
market, and thus of a possible financial amplification of the crisis. The
method we have used is to compare changes in profit expectations (by financial
analysts) since the beginning of the Covid-19 crisis with the fall in equities.
Focusing on CAC-40 companies, profit expectations for next year have been cut in
the last three months by 13.4% [1]. This reduction should therefore be fully
reflected in the change in the index. In fact, the fall there was much larger:
-28%. This would result in an amplification of the financial shock by just
under 15 percentage points.

This over-adjustment by
the stock market can be explained by, among other things, the current
prevailing uncertainty about the way lockdowns around the world will be eased, and
thus about an economic recovery, as well as uncertainty about the oil shock that
is unfolding concomitantly, with determinants that are both economic and
geopolitical. This over-adjustment may therefore not be wholly irrational (with
regard to the supposed efficiency of financial markets), but the fact remains
that it has led to major variations in the financial assets of consumers and
business.

Variations like these
are not neutral for economic growth. On the consumer side, they contribute to
what are called the wealth effects on consumption: additions to a household’s assets
give it a sense of wealth that drives it to increase its consumption [2]. This effect is all the greater in countries where
household assets are in the main financialized. If a large portion of household
wealth is made up of equities, then changes in share prices strongly influence
this wealth effect. The portion of shares (or of investment funds) in financial
assets is quite similar in France and the United States, respectively 27% and
29%. However, these assets account for a much larger share of the disposable
income of American households: 156%, compared to 99.5% in France. As a result,
French households are less exposed to changes in share prices. Empirical studies
generally suggest a greater wealth effect in the United States than in France [3].

As for business,
these changes in stock market valuations have an effect on investment decisions
through collateral constraints. When a company takes on debt to finance an
investment project, the bank demands assets as collateral. These assets can be
either physical or financial. In the event of an increase in equity markets, a
company’s financial assets increase in value and allow it greater access to credit
[4]. This mechanism is potentially important today. At
a time when companies have very large cash requirements to cope with the brutal
shutdown of the economy, the sharp decline in their financial assets is restricting
their access to lines of credit. While the financial amplification factors are
not reducible to the financial shock, the recent changes in the prices of these
assets are nevertheless giving an initial indication of how the financial
system is responding to the ongoing health and economic crises.

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[1] The data comes from Eikon Datastream, which for each
company provides analysts’ consensus on the earnings per share (EPS) for the
coming year and the following year. We then calculated the weighted average using
the weight of each CAC-40 company in the index of the change in these
expectations over the past three months. The fact that a 13.4% decline in
profit expectations for the next year will give rise to a 13.4% decline in the
stock price is made on the assumption that profits beyond the next year are not
taken into account, or, in other words, that their current net value is zero,
which is to say that investors’ preference for the present is very strong
today.

[2] More formally, we can speak of a propensity to
consume that increases as wealth increases. Wealth effects can be
distinguishable according to whether they are purely financial assets or also
include property assets.

[3] See Antonin, Plane and Sampognaro (2017) for a summary of these estimates.

[4] See Ehrmann and Fratzscher (2004) and Chaney, Sraer and Thesmar (2012) for empirical assessments of this transmission channel
via share prices or property prices, respectively.