Ukraine, Inflation, and the Economies of EMEA

Madhav Rajan:

Hello, everyone. Welcome to Economic Outlook 2022, hosted by the University of Chicago Booth School of Business. My name is Madhav Rajan. I’m the dean and the George Shultz Professor of Accounting at Chicago Booth. I hope all of you are doing well. Thank you for taking the time to engage with the school in this particular manner. Chicago Booth has a long tradition of informing public discourse through platforms such as Economic Outlook, which we began back in 1954, as well as our IGM, Initiative on Global Markets, and the Chicago Booth Review publication. Economic Outlook provides a forum for our pathbreaking thought leaders to confront the future, evaluate emerging trends, and share insights that help reframe our understanding of the world to come.

This is the final Economic Outlook event of our early 2022 series. EO Hong Kong was held last month with Randy Kroszner, Chang-Tai Hsieh, and Richard Wong, and we had more than 400 attendees there. Before that, we had Economic Outlook Chicago, with Austan Goolsbee, Raghuram Rajan, and Randy Kroszner, and that welcomed more than 3,000 attendees. Recordings of both those events, and key takeaway articles, are available on our website at ChicagoBooth.edu.

We have an amazing program today. I want to thank our distinguished panelists, Chicago Booth faculty Veronica Guerrieri and Randy Kroszner, and our alum José Antonio Álvarez, CEO of Banco Santander, for being here to share their insights related to post-pandemic recovery, inflation, and the economies of EMEA. My sincere thanks also to Chris Giles of the Financial Times for being here to moderate today’s panel on these very important topics.

Madhav Rajan:

Before we begin, I’d like to invite you to celebrate Chicago Booth’s new state-of-the-art campus at a special event in London on March 28, from 5:30 to 9:00 p.m. UK local time. You’ll hear from university leaders and notable alumni, including President Paul Alivisatos and David Booth, in a panel discussion about leadership and the future of business in London. The event will be followed by a networking reception. Information and registration can be found on our Leading in London page through ChicagoBooth.edu.So with that, it’s my great pleasure to introduce today’s panelists. Veronica Guerrieri is the Ronald Tarrson Professor of Economics and the Willard Graham Faculty Scholar. Veronica studies macroeconomics, search theory, growth theory, dynamic contracting, and labor and financial market frictions. Veronica has been a research associate at the NBER since 2013, and a consultant at the Federal Reserve Bank of Chicago since 2014. Randy Kroszner is deputy dean of executive programs at Chicago Booth and the Norman Bobins Professor of Economics. Randy, of course, was a governor of the Federal Reserve System from 2006 to 2009. He chaired the Committee on Supervision and Regulation of Banking Institutions and the Committee on Consumer and Community Affairs. And Randy took a leading role in developing responses to the financial crisis and initiatives to improve consumer protection and disclosure.

And finally, José Antonio Álvarez, who was named CEO of Banco Santander Group in 2015 and executive vice chairman in 2019. Previously, he was the bank’s CFO for a decade, and before that, head of its finance division. Before joining Banco Santander, José Antonio held executive positions at BBVA, Argentaria, and Banco Hipotecario de España, among many others. He’s a member of the board of directors of Santander Brazil, and, we are very proud to say, the Chicago Booth Global Leaders Group. Our moderator, Chris Giles, has been economics editor for the Financial Times since October 2004, after previously serving as a lead writer. His reporting beat covers global and UK economic affairs, and Chris also writes a UK economics column. Thank you all again, and with that, I’ll hand it off to Chris.

Chris Giles:

Thank you very much, Madhav. And welcome to the panel here, and from me here at the Financial Times, also, in London. I think the topic today is of extreme relevance at a time of enormous economic uncertainty and geopolitical uncertainty. So we’ve got a lot to get through: post-pandemic recovery, inflation, and the economies of the EMEA region. I’ve got lots of questions that have been pre-submitted to me by the audience already in advance. We’ll cover many of those already today, but I do urge and encourage people in the audience to submit further questions into the Q&A box. And I’ll be able to see those and present those to the panel as we go through this hour of discussion. And I think just to start with you, Veronica. Inflation, one of the key topics, we didn’t think we were necessarily going to be talking about inflation. It was supposedly dead, and we had the Great Moderation around the world in advanced economies, but now in the European region, 5.1 percent in February, the latest [inaudible] estimate. Do you think the ECB can continue its very, very loose monetary policy when inflation has risen as fast as it has, and keeps on beating expectations?

Veronica Guerrieri:

Yes, hi, thanks for inviting me. So, clearly we come from a situation, as you were mentioning, where inflation between 2014 and 2019 was averaging a 0.9 percent in the euro area. And so we are coming from an history where inflation was not so much a concern. If anything, the concern was deflationary pressures, and this was reflected also in the recent change in the political, or the strategy of the ECB, that is now much more symmetric in targeting the 2 percent, both from above and from below. So, clearly the debate in the last years has been about, how can we do to increase inflation? And how not? ... Should we be worried about inflationary pressures? Now things have changed quickly, not only in Europe, but in the rest of the world. In the US much more than in Europe, and actually, that’s an interesting question: why, in the US, inflationary pressures are a bit more pronounced than in Europe. It may be because of fiscal policy packages, or it may be because of the overall recovery of the economy. I mean, this is an open question. I think the ECB is trying to understand that. But despite these differences between US and Europe, the ECB, I think, in the last policy speeches have clearly made the point that they’re going to be proactive in responding to inflation, rising inflation.

Veronica Guerrieri:

Now, that said, I think if you look at [inaudible 00:08:50] expected inflation, the impression is that this spike in inflation nowadays is driven mainly by the particular type of shock that hit the European economy, or the world economy, which is the pandemic, and the bottlenecks and the supply chain disruptions that have been created by the pandemic. In fact, if you look into inflation data, it’s really the big chunk of this big spike is energy prices. And so, the overall, I think, agreement is that, or at least the consensus seem to be, that this is going to be something more temporary than persistent. And so, should the ECB be responsive to rising inflation? Yes, for sure. But maybe with caution, because of course we are still recovering from a very bad shock, and it looks like this is more a temporary spike, and so, we want to see what’s going on. Of course, now we have the war. We will talk about that later, maybe. So, there are other concerns to be afraid of. On the other hand, what’s happening in the long, medium term, I think expectations show that inflation is going to be reanchored to 2 percent. So I don’t think that the worry is, if the ECB is too contractionary now, then we are going to go back in a low inflation period, because things have changed in Europe, the political stance have changed. Next-generation EU, lots of fiscal packages, lots of fiscal effort in Europe show the sign of a more proactive political action that actually seems to go in the direction of not having a stagnating economy or low inflation levels as in the past. So overall, I think the ECB should not, and does not seem too worried about going back to a deflationary spiral. On the other hand, should they be very active in tightening? They should. They should, for sure, keep inflation expectation anchored to 2 percent, so they will be, and they have already shown sign of being reactive, but not too much, because the current spike, it looks more temporary than not.

Chris Giles:

OK. So thank you. Thank you, Veronica. So that’s quite the benign view, that this is a temporary spike and the ECB doesn’t have to do very much. José Antonio, do you agree with that? And particularly from a markets perspective, do you think the inflation we are seeing at the moment is here just because of the energy crisis and will go away? And in fact, even more benign, the ECB doesn’t have to do very much, and we’ve got rid of the deflationary threat that previously afflicted Europe, as Veronica said?

José Antonio Álvarez:

Thank you, Chris, and thank you for having me here. I’m not as optimistic as Veronica is. So I heard this message coming in the last summer: so don’t worry, this is going to be temporary. Well, we don’t want to need to raise rates. We heard this from the Fed, Bank of England, ECB. So later on in the fall, the Fed changed the message. At the beginning, it’s true that the temporary inflation was based on, “Oh, we have as a result of the pandemia, some supply-chain problems that translate into high inflation.” And as long as these problems, and the pandemia goes away, and these problems with the supply chain will dissipate, and the inflation will come back to what used to be the normal path, as Veronica explained very well, particularly in the EU, who has more worry about deflation than inflation for the last couple of years. But what has happened since that, the outcome of the pandemia in one particular front, probably in several, but one that attract my attention, the outcome was significantly different than the one we were expecting before, particularly in unemployment. So if we look backwards, if we look when we were trying to forecast, well, it was very difficult now, because it was a health crisis, and economists, we are not well equipped to predict a health crisis. But we were saying, “Now we’re going to see unemployment to go up significantly.” And at the same time, we were saying, “Oh, the asset prices are going to suffer.” So as a result of the combination of several things, including the actions from the governments and central banks, we got unemployment levels at the lowest we’ve seen, particularly in the eurozone, since 2007, ’06, and nothing to say about UK and US, where there’s labor shortage here and there and all these things.

José Antonio Álvarez:

Having this situation in the labor market, combined with a spike in inflation coming from energy supply chains and all these things, second-round effects, I wonder if those are going to push the inflation longer than we were expecting, let’s say, last summer. My idea right now is inflation is not going to be so temporary. So, it’s going to be projected, I don’t know for how long, and this will force the central banks to react, including the ECB. And they already did, somehow. After the last policy meeting, they changed the message. They haven’t clarified, as the Fed did, when, and for how long, and how many times they’re going to tighten the interest rates, but they sent a message saying, “OK, you know what? Inflation is just not temporary, it may last for the whole year, it may translate into 2023.” We cannot have such a real negative interest rates that we have today that are in the region of high 6 percent real negative interest rate. That is, in my view, too much. For that reason, I do expect even the ECB, and recognizing that there’s some structural factors that point to what Veronica said, demographics in Europe, blah, blah, blah, this point, this, but at least for a significant period of time, I do see inflation being persistent, and the ECB being forced to react, probably more than they thought only three or four month ago.

Chris Giles:

That’s really very interesting. I think, Randy, this gets to the nub of the issue on monetary policy at the moment: How much can we look through this inflation? How much is it very much a temporary spike caused by energy prices? And how much is it going to run into second-round effects, where companies feel they have the power to raise prices? And also, workers demand higher wages, and find that companies are willing to pay them. I was talking to the IMF today, in fact, because they came out with their assessment of the UK economy, where they said, “Look, we just haven’t had unemployed ... a labor market as hot as this, monetary policy still as stimulative as it was, even though the Bank of England has raised rates twice since December, and also fiscal policy’s still pretty stimulative.” So this is, if you ever wanted a situation where you’re going to have second-round effects, this is it. I mean, they’re pretty hard line. It’s got to be said that this is really the IMF doing the IMF sort of thing. What do you think about that? I mean, we haven’t had to worry about second-round effects for 20, 30 years in central banking. Is now the time where it’s really back on the agenda? You’re muted, Randy.

Randall Kroszner:

It is the core of the question, because there are lots of issues of whether, is this temporary? Is this permanent? Is it due to supply chain issues? Is it due to energy? Those are very important issues, but there’s also the issue of market expectations and individual expectations. And so people are not ... I think most people are not really focused on what is the cause of it. They just know that there’s a lot of inflation. Certainly, whether it’s in the UK, as you said, with incredibly tight labor markets; US with tight labor markets; much of Europe with super tight labor markets; people are acting in a different way than they have for 20 or 30 years. In the US, we call it the Great Resignation. If people aren’t allowed to work from home, and don’t get a 10 percent wage increase, they just walk, and they feel that they can go and get a job whenever they want, under whatever circumstances they want. That’s dramatically different than it was before, and regardless of whether the price increases are being driven by shorter-run factors, longer-run factors, that’s the key thing that we have to worry about: the second-round effects, or the unanchoring of expectations. And we certainly have seen firms and individuals operating in a dramatically different way than they had before. People being willing just to move on if they don’t get exactly what they want, and firms being willing to pass on increases in costs in a way that they haven’t felt comfortable to do in decades.

Randall Kroszner:

The key question is, is this a one-time adjustment? And so, obviously prices fell, and demand fell dramatically during the pandemic, and now we have to sort of readjust to that. Is this just sort of something, “Well, we do this one-time adjustment, maybe a little bit more than one time, but then get back on to the old path.” Or is it that people say, “My goodness, this is just something different. I haven’t seen this in 20 or 30 years, so I’m going to be acting differently than I have in the last 20 or 30 years. And I don’t believe any of those people. The president’s been telling me that inflation is going to come down; the central bank’s chair has said it’s going to come down. Well, I see gasoline prices keep going up, and I’m not worried about the core versus the headline number. My costs are going up.”And people tend to focus on the things that are most salient to them and where they can see the prices easily—things like energy prices. And I think there’s a very significant risk of this untethering of expectations, and that’s why I think it’s very important for central banks to be proactive. Even though, of course, they can’t do anything about the supply chain issues. They can’t pump more oil, they can’t build more computer chips, but it’s still their problem, because if inflation expectations become unanchored, then it’s really tough to put the genie back in the bottle. And I think that’s the key issue: Can central banks bring down inflation without bringing down the economy? And I think we run a risk that the central banks may have to run interest rates up much more than they are forecasting now, to try to make sure inflation expectations don’t become unanchored.

Chris Giles:

And so just to really try and make that really concrete for the audience. So we’ve got a quick question here from Pierre from the audience: Can inflation be temporary once it feeds into wages? Randy, I’m going to come back to Veronica in a second, but could you answer that question? And when you say that we are going to have to have monetary policies significantly tighter, what do you really mean? How much tighter?

Randall Kroszner:

The crystal ball is a little bit cloudy, because as you said, Chris, we haven’t been in exactly these situations before, but Pierre’s put his finger on exactly the key issue. So it could be that people will say, “Oh, well, this is a bounce back from the pandemic. Things are a little bit out of whack. I need an adjustment. But then in the future, I see things kind of going back to the way that they’ve been for the last 20, 20, or 30 years.” We really don’t have enough experience and data to know how people form their expectations and how they change their behavior related to the expectations. So this is one of the really great unknowns. I think there’s a lot more work that could be done, like the work that one of our colleagues, Richard Thaler, our most recent Nobel laureate, does, thinking about behavior and behavioral economics. Central banks can do a lot more to try to understand this. It’s not something where we just have to throw up our hands and say, “Oh, we don’t understand.” We could do a lot more systematic research. Not much has been done, but I think we could do a lot more on that. And then how much are they going to have to move? That’s closely related to that first question about expectations. So far, market expectations have not moved up dramatically. They’ve moved up, but they haven’t moved up nearly as much as what it appears that firms and individuals have. And the key question will be, are market expectations going to be catching up to where the firms and individuals are? If that’s the case, central banks are going to have to raise rates very significantly. I think there’s going to be a tightening in each of the seven Fed meetings for the next year. Some form of tightening that’ll get us probably around 2 percent. Inflation’s around 7 percent. That’s still pretty far from the old days, when interest rates …

Chris Giles:

We had real interest rates of plus two.

Randall Kroszner:

Yeah, yeah.

Chris Giles:

Minus five.

Randall Kroszner:

Yeah, exactly. And so last time we had inflation in the 5 to 10 percent area, the Fed was raising rates to 5, 10, even above of that percent. So I’m hoping we don’t get there, but I don’t have the confidence that I can say, “It’s just going to stay, we’ll get to two, and everybody will be happy.” I think that’s [crosstalk 00:22:36].

Chris Giles:

OK, Veronica. That was the reason for why we should be nervous. Those were the two reasons. Why should we be relatively sanguine about this? What are the reasons to not worry so much?

Veronica Guerrieri:

Well, the reason not to worry so much about inflation, or more generally about the [crosstalk 00:22:55]?

Chris Giles:

Well, you took the view that it was more temporary.

Veronica Guerrieri:

Yeah.

Chris Giles:

[crosstalk 00:22:59]

Veronica Guerrieri:

OK. Let me, first of all, clarify that when I said that I think it’s going to be more temporary, I want to emphasize that I still think that the central bank should act. I’m not saying that it shouldn’t act, because it’s still positive. So just say that probably my view, relatively to José or Randy’s view, is that it shouldn’t be so aggressive as they feel. And my impression is that, OK, energy prices are rising a lot, and I believe that this is ... I mean, energy prices rose by 27 percent or more, while inflation was like to 5 percent, right? So all other sector and prices have increased by 2, 3 percent, so much more around the target. So, these are for energy prices. So if there are bottlenecks in the economy that increase this energy price, that are going to be in part resolved by the strong recovery of the economy, then energy prices are going to go down, and then things are going to be a little bit better. Now, of course, the worry is what Randy was talking about, and what was the question from the audience about how about expectation of inflation, right? Is it the case that if we have this temporary last too long, then it becomes self-fulfilling, and then it becomes, even though the source of the shock maybe was temporary, maybe that you have this second-level impact if it stays there.

Veronica Guerrieri:

And so, unfortunately, it is a risk, even though I believe the source of inflation is temporary. And the problem is that we have to keep a very close eye to real-time data and expectation in inflation, which are the key important variables here to take into consideration. Now, the energy prices now are going to be affected, possibly, by the war Russia and Ukraine are going in. The problem is that that could feed back inflation through, if Russia decided to retaliate on sanctions by stopping or reducing access to natural gas, which for the euro area is like 40 percent, I think, of the gas comes from Russia. So that could be a problem. That could rise prices even more, and inflation even more, so that could be an additional source of concern for inflation. On the other hand, the optimistic part of me that is still there says, I mean, I don’t know if it’s optimistic or not, but in terms of inflation, it’s not clear what’s going to happen, because there may be actually demand effect coming from the uncertainty around the war, and investment may reduce, consumption may reduce. And so this may actually generate pressure downward on inflation. So it’s not an optimistic view, because of course this means that the economy is going to be hurt, but in terms of what the ECB should do, I don’t think it’s obvious. I mean, we have to see how the demand versus supply is going to play out.

Chris Giles:

And is this … going to the inflation that we are seeing in Europe, do you see that being sort of symmetric across most of the eurozone economies? We have a question here on how much do you think it’s going to deviate between economies?

Veronica Guerrieri:

Yeah, so I was looking at the data yesterday. I mean, there is clearly a decent amount of heterogeneity with some countries, actually France, I was surprised, has a particularly low inflation rate, while Italy has a higher inflation rate. Germany is higher than Italy, but the range of heterogeneity goes from 2.5 to 9 in some rare case. And of course, average is around 5. So it clearly is impacted, because energy prices play a big role. It clearly is impacted by the structure of the economy and how much each single country relies on that. But I don’t think that ... at the moment, I think in general, the impression is that there is this upward trend on inflation that is pretty homogenous, or at least all countries have this feel. And so I don’t think there is enough heterogeneity to push into the direction of substantially different economic advice. So at the moment, I don’t think that this heterogeneity should create problems of unity in terms of a decision of what to do. So the problem, inflation, it seems it’s rising almost everywhere, somewhere more than other, the prices is temporary or not. That’s the key question. I think that’s more similar for all countries.

Chris Giles:

And this raises, Randy, if I may come to you very quickly, a question that Bobby has just submitted. His question is whether inflation can be geographically contained in today’s global economy, or does the globalization of economic trade and the globalization of the global economy mean that you can’t contain it in one area, or one region, apart from the Venezuelas of the world?

Randall Kroszner:

Right. And that’s what I was going to say. Certainly, we can see that, unfortunately, there’s some countries in Africa that have extremely high inflation rates, some countries in Latin America that have very high inflation rates. So you can have a fair amount of geographic differences. But I think the key is that there is an interlinkage of monetary policies. The Fed has an outsize influence on interest rates globally, and then exchange rates and capital flows. So I think there are impacts there. And then the key is really, what is driving the inflation? If it is something like energy prices, that’s going to be global. It’ll have a differential effect, depending on what the energy consumption is relative to GDP in that country, but there are some very important common factors that I think make it difficult to just say, “Ah, we’ll get it right. And everybody else is going to have a different perspective.” Actually, I’d love to hear from José Antonio about why do you think there’s this, there seems to be a disconnect between the markets and individuals and firms? Because if you look at market expectations, they’re pretty sanguine. If you look at interest rate features, those sorts of things. But if you survey companies, and you work with a lot of companies, they have a totally different perspective. Why do you think there’s that disconnect?

José Antonio Álvarez:

Well, you are absolutely right, Randy. The markets think that the central banks are going to succeed in a relatively short period of time fighting inflation. The markets have strong confidence in the central banks being able to tackle inflation relatively quickly. Let’s agree in two things. Let’s agree, first thing, that the central banks are going to react rather sooner than later. Let’s agree in the second thing that the markets believe that we’re going to be living for a significant number of years with negative real interest rates. And this is central to me. The markets’ reaction is relatively limited, compared with the expectations of firms and individuals, just because when they look at the levels of debt as a result of the pandemia that has been accumulated around the world, and all the states, and governments, they say, “Oh, wait a minute, look at the level of debt. Is that sustainable, with the usual interest rates that at least me, I got in the college, that used to be plus 2, plus 4 percent over inflation? Oh, probably this is not sustainable with that level of interest rate. So let’s be pragmatic. Which level is sustainable?” And they say, “Oh, it’s going to be negative real interest rates." And when they look backwards, to the history … and probably you’ve seen, Randy and Veronica, you are more expert than I am, you’ve seen plenty of people writing about what happened after the Second World War, when we lived, the world lived, for, I don’t know, 15 years, 20 years, I don’t know exactly the numbers, with negative real interest rates. And probably the markets are betting on this scenario. We don’t know the level, the discussion of the level, I agree with you, well, it’s very difficult. But probably the market, there’s a consensus that the real interest rates are going to remain in negative territory for a while. That’s, to me, why the reaction is not as strong as you were suggesting, or expecting, based on individuals’ and firms’ expectations.

Chris Giles:

And that’s really interesting, because that then depends on there not being second-round effects or wage price spirals hitting the sort of levels of the 1970s. They can hit levels of the 1950s and early 1960s, but we don’t get into something more difficult.We’ve got a question from Mohamed here, which is, with inflation being at multiyear highs, how far are we off a wage price spiral? [crosstalk 00:32:34]. I was guessing that’s you.

José Antonio Álvarez:

We’re far away. We’re far away to price [inaudible 00:32:43] this scenario. So we are very, very far away. So if this happens, to me, I don’t know, the risk of central banks overreact and having a significant impact on the economic developments and economic growth is not a minor one.  This is the main risk I see going forward. The central bank will react, they are not able to get inflation under control, they keep reacting and they are always behind the curve, and at some point the markets say, “Oh, let’s wait. We were wrong. We need to price that. We are going to go for an inflationary scenario that is not priced today,” as Randy rightly pointed out, “and we need to reprice the whole bond market.” And in this case, this becomes more a kind of a ... a recession is not a minor risk in this scenario. So I’m not, in this scenario, I think that the confidence built over the last three or four decades by the central banks has strong influence in the behavior of the different agents in the markets, including the individuals and the behavior of the firms and individuals vis-à-vis with the inflation expectations. All of us, we are living in a world in which we think, “Oh, we learned in the ’80s how to tackle inflation.” And while for three decades, the central banks were good—they did very well in keeping inflation well under control, and the markets are still living there. The other scenario is much more ... it’s a bit scary. Let’s call it that way. So I prefer, at this stage, I’m not betting on this scenario at all.

Chris Giles:

It certainly is scary, and it is also hypothetical. A scenario that’s not hypothetical is tensions in Ukraine, and I think we’ve gone for half an hour without mentioning it, and I think we can’t leave it aside. And as Jeffrey asked here, clearly with a de facto, an actual Russian invasion of Ukraine, wouldn’t we then expect a dramatic increase in inflation over the near term? And other, rather serious effects on the European, Middle East, African economies? How do you see this? Veronica, how do you see the interplay of security and economics at the moment?

Veronica Guerrieri:

As I mentioned before, I think this is pretty scary. We are coming just right now out from a pandemic. We are still bleeding—in some sectors more than others, but we are still bleeding, and recovering, the prospects are good, and now this happens. It’s really, I mean, something that policymakers should be worried about. In the short term, the main economic impact that I can see from this disruption, as I mentioned before, is the possibility of issues with the provision of natural gas for Europe. That would be really dramatic for many parts of Europe. Some more than others—maybe Spain, a little better than others, for the particular way in which they get gas. But overall, as I mentioned before, 40 percent comes from Russia. So the US has been thinking about a contingent plan to provide some of the natural gas to the euro area in case Russia retaliate, and that’s comforting.

Veronica Guerrieri:

But again, to achieve 40 percent of the total natural gas that Europe uses is a big number. So in the short term, I don’t think that we can fix that if Russia decide to retaliate on that. And this of course is going to have two different types of effects, both very bad. One, on inflation: prices are going to rise even more, and so this may require even more tighter policy from the ECB. But on the other hand, when we have seen the stock market already reacted as well, so it may be that the economy is going to respond to this uncertainty in international relations for businesses, investment may respond, confidence may go down, and we can see another big demand shock in Europe, in the world, in Africa, in all the countries. And so if that happens, we are going to see another recession. So then at that point, it’s not even more clear, if we have high inflation and a big demand and shortages, what the ECB should do, and we are going to be in a ... there is going to be a lot of uncertainty, and this is going to be a tough political choice, without knowing where we are going. So I think these are the terms of the problem, both in terms of policy reaction, like what’s going to be stronger? This is going to be clearly initially a supply shock; in the middle run, may become a demand shock. And then, the only silver lining I can see is that this may be a good occasion for Europe to get unified more, maybe creating a more fiscal effort at the union level to invest in defense. And so, given that there is already a positive step in the direction with the next-generation EU to create an effort to support investment in some “good” investment, like for green transition; defense is another of these topics that can enter this project of fiscal unification. So on that side, I hope that Europe is going to do the right thing and move in that direction.

Chris Giles:

Presumably, one of the “good” investments that you … which needs to be done urgently is investing in some sort of gas storage and some strategic reserves for the winter next year. We’re hopefully through the worst of this winter, and then gas demand is going to go down a lot over the summer, but next winter is potentially very serious. Randy, how much do you think the Russia–Ukraine crisis is likely to spread wider than Europe, which is clearly on the front line here?

Randall Kroszner:

Sure. This is something where it has very big geopolitical implications, including the role of China, as we’ve seen that, I think one of the things that Putin and the Russian regime wanted to do is try to find the cracks in NATO and the relationship between the US and NATO. And exactly as Veronica said, the key question is, will this lead to more fissures? Or will it lead to more unification?
And so, obviously, I think Russia is taking the risk that they do this, and it actually leads to more dispersion, less unity. It’s also been an opportunity for Xi and Putin to become much more aligned. And so, as people often say, “Oh, well, Russia has outsize influence. Their GDP is the GDP the size of Italy, and so why ...” No casting aspersions on Italy, Veronica; as you know, I’m half Italian, but why is it that Russia gets so much attention? I think they use their resources ... well, obviously, the nuclear arsenal, but also being much more strategic and building a potential partnership with China, and then thinking about using the resources they have, the natural resources, much more strategically. So I think if it does lead to more fissures in the West, but more consolidation and consistency between Russia and China, I think that poses a much, much greater and long-term challenge.

Chris Giles:

Yes. And José Antonio, there’s a question here from Rick Davis, who says very simply, “Is a Russian invasion into Ukraine already discounted in the market? Are markets already pricing this?”

José Antonio Álvarez:

No, the markets are not, in my view, are not pricing a massive invasion in the sense that Russia take over the whole of Ukrainia. I think this is not a scenario that this has been already discounted by the markets. The markets are discounting, in my view, a relatively low-intensity kind of war, a kind of tension around Ukrainia, and the markets are also discounting what Randy mentioned, that probably this has, the first effect has been, and it’s already the case, that NATO becomes useful, more so than the majority of the people thought one or two or three years ago. So this has, the first reaction is to unite somehow the NATO members, having a mission. People, normally they look at the figures. From the figures point of view, aside from energy, that Veronica said, the 40 percent of the gas in Europe, I’m more worried about the confidence. I’m more worried about the persistency of these geopolitical tensions, start to deteriorate confidence, they start to deteriorate demand, rather little by little, and complicate in a significant way the reaction of the authorities, including the ECB. Veronica said the 40 percent in gas, very likely energy prices would remain high or go even higher, and this complicated reaction, the normal reaction, the pattern of the monetary policy, and we may need at some point the fiscal policy to come to the rescue, because the central banks may be in a position in which on one side, they have relatively high inflation, and on the other side, they have, as a result of losing confidence due to the geopolitical tension, having economic growth that is not that good, or is poor, and they may be forced to stay, and the fiscal policy needs to come … I don’t know, complicates significantly the situation. But the markets, by any measure, have discounted a full invasion of Ukrainia by Russia and taking over the country.

Chris Giles:

That’s a very good moment to come to fiscal policy, but just before we do, José Antonio, I just wanted to ask you, you’ve got extensive contacts with businesses across Europe, are you seeing what you were just saying you were worried about, that companies are beginning to look at what’s happening in Ukraine, and beginning to get nervous, and therefore beginning to think, “Is this the right time to invest?” Are these questions now being asked?

José Antonio Álvarez:

I should say, it depends on the sector. I bet on the recovery. I do think there are sector that are unduly penalized by the whole situation, not only this. So we have on one side the likelihood of rates going up, so [inaudible] sector this plays in favor. Probably there are other travel-related sector that were badly affected by the pandemia. There are plenty of opportunities arising there. And this is another obvious reason to go there. So I tend to think that there are good opportunities. In Europe, assets are not expensive. There are significant pockets of assets that are inexpensive today, and I think at this point, as I am betting on not having escalation on the tensions in Ukrainia to remain relatively low intensity level, I think there are significant opportunities across the market. I think it’s a good time to put some money at work, taking into account that interest rates—doesn’t matter, the reaction of the central banks—is going to remain very, very low, and well below inflation, so to protect your wealth, again, inflation is highly recommend to invest. At least Europe is relatively cheap.

Chris Giles:

Just before we do come to fiscal policy, we have a number of questions coming in about the effect of sanctions and whether the very, very timid sanctions to date suggest that either Putin has the upper hand or ... and what the effect they might have. Randy, how do you think this is going to affect? I mean, these are really difficult questions. Everyone is doing the game theory on this. When to introduce sanctions, how big they should be. Should we include energy in all this? These are huge questions for European, NATO, Western governments. What’s the balance at the moment?

Randall Kroszner:

You’re exactly right. They’re trying to consult with some game theorists to try to think what the optimal approach is. I think Putin has been very, very clever in taking these first steps that he would argue are not invasion and become more difficult to characterize an invasion, because he’s also trying to gather data. How much solidarity is there in the coalition? He’s trying to understand what the responses will be.  And so I think it’s actually valuable for NATO and the West to take a fairly strong stance, because I think they need to signal that they have the willingness and ability to undertake these sanctions, even as the first steps are being taken. Putin, even if he doesn’t do a full invasion, can at least then say, well, he’s gotten something out of this, but I think it’s very important for the West to take a tough line. Obviously, that is going to hit certain sectors very hard, certainly the banking and financial sector within Russia, and then others who have connections to that sector; energy sector is going to be hit hard. But I think, at least the way I would play it out, I think it’s good to take the tough stand early, to signal a willingness to stick together, even on relatively small first steps, because if they don’t do that, then I think you’re going to see the tanks rolling in much more rapidly than otherwise. And so you have to bear the pain in the short run, because I think in the long run that’ll mean there’ll be fewer negative consequences, but also politically, that can be very tough when there’s high pain in the short run, especially when it’s so focused on certain sectors.

Chris Giles:

Now, one of the things that we’ve learned during the pandemic is how powerful governments can be in defending their populations against external threats, and fiscal policy across the world was transformed. Not every country did it in the same way during the pandemic, and Europe certainly had a big change, both in the proactivity of fiscal policy, and also in the forward-looking investment that Europe was able to put in place. Veronica, just how much has European fiscal policy changed, and is this going to continue?

Veronica Guerrieri:

Yeah. I think fiscal policy has changed, not only in Europe, but overall, everywhere, and the reason for that has come from different sources. First of all, until before the Great Recession, basically was almost automatic that monetary policy was the tool to use to help stabilize an economy, and fiscal policy was a kind of a side show. Some places had some automatic stabilizer, a little stronger, little bit of intervention, but not big packages. Now, of course, why fiscal policy since the Great Recession became much more an active tool of stabilization? Well, first because the zero lower bound was hit in US, in Europe, in many countries. And so monetary policy didn’t have the power anymore to help the economy to recover, and so governments have been acting to help mitigate the adverse effect force of the financial crisis, and then the euro crisis, and then—actually, euro crisis, it’s a parenthesis, I’m going to go back—and then the pandemic.
The other thing is that we are in a very different environment in terms of, we were in a very different environment in terms of trends in interest rate of what we call secular stagnation. So interest rate have been particularly low for now for many, many years. And so there has been the idea that in policy circles, and also among economists, that actually, maybe that’s not a bad time to have fiscal policy more active, because borrowing is cheaper for governments.

Veronica Guerrieri:

Now, so this changes a little bit the stance of fiscal policy. Is it a good idea to spend more when interest rates are low? This is a big chapter to open. I mean, my view is that it’s true, that it’s cheaper, but on the other hand, it’s also true that it’s easier to reach the zero lower bound, so you need to keep some fiscal space in that, in case that happen. But in general, there has been a much bigger fiscal policy. Now how about Europe in particular, is where you started? Well, there has been a big change on top of that, after the experience of the euro crisis, of the euro bond crisis, because at the time there was a big financial crisis, and the worry, of course, was how can we avoid default, and the [inaudible 00:51:32], the European fiscal rules that are active at the moment—actually right now, there is an escape clause—but that could be active, if the escape clause, [inaudible] would require to do a big austerity package. And that’s what happened during the response to the euro crisis in 2011, 2012.
Now, of course, ex post, I think there is overall consensus that those austerity measures were too severe and actually generated double dip recession. In general, we learned that the countercyclical policy needs to be more countercyclical. There needs to be more room for countercyclicality in fiscal policy, and that lesson was learned and used for the pandemic, when big fiscal packages have been implemented. Now, there is an ongoing debate about, what should we do about European fiscal rules? And in 2023, January 2023, the escape clause ends, so if nothing changes, all rules are going to be back in place. It looks like there is a lot of pressure to change these rules. And then, the commission has already started to open requests for different proposals, and there has been a lot of proposals floating around, discussions, policy debates, and so forth. The idea is that we want … the rules that would be active now would be probably, if applied literally, too strict, and would maybe generate ... to restrict the moment in which you maybe need to recover.

Veronica Guerrieri:

And so maybe there is an idea that probably rules needs to be revised in order to make them more simple, more transparent, but also more countercyclical, which of course means that during an expansion you have to cut, and you have to create fiscal space, that’s an important part of the story. But I think that there is a trend towards that, and there is an idea, this revision of the fiscal rules should come also, because there is this, Europe has been made clear that there is this objective of doing a green transition that is going to require big investment.
So government cannot do it with the old rules. There is need for some new framework to think about it and to do it in a reasonable way, to avoid other sovereign debt crisis that of course, financial stability for the euro area is still a concern, and we should be aware of that. And I think that Europe is going in that direction, and next-generation EU has been a very successful blueprint for that, has been very successful. Now, we’ll see how ... Italy is a big player in that, so let’s see how it uses it, I mean, how the implementation is going to go. But I think that has been successful in several dimensions. First, in terms of defining what’s the perimeter of action. So there was digitalization, green transition, and inclusion were the three keywords. Of course, now maybe defense should be taken into consideration. And there has been a very careful structure to make sure that there was no ... I mean, money were used for the right purposes, and the monitoring was very attentive. And on the other hand, what was very successful is that Europe, to finance that created next-generation EU bonds that actually were pretty well rated in the market.
So, it seems that there is overall a general ... The market, the financial market, seems to show that there is appetite for euro bonds, or for investment at the euro level, if there is a fiscal union and there is some coordination that happens. So I think that this is going to go forward, that there is going to be more of that, especially for the green transition, there’s going to be more investment, and probably this is a step towards a fiscal union for Europe; defense may be the next step to talk about.

Chris Giles:

And Randy, when we’re looking wider, the global aspect of fiscal policy, do we now have to realize that we care too much about levels of government debt, and that it seems to be that we’ve ratcheted up government debt in advanced economies? Clearly, there are certain countries that cannot borrow and have no market access. But advanced economies seem to have enormous market access, even when the world is very uncertain, when inflation is high. Does this mean that we just have a lot more fiscal space than we thought?

Randall Kroszner:

Well, in the short run, that certainly seems to be the case, that the markets are letting ... Many advanced economies could get away with quite a bit, an enormous amount of increase in debt. Now, over the pandemic period, with the enormous increase in debt, actually debt service costs went down because interest rates came down so much. So I think as interest rates start to go up, the markets are not going to treat those countries quite as well, because it’s going to be more challenging to make the payments, and that’s also true on the corporate side.
And this is a very important issue, and we think more broadly about Middle East, Africa, and emerging markets generally, about the big differences in the way the markets are treating them. And so certainly there’s a role for the World Bank and IMF, but I think the developed countries have to be very, very cognizant of what the relative consequences are for what they are doing. And certainly, that could put a lot of pressure on emerging markets, a lot of pressure on many of the countries in Africa. And so I think that’s something that I don’t think should be ignored, because that, I think, has a very important both intermediate and long-term consequence.

Chris Giles:

Now it’s just two minutes to seven, so it’s a real shame, this is such a lively and interesting discussion that we’re coming to the end, but there’s a wonderful last question I’m going to put to all of the panel, from Ramona Fuchs, which is a very simple question, but often these are the hardest questions. Given this uncertain outlook, how can investors, private people, and companies best react? José Antonio, I’ll give you the hot potato first. What’s the best advice for people out there?

José Antonio Álvarez:

Well, the best advice to them is to keep going, and going back to the normal life before the pandemia. This is the first thing all of us, we should do, and I hope the pandemia allow us to go back to our, let’s say, all normal world. So this is my recommendation for everyone else, and taking out from our heads fear, and having confidence in our capacities to overcome whatever problems we are facing. So the optimism is the best prescription for the society as a whole.

Chris Giles:

That’s very good. Almost keep calm and carry on, but certainly carry on. Randy, how about you? What’s your advice to people?

Randall Kroszner:

So I think it’s always crucial to try to take a long-run perspective, because things can look very dark in the short run, and many people responded to different political events in the US by just selling everything, because they thought there’d be a problem, or during global financial crisis, selling everything, or the pandemic, selling everything.
If you have the wherewithal to be able to keep, to maintain your investments, not try to time the market, I think that’s extremely difficult to know when is the right time to respond to geopolitical uncertainties, and then know exactly when they’re going to resolve. So I think making sure that you have enough of a liquidity cushion to make it through foreseeable circumstances, but just take a longer-run perspective on things, rather than try to sort of time this or that. I think that’s [crosstalk 00:59:47] difficult.

José Antonio Álvarez:

You sound a bit pessimistic, Randy. So for having interest rates negative, and recommending liquidity is a bit pessimistic, huh? It’s a bit negative view.

Randall Kroszner:

Well, what it is is, I think it’s very important …

[crosstalk]

Randall Kroszner:

It’s important to have insurance, and unfortunately, insurance is now more expensive than it has been, because of the negative interest rates, exactly, negative real rates, as you said. But I think it’s always important to have some insurance, but I wouldn’t say that you want to go all in that direction. You want to make sure that you can survive through the volatility that we’re going to see in the short to intermediate run, but it’s not like, sell everything. I think that’s exactly the wrong kind of approach. I think, think about the long run, make sure you have enough liquidity to make it through in the short to intermediate run, but don’t fundamentally change things, because I share José Antonio’s long-run optimism, even if sometimes it seems that long run is very far in the future.

Chris Giles:

OK. So we’ve had the case for carrying on as if nothing’s happening, or not quite, that’s a bad paraphrase.

Randall Kroszner:

Yeah, yeah.

Chris Giles:

We’ve had the case for insurance. Veronica, what’s your [crosstalk 01:00:59]?

Veronica Guerrieri:

I’m glad by the end of the panel, José Antonio came on the optimistic side as well. I am also optimistic in a sense that … I’m kind of a combination of the two views, and so I think business should keep going. There is going to be some uncertainty, and so I see where Randy’s coming from and see where be careful on the balance sheet and on liquidity is definitely something important.
But I think that the right approach is to look at the medium term and take stock of what we learned from the pandemic. During the pandemic there were some good outcome—digitalization expanded, there was more step towards green transition. So going that direction—of exploiting the new technology and new sectors and new products, where there is hopefully going to be growing demand coming out from the pandemic—I think is the right way to go.

Chris Giles:

Thank you. I think that is the unifying message here, which is that if you look beyond the very short-term uncertainties, there is really quite a remarkable sense that economies have adapted very well to extraordinary times in the past two years. So I’d like to thank the panel hugely for a really stimulating hour. Thank you, Veronica, Randy, and José Antonio, and thank the audience for lovely questions, lots of them. Keep them coming, and thank you very much, everyone. Thank you.