Eric Chaney is the chief economist for the AXA group since 2008, in addition to being a member of the executive committee and the head of research at AXA Investment Managers. Before joining AXA, he was the managing director and chief economist for Europe at Morgan Stanley from 2000 to 2008.
Since 1997, he is a member of the French Economic Council of the Nation, the French Tax Council and the executive committee of the French Economic Association.
Eric Chaney is a former professor of Mathematics and editor of a mathematical journal of the University of Strasbourg, and a graduate from the Paris Graduate School of Economics, Statistics and Finance (ENSAE ParisTech).
In the Business Talk on the 15th of February Eric Chaney addressed the most important macroeconomic issues in 2013 at both European and global level. We had the opportunity to ask him in more detail about the current topics in macroeconomics and about his work as an economist.
Philine: We would like to ask you as specialist in macroeconomic risk, looking ahead for 2013, what is your biggest concern regarding the euro zone?
Chaney: Well, the first thing I’d like to mention is that the euro zone is in a better shape now than it was in 2012. So before talk- ing about risks, let’s talk about the good things. 2012 ended with a contraction of GDP in Europe and the US, which was bad for everything. However there are a lot of signs that there is a recovery on the way. We are still in the beginning of 2013, so it’s still early to say anything about GDP growth, but we can already see that the systemic risk associated with the euro zone has been reduced, due to better financial market conditions. This is also related to a real acceleration of global trade, since Europe in general, and the euro area in particular, is highly sensitive to global trade: even though it is a relatively closed economy, it responds highly to global trade conditions. Back in 2009 the collapse in global trade lead to a very deep recession in most of the world’s developed economics, deeper in Germany than in anywhere else in Europe, seeing the sensitivity of Germany to global trade. Currently, Germany is showing signs of recovery, precisely because global trade is recovering. Concerning risks, there are still risks linked to the management of the euro crisis, the way I would formalize it is that the ECB sent a very strong signal to the financial markets in 2012 saying we are the “insurer” for the euro in case of problems. With some conditionality on the governments, the ECB has committed itself to buy government bonds in an unlimited fashion and that has convinced the markets that the ECB was pretty serious about keeping the euro alive. But that was then. And this kind of nuclear deterrent that the ECB has invented, has never been tested. So the ECB said things, but did nothing, which is a perfect example of expectations theory at work, whereby expectations were fulfilled because the markets saw them as credible. So if progressively the political set-up does anything that lowers the credibility of the commitment of the ECB, the euro zone systemic risk could rise again. And this is a political issue, not an economic one. Let me mention the example of Spain whose risk is related to the political structure of the country and not only to its economy: During the good years (2000-2007), the country has moved from a centralized political system to a decentralized one with more autonomy to the regions such as Catalonia, the Bask country or Andalusia. This was great because this was what the Spanish people wanted, however it was not perfectly negotiated in terms of the fiscal arrangements between the central gov ernment and the regions, for the obvious reason that: there was a lot of money coming from taxes on properties and if you have a lot of money you don’t negotiate under realistic conditions. This does no longer work since the construction bubble is over and Spain is struggling to reinvent its political structure, notice that this is not economics per se but this very difficult situation has a lot of impact on the country risk, because of all the agreements needed between all the people. This is a risk that is highlighted by the fact that there will be a referendum not far from Toulouse, in Catalonia in 2014 about the possible independence of the Catalan country. We see that the political risk, which to some extent is linked to the euro crisis, could fuel again the euro crisis and I do not really see how monetary decisions could change that.
Philine: One heavily discussed topic last summer was the so-called Grexit, the possible exit of Greece out of the euro zone. Do you think this is still a risk?
Chaney: It could become a risk if the Greek people decided that enough is enough, that they are not happy with the con- traction of income and the conditions under which they are getting help from the euro-zone countries. This could happen, if there are new elections in Greece leading to a new government that decides to leave the euro-zone. The euro is an extremely peculiar system that is based on freedom. Nobody asked anybody to join the euro, so forget all the le- gal points made by a lot of specialists: the essential thing is the freedom of the member states. So if the Greeks decide to leave, they will leave. My view is that they will not leave. As long as the Greek government has a primary deficit they cannot leave without being lent money by their partners of the euro area. Once the Greek government has managed to generate a primary surplus excluding interest payment on the debt, the decision could be taken. But I have come to the conviction that the other euro area countries such as Germany, France and Italy will never kick Greece out of the euro area because after the PSI (Private Sector Involvement), i.e. the restructuring of the Greek debt, we had a big crisis in Italy and Spain. So nobody wants to take any risk again with Greece. The risk of contagion was totally underestimated. Germany asked for a restructuring of the Greek debt and the points made by Germany were understandable. They said “Look, we, the German, French and Italian taxpayers are going to lend money to Greece, and we want private investors to have their fair share of the efforts. We need to restructure the Greek debt, and private investors will have to pay. This is what actu- ally happened. There was a negotiation about the so-called PSI, and investors have lost 70 percent, but that is not a big deal, they are still “alive”. However, immediately afterwards, investors considered that there was risk on Italy (Italy has the largest bond market in Europe) there was a risk on Spain, there might be a risk on France, on Ireland, on Portugal, risk everywhere. This was a really painful lesson to learn. If you do that, then contagion comes immediately in the form of much higher interest rates.
What you have to understand is that the contagion was not through the exposure to Greek assets. The contagion happened because in this PSI private investors have lost 70 percent of their holdings of Greek debt (not the ECB, which did not lose anything). Investors drew the conclusion that holding the Italian debt was like holding a subordinated debt. You are not number 1 if there is a default, there is a super number 1 which is the ECB. This is why, suddenly, the spreads on Italy and Spain went up, because if you thought that you were a normal investor and you discover that you are subordinated investor you sell. This is exactly what we observed.
Philine: You said during your talk that the fear of inflation is not reflected by market prices. Do you think that all this discussion about inflation is unfounded or is there, nevertheless, a risk on the long run?
Chaney: There might be a risk of inflation in the long run. What is totally unfounded is this idea that because central banks are expanding their balance sheets to the size of their assets, this will automatically generate inflation. This assumption is totally unfounded from a theoretical standpoint. According to the monetary theory, there is a link between the supply of money and the level of prices in the long term. Monetary theory says: look at the amount of money created by banks (which includes of course money created by the central bank). As far as the euro area is concerned, money supply has been growing at a snake pace since the bankruptcy of Lehmann. Even at a lower pace than nominal GDP growth. If there is a risk in the euro area, according to monetary theory the risk is more deflation than inflation. People are thinking of the U.S. when making this assumption. In the U.S. money supply is growing at a rate slightly above the trend of savings and I see that as an insurance policy against the risk of deflation. The Fed considers that inflation is easier to fight than deflation. When we look at the example of Japan, a very modern economy, we realize that they have not managed to get out of deflation. So the Fed has taken the risk of going a bit too far in terms of stimulating money supply in order to be sure that the risk of deflation will be avoided.
If you want to talk about a risk of inflation (even though it is limited at this stage), it is coming much more from the policy of the Federal Reserve Board than from the ECB. But there is a bigger issue, which is the uncertainty about future prices: could be inflation, could be deflation. Central banks will have to reduce at some point the size of their balance sheets. If they don’t do it, we will have very high inflation. If they do it too quickly, we will have deflation. And this will happen in either 2, 3 or even 4 years from now. We do not know when they will do that. The theory is clear, but implementing the strategy will be tricky. What markets reflect is the uncertainty about future prices: the truth is that we could have deflation. The risk is higher than before the crisis.
Philine: You were talking about the future of the euro zone and the need for a fiscal union with a common budget. Do you think that within a reasonable amount of time this will be possible?
Chaney: I think that if the euro is to survive, which has not yet been demonstrated, there will be a minimal budgetary or fiscal union. Certainly not to the extent of Federal States like Germany or the U.S. or even Confederations like Switzerland, but a minimum will be required to make the new instruments that have been created such as the ESM (European Stability Mechanism) and the Banking Union work well. If we don’t do that, all these decisions that were taken during this crisis will unwind at some point. But this is a political decision and since it is a political decision and since we fortunately live in democracies, it will have to be explained to the peoples and underwritten by the peoples through votes at elections or referendums. But if there is no democratic support for this minimum fiscal union, I’m afraid that some countries will back up, saying “No, this is not what we wanted.”
Philine: A Banking union is theoretically constituted of four elements (single banking supervision, single regulator, common resolution schemes, and a unified deposit insurance) Do you think a banking union should include all these four elements?
On the Banking Union: the lesson we have learnt from the banking crisis in several countries (the Netherlands, Spain, and maybe Italy) is that what really matters is a clear idea of who takes the decisions regarding supervision, restructuring and resolution. Money is a different issue. When it comes to recapitalizing banks, especially in big amounts, the issue is linked to the issue of a fiscal union.
If we are talking about pooled or common insurance deposit schemes, it is a fiscal union issue, it is not a banking issue. I think we need to separate these two things, which are unfortunately not separated. But the key point is: who takes the decision? Take the example of the Netherlands. There was a big property asset bubble, which is now, in 2013, starting to deflate. This is implying a lot of risks for the Netherlands, an in particular for its banks. Many Dutch banks failed during the crisis. Was it for a lack of supervision? To some extent, but what the Dutch National Bank is saying is that “Well, we knew that things were wrong, but the government decided that it was ok. If the supervision had been at a supranational level, there would have been no political resistance to ask the Dutch banks to be much tighter in their loan behavior. Now look at the Spanish situation. We basically know how to solve banking crises because Sweden gave us the lesson in 1992. They had to learn it the hard way, but they know how to do it: you nationalize the banks; you separate the “good” bank and the “bad” bank. The good banks are immediately given back to the private sector, and then you have to deal with the bad assets. This is very painful because there are a lot of losses. When there are losses there are people who loose money and these people might be connected to the political system. Why has Spain failed to follow the Swedish model? It is because of the political connections that we are discovering now between the construction sector and the political parties of the regional level. Now again, if the supervision came from a supranational body, you don’t have this political connection, so you have a much higher probability of having a “good” supervision. This is why I think having a single supervisor in the euro zone is a great achievement. But if it is only supervision, it is not enough. If for instance the supervisor in Frankfurt or wherever decides that bank X in Germany has a lot of bad assets and should be restructured but the decision is left to the lender, who might be connected to this bank, then the lender has the choice to refuse to implement the decision of the supervisor. Then, the supervisor is totally powerless, so to say toothless. So that is why it is very important that the decision on restructuring and resolution is taken at the same supranational level to avoid the political interactions which hinder progress. Recapitalizing banks and insurance deposit schemes would make the system more resilient, but it cannot be done for the sake of a banking union. It is a political issue linked to the fiscal union and this has to be decided by the peoples.
Philine: Could this break the vicious circle between sovereign and banking risk?
Chaney: I think there were some illusions in the market, because on the 29th of June the Council of the Head of States expressed the need to cut the vicious link between sovereign risk and the difficulties of banks to have access to funding. Some people thought this to be a blueprint for a fully-fledged fiscal union containing deposit insurance schemes, and a super ESM to recapitalize banks.
This was an illusion because this is a political decision. The decision to move to a fiscal union was not taken, and has not yet been taken. In reality, what has contributed the most to cut this vicious link is the decision by the ECB to intervene in the market to correct the price perceived on the probability of a country leaving the euro, i.e. the convertibility risk. It amazes me that this decision was taken by the ECB directly after the decision taken by the heads of states concerning the move toward a banking union. The ECB came to the view that now they had enough commitment from the policy-makers, the parties responsible for the taxpayers’ money, to take a step further.
In the markets’ viewpoint, the decision by the ECB (the Outright Monetary Transactions weapon) complemented the decision of the head of states. And we can say that the vicious circle has been partially broken, but not totally because a lot of banks still have to be restructured in Spain and in Italy.
Philine: How do you measure political risk practically (e.g. elections this year in Italy in February or in Germany this Septem- ber)?
Chaney: If you are talking about quantitative measures, I don’t think it is possible with an internal model to put numbers on these kinds of risks. So it is better to look for quantitative measures coming from the markets. One very important market is the people: you have polls. You look at the polls; this is what we all do. Regarding the elections in Italy, we know what the platform of the PDL is, we know what the platform of the Central Left is, and of Mario Monti... We look at the polls and we don’t pretend to be smarter than the polls. So this is a quantitative measure, this was important in many elections, polls aren’t always predicting the right results, but you know, this is the best thing that we have. We don’t try to be smarter than that. An alternative way coming from the markets themselves is the information you can extract from the bonds market (particularly the CDS market), which is a measure of the credit risk for a given country. If you believe a political event such as an election might have an implication on the risk on a sovereign debt, you’ll find a quantitative measure of the risk in these kinds of markets. The market might be right or wrong, I’m not claiming that markets always reveal the truth, but it’s a good tool, since it’s aggregating the decisions of thousands of people buying and selling, so it has information that we can use.
Philine: During your talk you said that you always have to “respect the market”. What exactly did you mean by this?
Chaney: Working in the financial sector, and advising investors, you have to keep in mind that what matters most to investors is the return on their investment. They are not investing to lose money. This is especially the case of institutional investors, like pension funds, sovereign wealth funds and insurance companies who are investing the savings of people.
Investors want to have positive results. If you advise them to buy U.S. assets, because your theory implied that the dollar should go up, but the dollar goes down, contrary to what your theory has predicted, the investors will never listen to you again, because you have helped them lose money. Your theory might be sound from a technical point of view, but it was wrong in the real world, and you have to respect the market, especially when it goes in the other direction of you analysis. This is not a full proof that your analysis was wrong, but if you don’t listen to the market, is equivalent to writing an academic paper and not listening to your peers when they point out to a mistake you’ve done. The markets tell you something. But the market is not someone who tells you “This equation is wrong”, the market just tells you “You’re wrong”, so you have to try to understand why. This is why I emphasize that you have to respect the market. Otherwise you should find a job elsewhere but not in the financial sector.
Hussein: Going back to the U.S., you spoke of the risk of inflation and linked it to the policy of the Fed, and the timing of its deleveraging, do you think that having Mr. Bernanke at the head of the Fed (as Mr. Obama promised in his campaign) is a good sign for the financial markets?
Chaney: It is always good to have continuity when things are working well. The situation gets more complicated once the U.S. economy is in a better shape, and once the money supply starts accelerating again. The Fed knows that they will have to sell assets, and expect to make losses. It’s not a big deal; the central bank can afford to make losses. The risk however is the reaction of the people and of Congress, who might tell the Fed: “You have wasted the taxpayers’money”. Recall, there was a lot of critics against the Swiss National Banks, the decisions taken by Philipp Hildebrand to prevent the Swiss Frank from appreciating. In particular, the SNB made losses, which brought a lot of criticisms by the newspapers and politicians.
The Fed will anticipate this: they know that on some of the assets, they would make losses. One could say that to some extent it is fully internalized. But they might shy away from selling these assets due to political pressure, and, honestly, I don’t think it depends on whether the Chairman is a very distinguished economist, which is the case for Ben Bernanke or somebody more pragmatic. It depends on the power to resist the pressure from politicians, which is going to be quite strong. Note that during the crisis, the Fed (like the Bank of England and the ECB) became much more powerful than before, deciding on everything from regulation and supervision, and a lot of things that they were not doing before. You have to keep in mind that these persons are not elected, and there is always a risk that Congress (in the U.S. and the parliaments in other countries) tells the central bank that you became too powerful, and we need to restrict your powers. This risk cannot be neglected, and will be taken into account by the central banks, in order not to have their wings cut by the parliaments.
We live in democratic countries, and for the reasons pointed out above, taking the decisions on deleveraging will be very difficult. My hope is that they will take the right decisions at the right time, but I want to stress how difficult this will be.
Hussein: Do the central banks have the right tools to take these decisions or is there always a risk?
Chaney: The modern tools that the central banks were using before the crisis were DSGE models, very sophisticated Monte-Carlo simulations, except that there was no significant financial sector in these models. This was a big flaw. It was considered ex ante so difficult that it would have been stupid to try to put it into the model. Now we know that if you want to have a model-based approach, without the financial sector including the shadow banking system, you might miss the most important event which happens once every four years, but which leads to five percent contraction in GDP and the loss of welfare over 20 years.
They have to reinvent the models; there are a lot of people working on that. Maybe in ten years time, the central banks will have new tools and they will discover that something totally unexpected happens that was not taken account of in their tools. Monetary policy is much more a question of taking decisions. With the information that you have - statistics are very important in this regard - you need to have a good knowledge of all the financial transactions. This is why it is important to have a lot of financial transactions done in a single compensation sys- tem so that you get information from the central bank. That is very helpful, but in the end it is a question of taking decisions.
Let me illustrate that. Before the crisis, a lot of people in the academic world but also in the hedge-fund industry were telling the central banks “what you do is silly”: there is a credit bubble, you should go against this credit bubble, you should lean against the wind. You have no theory on that, no math- ematical approach, but when you feel that there is something wrong, you need to go against it and Ben Bernanke was against that.
In my opinion it was not a question of tools, of models, it was a little bit more a question of will, of political will and the ability to take decisions that cannot satisfy to everybody.
Philine: You hold a degree in pure mathematics. How did your academic career unfold to become an economist?
Chaney: I wanted to do some business. And I was involved in a project aimed at launching a scientific journal targeting non-mathematicians, and having as a goal to make mathematical tools accessible to the other scientists. For physicists it is relatively easy because (even though they don’t like mathematicians and vice versa), they are more or less in the same bucket. But if you think of biologists, economists and so on, they have no idea what is going on in mathematics. I realized how difficult the task was. I discovered then that there are some interesting mathematical models in economics, and so I decided to switch to economics. This in the end led me to the real business world: investment banking back then and insurance and asset management now.
Philine: What economic tools do you use in your daily work life?
Chaney: Can I tell you the truth? The most important tool is Excel. You don’t necessarily need to have things that are especially sophisticated, but I think what is important in my line of work as a business economist, is to have a very wide array of theoretical tools that you take from monetary theory etc. There are a lot of houses in the economic city. The wider is your understanding of basic models, the more nimble you will be because things will never turn out as you have been expecting. So when suddenly something unexpected is going on, as with the example of the depreciation of the yen, and people didn’t expected that, you need to recall what tool is the appropriate one to use in terms of ideas. I’m not talking about a fully-fledged model, but what kind of idea could be helpful?
Philine: Would you recommend students in economics to specialize or to rather stay generalized?
Chaney: Apart of being very proficient in Excel and in EViews, I would recommend having a good understanding of a broad range of economic theories, and to avoid belonging to a school of thought. The world is too complex to be explained by one line of thought. Maybe belonging to an approach has advantages when doing research; it’s different when doing practical economics.
In addition, I think it is very important to have a good understanding of the basic financial instruments, not necessarily the very sophisticated things. You need some understanding of the financial markets to be able to extract information.
Philine and Hussein: On behalf of the TSE students, thank you for your time, it has been insightful.