Mehreen Khan
Oh, we’re good to go. Hello, everyone, thanks so much for being here. My name’s Mehreen. I’m the Economics Editor at The Times. It’s a pretty big day for the world economy, so I’m glad that we’ve – you’ve had the time to make it here. This is a, kind of, brief interregnum in my day, ‘cause I’m going to go back and be turning on the TV until late in the evening. I’m sure that the topic of tariffs and Trump will come up, but today’s topic is “Guns Versus Butter.” I was just saying to Anatole that I’ve been writing about economics for The Times for the last three years, and it’s been a bit of a whirlwind.
I’ve been a Financial Journalist for ten years, and I’m writing about things that I never really thought a Financial Journalist would get to write about. One is inflation, which is a unique and weird phenomena for someone of my age. The other one, I think, is industrial policy, another area that I didn’t think Economic Journalists in the 2020s were going to be writing about. Trade wars, tariffs and now military spending or defence spending. So, I think the entire economics discourse around the world has been supercharged by policy areas that we’re all, kind of, a bit new to, or rediscovering from history books, and that’s a little bit about what we’re going to be doing today.
So, the debate around “Guns Versus Butter, so we’re going to be thinking about the imperative for more defence spending, and also the fiscal constraints that are facing so many advanced economies. The panel is going to be talking about where they think there is fiscal room, what defence spending should look like. What’s the best way to get bang for your buck? And whether the bond vigilantes might be getting a little bit restive about the fact that there’s going to be massive – potentially massive fiscal outlays happening in advanced economies, including the one that we’re in today. So, I’m delighted to be joined by a very exting – very distinguished panel – I was going to say “extinguished,” but that’s – hmmm, there we go.
David Lubin
Oh, okay.
Mehreen Khan
Next to me is Anatole Kaletsky, who is the founder of Gavekal, an economics research house. He’s also had a very extinguished car – not extinguished career, why do I keep saying that? Distinguished career as a Financial Journalist, and he is one of my very esteemed predecessors who was the Economics Editor of The Times in the 90s, also worked for The Economist and the Financial Times. Next to Anatole, we have Professor Lucrezia Reichlin, who’s a Professor of Economics at the London Business School. She’s going to be talking to us a lot about the fiscal questions in the European Union. And then, right at the end, we have David, who is here as a Research Fellow at Chatham House, studying the global economy and finance.
So, the title is “Guns Versus Butter.” That’s a phrase that I first came across in school studying Nazi Germany as a 14-year-old, and a couple of weeks ago I wrote a column about it, and I was really struck about the fact that I was trying to think about research and recent literature about the guns versus butter trade-off, and if we exclude the US, there was really nothing. So, it’s very difficult to find any Economist or Academics who’s been thinking about this question or this potential trade-off for European economies in the post-war era, and it was quite hard to find. If you are looking, I would recommend the work of Tim Barker, who’s been doing a lot of this work but in a US context, specifically thinking about what happened to US fiscal policy between the 70s up to the 2000s, but in Europe, there isn’t so much.
So, my opening question to everyone on the panel, Anatole, maybe we’ll start with you, is whether the guns versus butter trade-off is still a real and relevant one in the 202os, and if it is, then which countries does it most acutely apply to?
Anatole Kaletsky
Are you sure you want to start with me?
Mehreen Khan
Why not?
Anatole Kaletsky
Right, yeah. So, I think my simple answer, and I want to approach this as an Economist rather than as a thinker about geopolitics or defence. Although we may go back to that, but that’s not my area of expertise, and the views I have on it are probably not the – not conventional ones, in that I do think that, fundamentally, defence spending is a waste of resources, and it is something that for reasons unconnected with the guns and – versus butter trade-off, should be kept as low as possible, rather than as high as possible, which is the current view, but let’s leave that aside.
I think that whether there’s a trade-off between guns and butter really depends on the macroeconomic conditions of the economy that you’re talking about. So, in an economy, like the economies is all over the world in the 1930s that you referred to, which is operating at high levels of unemployment, with lots of excess capacity, where demand is fundamentally too weak and is well below the supply capacity of the economy, there is no trade-off between guns and butter. In fact, it’s the other way round. The more you spend on guns, the faster the economy will grow, and the more there is potentially to spend on other goods and services, including other forms of government spending.
So, that’s an extreme case of if you start an economy in a depression, as in the 1930s, as arguably a lot of the world was in the early 1980s, as well, with inflation falling rapidly, lots of spare capacity, lots of unemployment, there’s no trade-off at all. If anything, there’s a positive feedback between – just on the basis that you’re applying Keynesian policy, Keynes actually said, you know, back in the 1930s, that although there was a very the – strong theoretical case for using deficit spending to stimulate economic activity and bring economies out of depression, he doubted whether any government would have actually the confidence and the courage to do this, except in conditions of warfare, which turned out to be absolutely right. So, I think that’s the easy part of the question.
But of course, now, we’re not in a world of depression, so I think the que – the way that I would look at it now is that – is this. I think in an economy which is already straining up against its capacity limits and has tight labour markets at full employment, like the United States, there is very clearly a trade-off. And if you fail to recognise that trade-off, what you will get is definitely higher inflation. So, I think if the US, and to the extent that the US does move towards higher military spending – now there’s a lot of ambiguity about whether Trump actually wants to spend more or less, but if they did engage in higher military spending, even before we come to the tariff issue, the US would move into an even more inflationary condition in an economy that’s already, I think, on the brink of breaking out into a much higher inflation equilibrium than it’s been in for the last 20 years.
I think in parts of Europe, and Germany in particular, it’s the opposite. Although levels of unemployment in Germany are actually fairly low now by the standards of the last 30 years, there is clearly a huge amount of excess capacity in the German industrial sector. And will be much more as a result of the tariffs and trade wars, and, you know, the clear shift in Germany’s comparative advantage away from energy intensive manufacturing, and also auto manufacturing. They’ve got to find new areas of competitive – of comparative advantage. So, I think the – in the German economy, there is clearly a case for reallocating resources away from the industries that have been strongest in Germany. And therefore, if they end up building tanks rather than cars on the VW production line, this will actually be beneficial for the German economy. It will create greater growth in – actually probably improve long-term fiscal conditions, or certainly won’t harm long-term fiscal sustainability.
So, in Germany, I think there’s be ap – there will be absolutely no trade-off between guns and butter, and that’s why I’m pretty optimistic about Ger – the German economic outlook, after the extraordinary reversals that have happened literally in the last few weeks. My feeling, although I’d suspect, Lucrezia, you may disagree with this, I think that also applies to the EU as a whole. For most of the EU, there is still lots of – plenty of spare capacity, plenty of opportunity to bring more workers into the labour market, and also to increase the productivity of lay – of workers who are in the labour market. So, I think for Europe a big fiscal stimulus coming from military spending will actually be beneficial for all sectors.
I think Britain is the opposite, is a different case. Britain is also, I think, a country that could benefit from higher fiscal spending, but of course, we have fiscal rules which make that impossible and which impose a very, very strict trade-off between guns and butter. So, I think in the case of Britain there is a clear trade-off. The question is, is it really economically required? Is it required by the bond market, or is just a function of the particular fiscal policy that this government has chosen to pursue? And maybe we can discuss that later.
Mehreen Khan
Yeah, may – Lucrezia, I’ll ask you about the trade-off as well, but, you know, if you’ve been following economic policy in the eurozone, it’s basically, been lots of people begging Germany to do some more demand stimulative fiscal policy. And finally, it’s arrived in this bizarre form of Donald Trump and Friedrich Merz, who are the weird combination…
Professor Lucrezia Reichlin
We have it.
Mehreen Khan
…that finally delivered…
Professor Lucrezia Reichlin
Yeah.
Mehreen Khan
…what so many people have been wanting, you know, less deflationary policy. So, I mean should – do we have – should we be thankful that Trump has, basically, you know, supercharged the…
Professor Lucrezia Reichlin
Yeah.
Mehreen Khan
…finally broken the…
Professor Lucrezia Reichlin
I am really…
Mehreen Khan
…back of…
Professor Lucrezia Reichlin
I am really thankful.
Mehreen Khan
…German obstinate…
Professor Lucrezia Reichlin
I am really thankful.
Mehreen Khan
…ordoliberalism?
Professor Lucrezia Reichlin
Yeah, I agree with you. I mean, I think – well, first of all, let me start with the same line as Anatole, war is bad, okay. So, I would have rather have fiscal expansion to green our economy rather than…
Anatole Kaletsky
That’s right.
Professor Lucrezia Reichlin
…you know…
Anatole Kaletsky
That’s right.
Professor Lucrezia Reichlin
…to buy – you know, to build up defence. But, you know, it is a necessity, whatever one thinks, okay, so this is going to happen, and I think the change in the fiscal stance of Germany is huge, not only for defence, but also for infrastructure, it’s 500 billion. So, this is a complete change of the game in Europe. There will be a large effect on the – on Germany GDP. This – there are some numbers around, the IMF has done some calculations and so on, but also there will be multiplier and spillovers in the rest of Europe.
In terms of how we should think about this, I would actually disagree with Anatole, even if I’m surprised that you started so – with such a conservative stance, knowing you. Because there is lots of evidence that actually, one of the problem of Europe was not just the spare capacity, but the fact that aggregate demand has been consistently low, and every time…
Anatole Kaletsky
Hmmm, yeah.
Professor Lucrezia Reichlin
…that we came out of a recession, we came out much weaker…
Anatole Kaletsky
Yes, I agree.
Professor Lucrezia Reichlin
…and we never went back to…
Anatole Kaletsky
Hmmm hmm.
Professor Lucrezia Reichlin
…trend, unlike the US.
Anatole Kaletsky
Yes.
Professor Lucrezia Reichlin
So…
Anatole Kaletsky
Yes.
Professor Lucrezia Reichlin
…there is evidence that maybe running the economy hot…
Anatole Kaletsky
Hmmm hmm, yes.
Professor Lucrezia Reichlin
…is pushing the frontiers…
Anatole Kaletsky
Hmmm hmm.
Professor Lucrezia Reichlin
…pushing actually…
Anatole Kaletsky
Yes.
Professor Lucrezia Reichlin
…productivity…
Mehreen Khan
Hmmm hmm.
Professor Lucrezia Reichlin
…not just filling up the gap, but pushing the…
Anatole Kaletsky
Yes.
Professor Lucrezia Reichlin
…frontier. Now, if this is the case, okay, so we have, you know, the perfect conditions, because, you know, the – Germany is a big engine of our economy, so multiplier and spillovers in the rest of the economy, including for those economies like Italy which have less fiscal space, because we – Italy has a quite robust military industry, so that will benefit from that. And the beauty of that is that Germany has the fiscal capacity, because as public debt is relatively low. They will probably get in breach of the fiscal rules, but who cares, okay, so that…
Mehreen Khan
The European fiscal rules…
Professor Lucrezia Reichlin
The European fiscal rules.
Mehreen Khan
…because they no longer have any of their…
Professor Lucrezia Reichlin
Okay, so the…
Mehreen Khan
…own fiscal rules.
Professor Lucrezia Reichlin
…German fiscal rules are already in the bin, but, you know, also there. So, then there are – you know, I mean, I don’t want to take more time, but of course, what will happen depends on a lot of things. For example, you know, there will be a pressure interest rate, for sure. So far, we haven’t seen such a huge impact, but we have seen some impact, which will hurt highly indebted countries. We haven’t seen the spread between German debt and Italian debt increasing, so – which is good, because I think the market expect that the ECB will be there to fight fragmentation if this occurs. But, you know, so far so good, it’s not obvious that this is a stable equilibrium.
And so, we will have to see how monetary policy will accommodate this fiscal stimulus, will or will not. So, what the ECB will do is also important, and, you know, in general, the market for debt in Europe, you know, I think there will be changes, so, you know, we can maybe discuss this in the second round, but, you know, there are lots of question marks on that.
Mehreen Khan
Maybe just on this idea of “running an economy hot,” which is what Biden was, sort of, I wouldn’t say accused of doing. Just, kind of, just what they did, and it was clearly that there was – the imperative was political and also economic. But if Germany runs its economy hot, but is defence spending going to be a massive fiscal outlay for other countries outside of Germany in the Euros? I’m thinking about Spain, Portugal, where defence spending is very low. I mean, in Italy itself, there’s a huge political debate about whether they should be doing any of this.
Professor Lucrezia Reichlin
Hmmm hmm.
Mehreen Khan
So, is this very asymmetric in where this – where the impact…
Professor Lucrezia Reichlin
Well, I don’t…
Mehreen Khan
…of this is going to be?
Professor Lucrezia Reichlin
…believe so. I mean, for sure, Italy will be – will benefit, because our defence industry has the private sector, I mean, private-public, okay. So, Leonardo is a big defence company, is one of the largest in Europe and, you know, frankly, they’re quite happy about what’s happening, and the question, however, is that whether this will pay in terms of productivity? It also depends on they – whether the defence industry in Europe will go for aggregation and transnational aggregations. It’s a little bit the same story as we have with the financial sectors. I mean, we don’t have the scale, so the scale will be important platform for common procurement, that’s super important in Europe.
If you talk to the defence industry, the first thing they tell you is that the fragmentation in procurement is one of the big disadvantage that Europe has with respect to the US. So, for that, we need the political will and, you know, and this, you may put a question mark on that, because when it comes to open up, you know, the frontiers and, you know, try to think in terms of common – on common public goods, Europe, you know, it’s always difficult, okay, to get to the point of consensus. So, we have already seen that on all these issues, you know, Italy is on one side and France on the other side and German – you know. So, it’s – I think the risk is mostly political, but economically potentially, there is an upside, but, you know, the political issues is quite big, okay, the political fragmentation.
Mehreen Khan
David, same question to you…
David Lubin
I mean, I think…
Mehreen Khan
…on trade-offs.
David Lubin
…there are circumstances where there’s no trade-off. You know, one is a country like Russia, where there’s no debt to begin with. You know, so when Russia invaded Ukraine in 2022, jet – debt GDP ratio was 15%. So, there’s no trade-off for a country with a low debt stock. It’s also possible to argue that there’s no trade-off between guns and butter for a country that doesn’t provide much butter. China, for example, has a, you know, relatively large stock of public debt, but its provision of buttery things, education, welfare, pensions, is very minimal. And so I think for China that trade-off doesn’t exist, they just – you know, they could just go for it if they wanted to, because there’s no – nobody’s ex – what they’d be giving up in order to make room for additional defence spending is not that painful for households.
And I guess another possibility, or another area where you might think there’s no trade-off at all, arguably is, you know, a country, like, the United States that can sell a lot of debt, as long as the dollar remains the, sort of, you know, most prized reserve asset. It might not, maybe we’ll get into that discussion later. In an environment where, you know, there’s really no historical relationship between the level of the US public debt and bond yield. For lots of other countries though, of course, there is a trade-off, and particularly in this time zone.
And I think, you know, one issue is how temporary – whether you think that the increase in defence spending that’s required is temporary or permanent. If it’s temporary, borrow some more. If it’s permanent, maybe you can’t – you wouldn’t want to, sort of, just rely entirely on borrowing. You might want to rely on some combination of tax rises and spending cuts. My advice would be to bias the strategy towards spending cuts, because there’s some evidence that if you rely on tax increases, then the multiplier from additional defence spending can actually be very low or even negative.
But there might be circumstances where an increase in defence spend – an increase in defence spending has to be funded by additional borrowing. And I mean, I guess the good news at the moment, at least for Europe, is that the bond market, as Lucrezia was suggesting, the bond market’s been pretty tolerant. You know, German bond yields were 2½% at the beginning of March. They rose to 2.9%, ten-year bond yields rose 2.9% in the aftermath of the discussion about increase – you know, this €500 billion infrastructure facility, and the increase in defence spending, and now they’re 2.6/2.7. So, I think there’s no evidence that the, you know, bond market is, kind of, freaking out about the increase in German defence spending, and that’s very good news.
But I have to say that in the longer term, I think one issue worth raising is that we live in a world where the bond market has been given full competence, full rein, to price risk.
Mehreen Khan
Yeah.
David Lubin
But when national survival is at stake, it’s very common for governments to take that power away from bond markets. Between 1942 and 1951, the United States capped the bond yield at 2½% percent, capped T-bill yields at three eighths of a percent, and so you have financial repression as a mechanism to allow governments to do what they need to do for the sake of national survival. Because that’s, you know, if we’re talking about defence spending, that’s, kind of, what we’re talking about.
And so, I think it’s worth at least having the scenario in one’s mind that one of the consequences over time of the kind – the new kind of geopolitical environment that we’re in, may be to undermine the – some of the things that we take for granted about the function of capital markets and their role in pricing risk, and some of the things that we take for granted about international capital mobility. Because, you know, if countries have to start engaging in what I’ve called ‘financial repression’, in other words, capping bond yields at a level lower than the market would ideally want them, then it – you don’t have to take too many steps to work out that you probably have to start closing your capital account and prevent money from leaving. So, I think, you know, we may end up entering quite unconventional territory in terms of the structure of capital markets and structure of capital mobility, if we go – if we keep on going down this road.
One possibil – one possible way to, kind of, push that further into the future is if we start thinking more creatively, and if we can come to a consensus about thinking more creatively about the public sector balance sheet, there’s an argument that a number of Economists make, which I think is very convincing, and the Government of New Zealand already puts this into practice, where the focus is not on the liability side – not purely on the liability side of the public sector balance sheet, but on the whole public balance sheet itself. In other words, you look at the asset side of the balance sheet, you look at what governments have in terms of real estate, in terms of state-owned enterprises, in terms of infrastructure, and you manage those assets carefully in a way that generates income, and in a way that, you know, allows the whole balance sheet to be considered by the bond market, rather than just the liability side. And I think there may be something in that. Even if you don’t think there’s any valid arguments in thinking about the public sector balance sheet as a whole in this context, the reality is that the US is going down this road now.
Mehreen Khan
Hmmm hmm.
David Lubin
Scott Bessent, the US Treasury Secretary, talks about “monetizing the asset side of the balance sheet.”
Mehreen Khan
And what does that even mean? I mean…
David Lubin
Well, we’ll…
Mehreen Khan
…it seems, like, a complete nothing, but a statement…
David Lubin
I’m sure we’re going to find out after you…
Mehreen Khan
No, but I mean, so I guess public sector net worth is something that this government in this country considered. They, kind of, stepped back from it, but if we’re going to do financial repression, then we need to recruit central banks in the fighting to do financial repression…
David Lubin
Yeah.
Mehreen Khan
…which is…
Professor Lucrezia Reichlin
Well, not necessarily, because, for example, one of the things that the US has said is to give some incentive to banks to buy treasury through regulatory measures…
Mehreen Khan
Yeah.
David Lubin
Yeah.
Professor Lucrezia Reichlin
…and I mean that’s the obvious thing to do for them. I mean, that’s…
Anatole Kaletsky
Well…
Mehreen Khan
But is this a Wild West world?
Anatole Kaletsky
Well, no, no, well, no, I don’t think so. I think we’re already – and where I’d disagree with David is I don’t think the bond markets are going to be a constraint on military spending. In the end, the constraint is the real – is the capacity of the real economy to produce goods and services…
David Lubin
Hmmm.
Anatole Kaletsky
…and if you overstretch that, you get inflation. I don’t think the bond market is going to be a constraint because we’re already in a world of extreme financial repression, in the sense that we have rules which require banks to purchase enormous amounts of medium-term debt to stay in business. Even more importantly, especially in this country, we have the most extreme rules forcing pension funds to buy noth – virtually nothing but government bonds, regardless of the returns that are available on them.
So, we already have extreme financial oppression, which is, I think, one of the reasons why bond yields remained very, very low all over the world. Even in this country, you know, 4½/4.7%, is very low in a world where inflation is now running clearly well above not just 2% but above 3% in underlying terms. But they’re going to stay there, and why bond yields, as David said, have not really been responsive to government debt levels, and that’s been true not just in America, it’s been through pretty much all over the world. I mean, if you look at government debt to GDP ratios all over the world, they’ve roughly doubled in the last seven or eight years, partly as a result of COVID…
David Lubin
Yeah.
Anatole Kaletsky
…and so on, but they’re not going back to where they were…
Professor Lucrezia Reichlin
You had Liz Truss…
Anatole Kaletsky
…we’re never going back to 60%.
Professor Lucrezia Reichlin
Well, you had Liz…
Anatole Kaletsky
No, no, if you have an extreme explosion, you know, localised in one or two weeks, combined with all kinds of institutional disruptions, you get a Liz Truss type of effect.
David Lubin
Yes.
Anatole Kaletsky
But even the Liz Truss effect, you know, the bond yield now is about the same as it was, you know, in the – at the height of the Liz Truss panic.
Mehreen Khan
Yeah.
Anatole Kaletsky
So, I think we’re in a world where no government is going to go back, or even going to try to go back to the 60% debt to GDP ratio…
Professor Lucrezia Reichlin
And also, I mean…
Anatole Kaletsky
…and, you know, 100% is okay, you know.
Professor Lucrezia Reichlin
I think actually…
Anatole Kaletsky
Yeah, sorry.
Professor Lucrezia Reichlin
…your example on the US after the war – during the war is very interesting, because actually, the Fed was not – you know, was pegging, I mean, you know, that was the Fed…
David Lubin
Yeah.
Professor Lucrezia Reichlin
…the pegging, the long-term…
David Lubin
Yeah.
Professor Lucrezia Reichlin
…interest rate, and we did not – they didn’t – they did not get inflation, okay.
David Lubin
Yeah.
Professor Lucrezia Reichlin
So, that – so this is a typical example in which…
David Lubin
It worked.
Professor Lucrezia Reichlin
It worked.
Anatole Kaletsky
Yeah.
David Lubin
Yeah, yeah, yeah.
Professor Lucrezia Reichlin
So…
Anatole Kaletsky
And part of the reason I got – where I really – I think the most important point that’s been made in this discussion and Lu – is one that Lucrezia made, and where I completely agree. I was very conservative in my presentation, but the fact is that the European esp – experience, especially, and this includes Britain’s experience, suggests that by running an economy at very low levels of demand pressure, you do, after each cycle, seem to get into a lower and lower growth and productivity situation. So, that with each recession that we’ve had, or each slowdown we’ve had, in Europe over the last 20 or 30 years, as the economy emerged from that slowdown, even if unemployment kept down, you had productivity levels that were lower, potential GDP growth that seemed to be lower. And the only advanced economy that has managed to avoid that downward spiral has been the United States…
David Lubin
Hmmm.
Anatole Kaletsky
…because – and I don’t think it’s just because of their technology and science and all that. I think it is because they have made the conscious or semi-conscious decision of running the economy hot under Biden, or at least reasonably warm, you know, under Bush and Obama. Rather than allowing these, kind of, hysteresis effects to keep weakening the potential productivity growth. And I think that’s where Europe was, I think, until the recent turnaround, I think that’s very much where Britain is today. And there is a decent chance, I think now, that at least parts of Europe are starting to break out of that downward spiral.
Mehreen Khan
I mean, what – can we have independent monetary policy in this world of fiscal dominance that you’re all describing?
Professor Lucrezia Reichlin
Well, it’s – the Economists call it “locally fiscal dominance.”
Mehreen Khan
Local fiscal dominance.
Professor Lucrezia Reichlin
Locally recur…
Anatole Kaletsky
What’s that?
Professor Lucrezia Reichlin
Locally, no recurring. So, that – I mean, to – provided that there is some, kind of, illusion and expectations are not rational, you know, you can actually have a stable economy with that we with that, kind of, peg on interest rate, but I mean, that’s a theoretical argument. But I mean, in a way, we have this huge balance sheet by central banks and we have had also some radical changes in the op – in their operational frameworks so that they hold structural portfolios of bonds, you know, that – which means that the system is more robust in absorbing, you know, these large issuance. But also that they have different instruments, so that, as actually the UK example showed during the episode of Liz Truss, so that you could actually intervene in the bond markets, and then at the same time, keep interest rate, you know, going in the opposite direction.
Or I think there is a question on the ECB, because the ECB is much more conservative, whether they will be ready to, you know, for example, to slow down QT, facing this big fiscal expansion of Germany. There will be, you know, a lot of issuance of government bond from Germany. So, that’s – it changes the situation quite a bit, because, you know, the ECB will – always had the problem of facing scarcity of bonds because the German debt was not…
Mehreen Khan
It’s just not enough, yeah.
Professor Lucrezia Reichlin
…large enough. So, now, it’s large, so there is no excuse, okay, of not being actively in that markets.
David Lubin
I think the answer to the question here, “Can mon – independent monetary policy persist?” kind of, depends on whether the authorities and whether society really value low inflation.
Mehreen Khan
Hmmm hmm.
David Lubin
And actually, Russia’s a good example, at the moment. You know, the Central Bank of Russia is pursuing incredibly tight – you know, so the starting point is that there’s this huge fiscal expansion in Russia. You know, this year 50% of the budget is defence or internal security expenditure, and as a result of that, the economy is overheating massively. Wage growth, nominal wage growth is 20 – above 20%, in an economy where the inflation target is three and, you know, CPI growth is, like, at ten. But Vladimir Putin believes, has believed forever, that his legitimacy is under direct threat if he lets inflation come out and get out of control. And so he’s, kind of, given space to the Central Bank Governor to pursue extre – incredibly tight fiscal policy, as a way of keeping…
Mehreen Khan
Monetary policy.
David Lubin
Sorry, monetary…
Mehreen Khan
Yeah.
David Lubin
…policy, as a way of preventing inflation going – you know, staying in double digits, which it, kind of, is at the moment. So, you can, I think combine independent monetary policy and short-term interest rates with financial repression, and it really depends on a) whether the inflation threat is real, which in the US during the Second World War it wasn’t. Although post-war it, sort of, got bit worse, but in the case of Russia today is real. If it is real then – and if you really need to do something about it, and you should, you should let the Central Bank do its job.
Mehreen Khan
I mean, would the…?
Professor Lucrezia Reichlin
You cannot do it forever, so that’s the point. So, you can peg interest rate, but you cannot do it forever.
David Lubin
Yes, yes, yeah.
Professor Lucrezia Reichlin
Yeah, so that’s – then…
Mehreen Khan
But is the lesson of the, sort of, the incumbency bloodbath of 2024, that inflation is actually the most important economic metric in any economy? And it’s had such a scarring effect on the way people feel about their standard of living, which, you know, every government has almost paid a price, with the exception of…
David Lubin
Yeah.
Mehreen Khan
…maybe Mexico, and maybe…
David Lubin
Hmmm hmm.
Mehreen Khan
…Mark Carney this month…
David Lubin
Yeah.
Mehreen Khan
…in Canada. But if it’s about inflation, then actually this is…
David Lubin
Yes.
Mehreen Khan
…far more of an acute problem than…
David Lubin
Yes, and Vladimir Putin…
Anatole Kaletsky
Hmmm hmm.
David Lubin
…kind of, has internalised that very strongly.
Mehreen Khan
Yeah, and he doesn’t ha…
David Lubin
Yeah.
Mehreen Khan
He doesn’t have to get re-elected either.
David Lubin
Yeah, well…
Mehreen Khan
So, let’s talk about – oh, it’s been half an hour we haven’t spoken about Trump, but there’s another fiscal issue coming up, which is the tariff issue and…
David Lubin
Hmmm.
Mehreen Khan
…lots of countries who are in the direct firing line of the tariff onslaught are facing potential recession, so, Canada and Mexico being the two obvious ones. There’s now a pressure for them to have to fiscally respond to the fact that there’s going to be a big shock to the economy. This is another, you know, example in which fiscal policy is going to have to come to the rescue again.
Again, so, just to tie it back to the previous conversation of talking about central banks who’ve had – hold – held bonds for a very long time. They’re now, you know, shrinking their balance sheets, in the UK, it’s happening at quite a fast rate, they’re actively selling them back. Pension funds in the UK, the demand for longer duration bonds is not really there anymore. I mean, do – we all think that we can do fiscal policy well and the market is just going to absorb this, and I hope there’s people in the crowd who are, kind of, closer to the market side, as well, ‘cause I would love to hear what they think about, you know, the paradigm shift that is going to happen. But we all seem ve – relatively sanguine about advanced economies being able to withstand new fiscal pressures, potential new downturns, and central banks and our institutions just, sort of, having to, you know, carry along. Anyone – nobody’s super worried about the fact that this is a – there’s a tipping point here, and like, you know, we could be entering a…?
Anatole Kaletsky
I think all the evidence from the markets over the last few years, but – well, over the last 15 years, but over the last few years especial – three years especially, suggests that we – if you have a weakening of economic growth, which there will be in Canada, let’s say, or Mexico, as you said, as a result of Trump – incidentally, I don’t think there’ll be any necessary weakening in Europe or in China as a result of Trump, because their exposure to American – the American market is not as big as is often thought – believed. But if you have a weakening of economic growth, fiscal policy ought to become more expansionary rather than less expansionary. I mean, governments should be consciencely – consciously running larger budget deficits in those circumstances.
That’s what everybody believed, you know, in the era of automatic stabilisers, and so on, basically, and that’s the way the American Government has consistently operated, you know, right up until this point. And all the evidence suggests that, actually, that more expansionary fiscal policy in conditions of weak economic activity will lead to lower interest rates, rather than higher interest rates. And we can see this going on from day-to-day for those of us who follow the markets. Every time there is a weaker than expected datapoint coming out of the US, but even in Europe, we know that that will make the fiscal situation even worse…
Mehreen Khan
Hmmm hmm.
David Lubin
Hmmm.
Anatole Kaletsky
…and even more unsustainable, but despite that, bond yields go down.
David Lubin
Hmmm.
Anatole Kaletsky
And the reason they go down is because they assume that short-term monetary policy will be easier, and basically, the bond markets do not care about what the outlook is five years or ten years, or even three years from now. The bond markets these days – maybe this was different, you know, 20 or 30 years ago, the bond markets these days are dominated by very short-term momentum trading. What determines the price in the bond market is what people think the central bank is going to do, or even just say, over the next few mon – few weeks or months. And the idea that the bond market is somehow responding to long-term forecasts about what’s going to happen to fiscal sustainability or growth or inflation three years, or five years, or even two years from now, just doesn’t seem to be the real world.
David Lubin
Can I say that Mexico is actually a very interesting example here, because…?
Anatole Kaletsky
Sorry, I should have said outside emerging economies.
David Lubin
Okay.
Anatole Kaletsky
Maybe in emerging economy it’s…
David Lubin
‘Cause, I mean, you’ve…
Anatole Kaletsky
…different, yes…
David Lubin
…you’ve got the…
Anatole Kaletsky
…yeah.
David Lubin
…you know, two countries in emerging economies, Brazil and South Africa, that have what Economists call ‘r-g problems’…
Anatole Kaletsky
Yeah, yeah.
David Lubin
…in other words, the real interest rate is so high. I mean, in Brazil the – you know, the ten-year bond year yin – ten-year bond yield in Brazil is 15%.
Mehreen Khan
Hmmm.
David Lubin
Let’s say inflation is five, so you’ve got a real yield of 10%, potential growth is maybe 2%. So, you – you know, Brazil in order to prevent the debt stock from rising as a share of GDP, Brazil is under an arithmetic obligation…
Anatole Kaletsky
Yeah.
David Lubin
…to run very large…
Mehreen Khan
Yeah.
David Lubin
…primary surpluses, and that’s not going to happen. South Africa is in the same situation. Mexico is on the cusp of being – of having that, kind of…
Anatole Kaletsky
Yeah.
David Lubin
…r-g problem. And as a – and because they’re sensitive to that, they’re in the process of actually tightening fiscal policy.
Anatole Kaletsky
Yeah.
David Lubin
Last year’s budget deficit in Mexico was the largest since 1989. Everybody, you know, got very anxious about that and it obviously, was in order to get Claudia Sheinbaum elected, she got elected, and so, now, they’re trying to tighten fiscal policy, and they’re still – they still seem to be relatively committed to it. So, I mean, I take your point, Anatole, that…
Anatole Kaletsky
Yeah.
David Lubin
…you know, fiscal loosening is the right instinct…
Anatole Kaletsky
Yeah, yeah.
David Lubin
…but it, kind of, depends on whether…
Anatole Kaletsky
Yeah.
David Lubin
…you know, how close you are to – or how much you’re going to increase the probability of a Liz Truss moment…
Anatole Kaletsky
Yeah.
David Lubin
…and if your – you know, the relationship between your real bond yields and your potential growth rate is where that answer is…
Anatole Kaletsky
Yeah.
David Lubin
…kind of, contained, I think.
Anatole Kaletsky
No, the reason…
Professor Lucrezia Reichlin
So, for Europe that…
Anatole Kaletsky
…I keep going on about this is we have the misfortune right now of living in a country that thinks it’s Mexico, whereas in fact it’s much closer to Germany.
Professor Lucrezia Reichlin
Well, I mean, for Europe, you know, the – it really depends on whether the market thinks of Europe as a unitary market…
Anatole Kaletsky
Yeah.
Professor Lucrezia Reichlin
…or as a segmented market. And it looks like we have graduated from the situation of financial crisis because, you know, the spread seems to be less sensitive to these fiscal shocks, okay. So, that’s the measure of it, but they’re not zero though.
Anatole Kaletsky
Hmmm hmm.
Professor Lucrezia Reichlin
And so, I mean, there is a concern, I think, that now the ECB has the instrument to intervene in case the spreads would become larger, but there is always that question mark of whether the consensus will be there…
Anatole Kaletsky
Hmmm.
Professor Lucrezia Reichlin
…at the last minute to, you know, to give the ECB a complete free hand. And the TPI, which is this Transmission Protection Instrument, which has been designed exactly for that objective, is subject to the constraint that countries that benefit from that instruments, they have to be compliant with the fiscal rules.
Mehreen Khan
Hmmm.
Professor Lucrezia Reichlin
Now that we don’t have – we have had a suspension of the fiscal rules, or temporary fiscal – suspension of fiscal rules, there is a question mark of, you know, what is the trigger? In – under what condition they will be able to use it, and, you know, there could be situations in which, you know, the market will test the political will to use this, kind of, lender last resort type of instruments, you know, in a free way. So, I mean, I’m not 100% relaxed, but I’m relatively relaxed.
David Lubin
I think one problem in Europe is, you know, additional defence spending, if it’s going to have a large fiscal multiplier, would be great, because it, you know, can pay for itself…
Mehreen Khan
Pay for itself, right.
David Lubin
…in some respects, but as Anatole was suggesting earlier, you know, the sort of basic question is, to what extent is this new loosening of fiscal policy going to express itself in higher imports or higher prices?
Mehreen Khan
Hmmm hmm.
David Lubin
And if it does either of those, then the, you know, the multiplier gets, kind of, destroyed. And I think, you know, right now, for Europe, that’s a particular problem because something like 80% of European defence equipment is imported.
Mehreen Khan
Yeah.
David Lubin
Europe’s dependence on the US for, you know, the software upgrades for the F-35s, or, you know, in – or HIMARS, or, you know, intelligence and reconnaissance and surveillance software and co-operation, to, kind of, high – you know, the point of this increase in European defence spending is to – for Europe to take responsibility for its own defence.
Mehreen Khan
Hmmm hmm.
David Lubin
In order to achieve that goal truly, it has to, kind of, carve itself off from dependence on US hardware and software. That’s going to take a long, long time, and in, you know – I worry that in the, sort of, the beginning phases of this, because the import bill associated with a euro of expenditure and defence is so high, the multipliers might be low and it might be difficult quickly to get Europe to all – you know, get Europe to a position where it’s got genuine defence independence.
Mehreen Khan
I’m going to open it up in a second, but we’ve all very much stuck to our lane here on talking about the economics. Who’s thoughts about the politics of what it means to have rearmament drives, particularly in Europe? Lucrezia, I was speaking to a EU Ambassador from a Southern European country the other day, who wasn’t as sanguine about the idea of a militarised Germany, for obvious reasons, whose country is quite far away from the Russia-Ukraine border and was pretty concerned about it. I mean, we still have what we used to call – I don’t know what they call they now, populists or right-wing nativists…
David Lubin
Hmmm hmm.
Mehreen Khan
…parties in Europe. How comfortable are we with them potentially being executives one day and being in charge of huge defence budgets and big armies? What does defence spending do to a country’s politics, to a country – a population’s idea about its own sovereignty and what defence means? I mean, these are all – I know they’re all very big questions, and maybe not ones often for economic forums, but they should be, I think…
Professor Lucrezia Reichlin
They should be on the table.
Mehreen Khan
…part of the discourse, yeah.
Professor Lucrezia Reichlin
Of course.
David Lubin
Of course.
Professor Lucrezia Reichlin
I was in Washington last week and I was talking to somebody who said, “Are you going to rearm Germany for the third time?” You know, in the, last 100 years, you know, what happened last two times that happened…
David Lubin
Hmmm hmm.
Professor Lucrezia Reichlin
…and in a situation in which the FD has 30% of the votes…
Mehreen Khan
Of course.
Professor Lucrezia Reichlin
…and so that you’re going to have rearmament, and probably, you know, very, you know, right-wing, possibly anti-democratic political parties…
David Lubin
Hmmm.
Professor Lucrezia Reichlin
…both in France and Germany, and also what that – will that mean? Okay, because also we know that the foreign policy of these parties is friendly to Russia.
David Lubin
Hmmm.
Professor Lucrezia Reichlin
So, I mean this is a paradox, so that we are building up defence, but politically, I mean, the – I mean, I think these parties are quite pro-Russians and they, you know, they – it’s not obvious that they will have the majority, but they command a big, you know, a big portion of the electorate. So, I think there is a concern, for sure, and – but I think there is no choice, so that…
Anatole Kaletsky
Well, I would go further than that and say that I think there’s at least a political risk that if a hard choice is presented between more military spending and more spending on other – or maintaining spending on other government services, like education, health, pensions and so on, that actually military spending, everybody’s very excited about it now, but I think this rearmament is very politically dangerous.
Professor Lucrezia Reichlin
Yeah.
Mehreen Khan
Hmmm hmm.
Anatole Kaletsky
Because I think within a couple of years it could become extremely unpopular in this country, particularly if it is presented as a trade-off between high defence spending and low health spending, lower education spending, lower spending on policing and crime and so on. I think military spending could become very unpopular, and in the case of Germany, if that happens, it may not happen because maybe the German economy will boom and everything be great. But if there is a trade-off who’s it going to strengthen? It’s going to strengthen these…
Professor Lucrezia Reichlin
Yeah.
Anatole Kaletsky
…extreme parties…
David Lubin
Hmmm.
Anatole Kaletsky
…on the left and the right. And one of the, sort of, tragicomic aspects of what’s going on now is that, especially in Germany, there are two – there are – you – everybody is agreed on militarism. You know, the Social Democrats, the centra – the Conservatives, the Christian democrats. Even the Greens, have become an ultra-militaristic party who think it’s more important spend on defence than on environment. The only exceptions to this, the only pacifists left, are either so-called – are neo-fascists or post-communists. They’re [inaudible – 45:02].
Professor Lucrezia Reichlin
But the same in Italy.
Anatole Kaletsky
You know, exactly…
Professor Lucrezia Reichlin
The same in Italy.
Anatole Kaletsky
…and the same in Italy, yeah, yeah, yeah.
Professor Lucrezia Reichlin
The same in Italy, except that the, you know, the numbers are not as large, but it’s the extreme left and the extreme right.
Anatole Kaletsky
Yeah.
David Lubin
Yeah, I mean, I think it really depends on how pressing the existential threat is.
Mehreen Khan
Hmmm.
Anatole Kaletsky
Hmmm hmm.
David Lubin
I mean, if you’re, you know, confronting a question of national survival, then presumably, I hope, you should expect that, you know, the supp – popular support for defence spending would go up.
Mehreen Khan
Yeah.
David Lubin
But, you know, the reality is that we’ve had, you know, I don’t know, 35/40 years of a peace dividend in many of the countries that we live in, in this country, for example, and that has, you know, created a society that is just less war conscious, and for good reason. And thank – you know, it’s great that we had the privilege of being…
Mehreen Khan
Yeah.
David Lubin
…less war conscious. But I think that, you know, going back to your original question, Mehreen, about “guns and butter,” I think the pendulum is going to shift over the next few years, and it may well shift in a way that – in which popular support for military spending, because there’s a greater sense of existential threat, goes up.
Mehreen Khan
Yeah, I mean, I guess if the US is a prescient example in this sense, the enemy is not so much outside, but it’s inside, and I think we have to worry that illiberal parties in Europe very much see their enemies inside, be they immigrants or people who don’t…
David Lubin
Yeah.
Mehreen Khan
…look and sound the right way, and that is something that does worry me. But on that note, we will open it up now. So, I think we have the mike coming around, and I’ll group the questions. If you could just tell us your name and where you’re from. So, let me – I will start on this side of the room and then we’ll move this way. So, we’ve got – just, yeah, the lady in the glasses, or did I miss your hand? No? No, okay, so we’ll start with the gentleman in the second row with the glasses, and then next to you, and then we’ll bring it to the front. So, we’ll take these three here.
Alan Houmann
Thank you very much. Alan Houmann on the Chatham House Council. Is there any mileage in the idea of perhaps Canada, the EU, Japan, could urgently move to trade deals and economic integration? Would that be some offset to the problem they’re facing?
Mehreen Khan
Thank you, and then the gentleman – yeah.
Jerome Phillips
My name’s Jerome Phillips, I’m just a rank and file member of no special expertise. Wouldn’t it really be fairer and easier to simply increase income tax, ‘cause therefore, you could maintain much of your existing spending and you would then earmark that for defence? I mean, a government will have to explain this pretty frankly, but it could be done. Over to you, thank you.
Mehreen Khan
And then we’ll take – just at the front here, yeah.
Richard Castle
Is there a microphone?
Mehreen Khan
Yeah.
Richard Castle
My name is Richard Castle, I’m Head of Legal of Lim Miliband, and my question concerns the economic bullying by Donald Trump and this 25% trade tariff imposition against Canada and against Mexico. But at the same time, I wanted to ask about the equilibrium or the stability of the world economic system and the pendulum between China and the USA. So, are Trump’s actions leading into economic catastrophe, or what can we expect in the near future?
Mehreen Khan
Okay, and we’ll come back for another round. So, we’ve got three questions, one, whether the free trading nations outside the US can, kind of, agree a pact. I noticed that I think it was Olivia Blanchard said last week that “Canada should become the 28th member state of the EU.” I think it was only half a joke. Who wants to take that one?
David Lubin
I mean, I think, in a way, trade integration outside the United States is going to – is already, you know, making progress. I mean after the United States imposed tariffs on China in 2018, you see this, kind of, diversion of trade. You know, the total amount of trade doesn’t change, because it can’t really with tariffs. Tariffs is not what drives that. So, you know, Chinese exports to the United States go down, but export – import – US imports from Vietnam, from Mexico, from South Korea, from Japan, from Taiwan, all go up. It’s just, you know, it’s like squeezing a tube of toothpaste, it just goes to somewhere else.
And I think that that toothpaste, you know, and I don’t know quite how to extend the analogy, but, you know, the toothpaste makers should get involved, and in other words, you know, you should use trade policy to, kind of, ensure that trade doesn’t come completely to a halt just because, you know, the country responsible for 13% of imports is using, you know, using very aggressive trade policy.
Professor Lucrezia Reichlin
I mean, I guess the question is what will happen between the EU and China? Because I mean, that’s a real political question, and it seems that the EU is softening the stance with respect to China. I expect that this will happen, will continue, so that maybe also answers your question. But I mean, in terms of trade, the world can do without the US…
David Lubin
Yes.
Professor Lucrezia Reichlin
…I mean, per – you know. The question is whether there will be fragmentation or a complement to the US.
David Lubin
Yes.
Professor Lucrezia Reichlin
So, I mean these are the two extreme models, so that…
Anatole Kaletsky
And this I think is the link between the first question and the last question about, is this a catastrophe or will the world economy adjust? Well, my, sort of, extreme answer to that is, it’s a catastrophe for the United States. It may well be quite beneficial for the rest of the world economy if they can reorganise the global trading system over time around the United States. In the short-term the – America’s importance as a trading partner to other countries around the world has diminished dramatically. It’s still the biggest trading partner for Britain and I think for me – for the EU as a whole, but for most of the world, China is now a much more important trading partner…
David Lubin
Yeah.
Mehreen Khan
Hmmm.
Anatole Kaletsky
…than the US. So, if the world trading system restructured itself with the US outside and refusing to operate by WTO rules and recognising MFN tariffs and so on and so forth, but the rest of the world continue to do that, I think that could actually be a pretty decent outcome for the world economy. And I mentioned earlier that people overestimate how much impact these tariffs are going to have on the rest of the world. Well, ten days ago the OECD published their assessment on it and they have, you know, one of the two biggest models, most detailed models, of global interaction of world trade. The OECD has one, the IMF have one, and they came to the conclusion that a 10% tariff by the US with 10% retaliation from the rest of the world on the US would have an impact – would reduce US GDP by 0.7% over three years, which is sizeable but not huge.
But interestingly enough, the impact on China was one seventh of that. So, the impact – the damage done to the US would be roughly seven times what it is to China and roughly three times the damage to Germany and other EU markets. Now, of course, these outcomes all depend on the in – assumptions that you feed into them, but I find that pretty plausible if the other non-US countries pursue, you know, the right policies to insulate them from that impact of the US. And in the long run, what we know for certain is that countries that protect their instra – their industries and cut them off from the rest of the world, in the long-term, tend to lose productivity and to lose technological leadership. So, there’s no doubt at all that US will lead – lose technological leadership if they operate in this way.
David Lubin
I think I agree with that, but I think you have to be clear about the, sort of, time horizons…
Anatole Kaletsky
Yeah.
David Lubin
…because I think in the in the short run, you know, if you’re going to fight a trade war, you want to be big…
Mehreen Khan
Hmmm.
Anatole Kaletsky
Hmmm hmm.
David Lubin
…you want to be closed, i.e., not…
Anatole Kaletsky
Yeah.
David Lubin
…trade dependent…
Mehreen Khan
Yeah.
David Lubin
…and you want to be the deficit country…
Anatole Kaletsky
Yeah.
David Lubin
…because that gives you arithmetically more options to…
Mehreen Khan
That’s the US.
David Lubin
…impose tariffs – exactly. So, I think, you know, Trump, you know, I don’t agree with the policy, but I think there’s something rational in what…
Anatole Kaletsky
Yeah.
David Lubin
…he’s doing, because he’s actually implementing policy that starts from the position that the US is bigger and more closed…
Anatole Kaletsky
Yeah.
David Lubin
…than anybody else.
Anatole Kaletsky
No, and I think he’ll raise lots of money through the tariffs…
Mehreen Khan
Yes.
Anatole Kaletsky
…but the other risk is that he’ll raise lots of money, it is effectively a tax on consumption…
David Lubin
Yeah.
Anatole Kaletsky
…and he thinks he’s going to offset with tax cuts, but the tax cuts aren’t going to come ‘til 2026 and beyond. So, I think there could be a pretty serious slow – weakening of the US economy this year…
David Lubin
Hmmm.
Anatole Kaletsky
…just because they’re taking so much money out of the consumer economy.
David Lubin
Yeah.
Mehreen Khan
But we also had a question about the income tax. I…
David Lubin
Yeah.
Anatole Kaletsky
Hmmm.
Mehreen Khan
…thought it was probably one hinted at the – in the UK context, I imagine, so why would – why doesn’t a government just say we can pay for…
Anatole Kaletsky
Well, I think…
Mehreen Khan
…defence spending…
Anatole Kaletsky
…the straight answer…
Mehreen Khan
…with income tax?
Anatole Kaletsky
…to that is it would be very unpo…
Mehreen Khan
Yes.
Anatole Kaletsky
I would guess that if you said, “Let’s have a hypothecated income tax to pay for defence spending,” there’d be an overwhelming view, let’s become a pacifist nation, forget about it.
Mehreen Khan
I’m not sure – Nigel Farage is going to…
Anatole Kaletsky
Yeah.
Mehreen Khan
…have to lead the…
Anatole Kaletsky
Yeah.
Mehreen Khan
…lead the pacifist post-fascists in this country. We’ll take some more questions, I said I was going to come back to this side of the room. So, we got a gentleman here and one there, and then at the back, as well. And actually, we might just take a couple more. So, if you could be quick then we can get through them. Yeah, sure, go for it.
Ashal Draphan
Hi, my name is Ashal Draphan. I’m literally just a student who’s obsessed with this stuff. So, we’re talking about increasing defence spending, increasing spending overall, but this is all underpinned by a huge demographic crisis. It’s no Western nation has a feltilit – fertility rate above the replacement rate, none of it is above 2.1. You’re suggesting ways – hmmm, well, no, sorry, phrased it wrong, all the spending is being increased while the number of people who are taxable and are working is going down while we aren’t replay – placing in a cynical sense, we’re not having enough new workers enter the workforce. So, it’s more just a long-term crisis where we’re not having enough workers replace the workforce, while trying to increase the spending.
Mehreen Khan
Okay, so there’s more of a bearish view on the fiscal sustainability of advanced economies, and we got – put your hand – yeah, there we go.
Riley Sword
Thank you. Riley Sword, I run a geopolitical advisory firm here in London. David, your point about financial repression I found really interesting. I was just wondering if there are a couple of scenarios within which you could see that happening or is that simply in the case of war? And then, if you don’t mind, I was going to also ask generally to the panel, sort of, whether or not you give any credibility to the idea of the Euro replacing the dollar as the reserve currency?
Mehreen Khan
Yeah, I’m glad that came up, we’ve got some online questions about that, and we’ll go to the back, and then we’ll come to the front. Try and make them as quick as you can.
Tim Chittell
Hiya, Tim Chittell, currently serving in 16 Medical Regiment. We touched very, very briefly on some of the measures covered by the Russian Central Bank to try and keep that, kind of, 50% defence spending afloat, some of which have done – been quite remarkable and actually managed to keep it going for longer than many expected. Realistically, as it, kind of, comes into its third year of warfare, and the war has become really, kind of, a battle of sustainment and industry versus industry, what do we see economically within Russia breaking catastrophically first, that, kind of, leads to everything else squalling some, sort of, catastrophic failure?
Mehreen Khan
Yeah, and we’ll take these two at the front. Yeah.
Member
Mine was [inaudible – 56:47].
Mehreen Khan
Okay, we’ll do this.
Arnab Das
Thanks very much. Arnab Das from Invesco. I want to follow up a little bit on David’s point about the closed economy with the big trade deficit and the bully in charge. Does it make any difference – or what difference does it make that all the other big economies are surplus countries? And how does that change the adjustment, right? Because the US has a $1.2 trillion trade deficit, the eurozone has a big trade surplus, with the US and generally…
David Lubin
Hmmm.
Arnab Das
…and the same with China, the same with Japan. Canada is a deficit country, but has a surplus with the US, and so on, right? So, that’s one question. Then, secondly, on this fiscal response in Europe, which I guess would be the counterbalance to the rebalancing that the US is trying to do, I guess, from consumption towards investment, right, does it make any difference that eurozone fiscal footprint is already around 40 or 55% of GDP, depending on the country, right? And we’re now in – talking about increasing the size of the state even further. Maybe it can be financed because Germany has the fiscal space, but I just wonder about the scale of this on a structural basis.
Mehreen Khan
Okay, so we…
David Lubin
So…
Mehreen Khan
I’m going to have to ask you to be selective, pick the questions that you…
David Lubin
Yeah.
Mehreen Khan
…want to answer. David…
David Lubin
Can I just…
Mehreen Khan
…you’ve got one on…
David Lubin
….make a comment about the…
Mehreen Khan
Sure.
David Lubin
…link? I think that there’s a, kind of, connection between your question about financial repression and the questions people are asking about the dollar’s reserve currency status.
Mehreen Khan
Yeah.
David Lubin
In the past decades, the status of the dollar, the role of the dollar as an international currency, and the level of the dollar, in other words, the exchange rate, were completely separable concepts, as they should be. The problem now is that the US administration wants a weaker dollar, but they don’t have a conventional path to get to a weaker dollar. The conventional path is to tighten fiscal policy and loosen monetary policy, then you weaken the exchange rate, that’s not going to happen. So, what I think they’ve done is that they’ve, kind of, reached this conclusion that actually the problem – the reason why the dollar is overvalued, nothing to do with macro policy…
Mehreen Khan
Hmmm.
David Lubin
…it’s to do with the reserve currency status of the dollar. And the argument they make, sorry, I should be quick, the argument they make is that the reserve currency status of the dollar is a form of Dutch disease. So, in Dutch disease, you know, the, you know – an economy is selling a commodity and so, the currency appreciates because, you know, you’re getting foreign exchange as a result of selling that commodity, but the appreciation of the exchange rate destroys the manufacturing sector, and that’s what they believe. Certainly, JD Vance believes this, about the dollar. He says the re – he thinks the reserve currency status has left the dollar structurally overvalued, and so we should undermine the reserve currency status in order to weaken the dollar. How do you do that? Financial repression.
So, I think there might be a, kind of, convergence of, you know, the financial repression that might be needed to spend a lot more on defence with financial repression that I think the administration, or at least parts of the administration, are looking at for other reasons.
Mehreen Khan
Lucrezia, do you want to go for any…?
Professor Lucrezia Reichlin
Yes, I mean, on this issue – I mean, on the issue of the dollar status and the Euro status, I think that there are two different things. One is what’s going to be the world’s safe asset alternative to the dollar? And I think that the Euro has a long time to go, I mean and, you know, probably this is not a realistic alternative. But on payments, I think there is a lot going on. I mean, you know, the dollar is two things it’s, you know, it’s the international currency because it’s a safe asset, but is also the payment, the currency, the international currency, because we, you know, we exchange in dollars.
And I think on that, the Euro is speeding up the, you know, the project of digital Central Bank currencies, China is doing that, so I think it’s probably, on payments, we are going towards a more fragmented world in which the dollar will have less of a status. And then, you know, over time, and maybe this will also have an effect on the dollar, you know, as reserve currencies. And then there is the issue, so what’s going to happen to stablecoin and to these, kind of, instruments that apparently are going to get the access to the facility of the federal reserves? And so that – and that will be, you know, a channel through which the dollar can maintain its status…
David Lubin
Hmmm.
Professor Lucrezia Reichlin
…because there will be big private demand for these, kind of, instruments. So, I think that these are the topics in that.
On the fiscal stuff, are you worrying about government becoming big? But I mean, if you think of a consolidated balance sheet, including the central banks and the treasuries, I think the US, you know, is there already. I mean, there is not a big difference between the US and the – and Europe.
So – and I think maybe – I mean, the question is, is the world going towards a model in which the state has a much bigger role? If we’re moving to a world, like, a war economy type of economy, it’s very likely. Do we worry? I mean, I don’t know, I mean, I think that, you know, market economies have proved to be very unstable and so that, you know, we are, kind of, readjusting, you know, that’s a long-term question. But I mean, I think it’s not – this is an issue for Europe. I think it’s a issue for the world, you know. So, if you think of central banks, I mean they have replaced the market in the – as intermediaries in a big way, and so they have balance sheet which have balloon, just with respect to 20 years ago. So, if you look at the consolidated version, you know, this is the direction of travel, so…
Mehreen Khan
Anatole, you get the final word.
Anatole Kaletsky
I’ll just – I’d like to ask – answer Arnab’s question about the deficit countries versus surplus countries. And here I disagree with what David said that in a trade war it’s the deficit countries that are in the strongest position.
Mehreen Khan
Hmmm.
Anatole Kaletsky
I think that can – that’s true in certain circumstances, but I think it be – depends on whether you’re living in a, basically, inflationary or deflationary environment. In a deflationary world, David is right that it’s the deficit countries that have the advantage because they can protect themselves and they can generate lots more domestic activity and bring more people back into the labour force, and so on so forth. And that’s great, and – whereas the surplus countries suffer from deeper and deeper deflation.
If, as I believe, we’ve now moved into an inflationary world, much more like the late 60s, 70s and early 80s, then I think the boot’s on the other foot and the advantage lies with the surplus countries. Because what the surplus countries can do in a trade war, and should do, is expand fiscal policy to reduce – accept the reduction or the elimination of their trade surpluses by generating lots more domestic economic activity, consumption and domestic investment. And I think that’s – everybody agrees that that’s what China needs to do. That China is an economy whose main structural problem is underconsumption and, you know, not – and over taxation, you know, not giving consumers enough money to spend on services etc., etc.
I would argue that Germany has an underconsumption problem, as big or possibly bigger than China, because its current account surplus is actually roughly double China’s. So, I think this is an opportunity for Germans to have a good time, you know, spend more, be given more money…
Professor Lucrezia Reichlin
And the Chinese, that they…
Anatole Kaletsky
…have their taxes cut…
Professor Lucrezia Reichlin
…[inaudible – 64:38].
Anatole Kaletsky
…and not be like the Chinese. And I think maybe – and if that happens, then actually the people who suffer from the trade war are the deficit countries, the US…
David Lubin
Hmmm.
Anatole Kaletsky
…possibly the UK. And the surplus countries can benefit from a higher living standard and an economy that is running hotter, and therefore generates more productivity, as well, as Lucrezia said.
Mehreen Khan
So, we get a virtual cycle.
Anatole Kaletsky
Yeah.
Mehreen Khan
We have actually run over. I was told beforehand that Chatham House are very strict…
David Lubin
Yeah.
Mehreen Khan
…on timing, so if I want to be invited back, I’ve got to wrap up. But this was a fantastic discussion. Thank you everyone for all your stimulating thoughts and for the brilliant questions, and my final task is to thank the panel and say good night. Thanks [applause].
