Ashoka Mody is a professor of international economic policy at Princeton University, has formerly worked at the IMF and the World Bank, and is a returning guest to Macro Musings. In this episode, he joins David to discuss the global economic implications of COVID-19 and what it specifically means for Europe and the Eurozone.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Ashoka, welcome back to the show.

Ashoka Mody: Thank you very much, David. Thank you for having me.

Beckworth: Glad to have you on. This is quite a time. I'm wondering, where are you right now?

Mody: I'm in Princeton sitting in my home office in a complete mess, but doing my thing here.

Beckworth: Okay, so you are holed up in Princeton, New Jersey. How's the university? It's shut down. You're teaching classes from home I imagine?

Mody: Yeah. I hear it's the same with everyone, teaching on Zoom. I should say that I've been extraordinarily pleasantly surprised at how well the students have taken it. They're in a great deal of personal anxiety but the classes have been just a lot of fun in the last couple of weeks that they have done this on Zoom.

Beckworth: Oh great. If we'd only known we would've bought stock in Zoom three or four months ago. In fact, about three months ago Ashoka you and I were in San Diego. We were at a conference together. You gave a great presentation on the state of Europe. We had a little pre-conference before the AEA main meetings began, really fascinating, and we'll get to that. That seems so far removed now. The sun shined, it was beautiful, life was normal, and now we're in the pandemic lockdown stage of our existence, so what a change from the last time we were together.

Mody: It's just extraordinary, the speed at which things have moved, and the speed at which things move everyday now. It's just extraordinary, especially if you're trying to, not just, of course, those who are keeping track of the pandemic, they have an even harder problem with even just keeping track of the economic developments. There's this piece that we are going to talk about, *Charting the Crisis.* I did a draft of that, what? A week ago? I did two other pieces before that, almost back to back, and this morning I've done an update, because things are just moving so quickly, the data is coming in and it's becoming steadily worse.

Beckworth: Yes, it's hard to keep up with everything.

Mody: In the COVID world, they talk about how we have to act early to stop things from getting rapidly worse. I have the same sense in terms of economic policy too, that if we are going to do something to prevent the economic and financial crisis from snowballing, again, that same precautionary principle that the COVID folks talk about applies to us as economic policymakers, not quite at this extraordinarily high frequency that they are thinking of, in terms of days, even hours, but certainly in terms of several days, a week, delay could prove extremely costly.

In the COVID world, they talk about how we have to act early to stop things from getting rapidly worse. I have the same sense in terms of economic policy too, that if we are going to do something to prevent the economic and financial crisis from snowballing, again, that same precautionary principle that the COVID folks talk about applies to us as economic policymakers.

Beckworth: Yes, things are moving extremely fast, and I imagine for policymakers as much or more so than us, but even just trying to keep up with the news, the economic developments, as you said, it is a bit of a challenge, so it's good to be talking to people like you who know what's going on.

Beckworth: Let’s move to your article, titled *Charting the Course.* It's a great read, and you anchor it with four observations, or four guiding principles in the piece. I'll list them quickly, I'll summarize them, and then we'll go back and revisit them, and you can expound on what each one means and what you think it tells us about the world right now.

Beckworth: So the first one is the economic crisis is centered on global trade nodes. The second one is credit markets begin to take note. The third is that policymakers have responded enthusiastically, and the fourth is Europe is especially vulnerable. Let's go back to the first one, the crisis is centered on global trade nodes. What does that mean?

A Crisis Centered on Global Trade Nodes

Mody: I started thinking of the comparison with the great influenza pandemic of 1918-20. If you look at that, the domestic manifestations of COVID are almost exactly the same as at that time. Local businesses began to close down, transportation was hampered, and so the domestic manifestation is very similar. What you find is that, even so, the costs were large. 6 to 8% of GDP over three years, according to a study by Robert Barro and his colleagues, but B., and this is a new paper that's just come out in the last two or three days by Emil Verner at MIT and a couple of his buddies in the Federal Reserve system, which says that the crisis was also persistent.

Mody: Inasmuch as that once the pandemic went away, the economic crisis continued. I asked myself: if that was the case then, what is different now? What is different now is that we live in a very interconnected world. Not only that, the crisis, for some reason, has struck the most active nodes of world trade. It begins with China, which is the central node, and then it spreads to Europe, which has the other major set of nodes. Germany, Italy, and even France and Spain, but Germany and Italy in particular are extremely trade-intensive economies. Once you have the breakdown of the trade nodes, then you add an additional layer of stress on the world economic system.

Mody: The reason this is important is that, even if China, at some point, begins to heal itself and resume activity, there is some indication in the data that the freefall in China may have stopped. There was some PMI number which the right interpretation of that number is that things have not become worse, although other indicators show that things are continuing to become worse. Even if China does stabilize and wants to pump out stuff from its factories, there has to be someone to buy that. The major trade nodes are not going to be ready to buy stuff for a long time, so the network analogy of the trade tells you that, as long as there are weak elements in that system, the entire system will remain impaired.

The network analogy of the trade tells you that, as long as there are weak elements in that system, the entire system will remain impaired.

Mody: Just to conclude that, you also have the emerging markets now under enormous stress, so you've got a large number of stress points that entered their stress at staggered dates and will emerge from that at staggered dates, so the world system will remain in a state of some disrepair for a long time, and therefore that additional level of stress will delay the recovery.

Beckworth: Very sobering points you make there. This speaks to both the beauty and the benefit of globalization, but also the risk. We're much more interdependent than ever, which is great for labor specialization globally. That's lifted many people out of poverty in China, India, around the world. It's been great for humanity, but it also makes us so much more susceptible to shocks like this, and that's, I think, the big point you're making here. This is the big difference between the influenza pandemic in 1918 and COVID-19 today.

Mody: That's absolutely correct. Unfortunately for us, and for everyone, the COVID-19 not only comes at a time of high globalization and interconnection, it struck the very centers of that system, starting with China. It wasn't as though it struck some random countries. It struck the heart of the system.

Unfortunately for us, and for everyone, the COVID-19 not only comes at a time of high globalization and interconnection, it struck the very centers of that system, starting with China. It wasn't as though it struck some random countries. It struck the heart of the system.

Beckworth: Yeah. Very serious situation indeed. In fact, we've seen this in data in the US, now, again, China's been hit hardest first, and we're kind of coming late to the party here in the US, but oh, are we coming to the party, as you saw this week.

Beckworth: We are recording this April 3rd, and we just saw this week jobless claims jump to 6.6 million, close to 10 million total since we've been watching this closely. We are now beginning to feel the real repercussions here in the United States. China's been hammered already, and, as you said, it'll be hard to get this global system up and running again.

Beckworth: Something else you bring up that's very fascinating in your piece is that China was particularly linked to the Eurozone. They were very closely interconnected. In fact, the Eurozone was trading more with China than those countries within the Eurozone were trading with each other, and you note that's kind of ironic, because the whole point of the Eurozone was to facilitate increased trade within the European Union, and instead we see them trading more with China, which goes back to your point, makes them and us more vulnerable to the shock in China hitting there first.

The China Shock to the Eurozone

Mody: Yeah, the point I was trying to make there was, and this follows from my book, that the Euro was sold as the mechanism that would bring Europeans together economically and therefore politically. There was never a clear theoretical basis for the notion that reduced transaction costs will increased trade materially. In fact, Barry Eichengreen has a paper in the Journal of Economic Literature in 1993 where he says these costs are relatively trivial, and you're not going to expect to see large shifts in trade because of them. As far as volatility of exchange rate is concerned, people hedge all the time and there's no mystery.

Mody: So you see in the data, and all the recent studies in the last two, three years, and this is one of the themes that I pick up in the afterword of my paperback edition, is that now there is almost a consensus in the academic literature that the Euro did not increase trade among the member states of the Eurozone, but instead, because the Eurozone economies were growing relatively slowly, the bulk of the increase in trade occurred outside the Eurozone, and with China as the dynamo of this period, the global locomotive, the growth in European trade occurred in oodles with China, and especially Germany, which came out of the global financial crisis in 2009 not because of some great wonders they worked in their domestic economy, but because China was such a ready market for Mercedes Benz, BMWs, Audis, machine tools, high speed rail. The Chinese were gobbling this stuff, and the Germans, given their historical advantage in these mechanical industries, were pumping them out. So Germany looked like a wonder country, but really it was because China had this completely insatiable appetite.

The Euro did not increase trade among the member states of the Eurozone, but instead, because the Eurozone economies were growing relatively slowly, the bulk of the increase in trade occurred outside the Eurozone.

Mody: Then, when China now begins to slow down, which it had already begun well before the coronavirus crisis, starting in early 2018, and the German economy, heavily dependent on the internal combustion engine, begins to have its own problems with the changes in regulations and preferences for petrol-run cars, you have this additional shock, China shock. I'm waiting to see what the German numbers are going to look like. I think the German numbers, when they start coming out in terms of employment and output, are going to look pretty ugly.

Beckworth: That is a pretty remarkable observation. Greater trade between Germany and China than Germany and the rest of the Eurozone. You said the consensus in the literature now is that this is well understood, that the Eurozone has not increased trade within the Eurozone. I'm curious: have Europeans responded to this finding in the literature? What have they said? The proponents of the Eurozone, how have they responded to this observation or finding?

Mody: So you're asking a very interesting question of intellectual history. Most Europeans had seen a very important paper that came out in 2010, which said that the net effect of the Euro in creating trade between Eurozone member nations was zero. But people sort of disregarded that. Up until 2013, Mario Draghi would routinely, in his speeches, say, "And oh yes, by the way, the Euro increases trade between Eurozone countries." But now, with these additional studies coming out, senior Europeans have stopped saying that. There are those who continue to say that, but senior Europeans have stopped saying that. They don't go back and say, "We made a mistake," but they don't any more assert that the Euro creates trade.

Mody: What they then say, and this is what Mario Draghi's speech for the 20th anniversary of the Euro said, what we needed is single currency for a single market. We needed a single currency for a single market. What does that statement mean? I'm not completely sure what it means. You've got Sweden in the single market. You've got the Czech Republic, Hungary, and Poland in the single market. They don't have the same currency. Just to put a fine point on this, that in addition to China, with which Germany has expanded its trade so rapidly, the other three countries with which Germany is expanding its trade most rapidly are the Czech Republic, Hungary, and Poland, the three European countries that do not have the Euro, because Germany has extensive supply chains with them. There is no single currency, the zloty fluctuates. So does the Hungarian currency.

Mody: So the notion that you need a single currency for a single market is now sort of the cover that is used, but just like the notion that the Euro created trade was, in my view, a myth which now has been laid to rest, the notion that the single market needs a single currency remains the guiding mantra and support.

Beckworth: Okay, very fascinating. Let's move to your second observation, or your anchoring point for this essay, and that is credit markets begin to take note. So it's not so much the decline in the stock market, but it's problems in credit markets that really are key.

The Crisis in the Credit Markets

Mody: Again, it so happens that this is what I've been teaching in the last couple of weeks. The literature on this starts with a famous paper by Schularick and Taylor, and then there are any number of papers. Financial crises are preceded by financial booms. Every major study has this finding, that financial crises are preceded by financial booms. There is now a more careful literature which then asks why does that happen, and essentially has come to the conclusion that there are periods of irrational exuberance, often tied to low interest rates, during which people think that this time is different and, again, that's very well-documented.

Mody: Between 2009 and 2019, the world saw an explosion of debt for the same reason as we've seen explosion of debt in previous years. I noticed that you had a guest recently, Robin Brooks, of the Institute of International Finance, and Robin's group at the IIF puts out these magnificent numbers on global debt and they report that global debt, at the end of 2019, was some large number like $214 trillion, up from about $160 trillion in 2006 or some such number, about 50%. It's 320% of GDP. In terms of the records that we have seen in recent periods, this is the highest level of indebtedness in relation to GDP we have ever seen. The IIF studies further tell us that every category of borrower is now more indebted than 10, 15, 20 years ago.

Mody: If you go by the literature, the literature says whenever you have large amounts of debt which have increased rapidly in previous years, things are not going to end well, so where I'm going with this theme is that in any case we had a credit bubble which was likely, at some point, to begin to show signs of wear and then eventually burst. What the coronavirus crisis has done is, it said, "Guess what? It's time to take a pause." This is the period where we are taking a pause. We are seeing tensions in the credit market. We are not yet seeing a crisis. We are seeing tensions in the credit market, in all kinds of credit markets. Again, if the literature is right, this pause is possibly likely a prelude to debt defaults, which could then become very extensive.

Mody: This is, again, so different from the pandemic of 1918, 1919, where, again, the world, Emil Verner, etc., study shows that there were extensive bank losses. This one is now coming at a time where we have so much debt and so the losses could be also proportionately much larger. I'll just say one last thing and let you then ask more questions, but the bottom line here is two-fold. One is that we should expect debt defaults, which will create stress on the system, but B., that will also prolong the economic crisis. The economic crisis will be more persistent, both because of the interconnected nature of global trade, which we already talked about, and because once we begin seeing defaults, we are going to see another layer of the crisis, which will cause it also to persist.

The economic crisis will be more persistent, both because of the interconnected nature of global trade, which we already talked about, and because once we begin seeing defaults, we are going to see another layer of the crisis, which will cause it also to persist.

Beckworth: Ashoka, you're not making me feel very good over here, as I listen to you. You're presenting a very bleak picture, especially given these first two points.

Mody: I understand that, David. I don't feel good myself saying this. I'm just trying to, here, look at the data carefully and say where are we going with this?

Beckworth: Fair, fair.

Mody: What's going to happen? My hope is this comes back to a brief exchange that we had at the start, where all it means is therefore we need to take very aggressive action.

Beckworth: Yeah, for sure. You're stating facts, which are important. On this last point about the debt buildup, this speaks to the importance of financing more with equity, rather than leverage. I do wonder, though, how much of the debt buildup is private debt, or private credit extension, because that's definitely much more vulnerable, and then secondly, of the remaining that's public, what portion of the public debt is from countries like the USA, Germany, the UK, who print their own currency, who would be called safe asset debt? I'm sure it's still large, even if you take out the relatively safe portion of that debt.

Mody: That’s exactly where we need to go in terms of thinking this through. I am now, as you know, as you hinted in the beginning, I am thinking now more of the European situation, although this is also true of emerging markets more generally. Just very brief comment on emerging markets, there's a lot of corporate debt that Hyun Shin at the Bank of International Settlements has been worrying about for the last two, three years. Lot of dollar debt. Again, going back to a young Robin Brooks, he has been talking about how there has been a sudden stop of capital flows into emerging markets. A lot of that dollar debt is not being rolled over from how he interprets the data in terms of the currency devaluations of these countries, so there's that side of it.

Why is Europe So Vulnerable?

Mody: But on Europe, on Europe what we are seeing is that the ECB is still holding things up by its promise to inject liquidity into the banking system and to buy government debt. What we need to also understand is that the size of both the government debt and of the bank debt and corporate debt is large, so this is the paper we are going to do in my class this coming week, which says that, once you reach a government debt to GDP ratio of 100% of GDP, so this is not the Reinhart-Rogoff paper which became so controversial, but this is another paper, more recent paper, by David Romer and Christina Romer. They say that you lose policy space at that point, in terms of your ability to respond to fiscal stimulus.

Mody: Italy is 135% of GDP. Spain and France are 100% of GDP, so three of the big Eurozone countries are not going to be able to do fiscal stimulus of 5, 7, 10% of GDP, which is basically what is going to be needed for this crisis. We're going to need enormous amount of fiscal stimulus. Maybe Germany will do that. In the US, with this two trillion, they're already at about 9% of GDP, and I expect that it will go up even more, for a number of reasons, but Italy cannot do anything close to that, or Spain cannot do anything close to that. That raises a huge policy question of how that is going to be dealt with. A second issue in Europe also is that Europe has been traditionally overbanked.

Mody: This was a big thing in the hardcover version of my book, which I then sort of followed through in the afterword. Again, for historical reasons completely unrelated to the Euro, the Eurozone came into a situation where the banking sector debt to GDP was very high. The huge financial stress during the crisis on the banking sector, yes, the banks have cleaned up their act, the non-performing loans are low, have fallen, but they are still quite high, especially in Italy. More importantly, the banking system is very fragile. Its profitability is extraordinarily low, so market to book value ratios of all the major European banks were already well below one before this crisis started. What does that mean? That means that markets are saying, "You guys say that you have $100 on your books, $100 of assets on your books, sorry, we don't believe that you will get those $100 back. We think you might get $70 back. We think you might get $20 back." So Commerce Bank and Deutsche Bank have been trading at market to book values ratios close to 20%.

Mody: And the Italian banks, the best Italian banks were trading somewhere in the 70% range. Intesa Sanpaolo and UniCredit, but there is a lot of banking assets in Italy which is probably was coming into the crisis, worth very little, and now this crisis is going to create further stress, further defaults, further incidence of borrowers not being able to repay their debts. Then the question is: when those banks suffer that round of defaults, who is going to deal with them? Where do those insolvencies then reside in terms of somebody willing to bear that cost?

Now this crisis is going to create further stress, further defaults, further incidence of borrowers not being able to repay their debts. Then the question is: when those banks suffer that round of defaults, who is going to deal with them? Where do those insolvencies then reside in terms of somebody willing to bear that cost?

Beckworth: Yeah, so we are actually covering the fourth point in your essay, and that is why Europe is so vulnerable. You mentioned the banks already, you mentioned the debt levels, since they can't print euros to cover their debts. They don't have that option. They have to actually come up with real resources to do so. You mentioned Italy, and in your paper you mentioned Italy's government. You mentioned the GDP number, but it's 2.3 trillion in debt that they owe, is that right?

Mody: That's correct. That is the latest number. The Italian government debt is 2.3 trillion euros, which is approximately 135% of their GDP.

Beckworth: Okay. And their banks are also heavily loaded with a lot of that debt, right?

Mody: Yeah. Their banks have got approximately 5 trillion of assets. They have got a lot of debt also, yes.

Beckworth: Okay, so both the government is stretched and the banks are highly leveraged. It looks like a perfect storm is brewing there in the banking system in Europe, and this might be the catalyst that sets it off. Now, it hasn't been set off yet, let's be clear, but you're worried that it might be the catalyst that sets it off in the next few weeks or months.

Mody: Yes. You're absolutely right to emphasize that nothing has happened so far, but you see a couple of things. You see, number one, that as stock indices have come down everywhere, banking stock indices have come down faster, and so there is a clear sense, at least in the stock markets, that the banks are in trouble. What happens next, we don't know. We know that there is a lot of pressure on the authorities everywhere to use moral suasion to persuade banks to hold off on small business loans, certainly on mortgages, to exercise forbearance. That's good policy. Forbearance at this time is good policy. The question is, that if there is forbearance, where does that process stop?

Mody: In other words, if banks say, "Don't worry about it, we are not collecting on our debts," will the creditors of the banks also say, "Don't worry, we will hold off on our debts"? Where does that daisy chain stop?

Beckworth: Right. You mention in your paper a potential solution to maybe prevent this from getting worse or prevent the banking crisis from blowing up, is for the European Stability Mechanism to step in, but it may not be enough by itself, and therefore the IMF needs to step in, and you even alluded to the US stepping in, so help us understand that point.

How to Prevent a Looming Banking Crisis

Mody: So, David, this is a fast-moving target. When I first made this proposal, this was on March 10th. The proposal, at that time, was the following: that you follow the same template that you did in the global financial crisis. That template was that you lend money to the distressed country, and you lend a sufficiently large amount that if creditors choose to not roll over the debt of that country, there is a pot of official money waiting for them to tap into that so that their daily operational functioning is not compromised. In the global financial crisis, Ireland and Portugal got loans of about 100 billion euros plus or minus a little bit.

Mody: As you may remember I did the Irish one, but the numbers are large, so given that Italy is so much larger than either Ireland or Portugal, my back of the envelope number was that Italy would need a firewall, which would cover the potential lack of rollover of its government debt and any new capital injections it needed into the banking system, if the banking system came under stress, as we were talking about. I came up with a number of 500 to 700 billion euros. In the European system, the anchor for such lending is an entity called the European Stability Mechanism. The European Stability Mechanism's total lending authority is somewhere in the range of 400 to 500 billion euros, so a number like 500 to 700 billion euros just for Italy is not within the power of the ESM. Now, if you add to that Spain, it's certainly not within the power.

Mody: So that is where I said you will need a large amount of money from the International Monetary Fund, and even that may not be sufficient or you would need, perhaps, at least as a backstop, if not cash, the fallback position that the Americans might need to step in, not necessarily only in the European interest, but at that point, in the global interest because the spillover effects from Europe would then have implications for the entire global financial system.

Mody: I have moved on from that, David, because I feel now that the crisis, which, as we saw in early March, has morphed into something much larger in terms of its magnitude than we anticipated even three weeks ago. Today, the services PMI has come out for Italy. It is 17.5. As you know, the PMI of 50 implies that the economy, there are equal number of businesses expanding equal to the number contracting. You want to be well above 50. The Italians, the number is 17.5. That means the Italian economy is in deep contraction right now. That is for services, manufacturing is slightly better, but also well below 50. I think the composite number is somewhere in the range of 20. The Spanish number is maybe a little bit better, maybe 25, 28, something like that.

Mody: We are seeing very deep contraction. If you accept the premise that this is going to be a prolonged crisis, that even though, hopefully, it does not stay so bleak, but even when there is recovery, this is going to take a long time. We are seeing GDP contractions. I don't want to try to take a number of what that might be, but it's going to be bleak. It's going to be bleak. If the policy measure is to lend more money to the Italians and to the Spanish so that they can pay their private creditors, you still have to worry about the fact that that official money that you lent to them, the Italians will eventually have to pay that back to the official creditors. The question is, is that reasonable? Is that reasonable for them to have to pay back that money at a time when the shock that has hit them is so extraordinary?

We are seeing very deep contraction. If you accept the premise that this is going to be a prolonged crisis, that even though, hopefully, it does not stay so bleak, but even when there is recovery, this is going to take a long time. We are seeing GDP contractions. I don't want to try to take a number of what that might be, but it's going to be bleak. It's going to be bleak.

Mody: Even if it was reasonable in some realpolitik sense, will they be able to do it? Is it reasonable to expect that they will ever be able to repay any significant amount of new debt that they take on at this point, or are they, essentially, so deeply insolvent that this is the time for large grants? I'm using the word "insolvent" over here, not in that I know that they are insolvent, but I think there is a very good basis for us to not enter a policy program that then has to be undone or redone in a major way. The cleaner way will have to be that there has to be some kind of large grant.

Mody: So you see, here in the United States, the two trillion dollar stimulus budget has $150 billion for the states. Now, the state governors are saying that that is too small, and the next round is likely to increase it even more, but again, just by way of analogy, that 150 is just for the states, for their expenses. In addition, there are other transfers occurring. There's unemployment insurance being topped up, there is direct funding for some hospitals, and there are a variety of other ways in which the federal funds are going to the states. In addition, the states will send less of income taxes as their economy contracts, so the overall fiscal transfer from the federal government to the states, when this whole picture is complete, will be of a very large magnitude. That is how a monetary union with a fiscal union has to work.

Mody: I am not, in any way, trying to minimize the insanity of the disease and economic management here in the United States. All I'm just trying to say is the one lesson we can learn from here is that we cannot just laden the distressed countries with more debt at this time. In Europe, we need to have some vision of how to give them large fiscal transfers.

All I'm just trying to say is the one lesson we can learn from here is that we cannot just laden the distressed countries with more debt at this time. In Europe, we need to have some vision of how to give them large fiscal transfers.

Beckworth: And that's a nice segue into your final point, and that is policymakers have responded enthusiastically. We see that here in the US, but just going back to the point you made, the Eurozone's going to need grants more than additional debt at this point. You're making the case that additional debt is just going to worsen the problem, most likely, and therefore large grants. But who's going to pay for those large grants? Are policymakers going to enthusiastically do that in Europe, given the understanding we have that there's differences in views between the Germans, the Italians, the French. That's, I think, a big question.

Beckworth: Let's go back to your point in the paper about policymakers responding enthusiastically. Let's start in the United States. You see the US as responding enthusiastically. My question is: why do you think they are responding so enthusiastically? Relative to 2008, they do seem to be moving a lot sooner, quicker, and more aggressively. Why do you think that is?

Why Are Policymakers Responding More Rapidly?

Mody: David, I have a very straightforward interpretation of it here, at least on the monetary policy side. You know the US better than I do, but my sense is that lessons from past crises have become much more internalized. Even in the 2007 crisis there was some concern that the Fed responded slowly, but on the whole, seeing from a European perspective, the Fed responded at blazing speed.

Mody: Remember that the European Central Bank's first action was to raise policy rates in 2008, and the first reduction in interest rates occurred in October 2008, after the Lehman collapse, by which time the Fed was about to begin QE and had brought its interest rates close to zero. Seen from an American perspective, I can understand why that period between April and June of 2008 was a phase when a lot of people said the Fed should have acted faster, but overall I think the Fed did well then.

Mody: What is more important is that lessons from previous crises, reinforced by the global financial crisis, has led to this very rapid response here. It's been very multifaceted in terms of interest rate policy, QE, liquidity facilities, dollar swap lines, backstopping various specific credit markets, which might otherwise get disrupted. My sense is that the package is relatively broad-based and deep, and with a clear willingness to respond in relatively real time to new problems that might arise.

Beckworth: Yeah, I've been impressed with Treasury Secretary Steve Mnuchin and Fed Chair Jay Powell. They both have been very agile, very aggressive. They were the right people for this time, it seems like. They were put here to serve us, and I think they're doing their job very well. I do wonder, though, about the other countries, and let me just mention a few. You mentioned China, and there's some signs that it's recovering, but it still has a long ways to go. Let's say it does get on the mend for real, and we know with certainty that it's doing better, and it wants to get the global economy going. Should China, once again, try to add support to the global economy like it did in 2008? You mentioned Germany, how it benefited when China got things rolling again. Should China have a bigger, more aggressive role to play in this recovery as well?

China’s Role in the Recovery

Mody: So China is, in some ways, the most complicated. Europe, which we'll come to in a second, has its very deep political problems, but China, the Chinese have set themselves some goal of 6% GDP growth for a long time, but China is a relatively rich country, and rich countries do not grow at 6%. So the Chinese economy should have been already growing more between 3 and 5% of GDP, 3 and 5% a year. For a country at that income level, a 3 to 5 % annual growth is a high growth rate. But the Chinese have their internal compulsions. The consequence, therefore, was they kept boosting the economy through credit and fiscal stimulus. Each time they did that, they built up their financial bubble. The property prices, the leverage in the banking system.

Mody: Now, the Chinese are faced with this delicate task, which is yes, the economy is slowing down, but the financial leverage is very high. Do we want to raise the financial leverage even more to deal with this and worry about the financial leverage later? The extent of financial leverage in China is quite unprecedented. Maybe in the end the Chinese will do that, but maybe they will be more cautious, which is how I have been reading them over the past few years in terms of doing that. They will, therefore, certainly not have an aggressive stimulus of the type of they had in 2009. 2009 was just an amazing amount of stimulus. If they do something now, it will be much more modest and not nearly anywhere close to allowing China to play the role which it did in 2009 of almost single-handedly, in addition to the monetary and fiscal stimulus that the advanced economies had, but China added such a huge shot of adrenaline to the economy at that time, I don't think the Chinese will be able to do it.

Beckworth: Okay, so in short, China is not in a position to do what it did in 2008, 2009, because of leverage, buildup of debts and liabilities. It's concerned about that, and it worries about its own home front problems that arise from having lots of debt. Let's move to Europe. We've touched on this already, so there's a lot of limits on what European governments themselves can do, and you suggested going to grants. The other missing piece here is the European Central Bank. What this ultimately sounds like to me, the direction in which we're going, is the ECB may end up doing fiscal transfers, as least implicitly. Not saying so or being explicit about it, but implicitly doing fiscal transfers to those countries. Is that the path we're headed, you think, or something else?

The Possibility of Fiscal Transfers in Europe

Mody: I think, so David. You're basically, I think, leading us in the right direction. What is that Sherlock Holmes quote? “When you've ruled out the improbable then the impossible is the only option left.” My only concern with that, David, is the following: that because that is so politically charged, and because the ultimate consequences of that is going to be significant redistribution across the Eurozone countries, and everybody will recognize it as such, the ECB will take time to do that, and time is of the essence at this point.

My only concern with that is the following: that because that is so politically charged, and because the ultimate consequences of that is going to be significant redistribution across the Eurozone countries, and everybody will recognize it as such, the ECB will take time to do that, and time is of the essence at this point.

Mody: The ECB, in fairness to them, has a program, a pandemic program. They have promised to buy 750 billion additional euros of debt, so altogether, this year, they will buy something on the order of a trillion euros of debt. That said, the question is, is that going to be enough? Once they begin to acquire large amounts of Italian, especially Italian, but also Spanish debt, there will come a point where it will look as though the ECB owns Italy, and that will be politically very uncomfortable for all parties concerned, and will that cause them to slow down? Will that hesitation be seen by the markets as a problem?

Mody: It all depends, now, on the timing, is my reading. Will the ECB be able to stay ahead of the markets at critical moments when the markets begin to demand more than is politically feasible in a rapid response way by the ECB?

Beckworth: Yeah, so there's a lot of bad political optics involved here, and the ECB, understandably, does not want to go there unless it has to, but it does seem like it's inevitable there's going to be fiscal transfers done through the ECB. You mentioned buying up bonds from Italy, lots of bonds. That would be interesting, if the ECB did end up owning Italy outright. That's one way these fiscal transfers could take place. An inordinate amount of Italian bonds on the balance sheet of the ECB. But another way it could happen, also, would be just through higher inflation. If they end up buying lots of bonds, and let's say you get to the point where it does raise inflation, the Germans are going to take a hit in terms of their savings. They're very frugal, lots of savings. It would be a hit on them, an implicit tax on their holdings of liquid assets, which would be in a transfer from them to the Italians.

Beckworth: This ultimately is leading me to a very uncomfortable question, and that is this: could COVID-19 be the catalyst that eventually breaks up the Eurozone? We had this conversation when we had you on the show last. The Eurozone somehow survived the Great Recession and the financial crisis, and it was remarkable. Greece put up with 25%+ unemployment. They decided to stay in. Could this be the straw that breaks the camel's back in Europe?

Is COVID-19 the Straw That Breaks the Back of the Eurozone?

Mody: David, I will make two comments. One, I agree that the other way to repay debt is through inflation, but in the medium term, and I don't know what exactly is the medium term, but at least in the next 12 to 18 months, I expect a deflationary situation. As a number of people have remarked, it's hard to actually even measure inflation at this point, because some stuff is just not being bought and sold. Some services are just stopped. But, on the whole, given the size of the shock, there will first be deflation, and then, eventually, at some point, there will be inflation. I'm now thinking mainly of the next 12 to 18 months, before the inflation tax causes a massive redistribution of wealth to anonymous lenders who don't have any political leverage to prevent the losses being inflicted on them. In the short run, it will be inflicting losses on people who will be able to lobby for preserving their entitlements.

Mody: In terms of your larger question of what this is going to do to the Eurozone, making a prediction of what will happen to the Eurozone is very hard, because in principle, the ECB can do what we have just discussed. What we do know, with somewhat greater surety, is that especially the Italians, but also the Spaniards, will go through a period of a few years of extremely serious economic stress, which could cause the society there to begin to go into a state of anger and resentment, which could become very deep-rooted. The numbers are, I talked about the PMIs, but David, what I've not talked about is the unemployment numbers. You made reference to the US numbers. When the numbers come out for Europe, I'm already seeing signs in Spain, there is going to be just a huge amount of grief in those numbers. You're going to see relatively large numbers of people under great financial strain for extended periods of time.

What we do know, with somewhat greater surety, is that especially the Italians, but also the Spaniards, will go through a period of a few years of extremely serious economic stress, which could cause the society there to begin to go into a state of anger and resentment, which could become very deep-rooted.

Mody: I'm therefore more concerned about what it will do to the fabric of society in these countries and in Europe more generally, and how that will then be seen in terms of the broader picture of where Europe is and what it means to be a European today.

Beckworth: Okay. This is a very sobering discussion we've had today, Ashoka. We are running out of time, and I did want to talk about the afterword to your new book. You've got a paperback version of your book out, and I think we will save that for the bonus segment that we will put online after the show, so listeners, take a look at that, and we will actually put video footage up of that, but Ashoka, I want to thank you for coming on and for making us wiser, helping us understand the implications of COVID-19 for Europe and the global economy.

Mody: Fantastic. Thank you very much for having me. I'm sorry my message was so bleak. As we discussed, I'm just telling you how I'm reading the numbers.

Beckworth: No. We need to hear the truth, so thanks again.

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