Speaker #0That was an extract of Don't Fear the Reaper by Blue Oyster Cult. Since Mario Draghi talks to us about the possibility of a slow death, I thought that this was a pretty apt song, which probably also betrays my canonical age. But more seriously, Christine Lagarde, upon cutting rates, repeatedly praised Dorker's report on European competitiveness. And that's understandable because for a central bank, Any message which draws attention to the need of structural reforms to lift growth away from short-term demand management, and hence debating the monetary policy stance, is of course welcome. And the Draghi's report deserves to be praised because it provides a precise, if somber, diagnostic of the current state of the European economy. Draghi's statement on Europe losing ground is backed by irrefutable data. The productivity gap with the US is widening as well as the innovation gap. The EU fears badly on disruptive technologies and its old grip on incremental innovation, that means improving existing products, for instance, in the car industry, is deteriorating. Overregulation is rife. And moreover, Europe's long-held advantage on education quality is also eroding with Asia outperforming. This all combines into falling competitiveness. And finally, demographic dynamics are worse than the US. Such grim outlook, because it is a grim outlook, calls for massive action that is encapsulated in a call for large investment effort. But maybe paradoxically, I think that Draghi's report runs the risk of drawing attention to Europe's difficulties with swift decision making, which would, in the end... add to the sense of gloom, to a sense of helplessness in the EU or about the EU. Indeed, on the side of policy recommendations, while the report has the benefit of compiling a lot of common sense solutions, its impact may be blunted by, for instance, the impossibility to discuss national policies within its scope. Also, the fact that it is coming after the report by Enrico Letta. And finally, because it's sort of... internalizes the political limitations of action in the EU. So let's start with with the first problem I would say. Well there is a number of key issues raised in the report which are institutionally outside the scope of the EU. Education for instance is almost exclusively a national competence. The EU can of course improve its research framework. The report explores for instance a reform and extension of the important projects of common European interest scheme. But this is action which I would describe at the end of the chain, which does not treat the root cause of the problem. The same holds for the report's recommendations on energy. The massive difference in electricity prices across the Atlantic is of course a key competitiveness issue. But the report's recommendations to further reform the integrated European electricity market cannot deal with the key underlying issue, that is counterproductive political choices in key member states, for instance in Germany. While the report rightly explores means to reduce the regulatory burden created by EU institutions, a blind spot in the explanation of the gap with other large economic regions, in our view, is the role of national regulations, for instance, on the labor market. There's a well-established link in the academic literature between the flexibility of the labor market and the speed of implementation of innovation and ultimately productivity gains. Reforming the labor market, just like education, is the preserve of national governments. Conversely, the focus on investment, which we find time and time again in the report, could reinforce the current zeitgeist, which is increasingly favorable to raising fiscal spending, despite the lack of room for maneuver in this field, and less and less interested in changing structures. The last big wave of labor market reform in Europe came in the south, especially Spain and Portugal during the sovereign crisis of the early 2010s. Since then, it seems that European governments have internalized the difficulty to sell any deep structural reform in this realm to public opinion. The point for me which blunts the impact of Draghi's report as well is that the proposals in the financial sphere are quite similar to those which had been put forward by Enrico Letta in his early report. The points on fostering securitization in the EU, given the wide gap with the US, was already made. That makes sense. Shifting the risk away from banks, balance sheet, could incentivize more lending. And Draghi was probably more comprehensive. in its analysis and recommendations than LETA. For instance, it calls for a reduction in prudential requirements, the introduction of first-loss government guarantees on some products. But this approach, in our view, misses a key reason why securitization is so widespread in the U.S. There was a political choice in the U.S. to make long-term fixed interest rate mortgages dominant. The implicit government guarantee of mortgage-backed securities via Fannie Mae and Freddie Mac is there to promote fixed-term lending to households by banks. There is no political consensus in Europe around the type of mortgages, which should be the norm here, from fixed-term, for instance, in France to fully floating in Spain. So in all this kind of obsession in Europe about boosting securitization, there is some reverse engineering here. the EU would create a securitization market out of nothing. Why is securitization emerging in the US? Because there was an identifiable, politically consensual investment to fund. So you could say that securitization in Europe is a bit of a solution in search of a problem. In the same vein, changing regulation to promote infrastructure investment by insurance companies or pension funds, were also laid out in the Letta report, as well as the shift to a single supervisor for the financial industry beyond the banking sector. The idea of skewing institutional investors'asset allocation has been floating in policy circles in Europe for years. An issue here, when thinking about using capitalized pensions to bridge the investment gap with the US, is that pension assets stand at only 32% of GDP in the EU against 142% in the US. A logical consequence It's that to get any meaningful impact on risk investment, a very significant share of the pension fund's assets would need to be shifted away from safer investments to the point that the security offered by those schemes to existing and future pensioners could be put in question. Draghi's report highlights finally some of the institutional limits of the EU and commentators have often focused since the publication on his call for more. joint issuance at the EU level. But the project is only thinly sketched out in the report, internalizing, I think, the opposition from Kim in the States. And we know that Germany's finance minister, Christen Lindner, made his rejection very clear from the get-go. In any case, there are some issues around the existing next generation EU framework, which would need to be sorted out probably before moving to a second version of it. Only roughly a third of the total financing capacity has been spent so far. This may be at least partly explained by the fact that funding transits through national governments instead of being allocated directly by the EU through a single point of selection and delivery. And that's a key difference with the US IRA program. This comes from the fact that NGEU was a hybrid project with two objectives. Beyond fostering more investment in digital and environmental projects, projects Funding was distributed unevenly across member states to provide protection to the most fragile ones, such as Italy. Such equalization target can conflict with the goal of narrowing the productivity gap of the whole EU versus the rest of the world. So that would need to be sorted out probably before we can convince anyone in any of the European capital that it's time to go for a second helping. And that gets us to some of those new intrinsic. institutional limitations of the EU. The report falls short of calling for a treaty change, and that's probably reasonable because it takes on board the very unfavorable political conditions in member states at the moment. However, what it calls for, which would be using the full scope of the existing treaty to extend the qualified majority rules to more aspects of EU policymaking instead of unanimity and promoting enhanced cooperation, that means carve-outs within the EU or even... treaties across governments may not be much less daunting in the current political climate. So, as a conclusion on this, the policy content of the report makes a lot of sense, but Europeans have known for a long time what needs to be done. The key issue is political appetite at the national level. In our view, the European machinery aspects are secondary. Within the package, what may be realistically achievable is what is the most technocratic and least obviously controversial from a domestic political point of view, that is, the capital market union. Still, the projects with the most obvious direct impact on investment, for instance, additional joint funding in a streamlined distribution framework, would need much more maturation by national public opinions. And historically, this has been doable only in times of overt crisis, for instance, in 2011-2012, when the very existence of the monetary union was under threat. in a boiling frog configuration, which probably best describes our current situation in Europe. This is probably out of reach. Now, having depressed you to the hilt with those musings about Europe and the difficulties to get anything done there, I thought we should use this first podcast after the summer recess to look over the ocean, look over the Atlantic. and think about what's going on in the U.S. at the same time. And as much as in Europe we are looking at the U.S. with a lot of envy at the moment, and there's a lot of envy in the Draghi report, it seems that locally things are seen with pretty dark lenses, I would say. And I thought that it would be interesting to get a proper American colleague on the call. So I'm very, very happy to... have Matt Pacifico with me today. Matt is our head of US investment grade research. And I've been discussing, talking with him for years actually on market developments. And the first question I would like to ask you, Matt, is what's your view on the idea that there would be a disconnect between a macro conversation, which is focusing on recession risks in the US, While markets seem to be nonplussed, and for instance, we haven't seen anything dramatic on risk premium. So is it that markets are myopic and there's a sort of cognitive dissonance there? What's your view, Matt?
