Podcast Transcript: Shahin Vallée on Europe’s Geopolitical Risks, ECB Policy and French Elections

This is an edited transcript of our podcast episode with Shahin Vallée published on 21 January 2022. He is the head of the Geo-Economics Program at the German Council on Foreign Relations (DGAP). Before the German Council, Shahin was a senior economist for Soros Fund Management, and also served as a personal advisor to George Soros. In the podcast we discuss, how Europe fits into the US-China conflict, Germany in a post-Merkel world, chances of Euro break-up and much more. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.

Introduction

Welcome to Macro Hive Conversations with Bilal Hafeez. Macro Hive helps you successfully invest in markets from crypto to equities to bonds. For our latest analysis, visit macrohive.com.

We’ve had a tonne of requests from our Macro Hivers for more educational pieces, so we’ve just launched our new explainer series. These are short pieces that explain and deconstruct important topics for investors. Crucially, we keep the language simple and clear. Our first explainer is on quantitative tightening, what is it, and what are the mechanics behind it all. And our next one will be on the blockchain, so keep an eye out for those. On markets, we have an article that features our recent guest, Mark Yusko’s favourite thematic investment picks for 2022 and his favourite asset allocation approach, the permanent portfolio. On macro, we feature a guest piece on the possibility of more persistent inflation. And as you can tell, we’re open to all views as long as they are well-argued. On crypto, we look at how smart contract coins are outperforming others and we update our flow and on-chain analytics on Bitcoin to give you our latest view on Bitcoin. And as a Macro Hive member, you can get access to all of this work, our investment focus analysis, our webinars, transcripts, and our members’ Slack room where you can interact with the Macro Hive team and other members all hours of the day.

You can sign up to become a member by going to macrohive.com. Membership to Macro Hive cost the same as a few weekly cappuccinos. So, go to macrohive.com to sign up now. And if you’re a professional or institutional investor, we have a more high-octane product that features all of my views, our model portfolio, trade ideas, machine learning models, and much, much more. Hit me up on Bloomberg or email me on [email protected] to find out more.

Now, on to this episode’s guest, Shahin Vallée. Shahin is currently Head of the German Council on Foreign Relations Geo-Economics Programme. And before the Council, Shahin was a senior economist for Soros Fund Management and served as a personal adviser to George Soros. Prior to that, he was the economic adviser to Emmanuel Macron at the French Ministry for the economy and finance, where he focused on European economic affairs. Now, on to my interview.

Greetings, Shahin. It’s great to have you on the podcast. It’s been a while since we last spoke in person, and I’ve been following you on Twitter and so on. So, it’s great to have you back for us to be able to have a proper conversation.

Shahin Vallée (02:25):

Thank you. Thanks for the invitation. Good to see you again.

Bilal Hafeez (02:27):

And one thing I always like to do before we jump into our discussion itself is to learn a bit more about the person, the guest, and their origin story. So, what did you study at university? Was it inevitable you’d end up in the world of politics and economics and finance? I mean, what’s been your story up until now?

Shahin Vallée (02:42):

No, it was not inevitable. So, I grew up in France mostly, although I spent part of my childhood travelling and living in many parts of Africa. I studied Economics and Public Affairs in France mostly. And then I did a dual degree between Sciences Po in Paris and Columbia in New York. And so, I had big plans of working in public policy in France and in the end after graduating from Columbia, I ended up in finance. I started very briefly in private equity and very quickly found it interesting but too narrow. I was used to think about macroeconomic policy, international affairs. And so, I ended up on a foreign exchange strategy desk in London. And I did that for a few years, which was extremely formative. I looked at emerging markets. Then the global financial crisis and then the Euro crisis hit. And I was really fascinated with what was going on in Europe. Having worked on emerging economies before, I was one of the only person on the desk who actually understood what an IMF programme was and what a balance of payment crisis was. And so, I think I was in a position to understand what was happening in Europe better than many people who were actually on the Euro desk at the time. And so, I switched. I did a bit of prop and then quickly was drawn to public policy. So, I was hired. I was in very close contact during these crisis moments with the Cabinet of the President of the European Council and telling them what we’re seeing in the markets, how the markets were analysing and understanding policy responses. And then at some point, they said, “Well, instead of telling us what’s going on from the marketplace, why don’t you come over and work for us?”, which I did. So, I spent two years in Brussels working for the President of the European Council, worked and met Emmanuel Macron there who was my counterpart. He was the advisor to the French president at the time. I was the advisor to the President of the European Council. So, we were working very closely together. And then when he became minister, he asked me to work for him and be his advisor, which I did for more than a year. And then I went back to finance and worked for George Soros for Soros Fund Management in London. So, I’ve been navigating, I guess, public policy, finance, and the think tanking policy world for quite a while. And I quite enjoy this… I think revolving doors is a bad connotation, but actually, I actually own it. I quite like that.

Bilal Hafeez (05:02):

That’s good to hear. And you’re currently at the German Council of Foreign Affairs.

Shahin Vallée (05:07):

Yes. So, I’m working for the German Council on Foreign Relations. I head what’s called their Geo-Economics Programme, which is basically the intersection of international affairs with economic affairs. And so, it’s traditionally a very foreign policy think tank, but they realised that economic policy and finance was becoming in many ways, a matter of concern for international affairs and that there needed to be a bridge between people who think about foreign policy and people who think about economic policy. And that there are not very many places where these two things come together. So, the German Council is one of them.

Bilal Hafeez (05:44):

Great. And before we talk about some themes, I have to ask you, what was it like working for the European Council, the EU, Brussels and Macron? As an outsider, obviously, I’m from the UK. And so, the UK, we have this background noise that Brussels is too bureaucratic, everything moves so slowly, nothing happens. What’s it like from the inside?

Shahin Vallée (06:04):

No, I didn’t have this impression, actually. I mean, these were also particularly active moments. It was the moment of very acute crisis between 2012 and 2014. So, it was the moment of the tail end of the Greek crisis, still very deep in the crisis in Cyprus. Over the summer of 2012, Italy was also on the brink. So, these were very intense moments. No, I didn’t find the European Commission on Brussels more broadly ineffective. In fact, I was quite impressed by the ability to push policy for a continent of that scale with divided policy and divided political systems. Where I think I was disappointed but not surprised was the ability to take executive decisions, which in a situation of crisis is what you need, which is difficult when this executive decision has to be the intersection of 27 red lines. And the reality is that it’s very difficult to manage a crisis when you have to respond to 27 red lines at the same time. And I think that’s one of the reason why Europe’s crisis management has been so poor during that period, but I think Europe is also learning by doing. And even though the policy response during this COVID crisis hasn’t been perfect, I think it’s been far superior to what the Euro crisis response was. And I think that says something about the possibility of Europe to take executive and crisis management decision when it needs to. And I know a lot of people are very critical about the way the EU managed the COVID crisis, the vaccination strategy, the whole ordering process. And when you look back, none of it was perfect, but you should compare it to the American or the British or to a country in a political system where things were in principle a lot easier, because it’s a unitary political system with one executive, I don’t think the EU compare so badly. In fact, I think it’s been able to achieve both a very high level of vaccination in Europe and to export vaccines across the world I think a lot more effectively than most countries have. So, I think there is no inevitability about Europe’s incapacity to act, even though it happens often. I don’t think there is anything inevitable about it.

How Europe fits into the US-China conflict

Bilal Hafeez (08:14):

And I do definitely want us to talk about Europe, but obviously, there’s a global context here and you do focus on geo-economics. What are some of the global themes that you’re focusing on at the moment?

Shahin Vallée (08:23):

Well, I think there’s one big overarching theme, which is the position of Europe in the world that is increasingly going in the direction of a confrontation between the US and China. And I think that raises a fundamental question for Europe in a number of areas. I think, historically, the EU was viewed by the US and to some extent, viewed itself as the extension of the US and viewed the transatlantic relationship as a thing that dominated Europe and overdetermined Europe’s positioning in the world. I think that feeling is changing. It’s changing for many reasons, both, I think, because Europe realises that its interests are not always 100% in line with that of the US and that Europe needs to be able to speak with its own voice. And also, it’s happening because I think the US might be a bit less interested in this transatlantic relationship and might be more introverted than it used to be. In some aspect for the better, I think, lesser engagement of the US in the Middle East for instance may not be such a bad thing, but also sometimes for the worse. And I think, for instance, today, there is a great deal of uncertainty about the extent to which the NATO Security Alliance, which is really the structure that holds European Defence together, is an alliance that still makes sense. Is the US really prepared to put troops on the ground to defend Ukraine’s border or to prevent an invasion of Estonia? I think there was an easy answer to that question 10 or 15 years ago. I don’t think there is today. And I think what’s happening actually as we speak, at the Ukrainian border is an interesting illustration of that.

Bilal Hafeez (10:08):

And just from an institutional perspective or the executive perspective, who’s in charge of foreign policy in Europe?

Shahin Vallée (10:13):

That’s the Kissinger question. Who do you call? Well, there is not a single phone number and it’s part of the problem. So, the reality is that Europe is created institutionally both a President of the European Council that in principle has a role in high stakes international matters of this kind. There is also a High Representative for Foreign Policy, which is in charge of foreign policy and which in principle coordinates the foreign policy of the 27 member states. And then there’s a reality, which is that some member states are more equal than others and that what Germany or France would say on one issue or the other might match more. In part, at least in the case of France, because it has the military capacity to meet force with force if and when necessary. So, I don’t think there’s an easy answer to that, but I think it raises a fundamental question for Europe, which is not, “What is the right number?”, but how do we make foreign policy? And there is not a real answer to that question in the sense that foreign policy to a large extent is a policy that requires unanimity of all the member states. And I think that’s a real major problem that is, in fact, debilitating Europe’s ability to act, because if you need the consensus of 27 member states to impose sanctions on Russia or fight off a decision by China or decides to oppose Turkey in the Eastern Mediterranean. So, if you need a consensus for that, you’re pretty much unable to get that whenever you need to. So, you lose your executive capacity to act. And so, I think that’s one of the weaknesses of Europe’s foreign and de facto defence policy. The interesting bit is that the countries that are most adamant about the need for a common European sovereignty capacity to act, whatever name you want to put to this concept, and France is probably the most active country calling for that, are also countries that are very sceptical about the idea of abandoning their veto rights when it comes to foreign policy. So, in reality, if you wanted a real foreign policy that is able to act, you would move it from a unanimity decision making process to at least a qualified majority. So, you don’t need unanimous consent to act. You need a large majority in Europe to do so. The problem is that this would mean France and Germany accepting to be outvoted in certain circumstances. And that’s something that France, for instance, struggles to accept. So, I think there is a deep tension here between Europe’s desire to act and the realisation that this requires quite deep political changes to be able to act and to be able to grant the European level the necessary executive powers to make these decisions.

Europe’s nuclear energy dilemma

Bilal Hafeez (13:03):

And if we just use the current situation with Russia and Ukraine as a focal point here, a cynical view would be that Germany is trying to have its cake and eat it. Whereby it wants to get all the gas from Russia, it can whether it’s the Nord Stream of Ukraine and everything. So, it wants to have good relations with Russia, but then at the same time, it wants the NATO protection. It wants the US and to have that security umbrella, but it doesn’t really want to go all out against Russia. And so, you have this problem, which the US constantly talks about, “How can you rely on Russian gas at the same time, try to condemn Russian foreign policy?” You have to pick one or the other. How do you look at something like that? It seems like Germany is obviously quite central to all this dominant economic force.

Shahin Vallée (13:50):

Yeah, no, I mean, Germany’s position and its dependency on natural gas is a real issue. But to some extent, you could argue that Germany’s economic policy and its dependence on Chinese imports is also a source of vulnerability. So, I think there are several layers and several sources of vulnerability for the EU. The worry is that these sources of vulnerability are additive. The EU has the sum of all the vulnerabilities of its member states, which amounts to quite a lot because Germany is exposed in that sense, but you could argue that France for a while was exposed because it needed stability in the Sahel, because this is where we’re supplying a lot of its uranium for its nuclear power plants. You could argue that France needs to export its weaponry to Gulf monarchies in the Gulf, and therefore, has a vested interest in what’s happening there and may or may not be able to take a position, say, on the war in Yemen. So, I think, we have a cumulative source of vulnerabilities. Indeed, there isn’t an acceptance yet that we need to choose. I’m, for instance, struck by the decision, even though it’s a decision that is decades old, by the decision to basically shut down the last nuclear power plants in Germany now, when you have 100,000 troops at the height of Ukrainian border and potentially a natural gas crisis looming. That seems to me very much at odds with the idea of ensuring Europe’s economic strategy.

Bilal Hafeez (15:19):

Yeah. I mean, on the nuclear side, obviously, Europe has created this taxonomy on green energy. And maybe it’ll be good for you to talk about the taxonomy’s position on nuclear and then how has Germany received that, or Austria say.

Shahin Vallée (15:34):

Well, I don’t know if everybody’s familiar, but basically, the taxonomy is a piece of legislation in Europe that will force disclosure on the basis of whether activities are considered green or not. And it’s a fairly binary piece of legislation. And there was a big fight for more than a year as to whether nuclear energy, but also, I think it’s important to say natural gas, could be considered a source where they call it transition energy and therefore be allowed under the taxonomy. And that matters, because if it’s not in the taxonomy, the financing cost of these industries will rise because the banking system and asset managers won’t be able to lend to these industries or not with the same standards. And basically, the compromise that was found was to consider both natural gas and nuclear energy as a transition energy. And I think that’s the result of a typical European compromise, where basically, Germany needed natural gas to be considered a transition source of energy and France wanted nuclear. And so, they agreed both keep that inside the taxonomy. I think this has created a lot of discussion. I’m not so shocked by that, in the sense that I think the energy mix in Europe cannot be one today or even in the next 20 years that has zero nuclear. And so, we create the conditions to have nuclear power running for the next 20 years. It seems to me like a very reasonable decision to make given our emission reductions commitment. In fact, to some extent, the same goes for natural gas. I don’t think it’s possible to switch entirely from coal to renewables. We need at least nuclear and/or natural gas as a source of transition. I mean, it’s been framed as the worst compromise ever. And if you look at the science of what is possible to achieve insofar as energy transition, I find it an acceptable compromise, even though it has the allure of a dirty backroom deal.

Bilal Hafeez (17:36):

Yeah, understood, but there’s no real chance that Germany could switch on the nuclear reactors once again at some point, given this taxonomy change.

Shahin Vallée (17:44):

No, I think the commitment in Germany, especially with a coalition that now includes the greens, to walk away from nuclear is a deep commitment. I mean, people tend to forget, but this commitment was actually taken the first time around by the Schröder government. People say it’s actually Merkel, who switched off, who made that commitment in 2011 after Fukushima. In fact, no, it was a commitment that had been made before by the Schröder government.

Bilal Hafeez (18:14):

And what was the rationale for the Schröder to do this?

Shahin Vallée (18:14):

Remember, it was a Schröder green government. It was the first SPD Green Government. And so, as part of the agreement with the Greens was to move out of nuclear. It was 2003. The commitment at the time to move away from nuclear in 20 years sounded like a long way away and sounded possible. And then the Merkel government who came in unplugged it and then was forced to restate that commitment after Fukushima in 2011. I think there has been some benefits to that commitment by the way. The fact that Germany invested so much in renewables was, I think, in large part because of that commitment. What I find regrettable is that today, you have coal power plants in Germany running full steam because of that commitment or because no alternative was made quickly enough to coal power plants. And I think that, to me, is a big policy failure. But I don’t see a reversal of that. If there were to be a reversal, it would be a short-term reversal. Imagine the Ukrainian situation flares up and natural gas supplies dry up, then maybe temporarily, you could imagine that nuclear power plants will be resumed. But I don’t see that as a lasting solution.

Russia/Ukraine risks

Bilal Hafeez (19:28):

And in terms, I mean, do you have a view on the energy crisis in Europe for the next 12 months? I mean, obviously, electricity prices have shot up, gas prices. I mean, they’ve been volatile, but they’re still fairly elevated. The ECB is talking more about energy price shocks that could be more permanent. I mean, do you have a view on this?

Shahin Vallée (19:45):

Well, I think there’s one geopolitical aspect of that which is hard to predict, which is really dependent on what’s happening in Ukraine and Russia. If we enter into a full-fledged conflict where the EU take sanctions against Russia, it’s very likely that Russia will reduce gas deliveries or at least some of them. And that I think will exacerbate the current natural gas crisis. Whether the US is able to export sufficient liquefied natural gas to Europe remains to be seen and whether Europe has the ability to store that liquefied natural gas for long enough to meet the peak is a big question mark. So, I think the situation is fragile. And I think we have seen with this crisis that the European energy and electricity market, despite its integration, remains imperfectly integrated. And that’s a source of bottlenecks and potentially squeezes that affect natural gas prices, but also the electricity prices. So, I think what we’ve seen with this dry run to some extent is despite the efforts that have been made in integrating the European energy market over the last 20 years, we’re still a long way away from a system that is resilient to external shocks, whether they come from a geopolitical source or from simple price shock is the one we’ve seen globally.

Bilal Hafeez (21:03):

And do you have a view on Nord Stream 2? I mean, it feels like it’s going to be activated at some point. It’s going to work in the face of US objections. It’s just a question of timing.

Shahin Vallée (21:13):

Yeah, I struggled to see how it would be unless a major conflict between the EU and Russia erupts. I think the ship has sailed. I think the US, especially under Trump, could have been in a position to weigh heavier on Nord Stream and didn’t. And I don’t have the impression that this has changed radically with the Biden administration. And the reality is that inside Europe, there was also not a lot of vocal opposition to Nord Stream. There was some discomfort in the south, some discomfort, of course, in Eastern Europe, but that discomfort never coalesced into a real frontal opposition. In fact, the ones who could have driven a coalition to block Nord Stream 2 were the French and they toyed with the idea for a little bit and ended up abandoning. So, in reality, there hasn’t been a strong opposition, a strong European opposition to Nord Stream 2. Also, because for many, it was seen as a central pet project of Germany across the political spectrum. Keep in mind, I think that’s an important line, across the political spectrum. Both the SPD and the CDU were wedded to Nord Stream.

Chances of a Euro break-up

Bilal Hafeez (22:24):

Okay, yeah. And on even more pessimistic tone, I mean, people are always looking for Euro area breakup type scenarios. We’ve been thinking about at Macro Hive as well. We published these grey swans every year, these kinds of black swan type events, and one was around the Euro area breakup that people aren’t talking about it. But the one area I think is interesting is COVID policy and restriction of movement of people across borders, the fact that countries are able to control the borders a lot more effectively now and suspend the Schengen area and so on. And there’s a lot of discomfort around vaccination policies and all these sorts of things. I mean, do you think there could be something here in terms of causing some cracks in European integration?

Shahin Vallée (23:05):

No. So, maybe I’ll start with the Euro point briefly and then get to the COVID. On the Euro, I think, there’s been for the last 10 years, a lot of scenarios about breakup. What I come out of this with is that basically, I think the Euro area, I know you will get to this, has proven that it could be both fairly unstable because of the weaknesses of its architecture, and at the same time, extremely resilient, because basically, the cost of leaving the monetary union are seen now by everyone as just overwhelming. And so, I think we have this strange combination, where the Euro area is both unstable because of the weakness of its architecture and maybe we’ll get to talk about that in more details later, but also, extremely politically a solid because basically nobody… That’s visible even in France now. Italy, you could see Salvini had tried to come together with the Euro exit platform and eventually abandon it entirely when he joined government. Nobody in Italy now is talking about that anymore. And in France, in 2017, you had Le Pen, who basically flip flopped a little bit on this. And now, he’s basically firmly saying, “We are not going to leave the Euro.” The last one, Jean-Luc Mélenchon, candidate from the far left, who was a bit ambiguous about his relationship to Europe, just came out with an interview a couple of days ago in France, where he basically said, “I’ve changed my mind. I’m not going to threaten leaving the EU anymore.” So, I think to me, that has gone. The risk of fragmentation and breakup to me are as close as they get to zero. On COVID, you’re right that there was a moment where there was a great deal of frustration about the European vaccination strategy and response, the feeling that this had been very poorly managed, and that this was approved that Europe could not deliver. And I think, with the benefit of hindsight, nobody thinks that anymore. I mean, you saw Macron’s speech in the European Parliament today. He admitted, which I think for a president is not easy to do. He admitted that without Europe, France would not have been able to deliver the vaccination strategy and coverage that they have. I think it’s very honest on his part, because unlike the UK, which has been a great French frustration, unlike the UK or Germany, France actually doesn’t have a pharmaceutical company that has come up with a vaccine. So, basically, France could have been in any way dependent on supplies coming from BioNTech, Pfizer, or from AstraZeneca or others. So, without the coordination mechanism and a free for all, it’s not clear that France would have been able to secure these vaccines stockpiles that we had. So, I can see now, people who feel frustrated enough about either the health and vaccination strategy that has been developed by Europe or the economic policy response, whether it be and we’ll talk about it, I guess, the ECB or the EU to really argue that this has been so badly done and designed and undertaken that it warrants an aggressive anti-EU or an EU exit political platform. I think these platforms have really suffered in the last year really.

If the EU fiscal policy changed after COVID

Bilal Hafeez (26:17):

And in terms of the EU response and the ECB, I mean, what’s your sense of the EU fiscal response to COVID and then the ECB’s response?

Shahin Vallée (26:26):

I’ll start with ECB. So, there was an early mishap with ECB’s response. You remember the quote by Lagarde, “We’re not here to close spreads,” which really started a real panic in European government markets, which I think could have been disastrous had it not been corrected very quickly. I think this little mishap, in fact, forced a very bold monetary policy response with the PEPP programme, which effectively introduced what I have called a spread control framework. So, basically, the ECB went 180 degrees and from saying, “We’re not here to close spreads,” in fact, to design a policy framework that was specifically designed to keep the long end anchored and to keep spreads as low as they could be. So, I think the policy response from the ECB was bold, fairly effective, and adjusting for this little mishap in the beginning, very timely. On the fiscal front, I think it took a little bit longer, but in fact, very quickly, the fiscal rules were suspended, so unleashing the full power of national fiscal policy. And even though it took two, three months, the EU was able to come together with this NGEU/Recovery and Resilience Facility, which put together a €750 billion facility to basically help the recovery. I think that €750 billion is small in comparison to the fiscal needs that Europe had at the time. So, I don’t think we should judge that policy move on the size of it, but I think it had a major political contribution, because it basically signalled that Europe was prepared to underwrite, in common, a fiscal policy in response to that. And I think that both enabled the ECB to do what it wanted to do and I think that also enabled national fiscal policy to do more than it would have been doing otherwise. So, I think the NGEU RRF response was extremely important, not so much because of its size, but because of the precedent and symbol it created and the enabling of national fiscal policy and effectively monetary backing of that. So, I think that was a real major departure from really the crisis response in 2010, 2012 during the Euro crisis.

Bilal Hafeez (28:42):

And on the fiscal response, one of the hopes was that it would lead to the creation of a large Euro bond markets, bonds denominated in Euro like a common euro bonds or markets. It seems like the numbers just aren’t big enough, and it doesn’t feel like it’s going to be renewed. This seems like a one-off. So, those hopes seem to be dashed. I mean, is that a fair characterisation?

Shahin Vallée (29:02):

Yes. So, I think at the time, some people saw this moment as a Hamiltonian moment, at the beginning of a real leap into Europe’s fiscal federalism. And at the time, I warned that it could be that, but it could also be just a one-off and that we needed something important to ensure that it’s not a one-off, which is for the EU to make a commitment, basically to Europeanised to some extent its taxing power. So, basically, right now, we have created common spending, common debt, but we haven’t really agreed to a common taxation to back that spending and that debt. And to me, it is that common taxation that is the true Hamiltonian step. And so, we’re missing that. And so, I think the big question is whether we have that in the next few years, and I see two reasons why we might. That’s why I’m not giving up entirely on the idea that this could be a Hamiltonian moment, even though I don’t think all the elements to call it a Hamiltonian moment are here now. One is the fact that this debt has to be paid back. And so, the EU has not really agreed on what they call own resources, but they need to legislate own resources, so tax revenues to back this debt. So, I think when they do that, that could be depending on the tax they choose, depending on the amount they agreed to, that could be the real bold integration step. The other source of potential contiguity and enlargement of that Euro area safe asset or EU asset rather because it’s not the Euro area would be if we find that actually the precedent, the technology that was used for this COVID debt could be used for something else. I could totally imagine in a year’s time that we say, “Listen, we’re really far behind on our Paris commitment. We actually need to invest 500 billion more very quickly if we want to be able to meet our emission reductions commitment. Let’s borrow this 500 billion together through another joint EU programme.” And that to me, that sounds like very far today, but I wouldn’t be surprised if in two years times, that’s part of the policy discussion or we have big military conflict. And we realise that actually, we need to integrate Europe’s defence much more and we need to borrow 50 billion or 100 billion to create the embryo of a European defence capacity. And so, we create a new fund for that. So, I see two avenues basically to transition this one-off, temporary policy into something more permanent. One is to replicate it for other means. The other is we will have to discuss about the own resources to create long lasting own resources that could eventually back a larger flow of permanent debt for the EU.

Whether the ECB will hike in 2022

Bilal Hafeez (31:39):

So essentially, for that common fiscal or that Hamiltonian moment, we should watch on the tax side, the common tax policy of some kind in the next few years. Back to the ECB, the Feds have a huge pivot towards tightening policy work about inflation. The ECB, at this stage, they have started to sound a lot more hawkish. If we look at rates markets, they’ve started to price one hike by the end of this year. I mean, that may not be huge amount, but it’s something. I mean, do you think there is chance the ECB could tighten policy?

Shahin Vallée (32:07):

I think it would be a big policy mistake, but the ECB has made policy mistakes in the past. So, it can always make one. I don’t think so. I think there is a realisation or at least that’s my view and I think it’s true that it’s shared in Europe, that the sources of inflation in Europe are quite different from the sources of inflation in the US and that the sources of inflation in Europe don’t warrant monetary policy tightening. So, I don’t think there is a real strong case for monetary policy tightening. That being said, I think maintaining a loose monetary policy conditions in the face of tightening Federal Reserve or tightening Bank of England will prove a very meaningful challenge. As you know, I mean, the correlation at the back end of the curve between US and European rates is quite high. And the ability and this is the good old paper by Hélène Rey, the ability to tame the US financial and credit cycle is very difficult, even for Central Bank of the size of the ECB. So, I think the real difficulty I see for the ECB is to be able, even if it wants to stick to an accommodative policy, to continue to engineer an accommodative policy in the face of policy tightening in the rest of the world, in particular policy tightening in the US. And to be very specific, I’m not sure that the policy framework that is currently in place is the one that allows for that. Concretely, the ECB has committed to start reducing its PEPP programme. So, the programme for the pandemic emergency purchases. And I think reducing that is liable to contribute even at the margin to tightening and monetary conditions, in particular because I think Europe’s monetary and financial conditions are overdetermined by spread. I don’t know if I’m clear. By that, I mean that I think the single most important thing that the ECB did with the pandemic was precisely to introduce what I’ve called this spread control framework. Basically, keeping spread tight is what I think matters the most for financial and monetary conditions in the Euro area.

Bilal Hafeez (34:09):

So, we need to watch Italian spreads over bonds, for example. Europe has to make sure that they don’t blow out with the fact that the US bond yields are going up sharply. And one related point is, obviously, the ECB has negative policy rates. So, is that sustainable? I mean, could there be scenario where they say, “Actually, let’s just move to zero to help banks in Germany or elsewhere”? I mean, do you think there’s something about negative rates that could be problematic for Europe, or not?

Shahin Vallée (34:33):

So, my quick answer to that is no. So, I mean, I think, of course, it affects the profitability of the European banking system. So, I don’t think it’s policy that has no side effects, but I think the side effects are largely overtaken by the positive effect of the negative rate policy in particular on the exchange rate. That being said, I could totally imagine a normalisation strategy that will be very different from the normalisation strategy that is currently announced by the ECB and that is basically a version of what the Federal Reserve is doing. Meaning, we stopped tapering. Once we’ve stopped tapering, we will increase rates. Given what I’ve said about a spread control framework, I could totally imagine a sequence in Europe that would be the reverse. Meaning, we could start to hike rates at the front end very modestly, but keep our asset purchases programme to keep the backend anchored and to keep in particular spread anchor. And that to me is not a policy or a normalisation sequence that we should exclude entirely, which, for the moment, VCD is excluded or stuck to basically the same normalisation sequence as the Bank of England or as the Fed while I think the specifics of the European context would want an alternative normalisation sequence.

Whether Macron wins the French elections in April

Bilal Hafeez (35:43):

Now, I also wanted to talk about some domestic politics as well. Obviously, we have French elections this year. We have a few contenders in the field. So, maybe useful it’d be useful if you could provide some context of the election this year compared to the previous one. Obviously, there’s a number of different contenders, Le Pen, Pécresse, Zemmour, this colourful character. How are you seeing this field in the first round, second round election that we have?

Shahin Vallée (36:05):

So, I think there has been a real fragmentation of the French political system, which started in 2017 with a very weak or long Socialist Party, which really enabled Macron to emerge. And I think Macron has accelerated the key and fragmentation of French politics. So, we have now a great number of candidates, but very few in a position to really, I think, threat Macron’s reelection. To say things bluntly, basically, in 2017, we had around four candidates close to 20%. Now, you have basically Macron’s trailing alone, between 24 and 26%. And all the others are between 12 and 17, but nobody beyond that. So, the gap between the front runner and the others has widened considerably, which also means that the chances or the probability that somebody comes to the second round on the other side of Macron is very random. So, right now, you have basically three, four contenders that could make it.

Bilal Hafeez (37:05):

And just to be clear, for our benefit of our listeners who aren’t familiar with the French system, you have two rounds of voting. So, the first round, all the candidates are in there and the two with the largest sets of votes go through the second round. And there’s the votes on there. And the winner of that one then gets elected the president.

Shahin Vallée (37:19):

The president. Yeah, yeah, exactly. And so, the real question is how high the bar is to get into the second round. And before, the bar used to be above 20%. Now, the bar could be as low as 16, 17%, which makes it both more accessible to a broader range of candidates, including somebody like Zemmour, who we know, for the record, doesn’t have political party. He was not even a politician a year ago, declared his candidacy officially super late.

Bilal Hafeez (37:49):

Zemmour, just to be clear, is a TV personality.

Shahin Vallée (37:52):

Yeah, he was a TV anchor and journalist for many years and has gotten a lot of publicity and visibility thanks to that. And he has basically done something that’s quite remarkable, which he’s been managed to overtake Le Pen from the right, so being more anti-immigration, anti-Islam, being basically far more right-wing figure than Marine Le Pen was. Marine Le Pen also repositions herself slightly to the centre to appeal to a broader audience. So, she’s lost some people along the way. She’s lost some of the protest vote. So, in that sense, he’s captured that bigger share of the protest vote. And he’s done something which is quite remarkable. And it’s even more remarkable, because he’s been able to do that at the same time, which is also to speak to the establishment in the sense that because he doesn’t carry the Le Pen name, baggage and legacy, Zemmour, to some extent, is more accepted by a part of the establishment who would have never voted for Le Pen, but can imagine voting for Zemmour. So, I think he’s been able to straddle the political spectrum very well on the right by speaking to voters who felt Le Pen had become too soft and speaking to voters from the establishment who felt Le Pen was an extreme figure. So, I think that has allowed him to capture a big part of the vote on the right and to become a very important figure.

Bilal Hafeez (39:15):

I mean, it’s quite easy for international people to do this, but a lot of people have likened him to Trump. I mean, is that a fair comparison?

Shahin Vallée (39:21):

Yeah, I think it’s a fair comparison. It’s probably Trump at the end of his term in the sense Trump was facing a lot of opposition from the establishment, Republicans in the beginning of his term. And you’ve seen some members of the Republican Party in France basically moving to Zemmour. So, I think it’s a supercharged Trump in the sense that he’s been able to play outside of the party and inside the party, I think, a lot quicker than Trump has. So, I think he’s a real threat because of that, but he’s been declining in the polls. Le Pen has surged a bit more. So, right now, we’re in a situation where it can be either Macron-Le Pen, Macron-Pécresse, or Macron-Zemmour. I don’t really believe that a candidate of the left, despite the dynamics that are taking place on the left, where one candidate dropped out today, there might be another one dropping out soon, I don’t believe the dynamics on the left is such that you could have a left wing or green candidates to the second round. And really between these three, I think Macron wins with a far smaller margin than he did in 2017, but I think he wins versus Le Pen and wins versus Zemmour. So, the real question mark is, “Does he win versus Pécresse?” And the polls are ambivalent at the moment. I tend to think that it hasn’t been tested enough in the campaign. And that Macron and the debates and during the campaign show that he’s superior.

Bilal Hafeez (40:44):

And just for context, I mean, she’s a modern establishment figure, but she’s not as politically experienced, I suppose, in terms of winning elections.

Shahin Vallée (40:51):

She’s an establishment figure. She was a minister to Nicolas Sarkozy for many years. She’s been the president of the region Île-de-France, which is the region around Paris. So, she’s respected. She’s managed to unify the party around her candidacy. So, I think she’s a serious candidate. She’s probably the most serious candidate from the Republican Party that Macron could have had. And she’s managed to do something that was not obvious, which is she’s managed to unify the party because a part of the party was prepared to leave to Zemmour and she’s managed to hold them back. So, she’s done a very good job, and she could be a real serious contender. And if she got to the second round, I think this is where the reelection of Macron could really be at risk. I tend to think that Macron would still win over her, but I think it will be a very slim victory.

Bilal Hafeez (41:36):

And what’s the difference in policy? So, let’s say Pécresse won. What’s the meaningful difference between the two policy-wise?

Shahin Vallée (41:43):

So, I think she will campaign on a much more aggressive tax cut agenda, economic reform, cuts in public spending. I don’t really believe she will deliver half of what she says. So, at the end of the day, I don’t think she will lead a radically different economic policy to the one that Macron has led. Where I think she would be marking a more substantial difference is on Europe. I think she would lead a far less pro-European policy than Macron has. And I think her election would make the relationship with Germany and with Europe more broadly a lot more difficult than Macron’s. So, on the domestic front, she will talk a great game of a more aggressive pro-business agenda, that she won’t be able to deliver, in large part because most of it won’t be realistic. She will talk about cutting public spending and cutting the number of public servants. I mean, she was a budget minister, by the way. So, her record as a budget minister and the record of Nicolas Sarkozy’s government that she served on that, I think, speaks for itself. So, I think there’ll be a great deal of talk about this, but not a lot delivered.

Bilal Hafeez (42:52):

Understood. Just before we leave France and go to Germany, one question I had was, I noticed that France and Italy have formed more of an alliance of late. Macron-Draghi had that special relationship meeting a few months ago. So, is anything significant there? Is there a new Axis forming? Is there France, Italy, Axis forming to offset Germany and the Dutch or something?

Shahin Vallée (43:12):

It’s been presented as such. I don’t really believe in it. I think, of course, with a prime minister like Draghi, it’s a lot easier for Macron to engage with Italy than it was when it was Conte or when we had a government where Salvini was running the show. So, I think there will be more cooperation and engagement with Italy than there was, but for the French in general and for Macron in particular, I still think the bilateral relationship with Germany supersedes almost everything. I would not underestimate, however, the possibility that in some limited instances, France is willing and able to open a front against Germany, which it had on a few issues along the way. But what’s interesting is that even when France leads an alternative coalition against Germany, at the end of the day, it always tries to present it still as something that can be disguised as a Franco-German agreement. And to me, for instance, we talked about the RRF and NGEU. It’s a great example. It was branded and explained to the public as a Franco-German initiative, because indeed, Merkel and Macron agreed to it in Paris. But in reality, before that, there had been a coalition led by Italy and France, working in the background, to which Germany was opposed in the first place until it finally caved. And when it caved, then France ditched Italy and presented it as a Franco-German deal. So, I would not underestimate the ability of the French government to play around the Franco-German couple, build alternative coalitions, use Italy when it wants to, but at the end of the day, I don’t think there is a break or move away from the centrality of the Franco-German relationship.

Germany in a post-Merkel world

Bilal Hafeez (44:52):

And we have to round off our discussion on Germany, of course. The first question I really have on Germany is how important is Merkel. So, not having Merkel on the scene, is that meaningful or not or the institution is such that it doesn’t almost matter? It’s easy to go for the great person theory of history. So, she was instrumental in keeping Europe together, and she’s a massive figure in Germany. So, what’s the significance of her leaving the top of political tree?

Shahin Vallée (45:14):

I think this is what’s great and frustrating about the German political system is that at the end of the day, I don’t think it will matter so much that she leaves. I think the German political system is so cohesive and works through consensus to such extent that the chancellor is the result of a multi-layered consensus building exercise through the lender and the federal government, inside the federal government, between the parties, between the parties and trade unions and the business sector. So, I think, the chancellor embodies a national consensus a lot more than the French president does for that matter. The French president is an executive authority in itself that can take decisions that are wildly unpopular. I think it’s very different in Germany. So, I don’t see her departure as being a mark and turn in history or in Europe. And that’s for the better and for the worse as well, because it means that I also don’t think that there will be a complete sea change in Germany’s policy, whether it is foreign policy towards Russia or whether it is the ability and willingness to engage in fiscal risk sharing and raise common resources. So, I think we will see a lot more continuity than we imagined.

Bilal Hafeez (46:29):

Okay. And now in terms of the current coalition that we have, so in Germany, for a long stretch of time, we had Merkel at the top and the CDU in charge in some coalition or not, centre right party now. Now, we have an alternative. We have the socialist, the greens, and the liberals. Scholz is obviously leading. What’s your take on this coalition? I mean, it’s bit of a strange alliance. The greens and liberals are the free market guys together in this coalition with the centre left party.

Shahin Vallée (46:57):

Yeah, it was not an obvious one to come together. I think the fact that the FDP, so the liberals, had a fairly poor score, I think, helped the deal in the sense that they could not have too many demands, but they managed to secure a very big victory, which is to hold the Finance Ministry. And so, I think the big question is the extent to which the FDP holding the Finance Ministry is going to block a number of European integration agenda, whether it is reform of fiscal rules, the raising of common resources, or whether that’s something that, in fact, will be managed by the Chancery directly. And therefore, where we could have a slightly more flexible than the line that Christian Lindner would hold on his own. So, I think that remains to be seen. And I think there’s going to be a lot of infighting inside the coalition. What’s beautiful about the German system is that a lot of the hard issues have been hammered in the coalition agreement. So, presumably, they’re settled for the next five years. But these coalition agreements also always leave some room for interpretation and space for political infighting. So, there will be. And in fact, you already see that you have a Finance Ministry that is led by the FDP and Christian Lindner and you have an Economic Ministry that is being led by Habeck, which is going to fight a lot and create a counterweight. So, you’re going to have an internal discussion on economic policy, which I think is the topic where there is less consensus and the Economy and Finance Ministry will fight a lot. And that will be arbitrated at the end of the day by the Chancellor. And I think that’s a fairly healthy political situation.

Bilal Hafeez (48:29):

I mean, one question that’s come up on the fiscal side is that it seems like the coalition has committed to balanced budgets, the black zero, but many people are talking about how they may still do some fiscal spending in an off balance sheet way by classifying it differently through some counting gimmicks or credit guarantees and those sorts of things. So, we could still see loosening on the fiscal side. What’s your take on that?

Shahin Vallée (48:53):

Yeah. So, I was militantly advocating for a real discussion about reforming the constitutional debt brake during the campaign in Germany and have lost that battle. Even the most progressive forces in Germany were telling me, “Listen, we’re not going to discuss the constitution, but we can find loopholes.” And so, the fight has been concentrated on identifying and using and abusing these loopholes. And so, I think there is some space for fiscal loosening by trading off balance sheet vehicles, by using some of the spending agreed under COVID that was not spent. My fear is twofold here is that the loopholes exist and can be used, but they’re not going to change the face of Germany’s fiscal policy fundamentally. Especially in the face of acute investment needs in the green energy transition, I don’t think Germany is going to get a lot of extra fiscal space over and above the required investment for the green transition. I think that’s prominent. The second aspect that I find concerning is that by virtue of avoiding a conversation about the national debt brake, you’re also making it harder to have a discussion about the European fiscal rules which also have to be reformed. And so, the reason why I cared so much about a discussion in Germany about the constitutional debt brake was that if and when Germany would have that conversation, it would free up and enable a conversation about European fiscal rules as a whole. And that matters greatly for the aggregate fiscal sense of the Euro area, which I worry in the absence of a real debate on these rules, will by the forces of gravity return to a fairly procyclical adjustment, which I don’t think Europe should take the risk of in the current macroeconomic context.

Bilal Hafeez (50:34):

That’s great. Now, I just want to round off with a few personal questions I like to ask all my guests. What’s the best investment advice you’ve ever received?

Shahin Vallée (50:43):

So, when I was at Columbia, I was taking a lot of classes at the Columbia Business School and I had a professor called Paul Tierney who had been very successful. He said, “What made me so successful is not so much the investments I’ve made. It’s the investments I have not made.” So, not losing money and being able to walk away from something is sometimes more important than having the right call. And so, I think the way I apply this lesson is that I don’t touch cryptocurrencies for instance that has not proven to be a great choice so far, but I stick to it.

Bilal Hafeez (51:17):

We’ll have to have a separate conversation about your reason for crypto, but the other personal question was on productivity hacks that you may have. Obviously, you’re very knowledgeable. You know everything about everything. I mean, how do you keep on top of everything? Do you have a system? Do you have a set routine? What’s your approach?

Shahin Vallée (51:32):

No, I wish I had a system and a routine. No, I’m actually less organised than that. I think the thing that has changed my work quite a bit is Twitter. I actually find Twitter to be now almost an indispensable tool. It allows me to screen very quickly the news to see who’s saying what about what. I have found that a very powerful centralised place to get my information.

Books that influenced Shahin: Lords of Finance (Ahamed) and The Alchemy Of Finance (Soros)

Bilal Hafeez (51:53):

Yeah, no, that’s true. And what I like in particular is that Google Translate is very good to be able to read your tweets or other people’s tweets in different languages. And then the final personal question was just in terms of books. Are there any books that really influenced you?

Shahin Vallée (52:06):

Yeah, there are quite a few. One book, Lords of Finance, which tells the story of basically the financial crisis in the ’30s. And I think this has been a formidable to understand how public policy is made, how policy mistakes are made. So, I found that a fascinating account of international economic policy coordination during the interwar period basically. So, I really love that book. It was by Liaquat Ahamed. And I found some of George Soros’ books quite influential as well on financial issues. I’ve been a keen reader.

Bilal Hafeez (52:41):

Yeah. And if people wanted to follow you and your work, what’s the best way for them to do that?

Shahin Vallée (52:46):

You can follow me on Twitter, I think. I don’t have all of my work available there, but I think that gives you an idea of what I do. And follow me as well under DGAP website, where I publish things and working papers and policy briefs there as well. And feel free to contact me as well.

Bilal Hafeez (53:02):

And you have a Substack as well, I believe.

Shahin Vallée (53:04):

Yes, I have a Substack account as well. Yeah.

Bilal Hafeez (53:07):

I’ll include links to all of these as well in your show notes. You’re not promoting your substack that well aha, that’s the whole point. Well, with that, I mean, it was great speaking to you. Huge amounts to learn in our conversations, and let’s stay in touch. I mean, I follow you very closely on Twitter.

Shahin Vallée (53:20):

Yeah, no, thanks for your time, and I really enjoyed the discussion.

Bilal Hafeez (53:24):

Thanks for listening to the episode. Please subscribe to the podcast show on Apple, Spotify, or wherever you listen to podcasts. Leave a five-star rating and a nice comment and let other people know about the show. We’d be super grateful. Also, sign up to become a member of Macro Hive at macrohive.com. We’ll be back soon, so tune in then.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)