New CEPR Policy Insight - Euro area policy mix: From horizontal to vertical coordination
A new CEPR Policy Insight by Marco Buti and Marcello Messori argues that the forceful policy response of the EU and its member states to the COVID Pandemic, and in particular the move to a more structured ‘vertical’ coordination between national and EU fiscal policies, has led to a more balanced euro area policy mix, which has allowed the rapid absorption of the euro area’s dramatic recession and favoured a strong bouncing back of its economy in the current year.
Moving forward, the authors argue that transitioning to a structured vertical coordination between national and EU budgets would help ensure an adequate fiscal stance for the future, and avoid the overburdening of the single monetary policy.
Marco Buti (European Commission) and
Marcello Messori (LUISS School of European Political Economy)
The Policy Insight analyses the evolution of the monetary-fiscal policy mix in the euro area since its inception, and demonstrates how euro area policymakers have had to confront a ‘policy mix trilemma’: one cannot have, at the same time, (a) asymmetric fiscal rules of the Maastricht type, (b) monetary policy constrained by the effective lower bound (ELB), and (c) no central fiscal capacity.
The authors detail how in the pre-pandemic era, first a period of weak monetary dominance existed during the euro area’s first decade (1999-2007), followed by a short episode of coordinated expansion at the outset of the global financial crisis, and later sui generis fiscal dominance prevailed during and after the sovereign debt crisis (2011-2019).
Figure: How the policy mix trilemma has been solved so far
Sources: authors' elaborations.
During the pandemic, however, there was a much more forceful monetary and fiscal response than in previous crises. The result was that the policy mix trilemma was resolved by the ECB’s attainment of the ELB and by the implementation of a central fiscal capacity. The combination of national and EU budgets, coupled with the rapid and determined ECB measures, led to a more expansionary policy stance. Crucially, and for the first time, the EU rules-based framework has been complemented by direct policy support at the central level. The ECB adopted the Pandemic Emergency Purchase Programme and strengthened its utilisation of other monetary tools, and national fiscal authorities implemented sizeable fiscal expansions on the back of the suspension of the Stability and Growth Pact’s adjustment requirements via the General Escape Clause and the temporary state aid framework. Most importantly, the Union agreed on a programme of direct support via the EU multiannual balance, Next Generation EU (NGEU), which had at its core the Recovery and Resilience Facility.
This exceptional policy response entailed a more congruent policy mix, which was instrumental in maintaining the financial cohesion of the euro area and enabling a strong economic recovery in 2021. However, the authors argue, given the one-off nature of NGEU and the large accumulation of government bonds in the ECB’s balance sheet, even this solution of the trilemma is temporary and does not ensure future stability. Crucially, however, the measures taken during the Covid-19 crisis do have the potentiality to pave the way for the post-pandemic solution of the trilemma through a robust policy mix entailing horizontal and vertical coordination.
Going forward, future coordination between EU-level and national fiscal policies is crucial, notably with the setting up of a permanent central fiscal capacity that would enable an adequate fiscal stance and a more balanced policy mix to overcome the risk of fiscal dominance. In this new policy mix with vertical fiscal coordination, unconventional monetary policy would not be constrained to support the sustainability of national fiscal policies and, thus, it would avoid falling into a distortionary fiscal dominance condition. Subsequently, this would ease the gradual winding down of the government bonds accumulated in ECB’s balance sheet, when required by monetary policy considerations. As a result, the ECB will be able to escape the effective lower bound as well as a distortionary and unsustainable composition of its assets.
It is clear that such coordination requires building a central fiscal capacity within a coherent ‘European budgetary system’. The EU’s present governance is, however, currently inadequate. The authors suggest three non-mutually exclusive innovations to address this issue in the future:
- creating a central stabilisation function
- increasing the supply of EU public goods and
- setting up conditional transfers from the EU budget.
For any of these reforms to materialise, a credible and robust implementation of Recovery and Resilience Programmes is a conditio sine qua non.
Overall, the findings in this Policy Insight can help European policymakers effectively tackle the policy mix trilemma of asymmetric fiscal rules, no central fiscal capacity and constrained monetary policy in the post-pandemic economy. The outcome of these policy decisions will likely define the resilience of the euro area in the face of future shocks and the transition to a more sustainable growth model.
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