Editors' note: This column is a lead commentary in the VoxEU debate on EU economic policy and architecture after Covid.
The euro area is rebounding strongly from the Covid crisis. But this should not deviate attention from its chronically weak growth and inflation. Since the euro’s creation in 1998 and until 2019, euro area per capita GDP, measured at purchasing power parity, grew by about 10 percentage points less than in the US, core HICP inflation averaged about 1.3%, and the level of core HICP in 2019 was about 20 percentage points below the 2% trend. This is prima facie evidence of an insufficiency of demand, which is mostly due to the euro area’s asymmetric economic policy framework, focused on containing inflation and reducing public debt and deficits.1
The euro area’s economic policy framework was created in the early 1990s, when neutral interest rates were positive, the main risk was excessive inflation, and elevated risk premia in government bonds created ample room for expansionary fiscal contractions. The 1970s’ legacy of fear of inflationary bias of governments led to an economic policy framework with a strict separation of functions: monetary policy focused on cyclical stabilisation, and fiscal policy on debt and deficit reduction.
That framework was right for that world and helped avoid large policy errors, with the 3% deficit threshold becoming a powerful anchor. But that world no longer exits. Interest rates are zero and expected to remain so for several years, limiting the expansionary effect of fiscal consolidations, and the combination of low inflation expectations and the effective lower bound (ELB) constraint on interest rates create an asymmetric risk towards weak growth and inflation.
Today’s world requires an economic policy framework where monetary and fiscal policy can work together effectively to support inflation and growth, for two main reasons:
1. Effective macroeconomic stabilisation is a necessary condition for fiscal solvency. ‘Sound fiscal policy’ is not always equivalent to debt and deficit reduction – deficits and debt ratios must be instruments, not objectives, of policy. The perpetuation of the current fiscal policy framework focused solely on debt reduction could generate a vicious circle of weak growth, persistently low interest rates, and higher debt and deficits.
2. Fiscal space has increased with the secular decline in r*, which has lowered the debt service cost. Fiscal space is not defined by a level of debt, but by the relative demand for and supply of bonds. The last decades suggest that the demand for bonds is larger and more persistent than previously assumed2 – contrary to expectations, while public debts have risen interest rates have fallen.3 Thus, when economic growth collapsed because of Covid-19, fiscal policy was able to react forcefully.
The euro area’s economic policy framework has evolved in this direction. The ECB has purchased assets with maximum flexibility to offset deflationary pressures, the Stability and Growth Pact (SGP) has been suspended to avoid detrimental procyclical fiscal action, and Eurobonds have become a reality to enhance the stability of the euro area.
The euro area must now consolidate this transformation.4 This doesn’t mean assuming that the present economic setting of low inflation and very low interest rates will last forever. Rather, it means recognising that the focus must be on the policy mix, embracing the idea that the relationship between monetary and fiscal policy depends on the level of inflation (π) with respect to the inflation target (π*) and on the level of real equilibrium interest rates (r*), in a strictly symmetric fashion, as shown in Table 1 (see the discussion in Ubide 2020a and also in Bartsch et al. 2020).
Table 1 The optimal policy mix of monetary and fiscal policy
The euro area policy framework is designed for cases 1 and 2 in Table 1. It must be enhanced and adapted to be effective also in cases 3 and 4, which is where the euro area has been for a long while. The new ECB monetary policy strategy and the coming reform of the SGP are the key steps to create such an economic policy framework, which can deliver the optimal policy mix in both the euro area and each of its member countries.
The new ECB strategy, focused on symmetry and recognising that the ELB requires more persistent monetary accommodation, is a critical pillar because ensuring that inflation averages 2% over time is a necessary condition for the achievement of maximum sustainable growth, as persistently weak inflation and inflation expectations reduce the ECB’s ability to respond to negative shocks – which, in turn, is a necessary condition for fiscal solvency. But, from the starting point of the current inflation and interest rates, monetary policy will need the support of fiscal policy to reach its 2% inflation objective. Therefore, it must be complemented with a robust fiscal framework.
The reform of the fiscal framework, including the Stability and Growth Pact, must address two fundamental flaws:
1. The lack of tools to achieve the optimal fiscal stance for the euro area as a whole. The SGP is asymmetric, with detailed enforcement mechanisms to force countries to tighten fiscal policies but no mechanisms to force countries to loosen them.
2. The complexity, temporal instability, and procyclical bias introduced by the reliance on the output gap and structural balances to define the fiscal policy stance, which ignores the quality of fiscal policies, exacerbates hysteresis effects after large shocks, and enhances intra-euro area economic divergence.
These flaws can be fixed with four actions and a state-contingent fiscal policy rule. These four actions need not happen all at once. For example, a successful implementation of the Recovery and Resilience Plans is a necessary political condition to advance towards a permanent NextGen fund (see point 2 below).
1. Eliminate the 60% debt/GDP objective, which is arbitrary and introduces an undesirable tightening bias in fiscal policy.5 As Table 2 shows, from the current starting point, and considering favourable yet plausible and socially feasible paths for interest rates, growth, and primary balances, it is almost impossible to lower the debt to 60% of GDP in coming decades for the euro area and for several of its member states.6 The 60% objective should be replaced with country-specific recommendations based on the cyclical position of the economy (as per the state-contingent rule proposed below) and focused on raising the quality of fiscal policies and improving the long-term sustainability of its public finances.7
Table 2 Debt/GDP projections under different assumptions of (r-g) and primary deficit
2. Make the NextGen fund and the Eurobonds that finance it permanent, including the creation of new EU own resources to service the debt. Participation in this fund preserves public investment and reinforces the discipline of this new fiscal framework. The annual review and the national ownership of Recovery and Resilience Plans creates positive conditionality, as countries failing to deliver on their commitments would not receive disbursements from the NextGen fund. Furthermore, it ensures that countries don’t lose market access in a bad scenario, increasing fiscal space, allowing for cyclical stabilisation with national budgets and enhancing the stability of the euro area, as became clear during the Covid crisis.8
3. Introduce a Golden Rule principle for national budgets, with two elements:
a. Net public investment should be financed with debt, to prevent cuts to public investment during recessions. Public investment should include programmes that increase potential growth which are not financed by the NextGen fund. The specific programmes of the investment budget should be agreed between the member states and the Commission in the annual budget review.
b. A PAYGO rule for the current budget. Increases in current discretionary spending or tax cuts should be ‘paid for’ (offset with lower spending or higher taxes) on a five-year forward basis (the expected average duration of an expansion). The PAYGO rule would be suspended during recessions. A PAYGO rule introduces discipline, and the five-year forward period allows for a gradual adjustment. And the process of finding offsetting measures typically leads to improvements in efficiency.
4. Introduce mandatory spending reviews, performed by independent national fiscal councils, to improve the quality of spending as a condition for participation in the NextGen Fund.
These four actions should be complemented with a simple, state-contingent fiscal policy rule, focused on one instrument – the path of primary balances – and which would be the basis for the European Commission’s annual fiscal stance recommendations for each member state. This state-contingent rule achieves the right balance between supporting growth and inflation and ensuring debt sustainability.
1. While ECB interest rates are at zero (cases 3 and 4 in Table 1), the fiscal stance in each member state should be expansionary. Each member state, during the annual budget review process, will agree with the European Commission on a path of primary balances designed to reach its maximum employment and stabilise its inflation rate at the ECB’s objective as quickly as possible. By a composition effect, if each member state commits to reaching maximum employment and the inflation objective, the euro area will too. This reduces the odds of free-riding, whereby some member states fail to stimulate their economies enough. During this period, the debt/GDP ratio is a residual, which would increase or decrease depending on the nature of growth surprises – better-than-expected growth outturns will lead to opportunistic debt reduction.
2. When full employment has been reached, inflation and inflation expectations are at levels compatible with the ECB’s objective, and the ECB has started raising rates so that it has room to lower them in the face of a negative shock (case 2 in Table 1), fiscal policy should then shift its focus to debt reduction. Each member state, during the annual budget review process, will agree with the European Commission on a path of primary balances that, conditional on expected growth and interest rates, aims to gradually reduce the member state’s debt/GDP at least to the level prior to the previous recession.9 Considering that monetary tightening cycles typically last 18-24 months, this rule implies that fiscal policy would tighten the year after the ECB starts raising rates. Concerns about financial stability should be addressed with a robust macroprudential framework.
This state-contingent rule implies that, while the economy is in case 4 (as it is the case today), fiscal policy should remain expansionary until monetary policy has been able to tighten. To understand why, consider the symmetric case (case 1 in Table 1). When inflation is too high, both monetary and fiscal policy should tighten, but fiscal policy should remain tight until monetary policy has regained control of inflation expectations and can be eased again. Only once monetary policy declares mission accomplished on inflation should fiscal policy start easing. The same should apply when inflation is too low.10
This package of reforms creates an economic policy framework that can accommodate the economic heterogeneity of euro area countries and avoid exacerbating economic divergences, and is robust to all combinations of interest rates and inflation. The combination of a permanent NextGen fund and a state-contingent fiscal rule for national budgets provides the missing cyclical stabilisation and the ability to define the optimal fiscal stance at the euro area level, supporting the ECB in the pursuit of its mandate. The state-contingent fiscal rule provides much-needed fiscal forward guidance for economic agents, while the Golden Rule and the participation in the NextGen fund creates the right incentive structure for better-quality fiscal policies. The result will be an increase in the stability of euro area, a reduction in risk premium, and increased prosperity for all member states – so that the euro area doesn’t just bounce back, it bounces forward.
Author’s note: I would like to thank my former colleagues at the Peterson Institute for International Economics for countless discussions on this topic. The views or opinions expressed in this column are solely those of the author and do not reflect the views, policies, or positions of the author’s employer, Citadel.
Bartsch, E, A Bénassy-Quéré, G Corsetti and X Debrun (2020), It's all in the Mix: How Monetary and Fiscal Policies Can Work or Fail Together, Geneva Report on the World Economy 23, ICMB and CEPR.
Blanchard, O, A Leandro and J Zettelmeyer (2021), “Redesigning EU fiscal rules: From rules to standards”, PIIE Working Paper 21-1.
Buti, M and V Gaspar (2021), “Maastricht Values”, VoxEU.org, 8 July.
European Fiscal Board (2020), Fourth Annual Report.
Martin, P, J Pisani-Ferry, and X Ragot (2021), “A new template for the European fiscal framework”, VoxEU.org, 26 May.
Mian, A, L Straub and A Sufi (2021), “A Goldilocks theory of fiscal policy”.
Ubide, A (2015), “Stability bonds for the euro area”, PIIE Policy Brief 15/19
Ubide, A (2020), “Fiscal policy when interest rates are zero”, in The Euro in 2020, Fundación ICO.
Ubide, A (2020), “Memo to the European Commission on reforming Europe's economic policy to handle pandemic shock”, Peterson Institute for International Economics.
1 If the main cause was a decline in potential growth, which may have also happened, weak growth would have been accompanied by higher, not lower, inflation.
2 This could be due, for example, to elevated risk aversion which has increased savings. Mian et al. (2021) discuss this effect in a stylised model where government bonds provide a convenience yield.
3 Higher debt levels do increase interest rates. But there are other forces that swamp that effect (see the discussion of fiscal space at the ELB in Ubide 2020a).
4 For a wider discussion of recommendations for European economic policy post Covid, see Ubide (2020b)
5 As Buti and Gaspar (2021) state, the 60% objective has “no solid ground in either theory or empirical evidence. No such claim was made at the time (or ever)”.
6 These simulations only show favorable scenarios of (r-g). Obviously, any scenario with (r-g) ≥0 will show a worse debt outlook. Note that while these simulations show around 20% probability that the eurozone may reduce its debt/GDP to 60% by 2040, it also assumes no recession during those two decades, something very unlikely. Because of this near impossibility, the proposals to keep the 60% but enhance the flexibility of the path towards 60% would only dent the credibility of the EU policy framework.
7 This recommendation is similar in spirit to the use of standards in Blanchard et al. (2021)
8 This is the concept of Stability Bonds in Ubide (2014) and of a similar proposal in European Fiscal Board (2020). By boosting public investment on a multiyear basis and assuring market access for member states, it eliminates the need for a new euro area cyclical stabilisation tool. Of course, an increase in the size of the NextGen would make the framework more robust.
9 Using the primary balance as the instrument is economically equivalent to a spending rule net of taxes (as recommended by the European Fiscal Board 2020 and Martin et al. 2021) and makes the system consistent over time.
10 This framework fully respects central bank independence, as it relies on and supports the central bank meeting its mandate. In fact, a main risk of this framework is monetary dominance, where a premature tightening of monetary policy could induce an overly contractionary policy mix. The new ECB strategy, with its special focus on the ELB, reduces the odds of this adverse scenario.