In the wake of the Global Crisis of 2008, the Eurozone experienced a prolonged period of weak economic activity and very low inflation. Eurozone real GDP per capita was only 0.5% higher in 2016 than nine years before, in 2007. The annual rate of change in the GDP deflator has not exceeded 1.3% since 2008. To stabilise the economy, the ECB has lowered its policy rates near zero and engaged in multiple kinds of unconventional monetary policy. At the same time, fiscal policy has been mostly non-accommodative. The primary budget balance of the Eurozone as a whole has improved each year starting in 2010, including in 2012 and 2013, two years in which output contracted.
Appropriate stabilisation of large business cycle shocks requires monetary and fiscal policy
The scope for a common fiscal policy in EMU is the subject of an ongoing debate (e.g. Eichengreen and Wyplosz 2016, Tabellini 2016, and other contributions in Baldwin and Giavazzi 2016). In a recent paper, we review the business cycle models commonly used in academia and policy institutions with an eye to formulating lessons for business cycle stabilisation policy in the Eurozone (Corsetti et al. 2016). A key takeaway from the literature is that in the wake of a large recessionary disturbance, such as the financial crisis of 2008, accommodative monetary and fiscal policy together may be necessary to stabilise economic activity and inflation. In the words of Bernanke (2015: 504), in the aftermath of the financial crisis “(…) the Fed, especially with short-term interest rates close to zero, couldn’t do it alone. The economy needed help from Congress (…).” While the former Chairman of the Federal Reserve was writing about the US, his observation applies equally to the Eurozone. Motivated by the policy proposal in Sims (2012) and own research (Corsetti and Dedola 2016, Jarociński and Maćkowiak 2017, Schmidt 2016), our paper describes practical ways for the Eurozone to be able to implement an effective monetary-fiscal policy mix.
Our point of departure is the fact that public debt typically rises after a recessionary disturbance and fiscal policy faces a trade-off between business cycle stabilisation and keeping debt on a sustainable path – a trade-off that can be especially consequential if monetary policy becomes constrained by the lower bound on nominal interest rates for a long time. With a fiat currency, the monetary authority and the fiscal authority can coordinate to ensure that public debt denominated in that currency will not default, namely, that maturing government bonds will be convertible at par into currency, just as maturing reserve deposits at the central bank. With this arrangement in place, fiscal policy can focus on business cycle stabilisation until a recovery has been achieved and the central bank is no longer constrained by the lower bound. In the institutional arrangements of the Eurozone at the onset of the crisis, by contrast, an increase in national public debt after recessionary disturbance could give rise – and has indeed given rise – to fears of debt restructuring or default. As shown by the recent experience in the Eurozone, these fears make debt sustainability an overriding concern at the expense of business cycle stabilization, long before a recovery is achieved.
To make matters worse, expectations of debt restructuring or default can be self-fulfilling – a problem that became apparent at the peak of the European crisis in 2011 and the first half of 2012. While since then member states have been able to gain protection from speculative attacks on their debt through the European Stability Mechanism and via the ECB’s Outright Monetary Transactions programme, as a pre-requisite they must eschew accommodative fiscal policy. In principle, of course, countries can also prepare for ‘bad times’ by reducing public debt in ‘good times’. However, the reality is that a number of member states entered the euro with sizeable public debt, reducing debt is costly, and debt can rise rapidly in a recession (as the experiences of Ireland and Spain demonstrate).
A fund for the Eurozone
We attempt to define the conditions necessary for the Eurozone to have an effective business cycle stabilisation policy. We organise the discussion around an example of a specific – by no means the only possible – institutional setup. Its main features can be summarized as follows. Consider a centrally operated fund, similar to the European Stability Mechanism, able to issue non-defaultable debt (‘eurobonds’). By ‘non-defaultable’ we mean that the fund and the ECB would agree that maturing eurobonds, issued as part of a concerted policy intervention, would be convertible at par into currency, analogously to maturing reserve deposits at the ECB. The fund would stand ready to purchase national public debt, so long as a member state met predefined criteria concerning the national budget (conditional on the state of the economy). In so doing, not only would the fund shield member states in compliance with the fiscal criteria from self-fulfilling creditor runs, it would also help anchoring markets expectations about the level and dynamic of prices.
The fiscal criteria would be formulated so as to make fiscal accommodation possible following a recessionary shock, especially if the ECB policy rates had been reduced close to zero, while being consistent with long-run fiscal discipline for each member state. In particular, if a country were in violation of the fiscal criteria, the fund would be obligated not to lend to that country. The country could then restructure its debt as a last resort. Institutional procedures should be in place to help a country restructure in an orderly way (with the fund being treated symmetrically with other creditors) and, most importantly, without prejudice to full participation in the EU and the euro. After national public debt had been restructured, the fund would stand ready to resume lending if the member state satisfied the fiscal criteria again.
The fund would need to be subject to democratic control (e.g. the governing board of the fund could be elected by the European Parliament or the European Council) and, to protect its balance sheet, the fund should have a well-defined ability to tax uniformly across the member states (e.g. a VAT surcharge).1 In addition, seigniorage revenues of the Eurosystem could flow to the fund.
Once the fund was set up, there could be roles for it besides business cycle stabilisation. Specifically, the fund could act as a backstop for the Single Resolution Mechanism (SRM) and a Eurozone deposit insurance scheme. With a Eurozone-level backstop in place, the SRM would be able to wind down insolvent banks, including banks that had lost solvency due to restructuring of national public debt, while the common deposit insurance would act to prevent bank runs in all member states.
A number of existing proposals address some of the dimensions present in our discussion. We list a sample of these proposals in Table 1, highlighting differences and similarities to ours. It is worth stressing a key common challenge. To be fully effective, a plan for reform will need to address simultaneously three issues:
- First, how to set up a common fund or mechanism to reduce the vulnerability to sovereign risk in debt issuance and therefore relax the constraint on using fiscal accommodation in case of a large shock.
- Second, how to define fiscal criteria determining access to the fund-mechanism and, in case of failure, the need to restructure.
- Third, how to create a framework for orderly debt restructuring, without prejudice to full participation in the EU and the common currency.
Table 1 This proposal compared with other proposals featuring eurobonds or a Eurozone entity that would purchase national public debt
Note: * “Retires” means “converts into non-interest bearing perpetuities.”
One may note that, in effect, a non-defaultable eurobond already exists in the form of interest-bearing reserve deposits at the ECB. Furthermore, the Stability and Growth Pact (SGP) contains an ‘escape clause’ that essentially allows for the rules of the Pact to be suspended in periods of “severe economic downturn” for the Eurozone as a whole.2 Therefore, business cycle stabilisation policy could improve already within the existing institutional framework if, in the wake of a large recessionary disturbance, the ECB acted as the fund (by issuing reserves to purchase national public debt, as it has done as part of its asset purchase program) and if the SGP’s escape clause was applied until a recovery had been achieved. That said, a more explicit institutional arrangement, as outlined above, seems preferable in the medium and long run.
The fiscal rules of the SGP have been enforced, admittedly with limited success, by the European Commission and the European Council. The governing board of the new fund, given a democratic mandate and a limited, clear objective (to safeguard the fiscal criteria), could be expected not to yield to possible pressure and not to lend to a member state violating the fiscal criteria. Countries would have an incentive to comply with the criteria: doing so would guarantee the ability to run something close to optimal stabilisation policy, whereas violating the criteria would necessitate borrowing only from private creditors and raise the possibility of costly debt restructuring.
Making sure that the Eurozone is equipped with efficient instruments and procedures to shield economic activity from large adverse shocks, whatever their origins, is clearly a priority in the current process of institutional development. In light of the recent crisis, the costs of an incomplete monetary union are apparent – as are the gains from making fiscal and monetary stabilisation policy more effective.
In our setup, the Eurozone would be somewhere in between the two polar cases of a deep fiscal union and ‘fiscal renationalisation’. Each member state would need to abandon some sovereignty (think, for example, of the fund’s ability to tax), while gaining it in other areas (the fiscal criteria could be defined in general terms, with specific decisions about fiscal policy and decisions about structural reforms left to individual member states). A deep fiscal union is neither a necessary nor a sufficient condition for effective stabilization policy. In particular, a deep fiscal union committed to a balanced budget rule would aggravate, rather than smooth out, the business cycle. Similarly, national fiscal policies forced to tighten in a downturn – a pattern likely to arise under fiscal renationalisation – would make the business cycle more volatile.
Authors’ note: The views expressed in this column are those of the authors and do not necessarily reflect the views of the ECB.
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 A back-of-the-envelope calculation suggests that the present discounted value of a 0.5 percentage point Eurozone-wide VAT surcharge is equal to €1.2-1.7 trillion euros.
 The ‘escape clause’, introduced to the SGP in 2011, allows member states under the SGP’s preventive arm, in periods of “severe economic downturn” for the Eurozone as a whole, to deviate from adjustment paths to medium-term budgetary objectives; moreover, under the corrective arm, excessive deficit procedure deadlines can be extended. The escape clause has so far been neither operationalized nor applied (see Kamps et al. 2017).