The following chart illustrates the lack of coordination between monetary and fiscal policy in the euro area during and after the European sovereign debt crisis. The bars show the change in the primary budget balance as a percentage of potential output for the euro area as a whole. Positive numbers indicate a discretionary fiscal tightening, negative numbers indicate fiscal loosening. The red bars indicate the years when fiscal policy was procyclical and green bars the years in which fiscal policy was countercyclical. While fiscal policy was initially countercyclical during the global financial crisis, it turned procyclical during much of the European debt crisis. This reflected choices in fiscal policy that were often understandable from a national perspective. But, at a European level, these choices led to an aggregate fiscal stance that was not supportive to economic recovery. Monetary policy, on the other hand, was steadily accommodative during those years, as evident from the ECB’s expanding balance sheet. In the chart, this is shown by the solid white line. So during most of the sovereign debt crisis, monetary and fiscal policy behaved out of sync, rather than working in tandem to stabilize the economy.
Now let’s look in the same chart at what happened more recently, during the Covid crisis. This time, the policy response was entirely different. Both monetary and fiscal policy responded to the crisis with unprecedented heft and synchronicity. What helped, of course, was the much more symmetric nature of this crisis compared to the previous one. Every country in Europe was hit in a similar fashion, and in every country it was clear what the desired fiscal response should be. The ECB expanded its quantitative and credit easing instruments, as reflected by the strong growth of its balance sheet. This provided space to governments to increase fiscal spending, without triggering severe stress in sovereign bond markets. In fact, the aggregate discretionary fiscal stimulus in the euro area in 2020 has been estimated to be more than 4% of GDP. By comparison, the global financial crisis prompted a discretionary fiscal stimulus of about 1.5% of GDP.
I think this response to the Covid crisis offers important lessons for the fiscal architecture in the euro area. The successful coordination of fiscal and monetary policy was in great part due to the enormity of the economic threat as well as its symmetric nature. From the outset it was clear that we needed an all-out response from both governments and central banks to shield households and firms from income loss and avoid irreversible damage to the economy. Under these circumstances, policymakers decided to activate the general escape clause in the Stability and Growth Pact. The activation of this clause temporarily lifted all restrictions on fiscal policy. This helped prevent undue procyclical fiscal consolidations, such as during the sovereign debt crisis.
But shouldn’t an effective and concerted monetary and fiscal policy response also be possible under less dramatic circumstances than the Covid crisis? And wouldn’t we be better off with a framework that allows for more effective macroeconomic stabilization policies without needing to have recourse to an emergency clause that in effect requires the suspension of all fiscal rules? And if the answer to both these questions is yes, how do we ensure that we maintain a balanced macroeconomic policy mix in the EMU, during the current recovery phase and beyond?
Based both on theory and past experience, I think that, in order to make our monetary union more stable, we need a fiscal framework that enhances coordination between member states and allows for a better alignment of monetary and fiscal policy over the entire economic cycle. This requires sufficiently countercyclical fiscal policy also from a euro area wide perspective. Not only in bad times or when persistently low interest rates limit the scope for conventional monetary policy. But also in good times, so that governments reduce debt levels to pay for stabilization policies in the future. Repair the roof when the sun is shining, an integral element of countercyclical stabilization policy that often gets overlooked.
An enhanced fiscal framework to ensure stability of the EMU
As a central banker, it is not up to me to map out in detail how the EMU fiscal framework should be changed. That is a political decision. Nor would I want to give you the impression that I am advocating a complete overhaul of the framework. At the risk of repeating myself: fiscal policy serves many other legitimate objectives, and there are many constraints, especially in a monetary union where fiscal policy is and will remain primarily a responsibility of national governments. So the Stability and Growth Pact continues to serve an important purpose. My argument today is about evolution, not revolution.
What I will do is outline three features that I think would help to make the current framework more effective in allowing national fiscal policies to stabilize the economy at the euro area level.
And to encourage greater alignment between central bank and government policies.
First of all, we need a fiscal framework that would improve coordination of national fiscal policies within the economic and monetary union. The Next Generation EU fund is a big step in the right direction. It expands fiscal space across the union during a downturn and thereby allows the euro area fiscal stance to remain well-aligned to monetary policy. Furthermore, the fund’s expenditures are targeted at the most vulnerable regions and are focused on public investments that will help raise countries’ potential output. The combination of public investment and targeted structural reforms is needed to increase potential growth and make our economic and monetary union more resilient. We have seen, in the past, that growth-enhancing public investments are often first to fall victim to spending cuts.
That in itself is a major cost of the current fiscal framework. We still have a lot of work to do to make the Next Generation EU fund a success. But if it becomes a tangible success, it would of course set a precedent, with the promise of more to come.
Secondly, next to improving coordination of national fiscal policies, the SGP should be sufficiently flexible to allow for sizable and sustained expansionary fiscal policy, beyond normal automatic stabilization, if economic circumstances so dictate. As we discussed earlier, this is even more important in the current low interest rate environment. The activation of the general escape clause allowed for this flexibility during the early stage of the pandemic. And it may very well be needed in the face of another extreme event in the future. But a suspension of all fiscal rules should not be our only tool to achieve a balanced policy mix to deal with economic shocks. That’s because the emergency clause also has drawbacks.
The uncertainty about whether and when the clause is going to be activated makes the framework less predictable, and could discourage governments from engaging in countercyclical spending. Moreover, depending on the circumstances, a complete suspension of the framework could be too much of a good thing, if it hampers fiscal discipline. Finally, both deactivating and reactivating the clause could prove politically difficult. Therefore, flexibility should somehow be a more intrinsic feature of the system, and not one that arises only in emergencies.
So the European fiscal framework should allow for more coordination of national fiscal policies and more flexibility to deal with large shocks. In order for these two features to work, we need a third one.
A monetary union with multiple budgetary authorities requires sustainable national debt levels. Therefore, an enhanced fiscal framework should have robust and credible rules that make sure national governments keep their debt levels in check. Not only should member states build up sufficient buffers in good times. They should also increase potential economic growth that ultimately generates the debt repayment capacity. Economic life gets so much easier with half a percentage point more productivity growth! In many EU countries there is scope for structural reforms that would give a welcome boost to economic growth. Fiscal policy has an important role to play here by maintaining a sufficient level of public investment.
Ladies and Gentlemen. We are nearing the end of our journey. We’ve seen that the mix of monetary and fiscal policy matters for their effectiveness in stabilizing the economy. Especially when interest rates are persistently low and central banks have limited scope for manoeuvre. In that case, fiscal policy can play an important role, by raising aggregate demand and inflation. As the current low interest rate environment is likely to persist, we need a structurally larger role for fiscal policy in macro-economic stabilization for the foreseeable future. This does not replace, but should be assessed in conjunction with other fiscal objectives, such as debt sustainability and income redistribution.
The current fiscal framework in the EMU, despite its merits, is not well equipped to deliver that. The European sovereign debt crisis illustrated that very clearly. While the Covid crisis experience was more encouraging, it also revealed that fiscal flexibility is needed and has to be an integral feature of the framework, rather than an all-or-nothing button which may, or may not, be pressed in an emergency.
But more flexibility will only work if public debt is kept in check and the growth potential of our economy is enhanced. The European economic rulebook will have to be updated to facilitate this.
Does that mean that the Stability and Growth Pact, which our predecessors constructed thirty years ago, was bad economics? No, of course not. Against the economic backdrop of that time, it made perfect sense, and many elements continue to do so. But the economic landscape has shifted, and so have our views on macro-economic policy. Wasn’t it Keynes himself who once said:
“When the facts change, I change my mind. What do you do, sir?”
Of course, changing the rules takes time. What does that mean for fiscal policy in the meantime? Well, policymakers should continue what they started during the Covid crisis and use the current windfall of low interest rates to address the structural challenges our economies face. That will not only offer us a chance to improve the resilience of our monetary union, but also help to future-proof our economies.
Johan Witteveen was very critical of fiscal policy in Europe during the European debt crisis. I would have loved to hear his opinions on our discussion today. He would no doubt have added some profound insights, and probably have alerted us to some shortcomings in our thinking. And I would have liked the idea of him walking through the corridors of the Justus Lipsius building in Brussels, where the European finance ministers meet, to discuss policy issues and share his views.
Just as he used to do with my former colleagues at the IMF. Even if that’s no longer possible, his views on fiscal policy seem more alive than ever. Let them be an inspiration for us here, as well as for policymakers elsewhere in Europe, as we rethink the fiscal rules in our Economic and Monetary Union.