Gobernador. Webinar de la Comisión Europea. "A complete institutional architecture for a stronger policy mix" (715 KB)

03.12.2021

A complete institutional architecture for a stronger policy mix

"A stronger policy mix for the euro area?" - European Commission webinar

organised by DG ECFIN Directorate for Macroeconomic Policies

Pablo Hernández de Cos

Governor

The COVID crisis has tested the European project in unprecedented ways. The policy response, a successful monetary and fiscal policy reaction, informed by a euro area (and EU-wide) perspective, has been unprecedented too. Given the exogenous roots of the crisis, the need to respond with a balanced fiscal-monetarypolicy mix was clear. And its depth facilitated the adoption of far-reachingpolitical agreements that allowed the incomplete institutional nature of the Economic and Monetary Union (EMU) to be temporarily overcome, in particular through the deployment of some significant pan-Europeanfiscal instruments. To mention the most important, let me highlight the NGEU programme, and also the unemployment scheme SURE.

The need for a policy reaction from the aggregate angle was quite clear on this occasion. This is a novelty when comparing with the two previous crises, the GFC and the European sovereign debt crisis, when the endogenous roots of the shock showed a fundamental need for reform and action at the national level, that was only subsequently reinforced by some important steps aimed at pushing forward the overall euro area (and EU) architecture.

Let me start by reminding us how we got here.

Under the Maastricht Treaty, the design of EMU had two core elements: an independent common central bank targeting price stability, and a framework to coordinate national fiscal policies. The former was entrusted with monetary policy, while the latter was based on a set of fiscal rules geared towards ensuring that national fiscal policies did not endanger the price stability mandate. This meant that Member States could no longer rely on monetary policy to stabilise asymmetric economic shocks (domestic, or common with highly uneven domestic effects), while the exchange rate could not act as an adjustment mechanism between countries. Instead, they had to rely on additional adjustment channels, such as capital and labour mobility, and, especially, countercyclical fiscal policy.

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In addition, the set of fiscal rules included in the Treaty acknowledged that the fiscal behaviour of one country would affect the rest of the members and the monetary union as a whole. In particular, unsustainable fiscal policies in one country could generate economic and financial instability across the monetary union and influence the single monetary policy. Thus, the Treaty stipulates that Member States should avoid excessive deficits, and that the European Commission should monitor public finances to identify significant deviations that could endanger the macroeconomic and financial stability of the monetary union.

In practice, the Protocol operationalises these principles by means of two quantitative reference values: 60% for the ratio of government debt to GDP and 3% for the budget deficit-to-GDP ratio. The quantitative limits were defined taking into account the average economic situation prevalent at the end of the 1990s. In particular, annual potential GDP growth of 2% and an inflation aim of around 2%, together with a budget deficit limit of 3% of GDP, would stabilise the ratio of government debt to GDP at 60%.

The experience since its approval has shown that the design of the Maastricht Treaty left significant gaps in the governance of the euro area. In particular, these gaps have a significant bearing on the proper functioning of the policy mix.

First, due to the simplicity of the framework, the original rules did not take into account that the cyclical position of countries affects the headline deficit. Subsequent reforms tried to address this, at the cost of increasing complexity and relying on (initially praised, but now maligned) unobservable variables. But, in any case, as can be seen in the left-handchart of slide 3, the experience of recent decades has been one of pro-cyclicalcompliance with the rules, resulting in undesirable tightening during downturns and insufficient accumulation of buffers during upturns.

Moreover, despite its focus on debt sustainability, the framework did not avoid a general increase in debt (as can be seen in the right-hand figure in slide 3), which has, in any case, been a trend common to most advanced economies. Having to deal with multiple objectives (countercyclicality, long-run growth, debt sustainability), fiscal policy, in most cases, failed to deliver satisfactorily on any of them.

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Second, the original design was not well-equipped to prevent the build-up of domestic macroeconomic imbalances with the potential to generate serious economic and financial instability for the euro area as a whole. The European Semester and the

Macroeconomic Imbalances Procedure were established after 2010 to address this issue, but the experience so far seems to be mixed.1

Third, beyond what was stipulated in the no-bail-out clause, the Treaty did not

envisage the creation of a crisis management framework. This was partly addressed later through the creation of the ESM in 2012 amid a very serious sovereign debt crisis affecting some of the largest economies of the European Union.

Finally, and quite importantly, the Treaty had not envisaged the need for significant aggregate fiscal action to smooth the cycle and assist the common monetary policy.

This was evident, for example, during the low inflation period after the euro area sovereign debt crisis, when the degree of coordination of fiscal policies provided for by the fiscal framework fell short of the aggregate stimulus that was needed to complement monetary policy. And, also as a consequence of this lack of pre-established aggregate fiscal tools, during the COVID crisis, an ad-hoc response had to be adopted, in the form of temporary, centralised fiscal instruments. First of all, the general escape clause in the SGP2 was activated, permitting a very expansionary fiscal stance at the country level. Second, emergency assistance to countries was provided, without strict conditionality and at favourable interest rates, through the SURE and the Pandemic Credit Line of the ESM. Third, the NGEU provided funds to countries, earmarked for investments in digital capacities and the fight against climate change, in exchange for the implementation of structural reforms.

This brief historical review can be summarised as follows: beyond its foundational components (independent monetary policy, focus on national debt sustainability, no- bail-out clause), the framework has been continually adapted to a changing environment.

1 See Efstathiou, K., and Wolff, G. B. (2019). What drives national implementation of EU policy recommendations?. Bruegel Working Papers and "Country-specific recommendations: An overview - September 2020", European Parliament Briefing.

2 Stability and Growth Pact.

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Let me now come back to the present and first discuss some unpleasant fiscal

arithmetic. The main idea in the Treaty for the conduct of domestic fiscal policies was that excessive deficit and debt levels were to be avoided. In this regard, it is well known that, over the long term, and for a given inflation rate, the primary balance that allows a given government debt-to-GDP ratio to be stabilised depends on the differential between the real interest rate and the real output growth rate, the so-called"r-g" gap. The wider this gap, the higher the primary balance needed to maintain a stable medium-term government debt-to-GDP ratio. Over the period 1995-1999, the r-g differential was positive and close to 2 percentage points. As I have mentioned before, the medium-term stabilisation of existing government debt levels at around 60% (with inflation at 2%) was consistent with running a headline deficit of around 3% of GDP (see left-hand side figure in slide 4). In the current context, however, the observed prevalence of negative r-g differentials (see the right-hand figure in slide 4) would be consistent with government debt levels stabilising at a higher percentage of output. Given this situation, it is legitimate to ask whether a government debt level above 60% is now the correct figure? The question is not easy to answer, and it will depend on national considerations (the economic fundamentals in the medium-term, the vulnerabilities and resilience of the economy) and, of course, the prevailing financial and monetary conditions.

Moreover, the current high levels of government debt evidence the difficulties of

transitioning to the medium-termdebt anchors. At present, converging towards a debt- to-GDP ratio of 60% would require a substantial fiscal effort over a prolonged time frame. Using the historical average values of real growth, inflation and interest rates, the euro area would need to maintain a fiscal surplus of 1.1% of GDP over 20 years in order to reduce the debt ratio to 60% (see left-hand side figure in slide 5). This is substantially higher than the average primary deficit of 0.4% of GDP observed since 1995. For this constant fiscal effort to be at more plausible values, the macroeconomic environment would need to be far more favourable than it has been in recent decades. For instance, in order to bring the debt-to-GDP ratio back to 60% in 20 years while maintaining a primary deficit in line with the historical evidence, real growth in the euro area would have to be twice its historical value (1.3% on average over 1995-2021), or alternatively the implicit rate on government debt would have to be half the current one (see right-hand side figures in slide 5). Although simplistic, these exercises illustrate the significant

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