The euro zone must not return to its pre-crisis “normality”
Lorenzo Bini Smaghi, former executive director of the European Central Bank, explains why the former German finance minister recent surge because a return to “normal” is ill-advised.
As the recovery strengthens, discussions have started in Europe on how and when monetary and fiscal policies should ‘get back to normal’. Wolfgang Schäuble, the former German finance minister and current president of the Bundestag, recently stressed in the FT the need to restore fiscal rules as soon as possible.
His statements were made in an attempt to pressure heavily indebted countries to reduce their budget deficits and avoid moral hazard – a line of thinking similar to that before the pandemic. Still, that assumes the years before Covid-19 were ‘normal’. They were not. In fact, they weren’t even good.
In 2019, euro area GDP growth slowed (to 1.3 percent), inflation hovered around 1 percent – well below the level consistent with price stability – labor productivity stagnated and the overall current account continued to register a surplus of over 3 percent. percent of GDP. For many European citizens, especially its young people, this capped a decade that had indeed been lost.
This situation was not only irregular, but unsustainable.
It was generally accepted that before the crisis, the mix between monetary and fiscal policies was unbalanced. The European Central Bank relaunched its asset purchase program in September 2019 to counter deflationary pressures, while the overall fiscal stance remained relatively tight, with an overall primary surplus of around 1% of GDP (vs. 2.5% deficit in US). Fiscal policies differ from country to country. While debt (relative to GDP) was gradually declining in some countries such as France, Italy and Spain, in others, notably Germany and the Netherlands, it was declining rapidly due to significant budget surpluses.
Subsequent ECB presidents Mario Draghi until October 2019 and then Christine Lagarde have repeatedly called for a more balanced and favorable fiscal policy to reduce the burden on the central bank. Just before the pandemic, in January 2020, Lagarde recalled that “governments with budgetary room for maneuver must be ready to act in an efficient and timely manner. In countries with high public debt, governments should pursue prudent policies and meet structural balance targets … ”
Schäuble is therefore wrong to suggest that a return to normality should only concern highly indebted countries. It should also affect those who have consistently pursued excessively restrictive fiscal policies, thus creating an unbalanced policy mix in the euro area.
The German constitutional debt brake, introduced in 2009, is particularly relevant in this regard, given that it accounts for around a third of euro area GDP and the role played by the German Bund as a “safe asset”. In the global financial system. The rule’s implementation led to primary surpluses year after year from 2011 to 2019, producing a debt reduction of over 20 percentage points, the largest of any major advanced economy. As a result, the total outstanding German negotiable debt fell by € 110 billion over the period. Excluding compensation for the amount purchased by the European system of central banks as part of quantitative easing, floating debt on the markets is down by € 442 billion in seven years. That’s over a third! No wonder Bund yields turned negative.
According to recent projections, the re-establishment of the debt brake in 2023 would bring the debt-to-GDP ratio below the 60% required by the Growth and Stability Pact, the economic rules of the euro zone, in less than five years. Net of planned central bank holdings, the total amount of Bunds traded on the markets would decline by another 150 billion euros compared to 2019. At a time when net savings have increased globally, this would have a major deflationary impact in the financial markets.
The ECB will have to think about how to adapt its policies to the new environment. One question, to consider in its next strategic review, is whether it is still wise to base its purchase of assets in different countries on the share of its capital key. A switch to another approach, such as buying on the basis of negotiated debt shares, would be frowned upon in Germany. Yet the country’s economic policies could end up leaving the central bank little choice.
Schäuble invokes the ghost of John Maynard Keynes to support his argument. Yet if Europe is serious about taking Keynes’ advice, which is a call on governments to increase spending in times of economic hardship, it should revise its fiscal policy framework more symmetrically. The Stability and Growth Pact aims to avoid excessive budget deficits and high debt-to-GDP ratios. It should be amended to also discourage excessive budget cuts which can also result from inflexible national debt breaking. Otherwise, the euro zone could fall back on the same disappointing results that prevailed before the pandemic.