As crises progress, structural and governance issues tend to become increasingly important. Foremost in the Eurozone is the thorny issue of the budget, which continues to be the Achilles’ heel of European construction.
The eurozone is an incomplete monetary union: a combination of a single monetary policy and independent, and often uncoordinated, fiscal policies that are suboptimal. It is natural that in times of crisis we see the inefficiency of the institutional framework.
At the same time, the goals set for public work are increasingly ambitious. Governments are expected to fund the energy transition, to ensure investments in infrastructure, education and health, and to play a stabilizing role in downturns. Central banks are expected to ensure price and financial stability, but also to reduce financial fragmentation while helping to finance the energy transition.
This is squaring the circle: too many goals for a limited number of instruments, with even tighter constraints – ensuring price stability and debt sustainability. The situation has become inextricable for governments and central banks. The combination of external supply shocks and “uncertainty shocks” are weighing on the economic outlook for the Eurozone, which is facing, for the first time in its history, stagflationary pressures.
On the monetary level, a broad consensus has emerged over the past decades about following predetermined rules. Taylor’s rule was gradually imposed. But it seems insufficient or incomplete. There is no point in raising interest rates (vigorously) to reduce price pressures caused by a supply shock, except to consider that spillover effects on wages and the general price level are inevitable.
At the budget level, the rules of the Stability and Growth Pact are outdated. There is no real basis for identical numerical limits for each country in terms of debt (60% of GDP) and deficit (3% of GDP). These rules have proven pro-cyclical in the past. And the sanctions did not work.
However, it would be wrong to conclude that a purely discretionary disposition leads to better public decisions. Because the absence of rules can lead to increased financial and macroeconomic volatility. It remains necessary to establish market expectations. Yes but how ? Monetary normalization can only be achieved if a coordinated approach is adopted at the financial level (shock absorber). A strict separation between the rules of fiscal policy and monetary governance is ineffective.
We “by chance” experienced a period of tacit coordination during the Covid crisis. Indeed, while stimulating lowering inflation, the European Central Bank (ECB) was able to loosen its monetary policy, which lowered the cost of borrowing and allowed fiscal policy to absorb the shock. It is now urgent to consider clearer coordination methods.
In the event that it is not possible to provide a ready-made solution here, there are certain methods worth considering. Of course, the independence of the European Central Bank cannot be questioned. But nothing prevents him from interpreting his mandate differently. On the one hand, it could more explicitly take into account the origin of the inflationary shock (supply or demand) in Taylor’s “increasing” rule. Second, and above all, you must agree to separate its policy of buying securities from its policy of prime rates.
But to do so, the interpretation of the Stability and Growth Pact must be reviewed beforehand. Most of the EU countries can agree on a few key (existential) goals and on the fact that there is more to lose collectively by not achieving them than by increasing Europe-wide debt. To ensure the sustainability of the national debt, examination of the primary balance, debt burden, initial level of debt and the ratio of public expenditure to GDP should play a role in analyzing the efforts required. This means that country-specific rules will ultimately be more appropriate (and binding) than a single deficit-based rule.
In addition, multi-year national spending plans must be developed that commit governments to increase recurrent spending at a rate lower than real GDP growth, while protecting investment spending. The focus should be on aggregates that are controlled by governments and are measured unambiguously. Only a pragmatic, coordinated and innovative approach by governments and the European Central Bank will allow them to meet the challenges.