In July 2012 European Central Bank president Mario Draghi famously announced that the ECB would do “whatever it takes” to rescue the Euro. And he added: “Believe me, it will be enough.” In fact, it has so far been enough to avoid the break-up of the eurozone. It has, however, not been enough to push the eurozone out of the recession.
On August 22, 2014, Draghi again suggested something remarkable, which has not been in his initial official script: fiscal policy should take a much more active role in ending the recession.
Does the eurozone need a different fiscal policy? And if yes, will European politicians do whatever it takes? And will it be enough?
Why it is now time to act
First, many individual countries are still in deep recession, and with core countries like Italy and France increasingly suffering from unemployment, political support of the current crisis strategy is waning. The French government dissolution after a dispute over the austerity policy illustrates this clearly.
Second, the eurozone as a whole has still not recovered to pre-crisis levels, and Draghi diagnoses an overall lack of demand in the eurozone.
Third, Draghi argues that the recession is not only a temporary deviation from the eurozone growth path but that it lowers this growth path, with negative long-term consequences for living conditions and chances for people, especially the young.
Why the Eurozone needs a (different) fiscal policy
Fiscal policy must change. On the national level austerity policy has failed twice: in terms of reviving the economies and also in bringing down debt-to-GDP levels. On the eurozone level, the economy is doing much worse than the US and the UK while overall eurozone debt levels are much lower, suggesting room to manoeuvre for a eurozone fiscal policy.
Three points are important in assessing why fiscal policy needs to be changed now. They all have to do with the limits of monetary policy in the eurozone.
First, the ECB, like other central banks, is running out of its traditional ammunition, interest cuts. Policy interest rates are down to almost zero and cannot be lowered further.
Second, the situation is more complicated in the eurozone as the monetary transmission mechanism is not only impaired but also asymmetric: lending rates in problem countries remain high or are even increasing while decreasing in stable countries like Germany. Thus, problem countries are facing both monetary and fiscal tightening at the same time.
Third, and unlike the USA, UK and Japan, the ECB is not the lender of last resort to national governments, nor can it conduct quantitative easing by purchasing eurozone government bonds, which are non-existent. However, buying national debts of member countries is controversial and linked to a structural reform agreement of the member state with the European Stability Mechanism (ECM) – which countries try to avoid with a view on controlling their own (fiscal) policy agenda.
Will European politician do what it takes…?
Let’s assume that there will be an emerging consensus for less austerity, not least responding to the French and Italian demands. Will European governments and the EU Commission then do what it takes?
To start with, being more flexible within the rules of the Stability and Growth Pact by allowing individual countries higher deficits and longer adjustment time in return for some structural reform is something we can now reasonably expect.
However, addressing the overall lack of demand in the eurozone is more difficult.
Stimulating demand with fiscal policy of all eurozone countries in a coordinated way is difficult to engineer in a currency union with diverging business cycles. What helps Italy to recover could push the Italian inflation rates up to 1%, but German inflation to 3%. If this would be the result of an ECB monetary policy that aims at a eurozone average inflation target of 2% this would be acceptable to Germans.
In fact, it is part of the Maastricht agreement. However, if 3% inflation would be the result of a larger German fiscal deficit as part of a coordinated fiscal policy initiative, this will most likely meet fierce resistance in Germany as Oxford economist Simon Wren-Lewis has argued recently.
Thus, changing the overall fiscal stance is the critical part of Draghi’s suggestions and, not surprisingly, the ideas he voices remain either weak or vague.
Weak is the suggestion for budget neutral tax and expenditure cuts in areas where the stimulated expenditures overcompensate the demand reductions. It rests on assumptions about second-round multiplier and confidence effects and depends on proper implementation. It may or may not be helpful, but it is unlikely to be sufficient.
So we have to rely on the vague suggestions: “stronger coordination of national fiscal stances” and “complementary action at the EU level”. But as just argued, it is difficult to coordinate across a Europe of nation states with different needs. As for the “complementary actions”, Draghi relates loosely to the envisaged public investment program of the incoming EU-Commission president, which could contribute to ensure an “appropriate aggregate position”.
… and will it be enough?
Ironically, Draghi’s vague remarks may in the end be the strongest points for the future of the eurozone because they implicitly suggest the urgent need for a new structure of eurozone governance – more drastically than policy makers are willing to admit today. In plainer language than central bank presidents would employ, smarter fiscal co-ordination mechanism will have to replace the blunt Stability and Growth Pact, eurobond-financed eurozone public investments might see the light of day and provide the ECB with better monetary policy instruments, and the current balanced-budget fundamentalism should give way to a better golden rule for European fiscal policy.
The threats to the euro are now originating from politics inside countries. If right wing anti-Europeans like the French National Front will become a critical say in the near future, this may create a new and even more forceful speculative attack on the euro.
As I have argued earlier here, the critical issue is, how much fiscal autonomy the electorates of eurozone member countries are willing to give up in exchange for eurozone membership. Policy makers have a wild card: a careful re-design of fiscal policy and its coordination in the eurozone.
Not playing this card means, in the best case, prolonged stagnation. In the worst case we will be confronted with a break-up scenario – again. It is therefore wise to take Mr. Draghi’s remarks very seriously.