Europe has rebounded nicely, if unevenly, after its last double-dip recession by relying on the monetary stimulus of the European Central Bank (ECB) and other central banks. Today, however, Europe faces a potential economic iceberg when its next recession hits, though this issue seems strangely absent from the debate over who should run Europe’s major institutions later this year. Because the ECB and other European central banks will not be able to provide sufficient macroeconomic stimulus in the next downturn, a boost will have to be forthcoming instead from fiscal policy in Europe. This is both good and bad news. On the monetary front, policy rates remain at zero or negative and the ECB has accumulated a sizeable €2.6 trillion (22 percent of euro area GDP) bond portfolio, complicating
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Europe has rebounded nicely, if unevenly, after its last double-dip recession by relying on the monetary stimulus of the European Central Bank (ECB) and other central banks. Today, however, Europe faces a potential economic iceberg when its next recession hits, though this issue seems strangely absent from the debate over who should run Europe’s major institutions later this year. Because the ECB and other European central banks will not be able to provide sufficient macroeconomic stimulus in the next downturn, a boost will have to be forthcoming instead from fiscal policy in Europe.
This is both good and bad news. On the monetary front, policy rates remain at zero or negative and the ECB has accumulated a sizeable €2.6 trillion (22 percent of euro area GDP) bond portfolio, complicating further large-scale asset purchases. Measured at the EU or euro area levels, Europe has averaged general government deficits in 2018 below 1 percent of GDP, with gross debts falling since 2014. Fiscal space is thus available to combat the next downturn. Lower interest levels in Europe in the foreseeable future give governments the capacity to carry extra debt, reducing constraints on Europe’s fiscal capacity.
The problem of course remains political. The EU and especially the euro area remain half-built houses without the institutions to decide and implement a common fiscal policy, a major handicap that will come to haunt Europe even more in the future.
Because the next downturn will likely come in the next five to eight years, during the tenure of Europe’s new incoming presidents of the European Commission and ECB, the views of Europe’s presidential candidates on the role of fiscal policy is especially pertinent.
As I have argued elsewhere, the next ECB president must not only be willing to use monetary policy to combat downturns but also effectively push member states to be more forceful in using fiscal policy for the same purpose.
All fiscal stimulus acts with a time lag. Speed is of the essence if the stimulus is to work. Europe cannot afford to invent new institutions through which to channel fiscal stimulus, as it did in 2010, which is why leadership at the European Commission may be crucial.
Fiscal expansion may not be such an easy sell. President Emmanuel Macron of France has scaled back his 2017 proposal for a new euro area budget, ruling out countercyclical purposes. The so-called Budget Instrument for Convergence and Competitiveness comes into being in 2021, but as a new euro area institution without its own expert staff or experience, it cannot—as the argument sometimes goes—easily be scaled up in the next crisis. The European Stability Mechanism (ESM) is another possible fiscal policy conduit for the euro area, but it remains able to lend conditionally to member states only in a crisis. Changing its governance may prove time consuming in a downturn, accompanied by concerns over its use of bailout resources. The euro area will therefore not have its own preemptive fiscal institutional capacity in the next downturn, leaving the European Commission to do the job.
A limited quasi-fiscal and countercyclical role for the European Commission is not entirely novel, as the EU’s so-called "Juncker Plan"illustrated in 2014. It used public sector financial guarantees from the Commission (and European Investment Bank, or EIB) and policy support to mobilize private investment capital. The Commission also helped Greece overcome its deep economic crisis by eliminating the requirement for member state cofinancing of EU-funded investments. But the next European downturn might require something more ambitious and innovative.
Any plan to rely on the EU budget and the European Commission for countercyclical fiscal purposes will be seen as politically far-fetched, just as the creation of crisis-driven institutions were in 2010 and afterwards. These included the European Commission’s European Financial Stabilization Mechanism (EFSM) alongside the euro area’s larger and better known European Financial Stability Facility (EFSF). At that time, the turmoil in euro area government bond markets unnerved policymakers, creating the political space to creatively use the EU budget to raise up to €60 billion through the EFSM.
But an important difference between then and the next downturn is that the latter may not push Europe to the brink of financial collapse and thus galvanize leaders into immediate action. Instead, the risk will be that Europe’s economy during and after the next recession turns slowly "Japanese," trapped in a persistent near-deflationary stupor of insufficient demand and near zero nominal growth rates. Since Germany will soon be below the Maastricht 60 percent debt/GDP criteria, it will hopefully be better attuned to the risk of such secular stagnation and (again) not block indispensable fiscal integration in Europe in the next downturn.
What could the next Commission leadership do? Perhaps farsighted member states will expand the next seven-year budget and set aside a large reserve for "unforeseen contingencies,"though such a step would be politically difficult. Maybe the Commission should copy the 2010 EFSM model on a grander scale and be able to issue new bonds to cofinance explicit stimulus spending to ensure public investment levels in member states will be maintained in the next downturn. Through such a "European Public Investment Mechanism"(EPIM), the Commission could provide member states with cofinancing (say 50 to 100 percent) to sustain spending on infrastructure maintenance in the next downturn, while cofinancing aggressive actions by member states to combat climate change or continue education expenditures. An expansive definition of what constitutes "public investment"could be adopted to ensure rapid spending not hamstrung by having to rely on "shovel-ready new projects."
The EU’s yield curve—the interest rate on longer-term compared with short-term debt—is negative until the maturity of five-year bonds. In a downturn, it would be negative at even longer maturities. Accordingly, the European Commission could mobilize significant resources in financial markets at low or no interest cost for a considerable time, enabling the absorption and amortization of the cost of incurred debt through the regular budget for many years. Or the Commission could roll over outstanding EPIM bonds for the foreseeable future. (The debt would also probably be eligible for ECB purchase, should the central bank decide to restart any quantitative easing program). An expected long-term improvement in performance of the European economy following a successful stimulus through an EPIM program (relative to a stagnation scenario without it) ensures the existence of member states’ tax revenue in the future to repay in the long run the additional spending incurred through the EU budget.
The traditional moral hazard issue would no doubt arise over cofinancing member states’ public investments. Would such assistance reduce the incentives of member states to get their own house(s) in order? The answer is of course yes. A cofinancing of public investment scheme would constitute new fiscal transfers in addition to those already called for in the EU budget. To avoid the moral hazard trap, the Commission should carefully identify projects that have high fiscal multipliers and public investment value and also ensure that member states trim expenditures elsewhere over the business cycle. Careful monitoring of member state budgets by the Commission would be in order—another reason why the Commission is probably technically best suited to establish and implement a new common countercyclical fiscal policy in Europe.
One thing is for sure—monetary policy exhaustion in the next downturn will force European fiscal policy back on the political agenda. Europe’s next generation of leaders had better think about their responses in advance.
1. Cutting policy rates further into negative territory will be counterproductive, serious legal risks surround the ECB buying a lot more government bonds, and buying a macroeconomically relevant amount of private euro-denominated assets would potentially saddle the ECB with unacceptable amounts of credit risks and expose the bank to charges of favoring individual firms in shallow markets.
3. I am indebted to my colleague Jeromin Zettelmeyer for making this point clear to me.