The eurozone must not return to its pre-crisis ‘normality’


Lorenzo Bini Smaghi, a former executive director at the European Central Bank, explains why Germany’s former finance minister’s recent push for a return to “normal” is misguided.

As the recovery strengthens, discussions have started in Europe on how and when monetary and fiscal policies should “get back to normality”. Wolfgang Schäuble, the former German Finance Minister and current president of the Bundestag, recently underlined in the FT the need to reinstate fiscal rules as soon as possible.

His statements were made with a view to pressure high debt countries to reduce their budget deficits and avoid moral hazard — a similar line of thinking as before the pandemic struck. Yet this assumes the years prior to Covid-19 were “normal”. They were not. In fact, they weren’t even good.

In 2019 eurozone GDP growth was slowing down (to 1.3 per cent), inflation was hovering around 1 per cent — far below the level consistent with price stability — labour productivity stagnated and the overall current account continued to register a surplus above 3 per cent of GDP. For many European citizens, particularly its young, it capped a decade that had been effectively lost.

This situation was not only irregular, but unsustainable.

It was generally recognised that prior to the crisis the mix between monetary and fiscal policies was unbalanced. The European Central Bank restarted its Asset Purchase Program in September 2019, to counteract deflationary pressures, while the overall fiscal stance continued to be relatively tight, with an overall primary surplus of about 1 per cent of GDP (against a 2.5 per cent deficit in the US). Budgetary policy diverged among countries. While the debt (with respect to GDP) was coming down gradually in some countries such as France, Italy and Spain, in others, in particular Germany and the Netherlands, it was falling rapidly as a result of large budget surpluses.

Subsequent ECB Presidents, Mario Draghi until October 2019 and then Christine Lagarde, repeatedly called for a more balanced and supportive fiscal policy to reduce the burden on the central bank. Just before the pandemic, in January 2020, Lagarde reminded that “Governments with fiscal space should be ready to act in an effective and timely manner. In countries where public debt is high, governments need to pursue prudent policies and meet structural balance targets…”

Schäuble is, therefore, wrong to suggest that a return to normality should concern only countries with high debt. It should also affect those that have consistently delivered excessively restrictive fiscal policy, thus creating an imbalanced policy mix in the eurozone.

The German constitutional debt brake, which was introduced in 2009, is particularly relevant in this respect, given it accounts for about a third of eurozone 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 reduction of the debt by over 20 percentage points, the largest of any major advanced economy. As a result, the total amount of outstanding marketable German debt fell by €110bn during the period. Netting out for the amount purchased by the European system of central banks under quantitative easing, the debt floating in the markets is down €442bn in seven years. That’s by more than a third! No wonder bund yields became negative.

According to recent projections, the reinstatement of the debt brake in 2023 would bring the debt to GDP ratio back below the 60 per cent required by the Growth and Stability Pact, the eurozone’s economic rules, in less than five years. Net of foreseen central bank holdings, the total amount of bunds traded in the markets would fall by another €150bn compared with 2019. At a time where net savings have increased at a global level, this would have a major deflationary impact on financial markets.

The ECB would have to consider how to adapt its policies to the new environment. One issue, to be considered in its forthcoming strategic review, is whether it’s still wise to base its purchase of the different countries’ assets on the share of its capital key. A switch to another approach, such as buying based on shares of traded debt, would be badly received in Germany. Yet the country’s economic policies might end up leaving the central bank with little choice.

Schäuble invokes the ghost of John Maynard Keynes to support his argument. Yet if Europe really wants to follow Keynes’ advice, enshrined in which is a call for governments to up spending in times of economic hardship, it should revise its fiscal policy framework in a more symmetric way. The Growth and Stability Pact aims at avoiding excessive budget deficits and high debt to GDP ratios. It should be tweaked to also discourage excessive fiscal restriction that may result from inflexible national debt breaks too. Otherwise, the eurozone might fall back on the same disappointing outcomes which prevailed before the pandemic.


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