Crises destroy paradigms, break taboos, accelerate transformations. What once seemed unthinkable, outside the visual field, captured by the inertia and weight of the status quo, becomes suddenly possible. Imagine, pre-Covid, ordering takeout from a three-star restaurant. Or subletting a restaurant kitchen to virtual delivery startups. Or taking an academic year at Harvard online. Or training a sports team remotely via Zoom. A year later, the frontier of possibilities has greatly expanded, surely increasing potential growth.
The landscape in the eurozone after the battle against Covid is also radically different. Most of what seemed impossible a decade ago, whether due to alleged legal obstacles or obvious political interests, has come true. In 2008, when the Fed started buying bonds, it was argued strongly that the European Central Bank (ECB) could not do the same because it would incur in monetary financing against the Maastricht Treaty. Such opposition delayed asset purchases until 2015 and forced significant restrictions into the program, severely denting growth and financial stability in the euro area.
But when Covid arrived, bond purchases, with maximum flexibility, became logically the main instrument of monetary policy. Throughout the past decade, calls for the creation of a common fiscal policy financed with Eurobonds to complete the economic architecture of the eurozone, boost growth and reduce economic divergences, were met with the strong pushback that it was politically impossible, did not fit into the European legal framework, would damage the stability of the eurozone, and would generate moral hazard. Such an opposition generated a long and sterile debate with alternative financial engineering proposals, ever-more complex and far from reality, accompanied by risk-reduction and debt-restructuring schemes that perpetuated country risk and center-periphery growth spreads. But when Covid arrived, financial engineering was logically abandoned, and Eurobonds became a reality.
A fundamental problem is the definition of the ECB’s objective: inflation ‘below, but close to, 2%.’ What does ‘close’ mean?
The eurozone must now consolidate this transformation. Two crucial reforms must be completed in 2021-22 to determine its economic future: the reform of the ECB’s monetary policy strategy, and the reform of the Stability and Growth Pact (SGP). These reforms are interrelated and must create a coherent and effective economic policy framework that allows both the eurozone and each of its member countries to blossom to the their full potential, something that has not been possible until now.
The review of the ECB’s strategy faces the stark reality of excessively low inflation – an average core inflation of 1.1% in the last decade – and inflation expectations at the lowest level since its inception: the ECB’s Survey of Professional Forecasters shows the mean of the probability distribution of long-term average inflation just below 1.6%. Weak inflation and inflation expectations feed back into each other, in a vicious cycle that reduces the ECB’s ability to respond to negative shocks and severely limits future growth.
A fundamental problem is the definition of the ECB’s objective: inflation “below, but close to, 2%.” What does “close” mean? Is 1% “close”? What does “below” imply? That erring on the side of doing too little is preferable to erring on the side of doing too much? No major central bank is that ambiguous or asymmetric. The solution has three parts. First, simplify and redefine the target as inflation of 2%. Second, make explicit that the objective is symmetrical: the response to deviations below and above the objective will be similar. And third, accept that the initial starting point of such a long period of inflation below target requires a commitment to exceed the target for a period of time so that average future inflation, and with it inflation expectations, rise and stabilize at 2%. This must be complemented with a commitment to retain all the necessary flexibility in asset purchases to be able to fulfill its mandate. Credibility is buttressed with actions; words are not enough.
The reform of the SGP faces the stark reality that the world for which it was created no longer exists. In the 1990s, with positive equilibrium interest rates and higher inflation, fiscal policy could focus exclusively on fiscal consolidation. In today’s world, with zero interest rates and low inflation, sound fiscal policy is no longer always synonymous with fiscal consolidation: it must now help monetary policy, perhaps for many years, to boost growth, reduce unemployment and increase inflation.
When full employment has been reached, inflation is back at target, and the ECB has raised rates and has room to lower them in the face of a negative shock, deploy a strategy of gradual debt reduction
The solution has three parts. First, accept that the 60% debt/GDP target is just a wish, and should be eliminated. Given the current debt levels of most eurozone countries, and considering aggressive yet socially acceptable paths of fiscal adjustment, it will be impossible to reduce the debt/GDP ratio to 60% in coming decades. Reality cannot be ignored, and the 60% target was arbitrary in any case. The SGP is suspended in 2021, and must be reformed before reactivating it to avoid counterproductive austerity.
Second, define a new fiscal framework conditional on the level of ECB interest rates. While interest rates are at zero, deploy a fiscal strategy based, each year, on the level of the primary deficit necessary in each member state to reach full employment as quickly as possible, focusing on the quality of fiscal policy and the preservation of public investment, with an opportunistic debt-reduction strategy. When full employment has been reached, inflation is back at target, and the ECB has raised rates and has room to lower them in the face of a negative shock, deploy a strategy of gradual debt reduction, with different objectives for each country and implemented with a well-designed spending rule.
And third, create a new legal structure that makes the recovery and resilience fund and the Eurobonds that finance it permanent, including the creation of new EU own resources. Participation in this fund reinforces the discipline of the new fiscal framework.
These reforms of the ECB strategy and the SGP will remove the bias toward austerity and growth divergences across countries that has hitherto defined European economic policy, and offer a brighter post-Covid future. Politics is the art of the possible. The Spanish resilience and recovery plan is ambitious and well designed, with its combination of reforms and investments, and Draghi’s Italy will likely follow its template. Berlin, Brussels and Frankfurt have incessantly (and rightly) demanded reforms from the eurozone countries. It is now their turn.