The writer is Head of European Economics Research at Barclays
When Covid-19 struck the world, policymakers responded with an extraordinary co-ordination of monetary and fiscal stimulus. The result was a sharp V-shaped economic recovery from the pandemic lows.
As the eurozone confronts a surge in inflation spurred by the Ukraine war, it will have to step up co-ordination once more to avoid reawakening the ghost of the European sovereign debt crisis.
The European Central Bank is seeking to design a tool for the transmission of policy across the euro area, to curb so-called fragmentation when there is a more disorderly rise in bond yields in one country than another.
The various operational, legal and political challenges of this are many. But a key one is related to the conditions countries will need to satisfy before benefiting from the new facility. Conditionality means policy will have to be co-ordinated.
Back in the European sovereign debt crisis, financial conditions tightened on the back of the ECB’s interest rates hikes. As insolvency concerns mounted, governments in countries dubbed “peripheral” had to abruptly tighten fiscal policy to either secure IMF or EU support, or to maintain market access.
This failure to co-ordinate policy weakened activity further, particularly in those countries such as Italy that implemented “fiscal consolidations” which hit growth — mainly increasing taxes and by cutting public investment rather than reducing current government spending. A monetary fiscal doom-loop was created.
History does not repeat itself, but it rhymes. Although it is not Barclays’ base case for the eurozone outlook — we expect a shallow recession followed by a mild recovery — the current macro backdrop dangerously resembles that of 2010-2011.
The market nervousness from June 9-14 was a testament to that, as Italian bond yields rose sharply above German equivalents. The euro area outlook could take a turn for the worse if governments are forced to tighten fiscal policy rapidly again on the back of mounting debt sustainability concerns, the result of higher borrowing costs and lower real growth.
So far, the ECB’s commitment to prevent financial market fragmentation has calmed markets. The agreement of credible anti-fragmentation facility at its July 21 governing council meeting is a necessary condition if the ECB wants to prevent a fiscal crisis during its planned tightening, but we doubt it will be sufficient.
To start with, we believe the governing council will not ex-ante agree on levels of yields or spreads to target. The pricing of the yields of countries on macro and fiscal factors is an art as much as a science and council members are likely to have divergent views on that.
Also, the council could well disagree on whether sovereigns with weak fiscal and growth fundamentals face a liquidity or a solvency crisis when their borrowing costs rise.
In anticipation of such disagreement, financial markets could test the determination of the central bank to avoid fragmentation, putting pressure on individual countries by pushing up their sovereign bond yields.
The challenge ahead lies in designing a policy mix that simultaneously lends credibility to the ECB’s commitment to bring inflation down to target while minimising the risk of economies falling into such a path. In our view, some degree of co-ordination between monetary and fiscal authorities will be necessary.
National fiscal authorities should embark on credible fiscal consolidations that will not damage growth. This time around the EU Next Generation pandemic recovery fund will help to shield public investment from the tightening.
A degree of fiscal discipline should be reintroduced to reduce fiscal risks and moral hazard. Some fiscal support to low income households and small to medium-sized enterprises could be funded via European low interest rate loans, as was done during Covid-19.
At the same time the ECB, by internalising the impact of a tighter fiscal stance on growth and inflation, could commit to tightening monetary policy less and in a very gradual way. It needs to ensure its actions do not make the job of the national fiscal authorities even more economically and politically challenging.
Although not easy to co-ordinate, this seems to us a realistic compromise that could put the euro area on a more virtuous trajectory than the one in which high-debt governments continue to run large primary deficits, while the ECB tightens monetary policy.
Source: Economy - ft.com
