Luis de Guindos: Improving macroeconomic stabilisation in the
euro area
Remarks by Luis de Guindos, Vice-President of the European Central Bank, at the Global
Interdependence Center Central Banking Series conference, Madrid, 3 October 2019.
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Introduction
A decade after the global financial crisis, the level of economic activity in the euro area remains
disappointingly low. It took nine years for real per capita GDP to surpass its 2007 level. Likewise,
euro area inflation has stubbornly remained below the ECB's aim for much of the past decade.
Throughout this period, the ECB has acted decisively to support euro area demand and raise
inflation onto a sustainable path towards our aim of below, but close to, 2% over the medium
term. This has included lowering the key ECB rates to record low levels and adopting a wide
range of non-standard monetary policy measures.
By contrast, the contribution from fiscal policy to macroeconomic stabilisation in the post-crisis
period has been muted at best. From 2010 to 2012, economies representing around one-third of
euro area GDP carried out procyclical fiscal tightening to restore confidence in their public debt,
which significantly contributed to the second recession in that period. Since then, fiscal policy
has been broadly neutral.
At our last meeting, the Governing Council responded to the continued shortfall of inflation with
respect to our aim. Recent economic data point to a more protracted weakness in the euro area
economy. Prominent downside risks remain and inflationary pressures are muted. We
introduced a package of measures designed to support the euro area expansion, the ongoing
build-up of domestic price pressures and, thus, the sustained convergence of inflation to our
medium-term aim.
We also noted the need for countries with fiscal space to act in a timely and effective manner
and for all countries to reinforce their efforts to achieve a more growth-friendly composition of
public finances.
In my remarks today, I will focus on the roles of monetary and fiscal policy in supporting
macroeconomic stabilisation in the euro area. In particular, I will explain why now is a particularly
appropriate time for fiscal stimulus. I will also offer some thoughts on how to improve the current
fiscal framework.
Macroeconomic stabilisation in a monetary union
The literature on optimal currency areas points to the need to counter two types of shocks: those
that are common to all countries, and asymmetric ones that affect a subset of countries.
For common shocks, monetary policy can act to stabilise the economy.
But for idiosyncratic shocks, stabilisation becomes trickier. Monetary policy cannot target
individual countries, and those affected can no longer adjust their exchange rate to help cushion
the effects of the shock. Hence the literature emphasises the need for economic cycles to
converge, so that common shocks generally dominate. For asymmetric shocks, stabilisation
comes ex ante from greater cross-border risk-sharing to improve resilience, and ex post from
fiscal policy.
But in the light of recent experience, it is worth revisiting this classic separation between using
monetary policy for common shocks and fiscal policy for asymmetric shocks. Fiscal policy at a
national level in the euro area was unable to fully counter asymmetric shocks during the crisis.
And at an aggregate level, stabilisation may benefit from monetary and fiscal policy working in
tandem given the current environment of low interest rates.
Nominal interest rates have been declining in advanced economies since the 1980s. In large
part, this decline is attributable to the decline in average inflation over that period. Investors
require lower compensation for expected future inflation, and the fall in inflation volatility has also
reduced the inflation risk premium. The decline is also a result of a secular fall in the natural rate
of interest, which is the rate that balances desired saving and investment in the economy. While
the natural rate cannot be precisely measured, a range of estimates point to its decline.
There are a number of contributing factors to this decline, principal among which is lower
potential growth. Lower potential growth reduces the expected rate of return on capital, so
reduces the rate at which firms are prepared to borrow to invest.
Other factors that are believed to have further weighed on the natural rate of interest include the
ageing population in Europe, the role of income distribution, increased saving in emerging
markets and a general rise in risk aversion.
This fall in the natural rate of interest has important implications for the optimal policy mix in the
euro area. The interest rate at which monetary policy becomes accommodative falls directly in
line with the natural rate, so the effective lower bound on nominal rates has become a much
greater consideration when setting policy. Before the crisis, it was estimated that interest rates in
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the euro area would be likely to hit zero only once every 50 years. At the current natural rate,
rates of zero or below are likely to be a much more frequent occurrence.
As the experience of the past decade has shown, the decline of the natural rate is not an
impediment to monetary policy providing accommodation to the economy. But it does mean that
monetary policy has to remain accommodative for longer and make greater use of
unconventional measures. Those factors carry with them an increased risk of undesired side
effects.
In such a situation, economic theory tells us that fiscal policy should play a much more
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substantive role in business cycle stabilisation than it usually would. The reason for this is
straightforward.
In normal times, when output is close to potential and inflation is close to its objective, a fiscal
expansion threatens to push inflation above the central bank's aim. Central banks respond by
raising their policy rates, and the increase in interest rates partially crowds out private sector
demand. However, when the economy operates below potential the central bank has no reason
to fight a fiscal expansion. Policy rates would not increase and private sector demand would be
crowded in, leading to a much larger positive effect on aggregate demand and inflation.
In other words, when policy rates are close to the lower bound, fiscal policy becomes more
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effective in stimulating aggregate demand.
Moreover, while monetary policy must take the natural rate of interest as given, fiscal policy - if
enacted appropriately - can help raise it, in turn making monetary policy more powerful. Policies
to encourage more people, especially older workers, to participate in the labour force can help
raise rates. Increasing spending on education and public investment can support productivity and
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lift both potential growth and private investment.
Every policy implies trade-offs, of course. The side effects of very accommodative monetary
policy may become unduly tangible when the economy operates below potential for a long time.
In fact, while we believe that, overall, the benefits outweigh the costs, we acknowledge the
challenges that a sustained low interest rate environment poses for banks.
Reforming the fiscal framework
So there is a role for fiscal policy to play in helping to counter common shocks at the European
level. To the extent that Member States have created fiscal space, it would therefore be desirable
for fiscal policy in the euro area to support business cycle stabilisation more actively. Our current
assessment is that the fiscal stance is only mildly expansionary at the aggregate level.
But the current institutional framework is insufficient to deliver that required stimulus.
Fiscal policy remains a national responsibility in Economic and Monetary Union (EMU), with
some common rules applicable to individual countries. In its first incarnation, the Stability and
Growth Pact focused almost exclusively on fiscal sustainability, with little emphasis on fiscal
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stabilisation. In recent years it has undergone several reforms, some of them with the explicit
aim of providing greater prominence to stabilisation considerations, both at the country level and
at the euro area level. The result has been rules which are now viewed as complex and opaque,
with little evidence that they have delivered a more countercyclical fiscal policy stance in the euro
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area.
The Stability and Growth Pact has limited flexibility and does not lend itself to incorporating
areawide stabilisation elements. National fiscal rules, with a focus on domestic issues, tend to
neglect positive cross-border spillovers. They fail to recognise the benefits of cross-country
risksharing and the vital role played by the public sector in underpinning it.
In other words, rules based purely at a national level, or even rules that coordinate a fiscal stance
across countries, are not enough by themselves. Empirical evidence suggests that spillovers
from a fiscal expansion in one euro area country to others are positive, but small. So while it is
important for those countries with available fiscal space to use it domestically to support overall
stabilisation, a central fiscal capacity with the ability to allocate expenditure across countries
would be more powerful.
A dedicated centralised fiscal capacity would not interfere with domestic policy. By focusing on
common area-wide stabilisation it need not affect national fiscal space but rather provide an
additional layer. This focus would also help ensure that areas of expenditure that are vital for
long-run growth are not cut during a downturn, helping to preserve future fiscal space and
support real interest rates over the long term.
A central fiscal capacity of this sort would clearly need to be carefully designed to mitigate any
risk of moral hazard. But, crucially, it should have sufficient firepower to effectively contribute to
macroeconomic stabilisation. It needs to be sizeable and agile enough to react rapidly to
emerging threats.
But macroeconomic stabilisation in the euro area can only function properly when other EMU
features and institutions are adequately designed and operational.
First, the banking union needs to be completed. Unified banking supervision and the Single
Resolution Fund (SRF) have provided greater confidence that banks operating in other euro area
countries face the same conditions as in their home market. But the banking union will remain
incomplete until a common deposit insurance scheme has been introduced and the fiscal
backstop for the SRF has increased in size. While there is political agreement about the SRF
backstop and its terms of reference, there is not yet agreement on the European deposit
insurance scheme.
Second, it is imperative to accelerate progress on the capital markets union. This is ambitious. It
entails streamlining core aspects of national policies, such as taxation and insolvency regimes,
which are essential for integrating the legal underpinnings of cross-border markets. Capital
markets can smooth country-specific shocks by providing a larger pool of financial assets that
can be shared across borders. This helps to decouple wealth and income - and hence
consumption - from output.
Conclusion
Let me conclude.
The euro area risk outlook is again tilted to the downside. This is a conjunctural concern. The
global decline in the natural rate of interest over the past quarter of a century, however, poses
structural challenges. Policy rates will likely remain low, by historical standards, and may hit their
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lower bounds more frequently than in the past. We have learned from the experience in Japan
that it is possible to get caught in a vicious cycle of declining inflation expectations, falling inflation
and a binding lower bound on nominal interest rates from which it is difficult to escape.
It is thus of utmost importance that we enhance the firepower of euro area stabilisation policy by
means of a policy mix that, while continuing to make full use of monetary policy, assigns a more
substantive role to fiscal stabilisation policy. Laying the institutional foundations for a European
fiscal capacity would be an important step in this direction.
1
See Coenen, G. (2003), "Zero lower bound: is it a problem in the euro area?", Working Paper Series, No 269,
ECB, September.
2
Schmidt, S. (2013), "Optimal Monetary and Fiscal Policy with a Zero Bound on Nominal Interest Rates", Journal
of Money, Credit and Banking, Vol. 45, No 7, pp. 1335-1350; and Werning, I. (2012), "Managing a Liquidity Trap:
Monetary and Fiscal Policy", NBER Working Paper Series, No 17344, National Bureau of Economic Research.
3
Eggertsson, G. (2011), "What Fiscal Policy Is Effective at Zero Interest Rates?", in Acemoglu, D. and Woodford,
M. (eds.), NBER Macroeconomics Annual 2010, Vol. 25, University of Chicago Press, pp. 59-112; and
Christiano, L., Eichenbaum, M. and Rebelo, S. (2011), "When Is the Government Spending Multiplier Large?",
Journal of Political Economy, Vol. 119, No 1, pp. 78-121.
4
De Jong, J., Ferdinandusse, M., Funda, J. and Vetlov, I. (2017), "The effect of public investment in Europe: a
model-based assessment", Working Paper Series, No 2021, ECB, February.
5
There was an exemption clause for the deficit limits in the event of a severe recession.
6
European Fiscal Board (2019), Assessment of EU fiscal rules with a focus on the six and two-pack legislation, 11
September.
7
Kiley, M. and Roberts, J. (2017), "Monetary Policy in a Low Interest Rate World", Brookings Papers on Economic
Activity.