03.12.2021
A complete institutional architecture for a stronger policy mix
"A stronger policy mix for the euro area?" - European Commission webinar
organised by DG ECFIN Directorate for Macroeconomic Policies
Pablo Hernández de Cos
Governor
The COVID crisis has tested the European project in unprecedented ways. The policy
response, a successful monetary and fiscal policy reaction, informed by a euro area
(and EU-wide) perspective, has been unprecedented too. Given the exogenous roots of
the crisis, the need to respond with a balanced fiscal-monetary policy mix was clear. And its
depth facilitated the adoption of far-reaching political agreements that allowed the incomplete
institutional nature of the Economic and Monetary Union (EMU) to be temporarily overcome, in
particular through the deployment of some significant pan-European fiscal instruments. To
mention the most important, let me highlight the NGEU programme, and also the
unemployment scheme SURE.
The need for a policy reaction from the aggregate angle was quite clear on this occasion. This
is a novelty when comparing with the two previous crises, the GFC and the European sovereign
debt crisis, when the endogenous roots of the shock showed a fundamental need for reform
and action at the national level, that was only subsequently reinforced by some important steps
aimed at pushing forward the overall euro area (and EU) architecture.
Let me start by reminding us how we got here.
Under the Maastricht Treaty, the design of EMU had two core elements: an
independent common central bank targeting price stability, and a framework to
coordinate national fiscal policies. The former was entrusted with monetary policy, while
the latter was based on a set of fiscal rules geared towards ensuring that national fiscal policies
did not endanger the price stability mandate. This meant that Member States could no longer
rely on monetary policy to stabilise asymmetric economic shocks (domestic, or common with
highly uneven domestic effects), while the exchange rate could not act as an adjustment
mechanism between countries. Instead, they had to rely on additional adjustment channels,
such as capital and labour mobility, and, especially, countercyclical fiscal policy.
In addition, the set of fiscal rules included in the Treaty acknowledged that the fiscal
behaviour of one country would affect the rest of the members and the monetary union
as a whole. In particular, unsustainable fiscal policies in one country could generate economic
and financial instability across the monetary union and influence the single monetary policy.
Thus, the Treaty stipulates that Member States should avoid excessive deficits, and that the
European Commission should monitor public finances to identify significant deviations that
could endanger the macroeconomic and financial stability of the monetary union.
In practice, the Protocol operationalises these principles by means of two quantitative reference
values: 60% for the ratio of government debt to GDP and 3% for the budget deficit-to-GDP
ratio. The quantitative limits were defined taking into account the average economic situation
prevalent at the end of the 1990s. In particular, annual potential GDP growth of 2% and an
inflation aim of around 2%, together with a budget deficit limit of 3% of GDP, would stabilise the
ratio of government debt to GDP at 60%.
The experience since its approval has shown that the design of the Maastricht Treaty
left significant gaps in the governance of the euro area. In particular, these gaps have
a significant bearing on the proper functioning of the policy mix.
First, due to the simplicity of the framework, the original rules did not take into account
that the cyclical position of countries affects the headline deficit. Subsequent reforms
tried to address this, at the cost of increasing complexity and relying on (initially
praised, but now maligned) unobservable variables. But, in any case, as can be seen in
the left-hand chart of slide 3, the experience of recent decades has been one of pro-cyclical
compliance with the rules, resulting in undesirable tightening during downturns and insufficient
accumulation of buffers during upturns.
Moreover, despite its focus on debt sustainability, the framework did not avoid a general
increase in debt (as can be seen in the right-hand figure in slide 3), which has, in any case, been
a trend common to most advanced economies. Having to deal with multiple objectives
(countercyclicality, long-run growth, debt sustainability), fiscal policy, in most cases, failed to
deliver satisfactorily on any of them.
Second, the original design was not well-equipped to prevent the build-up of domestic
macroeconomic imbalances with the potential to generate serious economic and
financial instability for the euro area as a whole. The European Semester and the
Macroeconomic Imbalances Procedure were established after 2010 to address this issue, but
the experience so far seems to be mixed.1
Third, beyond what was stipulated in the no-bail-out clause, the Treaty did not
envisage the creation of a crisis management framework. This was partly addressed later
through the creation of the ESM in 2012 amid a very serious sovereign debt crisis affecting
some of the largest economies of the European Union.
Finally, and quite importantly, the Treaty had not envisaged the need for significant
aggregate fiscal action to smooth the cycle and assist the common monetary policy.
This was evident, for example, during the low inflation period after the euro area sovereign debt
crisis, when the degree of coordination of fiscal policies provided for by the fiscal framework fell
short of the aggregate stimulus that was needed to complement monetary policy. And, also as
a consequence of this lack of pre-established aggregate fiscal tools, during the COVID crisis,
an ad-hoc response had to be adopted, in the form of temporary, centralised fiscal instruments.
First of all, the general escape clause in the SGP2 was activated, permitting a very expansionary
fiscal stance at the country level. Second, emergency assistance to countries was provided,
without strict conditionality and at favourable interest rates, through the SURE and the
Pandemic Credit Line of the ESM. Third, the NGEU provided funds to countries, earmarked for
investments in digital capacities and the fight against climate change, in exchange for the
implementation of structural reforms.
This brief historical review can be summarised as follows: beyond its foundational
components (independent monetary policy, focus on national debt sustainability,
nobail-out clause), the framework has been continually adapted to a changing
environment.
Let me now come back to the present and first discuss some unpleasant fiscal
arithmetic. The main idea in the Treaty for the conduct of domestic fiscal policies was that
excessive deficit and debt levels were to be avoided. In this regard, it is well known that, over
the long term, and for a given inflation rate, the primary balance that allows a given government
debt-to-GDP ratio to be stabilised depends on the differential between the real interest rate and
the real output growth rate, the so-called "r-g" gap. The wider this gap, the higher the primary
balance needed to maintain a stable medium-term government debt-to-GDP ratio. Over the
period 1995-1999, the r-g differential was positive and close to 2 percentage points. As I have
mentioned before, the medium-term stabilisation of existing government debt levels at around
60% (with inflation at 2%) was consistent with running a headline deficit of around 3% of GDP
(see left-hand side figure in slide 4). In the current context, however, the observed prevalence
of negative r-g differentials (see the right-hand figure in slide 4) would be consistent with
government debt levels stabilising at a higher percentage of output. Given this situation, it is
legitimate to ask whether a government debt level above 60% is now the correct figure? The
question is not easy to answer, and it will depend on national considerations (the economic
fundamentals in the medium-term, the vulnerabilities and resilience of the economy) and, of
course, the prevailing financial and monetary conditions.
Moreover, the current high levels of government debt evidence the difficulties of
transitioning to the medium-term debt anchors. At present, converging towards a
debtto-GDP ratio of 60% would require a substantial fiscal effort over a prolonged time frame. Using
the historical average values of real growth, inflation and interest rates, the euro area would
need to maintain a fiscal surplus of 1.1% of GDP over 20 years in order to reduce the debt ratio
to 60% (see left-hand side figure in slide 5). This is substantially higher than the average primary
deficit of 0.4% of GDP observed since 1995. For this constant fiscal effort to be at more
plausible values, the macroeconomic environment would need to be far more favourable than
it has been in recent decades. For instance, in order to bring the debt-to-GDP ratio back to
60% in 20 years while maintaining a primary deficit in line with the historical evidence, real growth
in the euro area would have to be twice its historical value (1.3% on average over 1995-2021),
or alternatively the implicit rate on government debt would have to be half the current one (see
right-hand side figures in slide 5). Although simplistic, these exercises illustrate the significant
effort needed for the transition to the medium-term fiscal targets, and, indirectly, how it would
limit fiscal policy's capacity as a stabiliser for the duration of the adjustment process.
These are just some of the arguments behind the broad consensus on the need to
reform the fiscal governance framework in the European Union. However, while
everyone appears to agree that reform is needed, views differ on the necessary steps forward
and their sequencing. I personally believe we need a coordinated effort aimed at reinforcing the
euro area and making it more resilient to shocks. And, in my view, this would involve reforming
several areas of economic governance: fiscal and structural policies, the banking sector and
capital markets.
Allow me to offer a number of reflections on the desirable elements of such a reform,
with a view to improving the operation of the policy mix in the euro area. I can tell you
now, in my view any meaningful revision of the European fiscal framework calls for a
paradigm shift, rather than the incremental reform approach that has prevailed over
the recent decades.3
Reform of the fiscal governance framework and the policy mix
Starting with the reform of the fiscal governance framework, I believe that an optimal
design and implementation of the European fiscal rules should fulfill the following
three objectives. First, ensure debt sustainability and contribute to building up sufficient
buffers in good times for use in subsequent crisis periods, especially against a backdrop of high
public debt ratios. Second, provide for an optimal aggregate fiscal stance for the euro area as
a whole. Third, offer support for long-run growth.
In my view, the primary tools to achieve these objectives should be developed along the
following lines:
First, existing fiscal rules should be made simpler and more credible, and their
governance should be strengthened. This is important in order to address one of the
shortcomings identified in their design: the failure to ensure that countries build up fiscal buffers
in good times for use in crises. Greater automaticity in the correction of deviations and affording
a more prominent role to national independent fiscal institutions may be the right way forward.
In this sense, at present the European Fiscal Board is an independent body that advises the
Commission on the implementation of the fiscal framework and on the appropriateness of the
national fiscal stance for the euro area as a whole, but has no formal role vis-à-vis independent
national fiscal councils. It might be desirable for this institution to play a role in coordinating and
overseeing national institutions.
Second, improved fiscal rules should be supplemented with supranational fiscal
mechanisms for risk sharing. This would increase the scope and effectiveness of fiscal policy
in the euro area, enable the smooth operation of the monetary and fiscal policy mix from a wider
euro area perspective and help achieve common, long-run objectives, such as tackling climate
change.
In the current setting, it is more challenging to achieve the effective fiscal stabilisation
of the monetary union as a whole than policy coordination between Member States.
First, the current rules do not envisage mechanisms for correcting national measures that are
judged to be incompatible with the overall desired fiscal stance. Second, having an appropriate
monetary union-wide fiscal stance is no guarantee that individual fiscal policies will be adequate
for national fiscal sustainability and cyclical stabilisation targets, as has been observed in recent
years.
A possible solution to this coordination problem could be to establish a central
mechanism entrusted with setting the euro area's overall fiscal policy stance and
responding to tail events, with national authorities focusing on medium-term goals
and placing debt sustainability as their primary objective (see slide 7). This fiscal policy
tool could be automatic, such as a common unemployment insurance scheme or a more
general stabilising instrument dependent on the cyclical position. In any case, risk sharing must
be accompanied by an incentive system that prevents negative cross-country externalities and
moral hazard, something of utmost importance in a monetary union.
Furthermore, I believe that such a central instrument would also be suited to tackling
global challenges, such as climate change or the process of digitalisation, and might
be a better option than national "golden rules". These rules exclude specific types of public
expenses from deficit calculations, on the grounds that these could be growth-enhancing and
thus need to be protected. This option is attracting much attention in current EU debates. In
particular, it is argued that in the current context, with countries having to expend a great deal
of effort in the fight against climate change, such investments should be excluded from the
expenditure target or budget balance in order to safeguard them from EU fiscal rules. However,
a golden rule would add an additional layer of complexity to an already intricate system (see
slide 7) and would require the definition of the types of spending to which it ought to apply. In
my view, a far more efficient option would be the umbrella of a European financing instrument,
which would make it easier to achieve the significant common investment needs required to
meet the current net zero targets and stave off climate risk scenarios, regardless of the national
fiscal space available.
The third point I would like to highlight as regards the key elements of the fiscal
governance reform, is that fiscal policy design should put greater emphasis on
enhancing the growth potential of European economies. Indirectly, this would also
help provide more space to monetary policy, since increasing the economy's growth
potential would lift the natural rate of interest.4 Indeed, public spending, if well-targeted,
well-designed and complemented by structural reforms and private investment, could help raise
productivity levels and thus potential growth. In this regard, the magnitude and composition of
NGEU funds is an important step in the right direction. It is also a first step towards greater fiscal
integration, since its grant component entails some degree of risk sharing. However, the NGEU
cannot be considered a true macroeconomic stabilisation mechanism, which should be
permanent and have sufficient funding and tax and debt capacity to complement the ECB's
single monetary policy.5
Structural policies and the European Semester
The second broad area of reform I would like to talk about is structural policies.
The magnitude of the structural challenges ahead reveals the need to revamp the
European Semester. This mechanism to coordinate the policy actions to correct
countryspecific imbalances and implement necessary structural reforms has had limited success. And
the challenges ahead, especially in the aforementioned areas of digitalisation and the climate
transition, are enormous. As shown in Slide 8, according to the European Commission's
assessment, governments' policy responses to country-specific recommendations have
provided insufficient progress to address the necessary structural challenges. This clearly calls
for a thorough discussion about how to increase their effectiveness. In this sense, a revamped
European Semester could use the experience of the Recovery and Resilience Facility, within the
NGEU programme, to provide the correct incentives to Member States. The explicit link in NGEU
between the implementation of agreed structural reforms at the country level and the access to
grants has provided, according to the Commission's assessment of the national plans, much
greater government commitments than in the past. Indeed, if the reforms announced in the
Recovery Plans are fully implemented, the large majority of the structural challenges that
European institutions have highlighted in the past will be addressed (see Slide 8). Of course, it
is now crucial that their implementation over the coming years confirms these positive
developments. And, in this regard, the link between the access to funds and the implementation
of reforms should be seen as a crucial incentive.
Allow me to also highlight the importance of insisting on a European, medium-term,
economic growth-enhancing agenda. In this context, recent energy market developments
and the global value chain bottlenecks highlight the importance of reflecting on the principles
and way forward for achieving a European "strategic autonomy". EU-wide structural policies
promoting European integration and strengthening the single market will also make our
economy more competitive internationally. The Important Projects of Common European
Interest, developing new batteries and microelectronics, and those under way in the fields of
Hydrogen and Cloud Infrastructure and Services, supported by NGEU funds, are good
examples of this. Nevertheless, while it is important to promote these developments from a
European perspective, we should also keep in mind that increasing the scale of these projects
might generate divergences across Member States. In order to make this compatible with a
level playing field and to extract the advantages of economies of scale, it is therefore necessary
to fundamentally improve our risk-sharing mechanisms and move further and faster towards a
frictionless single market, both for capital and for labour.
Banking union and capital markets union
The final elements of reform I would like to mention today relate to the completion of
the banking and capital markets unions.
Completing the banking union should be seen as a priority, in particular by overcoming
the current deadlock over its third main pillar, the European Deposit Insurance
Scheme (EDIS) with a mutualized component. The commitment to deploy such a scheme
would have a strong impact on citizens' trust and would contribute to increased risk-sharing in
the euro area. In addition, it would help align financial responsibility with the pan-European
decision-making that already exists in the areas of banking supervision and resolution. The
current misalignment makes EMU governance more prone to institutional and political frailty. As
a complement, it is also crucial to eliminate certain regulatory barriers and practices that are
hindering the emergence of a fully fledged European banking market.
In addition, completing the capital markets union is essential to enhancing the euro
area's capacity to cushion macro-financial shocks and to providing a better
environment to channel private investment. Currently, the limited development of equity
markets and the sizeable home bias in portfolios have significant negative consequences for the
smooth functioning of the monetary union. Indeed, they set a limit on the capacity of risk-sharing
mechanisms in the euro area. Moreover, an enhanced capital markets union could improve the
channelling of the abundant aggregate savings to satisfy investment needs in the areas of
infrastructure, energy and innovation, in which private investment is crucial. For example,
according to European Commission estimates, the energy transition will require additional
investment of over €400 billion each year over the next decade. Public investment, and
supranational investment coming from the NGEU funds, can only account for a small portion of
this amount.
Moreover, a fundamental, game-changing feature for a more integrated capital market
would be the existence of significant pan-European safe assets. A common safe asset
would most likely become a common benchmark, allowing the prices of equities and bonds
across the euro area to reflect fundamental risk more clearly. It would facilitate the development
and integration of capital and financial markets in the euro area, as flight-to-quality movements
would no longer imply flight-to-core-countries movements. This would be particularly relevant
in times of stress, when it would help mitigate the possibility of monetary policy transmission
being hampered in a context of fragmented bond markets. In this sense, the experience with
the issuances to finance the SURE and NGEU programmes can serve as the prototype for this
safe asset. Although relatively small in size, they have been a success in terms of market
appetite and have helped most Member States reduce costs because of the pooled financing
(see slide 9).
Final reflections
As I mentioned at the beginning of my address, the fiscal-monetary policy mix has
passed the demanding test posed by the COVID-19 crisis, so far, with good marks.
The ad hoc decisions taken by policymakers were adequate, and compensated for the lack of
a complete euro area institutional architecture, enabling monetary and fiscal policies to do their
job, without overburdening each other. Incidentally, the immediate tests we face are normalising
fiscal policies once the recent improvement in the economic outlook proves to be sufficiently
sustainable and adjusting the extraordinary monetary policy measures we introduced once the
ECB's medium-term inflation target is considered to be sustainably achieved.
Going forward, the challenge is how to enshrine this success story in a stable and
predictable framework, while also taking into account a number of additional
challenges that lay ahead. As I said earlier, to ensure a proper operation of the policy mix in
the euro area a number of reforms are needed in several areas. First, a meaningful revision of
the European fiscal framework entailing a paradigm shift that incorporates supranational
elements of fiscal burden-sharing, while at the same time guaranteeing full national
responsibility. Second, a European, medium-term, economic growth-enhancing agenda
promoting the development of a flexible, thriving economy, while pursuing deep reforms in all
corners of the euro area, and the EU in general. Third, the completion of the banking and capital
markets unions, to cement a framework that genuinely cushions macro-financial shocks and
provide an optimal environment to channel private investment for the climate and digital
transitions.