The euro needs sound and pragmatic long-term policies more than ever
It was not until autumn 2019 that the close interlinkages between fiscal and monetary policy started to gain due attention. Low GDP growth and interest rates had for some years necessitated the Eurosystem to enter into significant purchases of government bonds for setting an appropriate monetary stance. It also became more commonly understood that the tight fiscal policies after the 2008 financial crisis had prolonged the recession. Additionally, the need for public investment for moderating climate change gained recognition.
Over the years, the academic community had been quite active in both expressing outright criticism and presenting constructive proposals (e.g. Baldwin and Giavazzi 2015, Pisani-Ferry and Zettelmeyer 2019), which has, however, sometimes led to disappointment when the proposals did not win much ground (Bénassy-Quéré et al. 2019). Some colleagues warned that some proposals could impede refunding of government debt of the high debt countries triggering a self-fulfilling liquidity crisis (Micossi 2018, Tabellini 2018, De Grauwe and Ji 2018).
The reasons for slow progress with reforming the euro were many, one of them certainly being deficient understanding of the links between the fiscal and monetary domains. New orientations started to gain ground last autumn when the new European Commission headed by Ursula von der Leyen was installed and Christine Lagarde started as president at the ECB, although diverging views still appeared even inside the ECB governing council, as the readers of the Financial Times know.1
The Covid-19 pandemic then struck and changed the scenery. It may sound like a paradox, but the sudden unexpected shock which requires immediate action also requires a shift to long-term sustainability of government finances. The rationale is that only then can short-sighted fiscal discipline be set aside and allow the inevitable increase in public debt.
This is the thesis here, together with the view that it is imperative to concentrate on proposals that are compatibility with the current EU Treaty. An attempt to change the Treaty can easily fail, at the latest in a referendum in any one member state, and it would only turn out to have offered a platform for populist attacks on the euro and the EU.
Measuring sustainability meaningfully
I argued for a shift in the focus of fiscal policy to sustainability in a column on Vox last November (Oksanen (2019). Then, important analysis was published by the European Commission in its Debt Sustainability Monitor 2019 (European Commission 2020), which gave material and inspiration for critical comments and modified results I recently reported in Oksanen (2020).
In the paper, I argue that the conventional time horizon for the sustainability gap (S2) estimates until 2070 is too long and leads to complacency for several countries as, according to the projections for ageing-related expenditures, significant decreases are supposed to emerge from 2050 to 2070. This decreases the S2 estimates, giving a complaisant picture, while the projections for 2050-70 can be questionable or even implausible. Also otherwise, measuring the sustainability gap under the current policies is only a first step; designing sustainable policy options is the real challenge.
The time horizon for fiscal policy can also be too short, as it is under the short- and medium-term SGP rules, directing attention away from policy options that can only be implemented over the longer term. In Oksanen (2020), I present a 30-year horizon as the most appropriate working hypothesis. This removes the obvious uncertainty of circumstances and policies in the more distant future and expands the new scenario results to comprise gradual budgetary adjustment.
Increasing the retirement age
The 30-year horizon also allows analysis of new policy options for gradually tackling the increase in ageing-related expenditures as it corresponds to burden sharing across generations (Beetsma and Oksanen 2008: 568-9). An increase in retirement age – or more precisely, increasing it by more than just linking it to life expectancy – is often ignored, one reason being that it can and should be increased only gradually for both economic, social and political reasons.
The new results show that increasing the retirement age by one year per decade, in addition to linking it to life expectancy, would improve the sustainability of public finances to a certain extent, though further work on extended policy options is also called for, including those for moderating climate change.
Compatibility with the EU Treaty
The proposed shift to long-term sustainability can be argued to be compatible with the current EU Treaty. This is based on the three Court of Justice of the EU rulings on the euro in 2012, 2015 and 2018.2 They express constructive balancing of partially conflicting objectives under difficult and unforeseen circumstances.
A most relevant provision is the requirement of ‘strict conditionality’ for financial assistance added to the Treaty in 2011. The interpretation needed here is that budgetary discipline does not have to mean short-term austerity, but that it can and should mean transparency of the policy line for the long term. A fiscal policy programme with time horizon up to 30 years can be more appropriate, and it is what ‘sound public finances’ in the Treaty should be understood to mean. Shifting emphasis to long-term sustainability might be equally tough as pursuing short-term austerity, notably as it may bring to the table for example the need to increase the retirement age.
Thus, no obstacles should arise from the Treaty. The protocol on the excessive deficit might have to be modified, but this can be done by unanimity at the Council, or, alternatively, flexibility in its interpretation could continue, given also the need for simplification and partial depletion of the overly complex rule book.
The chances for making progress under Covid-19
Although the Covid-19 shock requires prompt action it also helps to shift attention to a more long-term horizon in policy making. This is already coming out in taking positions on the Next Generation EU initiative. The difficult negotiations might be solved by a commitment that all governments produce long-term policy programmes for fiscal sustainability. Angela Merkel has already told the four governments opposing the proposed extensions of the EU activities that all the governments should show a willingness to make their economies more ‘future-proof’.3
Furthermore, for the most vulnerable members, credibility of their long-term policies will be an inevitable condition for preserving access to credit at reasonable interest rates. This is what they will need in any case as, whatever comes out from the difficult negotiations on Next Generation EU, not known at the time of writing (12 July), assistance from the EU will not satisfy the fiscal needs prompted by the Covid-19 shock. It is an easy calculation that a one percentage point increase in the interest rate for a country with a 150% debt ratio will (over time) require 1.5 percentage points higher tax rates.
Good alternatives are missing
It is important to keep in mind how short-sighted fiscal austerity led to the fall of euro area GDP in 2012-13 and avoid repeating the same mistake now. Also, issuing mutual debt at large scale, proposed by too many to be quoted, is excluded by both legal and political obstacles. The same holds for the proposal that the Eurosystem would effectively forgive a fraction of the government debt by converting it into perpetuities without interest (Vihriälä 2020). It breaches the Treaty, the own capital of the Eurosystem would go into the red, and it would rather be an accounting trick between each government and the national central bank without having lasting positive impacts. The parallel operation that the governments increase their debt and the Eurosystem buys some of it on the secondary market has the same positive impact without breaching the Treaty.
In general, the various ‘financial engineering’ proposals that leave long-term sustainability unsolved are questionable, even dangerous if they create the illusion of a solution. Shifting the emphasis to long-term sustainability and solvency is not an easy way out either. In democracies the governments are not in the position to strictly commit their member states to pursue the declared policy line beyond the electoral cycle. A blueprint for finding a solution to this could be that the member states present long-term policy programmes with a 30-year time horizon, rolling and updating them at least according to their electoral cycles. This enhances transparency on which fiscal discipline in the long term can be built on.
Sustainability and solvency will be the anchors for financial stability
The orientation to the long term promoted here is comprehensive as it encompasses both fiscal and monetary realms. It is pragmatic and it does not promise to solve the problems immediately, but it means that in the not too distant future a basic understanding should develop for orienting economic policies gradually towards the long term. This is a prerequisite also for containing the short-term effects of the Covid-19 shock right now or any other serious shocks to come, and also for smoothing the effects of more normal short-term fluctuations.
Baldwin, R and F Giavazzi (eds) (2015), The Eurozone Crisis, A Consensus View of the Causes and a Few Possible Remedies, A VoxEU.org eBook, CEPR Press.
Beetsma, R and H Oksanen (2008), “Pensions under Ageing Populations and the EU Stability and Growth Pact”, CESifo Economic Studies 54: 563–592.
Bénassy-Quéré, A, M K Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani-Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro and J Zettelmeyer (2019), “Euro area architecture: What reforms are still needed, and why“, VoxEU.org, 02 May.
De Grauwe, P and Y Ji (2018), “Financial engineering will not stabilise an unstable euro area“, VoxEU, 19 March 2018.
European Commission (2020), “Debt Sustainability Monitor 2019”, Directorate-General for Economic and Financial Affairs, Institutional Paper 120, January.
Micossi, S (2018), “The crux of disagreement on euro area reform”, VoxEU.org, 5 April.
Oksanen, H. (2019), “Pragmatism with a long-term vision should prevail in euro reform”, VoxEU.org; based on Oksanen, H (2019), “Reforming the Euro pragmatically: Towards sustainable fiscal policy and a revamped Eurosystem”, CESifo WP No 7912, October.
Oksanen, H (2020), “Sustainability and Solvency of Government Finances under the Euro: Illustrations and Policy Options”, CESifo WP No 8396, June.
Pisani-Ferry, J and J Zettelmeyer (eds) (2019), Risk sharing plus market discipline: A new paradigm for euro area reform? A Debate, a VoxEU.org eBook, CEPR Press.
Tabellini, G (2018), “Risk sharing and market discipline: Finding the right mix”, VoxEU.org, 16 July.
Vihriälä, V. (2020), “Make room for fiscal action through debt conversion”, VoxEU.org, 15 April.
1 See https://www.ft.com/content/f8706bac-f0bb-11e9-ad1e-4367d8281195
2 These three rulings are: ‘Stability mechanism for the Member States whose currency is the euro’ (Pringle) in 2012, ‘Compatibility of the OMT (Outright Monetary Transactions) programme announced by the ECB in September 2012 with EU law’ in 2015, and ‘Validity of Decision of the ESCB of 4 March 2015 on public sector asset purchase programme (PSPP)’ in 2018. The last one was challenged by the German constitutional court on 5 May 2020, but a resolution is emerging and damage to monetary policy avoided (see https://www.ft.com/content/99447f21-46db-465b-8ed0-9a214a898a74).
3 See https://www.ft.com/content/fcfdc50b-019e-461a-8e65-3916971ef2dd.