14 March 2019

Financial Times: Europe must learn to love fiscal stimulus

Even as the economic outlook has been downgraded, European policymakers — with the recent exception of Mario Draghi, president of the European Central Bank — have waved off the slowdown, stressing temporary factors like dry rivers in Germany and yellow vests in France. [...]

But the impulse to deny problems also reflects a deeper anxiety: that, a decade after the global crisis, Europe has run out of bullets. Fiscal stimulus is constrained by a narrative that public debt has become dangerously high in most countries. Monetary policy is constrained by an aversion to “unconventional” actions, like quantitative easing, prompting the ECB hastily to declare the programme a success and end it in December.

Another constraint is the upcoming change at the helm of the ECB, with potential successors to Mr Draghi and others on the executive board keen to burnish their conservative credentials. This may have weighed on the ECB’s decision last week, which, even if it exceeded market expectations, was limited in scope.

Given how slowdowns can slip into recessions, is Europe beyond saving? Not quite.

One cause for hope is that the slowdown has swept up not only chronically weak countries like Italy, but also seemingly impregnable ones like Germany. They may be at opposite ends of the risk spectrum, but the global trade shock has put these net exporters in the same boat. Thus, even Germany is becoming receptive to policy stimulus. The voices calling for the government to go beyond the limited fiscal action it has taken to date now span the political spectrum.

The most effective mode of fiscal stimulus — a common, eurozone-wide budget — is a bridge too far politically. But a co-ordinated fiscal easing across the eurozone, which the IMF has shown delivers more bang for the buck, is within the realm of the possible. Indeed, this was a key response to the global crisis a decade ago, and instrumental in mitigating its impact.

Although sovereign debt is higher than it once was, it has declined in recent years, partly because interest rates have been lower than economic growth. Thus, most countries, certainly the largest ones, have the fiscal space to support growth without jeopardising debt sustainability. (Italy may be an exception, but this too is debatable.) If the goal is to boost demand, fiscal stimulus should favour investment and other spending over tax cuts.

As for monetary stimulus, the case for stronger action is compelling, even when viewed narrowly in terms of the ECB’s price stability mandate. Near-term inflation is falling far short of the ECB’s target of “below, but close to 2 per cent”, and longer term inflation expectations are back at levels that were used to justify QE in the first place in 2015. European inflation is starting to look congenitally weak, like that in Japan.

Last week, the ECB deferred the expected raising of interest rates in September by three months and, in order to effectively delay banks’ repayments, launched a third round of Targeted Long-Term Refinancing Operations. But deferring planned negatives is a rather modest definition of “stimulus”.

A bolder step would be to revive QE — not the old programme that mostly focused on purchases of sovereign bonds, but one that puts the emphasis squarely on private sector assets. The latter could cover equity, corporate bonds and senior bank debt. Buying private assets rather than sovereign bonds may be more stimulative, as sovereign risk spreads are already quite compressed. A focus on private assets would also get round the ECB’s cap on holdings of any one sovereign’s debt (lest it become a dominant creditor in the event of a restructuring). [...]

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