20 December 2021

Bruegel: Policy coordination failures in the euro area: not just an outcome, but by design

The rationale behind the Maastricht fiscal criteria was to prevent excessive spending (driven by uncoordinated fiscal policies) in response to external shocks.  Excessive spending would in turn put market pressure on those ‘undisciplined’ fiscal authorities and compromise the long-term stability of the monetary union.

In reality, fiscal policy was too loose during economic booms, when it ought to have aimed to build up buffers and too restrictive in recessions, when it ought to have cushioned shocks. Fiscal policy in the euro area on average has therefore been procyclical.

Additionally, monetary policy, through the European Central Bank (ECB), has had to do a lot more than envisaged in order to compensate for the fiscal inaction during recessions. Now at the zero-lower bound, the ECB has less room for manoeuvre by conventional means and has built up an unprecedented balance sheet position. We still need to understand what this means for the real economy, monetary policy effectiveness and the independence of the central bank.

We argue that the procyclical nature of fiscal policy in the euro area and the subsequent overuse of monetary policy are not just outcomes. Rather, they are a failure of the fiscal framework to recognise (even unintentionally) that there are strategic interactions that, if not appropriately accounted for, lead to such outcomes.

A setup that aimed to prevent negative spillovers produced a strategic environment where, in the face of a negative shock, all countries ended up being more restrictive than they ought to. This prolonged the recessionary period caused by the negative shock and forced monetary policy from its first best.

By contrast, explicit cooperation between fiscal authorities can help improve outcomes for all. Fiscal authorities will be playing a bigger role to address the shocks, without ignoring the negative externalities in place. Also, monetary policy will not be as active so that macroeconomics management achieves better outcomes. The non-cooperative versus cooperative outcomes comparison serves as a good way of contrasting the overall macro response in the financial crisis to that in the pandemic crisis in the EU.

The Maastricht criteria were never a good tool for fiscal coordination

We describe this strategic interaction in the context of European monetary union based on the Hamada diagram (see here).

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