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Monetary policy is reliant on fiscal policy with regard to safeguarding price stability. Escalating public debt inevitably drives prices higher. But growing government debt can still pose a threat to price stability even before it begins to spiral out of control.
The importance of sound public finances for monetary policy
High levels of government debt make it difficult to safeguard price stability in more ways than one.
To say that independent monetary policy alone is a sufficient condition for stable money would be premature, if not naive. If a sovereign runs up so much debt that the burden soon becomes unsustainable, the central bank comes under much greater pressure.
Recent research findings suggest that it can take some time for a central bank that has a credible track record to forfeit its credibility.
Once a central bank has lost its credibility, inflation expectations may surge dramatically. Bringing them back under control can be both time-consuming and costly for the economy.
Preconditions for sound public finances
Sound public finances thus remain a necessary precondition for price stability. And ensuring sound public finances is even more crucial in the monetary union. This is because one of the fundamental problems of a monetary union featuring decentralised fiscal policies is that member states have a greater incentive to incur debt.
There are two conceivable approaches to realign liability and control and, in doing so, to create a stable monetary union. The one is to take a quantum leap towards a genuine fiscal union. The other is to try to reassert the principle of individual responsibility.
Regardless of which path monetary union takes, it must be ensured that, in future, budgetary imbalances of one country do not automatically jeopardise financial stability.
Price stability requires sound public finances, and sound public finances call for a coherent framework for monetary union. However, the question of designing the overall framework does not solve the problem of the current deficits.
Consolidation versus growth
There is no disputing that austerity measures can impede growth in the short term. But it is equally indisputable that the debt situation in the countries concerned is simply unsustainable. I therefore believe that there is no alternative to resolute consolidation. This is the logical consequence of the fact that this crisis is essentially a crisis of confidence. In order to restore confidence in public finances, fiscal policymakers must now show that they are able and willing to improve their structural budgetary position.
In order to ensure sound public finances in the euro area over the long term, the architecture of monetary union has to be further developed in a coherent manner.
Consolidation and growth do not conflict with one another. Instead, the one is the precondition for the other.
If Europe resolutely executes the necessary reforms, monetary union will end up stronger.