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The COVID-19 shock initially looked to be mostly a supply-side story, for which both monetary and fiscal stimulus can do little. However, the almost immediate sharp tightening in financial conditions related to liquidity, financial market tensions, and the collapse in confidence and aggregate demand call for an energetic macroeconomic policy response. Monetary policy and national fiscal actions are unprecedented but may still not be enough. A powerful fiscal response at the centre looks necessary.
Both the symmetric nature of the shock and limited fiscal space in several member states argue for a response at the supranational level. However, the political hurdles that the creation of new fiscal instruments at the European level – especially if they entail risk sharing across member states – would have to cross are daunting. The problem would remain even if European leaders decided to go for a quick fix through the European Stability Mechanism, and a more permanent solution would have to be developed over time. This can only be achieved if it is seen as benefitting all, which is what our modelling exercise, discussed below, suggests.
There is a strong case for creating a European safe asset to replace national sovereign bonds in their role as collateral for banks in repos and inter-bank loans. Proposals have also been put forward to create a fiscal capacity at the centre of the euro area to finance deficit spending. Authors have combined these proposals into one comprehensive package and quantified its impact on the resilience of the euro area economy in the face of major adverse shocks like the one we are currently experiencing.
Their simulation suggests that with a safe asset and centralised fiscal capacity, macroeconomic stabilisation becomes much more effective in the face of the outbreak of COVID-19 hitting the euro area economy. Fiscal stimulus at the centre would provide substantial demand offset, with a much more muted increase in government debt in the periphery and a more modest monetary policy response. Both the ‘core’ and ‘periphery’ of the euro area would gain.
The policy response to the COVID-19 shock is an opportunity to provide a lifeline to the economy while also permanently fixing some of the vulnerabilities of the euro area policy framework.