The euro must prepare for future shocks

Monetary policy is not enough on its own — fiscal co-ordination is essential

Laurence Boone


Eurozone finance ministers at the Eurogroup Finance Ministers' meeting in Brussels last December © EPA


For the past year, the OECD has been warning about the accumulation of risks and uncertainty that undermines investment and the world economic outlook. Its 2019 global growth projections fell from 3.7 per cent in September 2018 to 3.2 per cent in the latest forecast in May, well below the growth rates seen over the past three decades.

The summer is providing little respite amid heightened trade tensions, the possibility of a no-deal Brexit and renewed market volatility. Brexit alone illustrates the magnitude of these risks: if the UK were to start trading with the EU on World Trade Organization rules, gross domestic product in the remaining EU27 area would contract by around three-quarters of 1 per cent over a few years, with steeper declines in some countries and individual sectors.

In such a challenging environment, Europe will be in a stronger position if further progress is made on economic management across the bloc.

Speakers at the European Central Bank’s annual conference earlier this summer reviewed the first 20 years of the euro, judging it against benchmarks for outcomes, institutions and policymaking. The consensus view was that outcomes, in terms of the convergence of living standards, have been uneven. However, the eurozone has been strengthening its institutions and policy toolbox. Looking back in this way can help disentangle policy mistakes from institutional constraints. And it will make it easier to build political support for joint action across the eurozone in the future.

On the monetary side, the ECB has been impressive and continues to fight stubbornly low inflation. It was instrumental in lifting the eurozone out of the financial and sovereign debt crises, and fulfilled its role of lender of last resort, providing liquidity to banks.

Yet the central bank was not as quick to react to the slowdown in activity at the same time. It did not initiate quantitative easing, on top of larger liquidity support and negative interest rates, until March 2015. Why did it take so long for the ECB to start quantitative easing when growth was anaemic, inflation falling and other central banks had already increased their balance sheets? The US Federal Reserve, for example, started QE on a large scale five years earlier.

There were institutional reasons for the delay. It took time to forge a consensus amid legal uncertainty. And there were entrenched opposing views in the ECB’s governing council. There were also concerns about the asymmetry of the central bank’s mandate to ensure price stability.

Mario Draghi, the president of the ECB, addressed the question of asymmetry at a press conference in July, insisting that there was “no question” of accepting permanently lower inflation rates. But a firmer consensus on the governing council and policy support from the eurogroup of EU finance ministers, while respecting the independence of the ECB, would permit a swifter response to new developments.

It is on fiscal policy that support from the eurogroup will be most crucial. After a large synchronised stimulus in 2009, the fiscal stance reversed quickly. Tightening started much too early, while the output gap in the eurozone was still widening.

Adjustment measures were decided at the country level, ignoring cross-border spillovers. Since then, rules have been reformed but the lack of co-ordination remains.

Fiscal co-ordination is challenging and spillovers are difficult to measure. But there is little doubt that cross-border fiscal effects are significant in an integrated currency area such as the eurozone. In addition, political incentives are weak. Some member countries have been reluctant to respect the fiscal rules, while others have neglected the EU’s macroeconomic imbalance procedure. The combined effect has been to undermine incentives to co-ordinate policy.

However, looming threats to growth in the eurozone should encourage member states to put their differences aside and formalise greater fiscal co-ordination. This would boost confidence in the ability of the eurozone to deal with shocks and assume some of the burden currently borne by monetary policy.

External shocks could be caused by a no-deal Brexit (the likelihood of which is growing), or escalating trade and currency tensions. They would call for a co-ordinated fiscal response, parallel with monetary accommodation. The OECD’s estimates of the impact of these shocks show that individual countries will struggle to absorb them without such a package.

Over its first two decades, the euro has proved to be impressively resilient. The next few years will bring further tests. But they will also be an opportunity to improve the single currency’s governance structures, allowing the eurozone to make a more positive contribution to global economic and financial stability.


The writer is chief economist at the OECD

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