The author is Head of European Economics Research at Barclays
When Covid-19 hit the world, policymakers responded with an extraordinary coordination of monetary and fiscal stimulus. The result has been a strong V-shaped economic recovery from pandemic lows.
As the euro zone faces a war-spurred inflation spurt in Ukraine, it will need to step up its coordination once again to avoid raising the specter of the European sovereign debt crisis.
The European Central Bank is looking to design a tool for transmitting policy across the Eurozone, to curb what is called fragmentation when there is a more disorderly rise in bond yields in one country than another.
The various operational, legal and political challenges that arise are numerous. But one of the main ones is related to the conditions that countries will have to meet before benefiting from the new facility. Conditionality means that the policy will have to be coordinated.
During the sovereign debt crisis in Europe, financial conditions tightened following interest rate hikes by the ECB. As insolvency problems grew, governments in so-called “peripheral” countries had to sharply tighten fiscal policy to gain support from the IMF or the EU, or to maintain market access.
This inability to coordinate policies has further weakened activity, especially in countries like Italy that have implemented “fiscal consolidations” that have hurt growth – mainly by raising taxes and cutting public investment. rather than cutting current public spending. A catastrophic monetary fiscal loop has been created.
History does not repeat itself, but it rhymes. While not Barclays’ base case for the Eurozone outlook – we expect a shallow recession followed by a mild recovery – the current macroeconomic backdrop looks dangerously similar to that of 2010-2011.
The nervousness of the market from June 9 to 14 is proof of this, with Italian bond yields having significantly exceeded their German equivalents. The outlook for the eurozone could deteriorate if governments are again forced to rapidly tighten fiscal policy amid growing concerns about debt sustainability, a result of higher borrowing costs and weaker real growth .
So far, the ECB’s commitment to preventing financial market fragmentation has calmed markets. The agreement of a credible anti-fragmentation facility at the July 21 Governing Council meeting is a necessary condition if the ECB is to prevent a fiscal crisis during its planned tightening, but we doubt it will be sufficient.
For starters, we believe the Governing Council will not agree ex-ante on yield levels or spreads to target. Pricing country returns on macroeconomic and fiscal factors is as much art as science and board members are likely to have differing views on this.
In addition, the board may well disagree on whether sovereigns with weak fiscal and growth fundamentals face a liquidity or solvency crisis when their borrowing costs rise.
In anticipation of such a disagreement, financial markets could test the central bank’s resolve to avoid fragmentation, putting pressure on individual countries by pushing up their sovereign bond yields.
The challenge is to design a policy mix that simultaneously lends credibility to the ECB’s commitment to bringing inflation back to its target while minimizing the risk of economies falling on such a path. In our view, some degree of coordination between monetary and fiscal authorities will be necessary.
National fiscal authorities should embark on credible fiscal consolidations that will not harm growth. This time around, the Next Generation European Pandemic Recovery Fund will help protect public investment from the crunch.
Some degree of fiscal discipline should be reintroduced to reduce fiscal risks and moral hazard. Some tax support for low-income households and small and medium-sized enterprises could be financed by low-interest European loans, as has been done during Covid-19.
At the same time, the ECB, by internalizing the impact of a more restrictive fiscal policy on growth and inflation, could undertake to tighten its monetary policy less and very gradually. It must ensure that its actions do not make the work of national budgetary authorities even more economically and politically difficult.
Although not easy to coordinate, this seems to us a realistic compromise that could put the eurozone on a more virtuous path than one in which highly indebted governments continue to run large primary deficits, while the ECB tighten its monetary policy.