Simon Wren Lewis writes despairingly about the state of Eurozone fiscal policy; Northern core countries like Germany, France and the Netherlands pursuing zero deficits or surpluses, at a time when ECB interest rates are at the effective lower bound, and core inflation is stubbornly well below its 2 per cent target. Endorsing his post in its entirety, I have just a few things to add.
Tight fiscal policy would not be a problem if unconventional monetary policy [buying sovereign and private sector assets, in the case of the ECB] was a perfect substitute for counter-cyclical fiscal policy. But this is a minority position in the econ and policy-making community. And Northerners find it distasteful because they see it as coming close to breaking a taboo about monetary and fiscal separation.
The Eurozone institutional structure encodes learning from the German hyperinflation in the 1920s. Insulate monetary policy from fiscal policy as securely as possible, in case fiscal policy gets out of control and monetary financing begins to look tempting; and make sure fiscal policy is biased towards the conservative side anyway, to guard against this happening at all. What Germany – or the Allied powers that imposed the post World War 2 constitution – thought had been learned from that episode was forced on the rest of the Eurozone as a condition for its creation.
Those institutions hard wire a lesson that was worth learning. We are better off with the much diminished possibility of hyperinflations. But the trouble is, we have learned another lesson in the last 10 years, which is that the chance of hitting the zero bound is higher than we thought, and that means that the delegation and assignment scheme implied by the old institution is deficient.
Eurozone politicians from the Northern core are behaving as though the monetary policy objectives delegated to the ECB are only the ECB’s problem, ie objectives that are only pursued with monetary policy tools. But this is not appropriate when conventional policy is trapped at the effective lower bound, and assistance is needed. Given what we know now, delegation of macroeconomic stabilisation to the central bank unconditionally, and shooting for fiscal surpluses unconditionally, is misguided.
The financial crisis has revealed a deficiency in the currency union model that we did not think so important beforehand.
In a country with a government ultimately responsible for its own monetary and fiscal policy, it is in principle easy for that government to organise itself so that fiscal policy steps in when monetary policy runs out of room [Labour’s proposals code for this explicitly, and pretty well].
When there are many fiscal agents, there is no mechanism to coordinate the new fiscal policy, in particular to encourage individual countries to care about the overall Eurozone monetary policy deficiency / inflation target undershoot.
The Stability and Growth Pact was a leaky [ie never perfectly enforced] attempt to coordinate against overly loose policy; the worry being that badly behaved governments would over-borrow, counting in some way on the common central bank and other implicit aspects of the union to bail them out if necessary. But there is no attempt to coordinate for the reverse problem, overly tight policy. That is not so surprising, because before the crisis, under-stimulation was not recognised to be a very likely circumstance, given the history of most Eurozone countries’ macroeconomic policy.
The issue is compounded in the Eurozone by fixing in stone [that is, Article 127 of the Lisbon Treaty] the monetary policy mandate. The ECB pursues ‘price stability’ [in line with the German constitution] and interprets for itself what that means. It chose the lexicon ‘close to, but below 2 per cent’. A response to the lessons of the financial crisis could comprise 1) more aggressive and institutionally coded for countercyclical fiscal policy at the effective lower bound or 2) a higher inflation target, or, ideally, some combination of the two. In the UK, the government retained the right to define and redefine the target for the central bank. In the Eurozone, this right rests with the ECB, and the ECB’s mandate effectively forbids a higher target.
This feature of the Eurozone was a feature, not a bug; but now it has become both.
Monetary union would not have been possible if the German authorities thought it likely that the other governments could gang up on it and hike up the inflation target. Encoding the target in the Eurozone Treaties, which conferred many other benefits and so was much less likely to be torn up as a whole, was a guarantee against this happening. In the old world when the effective lower bound seemed like a curiosity [even if one suffered by Japan by the time EMU got going], there were no obvious costs to making it so hard to move the inflation target. Now we know that there are.