Fiscal policy is coming and here’s why it will lead to the restructuring of the euro zone
As the ECB council just had its first meeting under the chairmanship of Christine Lagarde, there is little doubt a transition from monetary to fiscal policy is looming for the euro zone. Here’s why the policy shift may bring the first major overhaul in its twenty years history.
Monetary policy appears to be on its last leg as the call for the deployment of fiscal policies become louder. Below a few compelling arguments that suggest the handover from monetary to fiscal is coming;
- It has become accepted that monetary policy has had very little impact on economic growth. On the contrary there is plenty of evidence that monetary easing has been hindering credit expansion. While the idea of fighting debt with more debt may have had some theoretical merit a decade ago we have now conclusive data pointing to the opposite. To this regard, the latest assessment is coming from none other than the ECB itself. Even a cursory read of the summary for the latest Financial Stability Review point to low interest rates and QE as the main drivers of “asset mispricing”, “debt sustainability concerns” and “risks to capital markets”, In other words a decade of monetary intervention has little to show in the way of the economy reaching escape velocity, but has significantly increased the risk of future financial instability.
- Economic stagnation and income inequality have been breeding political unrest. Old and new politicians in continental Europe are itching to spend money, appease their electorate and bolster their power base. Needless to say negative rates provide a very convenient cover as they effectively represent an incentive to increase deficits rather than to restrain it. When rates are negative, governments are literally paid to spend taxpayers money. Should “stagnation” turn into “recession”, MMT is likely to kick in as the combination of political turmoil and zero rates provide sufficient cover to turn on the spigots and provide liquidity directly to the people, bypassing the transmission mechanism of the banking system.
- Europe, as most advanced economies, desperately need inflation to trigger animal spirits and self-sustaining growth. More importantly, inflation will go a long way to increase nominal GDP growth above from the ever low cost of debt hence improving debt/GDP ratios at least in nominal terms. Fiscal policy may succeed in creating inflation where monetary policy, tied to bank lending, could not as it would inject liquidity straight into the economy and resuscitate the velocity of money.
- A decade of ever shrinking rates has left European banks in a pitiful state. As the bulk of European economy is financed through bank debt (83% of total corporate funding vs 32% in US), the situation is not sustainable and pose a systemic risk. Simply put, banks cannot operate in a negative rates environment. An healthy banking sector is therefore a matter of priority and a shift to fiscal policy may provide the ECB for a plausible set up to start increasing rates.
Whether fiscal policy will be able to restore the continent to economic health is yet to be seen. A restructuring of the common monetary zone may become however the unintended consequence of policy shift. Whilst monetary efforts could be coordinated and deployed under the stewardship of the ECB, fiscal policy falls under the domain of the member states. Some member state have ample room to expand their budget while some others don’t. Italy, the country that more than any other except Greece, has maxed out its credit line under the Maastricht rules, is most at risk. Without the ECB backstop, a modest, 200–250 bps increase in rates will expose the harsh reality of a debt that already, at the lowest rates ever, requires 9% of total revenues to cover interests expenses.
The only OECD country to have its nominal growth rate below its average debt servicing cost, even assuming zero deficit, Italian debt continues to grow. It is therefore hard to imagine how the euro zone partners may agree to keep QE going only for Italy and keep purchasing Italian bonds without some meaningful reform plan. The current ESM reform treaty, article 16 clearly states that “conditionality attached to the ESM loans shall be contained in a macro-economic adjustment programme”. Reining in public debt and/or a restructuring of the same would be the least. After all, goes the argument, Italy’s private wealth is one of the largest in the world and four times total government debt. So why wouldn’t Italians put hands to their own pockets before asking for help from their European partners? And therein lies the proverbial rub.
The overwhelming majority of Italians opposes any fiscal tightening. On the contrary, every major political party has a platform to expand the deficit rather than reduce it. A clear testimony to such sentiment is the recent debate around the ESM reform. Euro zone partners and international investors that are banking on Italian debt restructuring will be disappointed as there is no political will for it whatsoever. Since tertium non datur, Italians may prefer to exit the never-much-loved common currency project rather than take the bitter medicine that lead to fiscal recovery.
Twenty years after its inception, the euro zone may just ready for its first major makeover.
This article was originally published on LinkedIn.