Pulling Together, Virtuously

May 11, 2022

As Prepared for Delivery

It is a great pleasure to be here with you today to celebrate the thirtieth anniversary of Banka Slovenije. Strong institutions make for good policymaking. Major congratulations are due.

I will leave a discussion of the history of money in Slovenia, the Czech Republic, and Croatia to the expert panelists of our first roundtable. I plan to take a broader perspective.

First, I will flag two familiar global trends that fundamentally affect policymaking in advanced economies, along with two internal trends in the euro area. I will then discuss euro area policies, where I will stress the centrality of monetary-fiscal coordination.

Weaving in the architecture, my overarching point will be that policies at the national and union levels are complements, not substitutes. I will argue that a virtuous circle is within Europe’s reach.


Let me start with the two global trends.

The first is the balance of supply and demand for savings, which has steadily pushed down the neutral real rate of interest and eroded monetary policy space.

Drivers have included a growing supply of savings linked to population aging, and subdued demand for savings as productivity growth in advanced economies has seen a trend decline and the capital intensity of production has fallen.

As the neutral rate fell, public debt generally increased. The average gross public debt ratio of the twelve founding members of the euro area, for instance, rose from 60 percent of GDP in 1991 to nearly 100 percent in 2021.

The resulting increase in fiscal vulnerabilities has been offset by the second and related trend that I would like to emphasize—interest rates have generally fallen by more than growth rates. With this, the average interest bill of the twelve original euro adopters fell from 5 percent to 1½ percent of GDP over the last 30 years, making it easier to shoulder large public debt burdens.

But there are forces that could reverse this helpful trend, including drivers of deglobalization and large investment needs associated with the green transition.


Let me next briefly survey two trends within the euro area.

A natural place to start is income convergence. While this is not strictly necessary for the smooth functioning of a monetary union, it is the glue for social and political cohesion.

Among the twelve original euro adopters, per-capita incomes converged in the three decades to the signing of the Maastricht Treaty in 1992. Convergence then slowed, before stalling in the first decade of the euro. Following the global financial crisis, per-capita incomes began to diverge, unwinding much progress previously seen. Outcomes were better for newer euro area members, but there too the pace slowed.

In many respects the global financial crisis proved a turning point—by triggering a reversal of north-south capital flows, it helped precipitate the euro area debt crisis.


A second internal trend concerned the synchronization of business-cycles. This, more than income convergence, is central to the functioning of a monetary union: it determines the appropriateness of the single monetary policy for each member country.

Here, the early years of the euro were good. For the twelve original euro adopters, concordance measures, of whether countries are in the same phase of the cycle at the same time, were high at the launch of the euro and increased until the global financial crisis. Equally, the amplitude gap—the difference in the size of fluctuations in national growth rates over the cycle—continued to narrow.

Again, the global financial crisis turned the tide. While the concordance of business cycles continued to increase, differences in amplitudes began to widen. In other words, while the common monetary policy still pulled in the right direction overall, the optimal degree of tightness or looseness of monetary settings over the cycle began to diverge across countries.


And now to the policy implications. The issue of national specificities naturally takes me to the topic of fiscal space.

To the extent that business cycles are less-than-perfectly harmonized across countries, and in the absence of a central fiscal stabilization capacity, being in a monetary union places a greater burden on national fiscal policy to act countercyclically . Countries need prudent budgetary policies in good times to ensure that they have the fiscal space they need in bad times.

Alas, what we saw in some cases was quite the opposite. Having failed to capitalize on periods of relatively strong growth—or indeed to have reined in undue risk taking in the financial sector—several euro area countries found themselves with little fiscal space when shocks struck. Adverse market dynamics then pushed several countries into procyclical fiscal tightening.

At the level of the currency union, this widened the business-cycle amplitude gap at a time when the effectiveness of monetary policy was beginning to decrease as rates pushed down to the lower bound.

Today, in the wake of Europe’s strong policy response to the COVID-19 pandemic, there is no getting away from the fact that, in many countries, public debt has ratcheted up once more.


Against that backdrop, let me turn to monetary policy—this is after all a gathering of central bankers.

We have seen four major crises in the span of less than fifteen years. Heightened uncertainty suggests that “tinkering around the edges” of business cycles is no longer a robust strategy for monetary policy. This is especially true given the low neutral rate which, in effect, means “conventional” monetary policy space is constrained. When the time comes for central banks to respond in the next crisis, they will probably again see a narrow corridor for policy rates, hemmed between a low neutral rate and the effective lower bound.

The implication, of course, is that we should expect once unconventional monetary policy tools to become increasingly conventional. And in an environment with less monetary policy space, monetary policy needs to be agile in all stages of the business cycle, especially at times of sudden large shocks.

Among the major central banks, the ECB remains unique in that it operates in a currency union that is not a fiscal union. Careful lines have had to be drawn between policies aimed at delivering a certain stimulus for the union as a whole, on the one hand, and policies to ensure proper policy transmission to all corners of the union, on the other. The ECB has proven to be a learning institution, adapting well to uncharted territory.

Today, of course, the challenge is too-high, not too-low, inflation. Policymakers and market participants agree that the time for policy rate lift-off in the euro area is fast approaching. If policy is not agile enough, inflation expectations risk becoming unanchored—which would likely demand a higher and more economically costly peak policy rate. In such a world, the challenges of the lower bound and the need for monetary space might fade from memory. If policy is too assertive, inflation could be knocked back into its below-target equilibrium of the last decade—with all the negative implications for future monetary policy space. At times like these, data dependence is critical. But more to that in the second session of today’s conference.


Now let me bring this all together and touch on an issue that is one we neglect at our peril: monetary-fiscal coordination.

As I discussed earlier, cyclical differences in national fiscal policies have contributed to diverging business-cycle amplitudes across the euro area. This divergence, coupled with scarce monetary and fiscal policy space in some countries, means policy coordination must receive higher priority at both the national and union levels than in the past.

In essence I am underscoring here that monetary policy cannot do it alone.

In the context of a monetary union, differing degrees of fiscal space can and do complicate monetary policymaking. The impact of common shocks can be asymmetric across countries, especially if limited fiscal space gives rise to procyclical budgetary policies. This reduces the potency of monetary policy easing in the more-vulnerable countries. And it also complicates decisions to tighten monetary policy lest they destabilize some domestic credit markets.

Cyclical incongruence with monetary policy settings can also place higher demands on national budgets. At the national level, as I noted, where deficits and debt are high there is a need for fiscal policies to focus on rebuilding fiscal space.

This makes it all the more critical for countries to improve the composition, quality, and overall design of their fiscal policies, including to help lift growth.

And fiscal consolidation and reprioritization must be complemented by structural reforms to reduce competitiveness gaps across countries, thereby facilitating convergence and enhancing policy transmission.


Finally, architecture has a crucial role to play in squaring the circle .

At a high level, more progress on risk reduction and improving economic resilience at the national level would help build political support for a stronger shared architecture—which in turn would further reduce risks and enhance the impact of national reforms.

Many steps to shore up the architecture have been taken since the global financial crisis, including erecting key pillars of the banking union. I always think of the single supervisory mechanism, a formidable system of European banking supervision that did not exist a decade ago.

But the efforts are far from complete.

Perhaps the biggest missing piece is a permanent central fiscal capacity for macroeconomic stabilization in the euro area. A well-designed fiscal stabilization instrument—combined with a needed reform of the fiscal rules—would help counter the tendency toward procyclical fiscal policy at the national level and thus support a better monetary-fiscal mix.

It would also help narrow the differences in the amplitude of business cycles across euro area countries, making the common monetary policy a better fit for all participating member states.

Of course, here as in other areas, a key roadblock is fears of moral hazard.


Let me conclude by emphasizing two points.

First, monetary-fiscal coordination must receive higher priority at both the national and union levels, and doubly so in an environment of constrained policy space and high uncertainty. Monetary policy needs to be agile in all stages of the business cycle and, with less-than-perfectly-harmonized cycles across countries, it cannot do it alone. Fiscal policy must play its part—and to support economic activity in bad times, space must be created in good times. Having a central fiscal stabilization capacity in the euro area would help greatly in this endeavor.

Second, the experience of the pandemic has shown us that, depending on the challenge faced and given appropriate policy design, solidarity can overcome fears of moral hazard. During the pandemic, monetary and fiscal policies worked in tandem. The political agreement on Next Generation EU was a watershed, and one that should help boost productivity and growth in the medium term. Lessons should be applied to addressing remaining weaknesses in the architecture, to help narrow the divide between risk sharing and risk reduction.

Finally, let us always remember that a rising tide lifts all boats. Growth makes it easier for countries to reduce fiscal vulnerabilities. Stronger fiscal positions, coupled with reforms to boost potential growth, encourage more cross-border investment and private risk sharing. That improves business-cycle synchronization—making monetary policy more effective—and promotes income convergence. And convergence, ultimately, is the glue for social and political cohesion in the union.

Europe faces grave challenges emanating from the war in Ukraine. But the solidarity, creativity, and boldness with which it has acted in the last two years make me believe a virtuous circle of mutually reinforcing national and union-level reforms to raise growth and make Europe more resilient is possible. Policymakers should seize the opportunity.

Thank you.

IMF Communications Department


Phone: +1 202 623-7100Email: MEDIA@IMF.org