Pulling Together, Virtuously
IMF News, May 11, 2022
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- Published: May 11, 2022
Global trends affecting advanced-economy policymaking
- Neutral real rate of interest has been steadily pushed down by the balance of supply and demand for savings (drivers include 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:
- For the twelve founding members of the euro area, average gross public debt rose from 60 percent of GDP in 1991 to nearly 100 percent in 2021.
- Declining interest burdens have partly offset fiscal vulnerabilities:
- The average interest bill of the twelve original euro adopters fell from 5 percent to 1½ percent of GDP over the last 30 years.
- Risks that could reverse past helpful trends include drivers of deglobalization and large investment needs associated with the green transition.
Two internal euro area trends
- Income convergence
- Per-capita incomes converged among the twelve original euro adopters in the three decades to the signing of the Maastricht Treaty in 1992.
- Convergence then slowed, stalled in the first decade of the euro, and following the global financial crisis per-capita incomes began to diverge, unwinding much prior progress.
- Outcomes were better for newer euro area members, but the pace slowed there too.
- Business-cycle synchronization
- Concordance measures were high at the launch of the euro and increased until the global financial crisis; amplitude gaps (differences in the size of fluctuations in national growth rates) continued to narrow initially.
- After the global financial crisis, concordance continued to increase while amplitude differences began to widen—meaning the common monetary policy direction remained broadly right but the optimal degree of tightness or looseness diverged across countries.
- The reversal of north-south capital flows during the global financial crisis helped precipitate the euro area debt crisis.
Fiscal space and national policy implications
- Being in a monetary union without central fiscal stabilization places a greater burden on national fiscal policy to act countercyclically when business cycles are less-than-perfectly harmonized.
- Several euro area countries failed to build fiscal space in good times (or to rein in undue financial-sector risk taking), leaving little room when shocks struck; adverse market dynamics pushed some into procyclical fiscal tightening.
- The widening of business-cycle amplitude gaps coincided with monetary policy effectiveness decreasing as rates approached the lower bound.
- In the wake of COVID-19, public debt has ratcheted up once more in many countries.
- Policy prescriptions for national-level fiscal policy:
- Rebuild fiscal space where deficits and debt are high.
- Improve the composition, quality, and overall design of fiscal policies, including measures to help lift growth.
- Complement fiscal consolidation and reprioritization with structural reforms to reduce competitiveness gaps and facilitate convergence and policy transmission.
Monetary policy challenges and implications
- There have been four major crises in the span of less than fifteen years, increasing uncertainty and reducing the robustness of "tinkering around the edges" strategies.
- Low neutral rates constrain conventional monetary policy space; central banks will likely face a narrow corridor for policy rates, hemmed between a low neutral rate and the effective lower bound in the next crisis.
- Unconventional monetary policy tools should be expected to become increasingly conventional; monetary policy must be agile in all stages of the business cycle, especially during sudden large shocks.
- The ECB operates in a currency union that is not a fiscal union, requiring careful delineation between union-wide stimulus and ensuring policy transmission to all members. The ECB has adapted and "proven to be a learning institution."
- Current inflation dynamics:
- Challenge is "too-high, not too-low, inflation."
- Time for policy rate lift-off in the euro area is "fast approaching."
- Risks:
- If policy is not agile enough, inflation expectations could become unanchored, likely demanding a higher and more economically costly peak policy rate.
- If policy is too assertive, inflation could be pushed back into a below-target equilibrium, with negative implications for future monetary policy space.
- Data dependence is critical for decisions on timing and pace of policy moves.
Monetary-fiscal coordination and euro area architecture
- Monetary policy cannot do it alone in a monetary union with asymmetric impacts of common shocks and differing fiscal space.
- Limited fiscal space leading to procyclical national budgets reduces the potency of monetary easing in vulnerable countries and complicates decisions to tighten policy.
- Greater priority must be given to monetary-fiscal coordination at both national and union levels in an environment of constrained policy space and high uncertainty.
- Architecture improvements and risk management:
- More progress on risk reduction and improving national economic resilience would build political support for stronger shared architecture, which would in turn reduce risks and enhance national reforms.
- Key steps since the global financial crisis include erecting pillars of the banking union, notably the single supervisory mechanism.
- A major missing piece is a permanent central fiscal capacity for macroeconomic stabilization in the euro area.
- A well-designed fiscal stabilization instrument—combined with reform of the fiscal rules—would help counter procyclical national fiscal policy, support a better monetary-fiscal mix, and help narrow amplitude differences across countries, making the common monetary policy a better fit for all member states.
- A key roadblock to shared instruments is fears of moral hazard, which must be addressed by appropriate policy design.
Conclusions and policy recommendations
- Priorities:
- Monetary-fiscal coordination must receive higher priority at both national and union levels, especially with constrained policy space and high uncertainty.
- Monetary policy needs to be agile across the business cycle; fiscal policy must create space in good times to support activity in bad times.
- Establishing a central fiscal stabilization capacity in the euro area would greatly help this endeavor.
- Lessons from the pandemic:
- The pandemic demonstrated that, with appropriate design, solidarity can overcome fears of moral hazard.
- Monetary and fiscal policies worked in tandem during the pandemic; the political agreement on Next Generation EU was a watershed expected to boost productivity and growth in the medium term.
- Apply lessons to address remaining architecture weaknesses to narrow the divide between risk sharing and risk reduction.
- Growth and convergence dynamic:
- Growth makes it easier to reduce fiscal vulnerabilities.
- Stronger fiscal positions and reforms to boost potential growth encourage cross-border investment and private risk sharing, improving business-cycle synchronization and monetary policy effectiveness, and promoting income convergence—the "glue for social and political cohesion."
- Final appeal:
- Despite challenges from the war in Ukraine, recent solidarity, creativity, and boldness give reason to believe a virtuous circle of mutually reinforcing national and union-level reforms to raise growth and resilience is possible; policymakers should seize the opportunity.
Source: Pulling Together, Virtuously — Remarks at the Banka Slovenije Conference by Alfred Kammer, May 11, 2022.