Europe needs to move from fear of the ‘moral hazard’ of fiscal co-operation to confidence in its collective benefits.
Europe finds itself in crisis mode—again. For about 15 years crisis management has been the modus operandi of the European Union, with each crisis appearing further to test the limits of the political will to co-operate.
This time, however, is different. Muddling through will not work, and the only way to overcome the crisis will be by co-operating and leveraging one another’s strengths.
The experience of European co-operation, though, leaves much to be desired. In previous crises, such as the eurozone crisis, it was superficial. The power imbalance between north and south was clear, as was the political outcome.
In a monetary union, persistent large deficits and surpluses on the current account are equally bad, requiring adjustments on both sides. Yet only the deficit countries were subjected to painful economic strain. Overall, this induced a deflationary bias in the euro area—such as John Maynard Keynes had sought to avoid in the world economy through the global financial order established at the Bretton Woods conference of 1944.
The contractionary eurozone fiscal policy, and associated sluggish wage growth, led to a weak economic performance and persistent undershooting of the 2 per cent inflation benchmark of the European Central Bank. This, in turn, forced the ECB into the corner of very expansionary monetary policy—for which it was criticised (ironically) by the conservative politicians in Germany and elsewhere who had insisted on austerity and wage squeeze in the first place.
A decade on, the response to the Covid-19 crisis—above all the Recovery and Resilience Facility—appeared a genuinely European product. Since the outbreak of the pandemic was clearly an external, symmetric shock, the ‘blame game’ of the eurozone crisis was not repeated, although a certain scepticism, especially on the part of the ‘frugal’ states, remained. Among them Germany insisted the recovery fund be temporary.
In recent months we have faced another external shock, of even more disruptive potential. The manner in which European economies have dealt with the many challenges resulting from the Russian war in Ukraine suggests willingness to share the burdens and move forward collectively is limited.
The latest €200 billion energy-support package from the German government was labelled ‘anti-European’ by policy-makers who perceived a neglect of solidarity in Berlin while noting that a large domestic stimulus could be issued without any financial repercussions (yields on German government bonds even fell initially). It was interpreted elsewhere in Europe as a sign of the increasing isolation of Germany—which had informed neither the European Commission nor its longstanding French partner in advance.
Although this criticism is understandable from the point of view of economically weaker member states—and the communication could have been better—a fiscal impulse was right to prevent the economy from collapsing. Speed was the determining factor, as the Free Democrat finance minister, Christian Lindner, had been blocking the release of further funds for a long time.
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A severe recession in Germany is not in the interest of its European partners, just as a severe recession in the rest of Europe would be bad news for Germany. To stem the latter risk, however, more needs to be done—and not every member state is in a position to intervene in the way the German government did.
The Austrian economist Philipp Heimberger repeatedly points out that as the largest eurozone economy Germany enjoys an ‘exorbitant privilege’ on bond markets, which allows its government to borrow more cheaply than other member states. This is especially so amid radical uncertainty when funding needs go through the roof, risk premia soar and there is a flight to safety.
A return to austerity—or a ‘downward adjustment’ of demand to restricted supply, as some economists put it—would cause severe damage to Europe and potentially enhance the threat from the populist radical right. To leave the crisis behind in an enduring way, we must acknowledge the deep interdependence among European economies, leverage one another’s strengths and overcome shortages through expanding supply via strategic investments. The correct strategy is hence to combine the ability to issue comparatively cheap debt, which some countries can bring to the table, with the diversified, solid energy supply others can offer.
Overall, we have two types of funding need. First, households and enterprises need assistance to cope with rising prices. This falls on the shoulders of government, which must prevent the shutdown of otherwise solid businesses. Some claim such support could exacerbate inflation and negate monetary-policy constraint, but it would likely only dampen the reduction in demand. Carefully crafted fiscal measures can in any event lower consumer-price inflation and, in as much as inflation is compounded by inflationary expectations, reduce such knock-on effects.
All policy initiatives must of course sustain incentives to minimise gas consumption. Otherwise, some of the assistance would end up in the pockets of gas suppliers and avoidable shortages could arise.
Secondly, we need investments to expand energy supply and reduce dependencies. These must be strategically targeted towards taking the pressure off gas, focusing on renewables, fuel-switching and energy efficiency. In the long-run, investments in basic research and development, new technologies and circular business models ought further to reduce the appetite for fossil-fuel energy in all European economies.
Even among economists, the tremendous need for investment in Europe is hardly disputed. Yet this will demand a tour de force of European co-operation, as borrowing costs have risen widely and will most likely continue to rise in the short term. The commission ought to take the lead in relaunching the debate as to what instrument would best address the challenges we face. With the pandemic shock, the EU recovery fund brought some breathing space for governments to increase resilience and stabilise the economy. In response to the Russian aggression and its economic fallout in Europe, an instrument of similar function and scale should be put in place.
The commission, with its triple-A credit rating, and member states with similar standing on financial markets should throw their weight behind an instrument that would facilitate cheap Europe-wide borrowing. With interest rates rising globally, there is no alternative if we want to solve the problem at root while preserving political and social stability in Europe.
In addition to a reform of the eurozone fiscal rules, as called for by the French government—a commission proposal was expected today—common European debt will be the way to go. It will lower borrowing costs for member states not otherwise able to fund their investments.
European bonds would give investors worldwide an opportunity to invest in a highly liquid and safe asset, denominated in euro, hence strengthening the euro as a reserve currency and the EU as a whole. Having a stronger, leading-reserve currency status would give member states a lot more leeway and stability in economic policy, as the currency would be less vulnerable to future flights to safety.
The ‘comparative advantage’ of the German economy could serve as a chip on the table in return for tighter co-operation on energy supply and security. In past decades, the German economy became highly dependent on Russian energy and it will rely on its European partners to overcome the energy crisis. This includes, among other things, the building of pipelines through their territories as well as the sharing of energy resources other member states may be able to spare.
If there is scope to share such resources or solicit co-operation from member states in the building of infrastructure, a backing of European debt would serve as a strong incentive. In the long run, member states should work jointly and constructively to deepen a common European energy policy, including common purchasing via the commission, and accelerate the transition towards renewables.
Such a bargain is likely to be contested in ‘frugal’ member states. The predominant concern of conservatives about a common fiscal policy is moral hazard—that it encourages ‘spendthrift’ behaviour by the national beneficiaries. Yet, if there is a problem of moral hazard, tilting the balance from the national towards a common fiscal policy could help reduce it.
The fiscal ceilings in the Stability and Growth Pact—3 per cent budget deficit and public debt of 60 per cent of gross domestic product—are time-inconsistent and enforcement is (and will remain) weak. In a crisis, when governments must decide whether or not to stick to the rules, there is a strong incentive to opt out. The no-bailout rule is time-inconsistent, too: the ECB and the other member states have again a strong incentive to violate it to save the euro, thereby preventing contagion.
Common European debt will not exacerbate this. On the contrary, it is easier to abide by fiscal rules if, when hit by an adverse shock, a European budget can help one’s economy. A common fiscal policy would mean the rules for the member states could be stricter and enforcement easier.
There is an opportunity here for a pragmatic bargain among European member states. One side can expand access to much-needed capital on terms advantageous for all—a financial prerequisite for sustainable exit from the crisis—while the other could help ensure that available energy is used, disseminated and developed in an equitable way.
This would be a strong political signal of unity and co-operation, from which every member state could benefit. It would most certainly register in Moscow, Beijing and Washington.
This article is part of a series, ‘Beyond the cost-of-living crisis: addressing Europe’s lack of strategic autonomy’, supported by the macroeconomic institute, IMK, of the Hans Böckler Stiftung