The environment of persistently low interest rates is not going to last forever. But a recent drive to change European fiscal rules assumes low rates forever, and may have dangerous and unintended consequences. So far, after years of continuous growth, many European countries have not yet tackled the issue of debt: will they be able to do better with looser and less punitive rules?
In the aftermath of the European elections, the race to describe which (different) path the European Union should undertake has started. Among those who contributed with reform proposals, we find the IMF’s Olivier Blanchard, in his column “Europe Must Fix Its Fiscal Rules,” explained how Europe could better take advantage of the current low interest rate framework.
According to French economist Blanchard, Europe must begin to fix its rules about public debt and public deficit to align them with the current low-interest framework, which is different to the one the rules were initially written for. Admittedly, the fiscal-arm of the European economic-policy is surely something that can be improved. Nevertheless, Dr. Blanchard’s proposals would work as a shield for fiscally irresponsible policies put in place by countries now most in need of reform. These countries —especially Italy — have been putting off these needed reforms for years, and that have largely taken advantage of the east-money policies of crisis periods to do so.
A Closer Economic and Monetary Union?
Some parts of Dr. Blanchard’s proposal do indeed raise questions. The idea of creating a larger common European budget, in fact, is the notorious third pillar of an economic and monetary union which has been missing in the eurozone framework from its very beginning. One aspect of this are ongoing demands that the eurozone change the Growth and Stability Pact to abandon the 3% deficit cap and the 60% debt/GDP cap. Regarding the debt parameter, Dr. Blanchard argues that under a low interest rate regime, the need to have such a low debt/GDP ratio is questionable. Hence, Europe must allow its member states to coordinate and carry out a fiscal expansion, either at an individual level or with a common budget financed through the issuing of the often invoked eurobonds.
The Keynesian, centrist reading of the European reality, however, does not take into account any of the concerns about the moral hazard which is intrinsic to any monetary union. Moreover, it does not take into account the recent history of the debate over the budget proposals between the European Commission and the member states. In fact, Dr. Blanchard is of the view that “The eurozone has gone so far in piling up constraints, on the assumption that governments will always misbehave or try to cheat, that the result is sometimes incomprehensible.”
On the contrary, we are of the opinion that what the eurozone history can tell us, is that if the increase in debt was contained during recent times, that was exactly thanks to those constraints and rules, since southern member states (i.e., Italy and Greece, et al) have always pushed for more debt and never for less.
Moreover, we do not understand the need for a Keynesian fiscal stimulus to push the eurozone back to its “potential level.” For example, the European Commission calculated for Italy (one of the countries which would benefit the most from a loosening of the eurozone fiscal rules) a -0,1% negative output-gap for 2018 and a -0,3% negative output-gap for 2019, which they predict will close again in 2020. That considered, to increase the fiscal room of a country like Italy would mean to permanently enlarge the public sector, since to boost GDP beyond its potential level the stimulus must be perpetrated indefinitely.
The path that has brought interest rates down to the zero lower-bound has not been coincidental either, but it has been a direct consequence of the policy carried out in these years by the ECB. Thanks to those policies, which have had a Cantillon-effect backlash that have modified the relative prices of government bonds for the sake of countries with larger debts. Those very member states with troubling and urgent issues have been able to “kick the can” and ignore the risk-pricing assessments made by the market because of the protection and the extended time granted to them by the quantitative easing.
All this contradicts what Dr. Blanchard implicitly argued about moral hazard: the expansive monetary policy and consequent lowering of the interest rates — which was meant to grant time and breathing room to the troubled countries to fix their numbers while allowing them at the same time to use fiscal policy as a cyclical tool — was instead used to put off the need for decisions and reforms that was already compelling years ago, worsening those structural problems that hold to the present disappointing level their potential GDP.
To remove those rules would allow a serious situation not to worse. The current interest rate scenario is not going to , but it will indeed change as soon as the quantitative easing ECB comes to an end. Removing what few restraints exist strikes an unnecessary hazard.
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