Achieving the right fiscal-monetary mix (in the context of the economic governance review)- Compilation of papers

Achieving the right fiscal-

monetary mix (in the

context of the economic

governance review)

Compilation of papers

Economic Governance and EMU Scrutiny Unit (EGOV)

Directorate-General for Internal Policies

PE 747.830 - September 2023

STUDY

Requested by the ECON committee

Monetary Dialogue Papers, September 2023

IPOL | Economic Governance and EMU Scrutiny Unit (EGOV)

2 PE 747.830

Achieving the right fiscal-monetary mix (in the context of the economic governance review)

PE 747.830 3

Monetary Dialogue September 2023

Abstract

Alignment of monetary and fiscal policies has proven to be

decisive for the euro area's ability to withstand successive crises

over the years. Today, the European Central Bank (ECB) continues

its fight against inflation by implementing a monetary policy

tightening unprecedented in pace and scale. At the same time,

after allowing for some deviations from regular budgetary rules

with the activation of the general escape clause in 2020, the EU is

set to reapply its fiscal rules fully from 2024. In addition, co-

legislators are currently discussing the proposed legislation by

the European Commission for the reform of the economic

governance framework. Five papers were prepared by the ECON

Committee’s Monetary Expert Panel, discussing the interaction

between monetary and fiscal policies in the euro area.

This document was provided by the Economic Governance and

EMU Scrutiny Unit at the request of the Committee on Economic

and Monetary Affairs (ECON) ahead of the Monetary Dialogue

with the ECB President on 25 September 2023.

Achieving the right fiscal-

monetary mix (in the

context of the economic

governance review)

Compilation of papers

IPOL | Economic Governance and EMU Scrutiny Unit (EGOV)

4 PE 747.830

This document was requested by the European Parliament's Committee on Economic and Monetary

Affairs.

AUTHOR(S)

The economic governance review and its impact on monetary-fiscal coordination

Zsolt DARVAS, Bruegel and Corvinus University of Budapest

Jeromin ZETTELMEYER, Bruegel and CEPR

Monetary-fiscal interaction: achieving the right monetary-fiscal policy mix in the euro area

Kerstin BERNOTH, DIW Berlin

Sara DIETZ, Hengeler Mueller

Rosa LASTRA, Queen Mary University of London

Marie RULLIÈRE, DIW Berlin

Big central banks and big public debts: The next challenges

Charles WYPLOSZ, The Graduate Institute, Geneva

An effective policy mix for the EU’s post-pandemic challenges

Paolo Canofari, Università Politecnica delle Marche, Ancona.

Giovanni Di Bartolomeo, Sapienza Università di Roma and University of Antwerp.

Marcello Messori, Luiss Guido Carli, Roma

Fiscal adjustment supports the fight against sticky inflation

Daniel GROS, Bocconi University, CEPS

Farzaneh SHAMSFAKHR, CEPS

ADMINISTRATOR RESPONSIBLE

Drazen RAKIC

Giacomo LOI

Maja SABOL

EDITORIAL ASSISTANT

Adriana HECSER

LINGUISTIC VERSIONS

Original: EN

ABOUT THE EDITOR

The Economic Governance and EMU Scrutiny Unit provides in-house and external expertise to support

EP committees and other parliamentary bodies in shaping legislation and exercising democratic

scrutiny over EU internal policies.

To contact Economic Governance and EMU Scrutiny Unit or to subscribe to its newsletter please write

to:

Economic Governance and EMU Scrutiny Unit

European Parliament

B-1047 Brussels

E-mail: [email protected]

Achieving the right fiscal-monetary mix (in the context of the economic governance review)

PE 747.830 5

Manuscript completed in September 2023

DISCLAIMER AND COPYRIGHT

The opinions expressed in this document are the sole responsibility of the authors and do not

necessarily represent the official position of the European Parliament.

Reproduction and translation for non-commercial purposes are authorised, provided the source is

acknowledged and the European Parliament is given prior notice and sent a copy.

IPOL | Economic Governance and EMU Scrutiny Unit (EGOV)

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CONTENTS

THE ECONOMIC GOVERNANCE REVIEW AND ITS IMPACT ON MONETARY-FISCAL

COORDINATION 7

Zsolt DARVAS

Jeromin ZETTELMEYER

MONETARY-FISCAL INTERACTION: ACHIEVING THE RIGHT MONETARY-FISCAL POLICY MIX IN

THE EURO AREA 35

Kerstin BERNOTH

Sara DIETZ

Rosa LASTRA

Marie RULLIÈRE

BIG CENTRAL BANKS AND BIG PUBLIC DEBTS: THE NEXT CHALLENGES 65

Charles WYPLOSZ

AN EFFECTIVE POLICY MIX FOR THE EU’S POST-PANDEMIC CHALLENGES 91

Paolo CANOFARI

Giovanni Di BARTOLOMEO

Marcello MESSORI

FISCAL ADJUSTMENT SUPPORTS THE FIGHT AGAINST STICKY INFLATION 119

Daniel GROS

Farzaneh SHAMSFAKHR

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The economic governance

review and its impact on

monetary-fiscal

coordination

Zsolt DARVAS

Jeromin ZETTELMEYER

External author:

Zsolt DARVAS

Jeromin ZETTELMEYER

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Abstract

This paper analyses how the fiscal framework proposed by the

European Commission in April 2023 might affect the interplay

between fiscal and monetary policies, from three perspectives: its

impact on the medium-term fiscal stance in the euro area, its

design, and its implications for the ECB’s Transmission Protection

Instrument (TPI). It concludes with recommendations for

amending both the fiscal governance proposal and the TPI.

This document was provided by the Economic Governance and

EMU Scrutiny Unit at the request of the Committee on Economic

and Monetary Affairs (ECON) ahead of the Monetary Dialogue

with the ECB President on 25 September 2023.

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CONTENTS

LIST OF ABBREVIATIONS 10

LIST OF FIGURES 11

LIST OF TABLES 11

EXECUTIVE SUMMARY 12

INTRODUCTION 13

IMPLICATIONS OF THE PROPOSED FISCAL GOVERNANCE FRAMEWORK FOR THE FISCAL

STANCE IN THE EU 15

DOES THE PROPOSED FRAMEWORK OPTIMALLY TRADE-OFF FISCAL SUSTAINABILITY AND

FLEXIBILITY? 21

REEXAMINING THE TRANSMISSION PROTECTION INSTRUMENT IN LIGHT OF THE

PROPOSED FRAMEWORK 25

4.1. Would the proposed framework complicate the application of the TPI? 26

4.2. Does the proposed framework offer an opportunity for improving the TPI? 27

CONCLUSION 30

REFERENCES 32

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LIST OF ABBREVIATIONS

CFC

Central fiscal capacity

DSA

Data sustainability analysis

European Commission

ECB

European Central Bank

EFB

European Fiscal Board

EGR

Economic governance review

ESCB

The European System of Central Banks

ESM

European Stability Mechanism

European Union

GDP

Gross domestic product

IFIs

Independent fiscal institutions

Member states of the European Union

MTO

Medium-term objective

NRRP

National recovery and resilience plan

OMT

Outright Monetary Transactions

TPI

Transmission protection instrument

Quantitative easing

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LIST OF FIGURES

Figure 1: IMF projections for the euro area, and adjusted growth projections corresponding to the

proposed new fiscal rules, 2022-2028 19

LIST OF TABLES

Table 1: Fiscal adjustment based on European Commission forecasts (2023-24), proposed framework

(2025-28), and current framework (2025-28) 18

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EXECUTIVE SUMMARY

• Fiscal and monetary policies interact through multiple channels and interfere with (or

support) each others’ objectives. The interplay between monetary and fiscal policy is hence

important for economic welfare. This paper analyses how the fiscal framework proposed by the

European Commission in April 2023 might affect this interplay, from three perspectives: (1) its

impact on the medium-term fiscal stance; (2) its capacity to reconcile debt sustainability and

flexibility; and (3) its implications for the European Central Bank (ECB)’s Transmission Protection

Instrument (TPI).

• The proposed framework would lead to substantial tightening in the medium term. In the

short term, tighter fiscal policy supports disinflation. But if the ECB’s inflation target is reached by

2025, as both ECB and International Monetary Fund expect, then continued fiscal consolidation

under the new fiscal framework might result in an overly tight fiscal stance, requiring the ECB to

offset it.

• The proposed new fiscal framework is broadly balanced between the objectives of ensuring

debt sustainability and preserving flexibility, but with room for improvement. We

recommend strengthening the requirement that seeks to prevent excessive ‘backloading’ of fiscal

adjustment, while the requirement that debt falls within the first four years of the application of

the framework should be removed or modified substantially, as should the minimum adjustment

requirement of 0.5% of GDP for countries with deficits above 3%. We also recommend a review of

the Commission’s debt sustainability analysis methodology, and a role for independent fiscal

councils in the process of activating the framework’s escape clauses.

• While the proposed fiscal framework would not complicate the activation of the

Transmission Protection Instrument (TPI) compared to the current framework, we

recommend amending one of its eligibility conditions. The ECB has delegated the assessment

of three of the four TPI eligibility conditions to the Council and the Commission. Since these

conditions will continue to be evaluated by the Council and the Commission under the proposed

framework, their application under the TPI does not change. One eligibility condition, however –

whether a country’s debt is sustainable – has not been delegated by the ECB. We argue that since

debt sustainability is a necessary condition for compliance with the proposed framework, this

condition is either redundant, or there should be a presumption that the ECB will follow the Council

and Commission when it decides on debt sustainability. This would not reduce the ECB’s

independence, since the decision on whether activation of the TPI is required remains at the

discretion of the ECB.

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INTRODUCTION

Monetary and fiscal policy pursue different objectives. Monetary policy in the euro area has only one

primary mandate, price stability

. Fiscal policy, in contrast, has many objectives: provision and financing

of public goods, output stabilisation, redistribution, intergenerational equity and improvements in

economic allocation. Unlike monetary policy, which is centralised in the hands of the ECB, fiscal policy

in the euro area remains in the hands of national governments.

While they have different objectives, fiscal and monetary policies interact through multiple channels.

Monetary policy influences both inflation and real output, and thus fiscal revenues directly, and fiscal

expenditure indirectly. Monetary policy operates in part by influencing real interest rates, which impact

government borrowing cost. Fiscal policy influences the price level both through aggregate demand

and through its impact on the supply side (via labour supply and public investment, and potentially

muting the transmission of supply shocks, such as commodity price shock). It also influences measured

inflation through changes in excise and VAT tax rates. Finally, unsustainable fiscal policy can threaten

price stability, either through the dislocations induced by a debt crisis, or by leading to pressures for

debt monetisation to stave off the crisis. Such fiscal-monetary interactions were important

considerations in the creation of EU-wide fiscal rules before the euro was launched.

The potential to interfere with (or support) each others’ objectives implies that the interplay (“mix”)

between monetary and fiscal policies is important. Fiscal policy that gets in the way of monetary policy

objectives, and vice versa, can generate welfare costs. For example, if fiscal policy seeks to raise real

output above potential, it may raise inflation, forcing monetary policy to tighten. The result will not be

higher output, but rather higher real interest rates, which raise the cost of borrowing and reduce fiscal

space. Another example applies to a setting in which interest rates are close to their effective lower

bound and inflation is below the central bank’s target. In this case, reaching price stability without

compromising financial stability may require support from (expansionary) fiscal policy.

By influencing fiscal policy, the EU-level fiscal governance framework will have an influence on the

interplay between fiscal and monetary policies. The purpose of this paper is to analyse how the

framework proposed by European Commission in April 2023 (EC, 2023a,b) might affect this interplay.

We tackle this question from three angles.

First, by quantifying the potential impact of the framework on the fiscal stance in the next five years.

Inflation in the euro area is running high, and underlying inflation has proved to be persistent. A

frequently voiced view is that fiscal policy should be tighter in support of the disinflation process (see,

e.g., IMF, 2023). Fiscal policy is in fact projected to tighten this year, and next, before the proposed fiscal

framework would come into effect. The question is how the proposed framework might influence the

fiscal stance from 2025 onward if it were to become law next year.

Second, from a design perspective. We assume that fiscal policy makers are disciplined by elections,

but also subject to incentives that could result in overborrowing and in some cases in a bias toward

current spending. The purpose of fiscal frameworks is to ensure debt sustainability and ideally to

protect public investment, while otherwise providing flexibility to fiscal policy, allowing the fiscal

authorities to pursue their many objectives. Frameworks that achieve these objectives are also in the

The authors thank Marco Buti, Grégory Claeys, Maria Demertzis, Francesco Papadia, Lucio Pench, Lucrezia Reichlin, André Sapir, Armin

Steinbach, and Stavros Zenios for valuable comments, and Lennard Wleslau for preparing Figure 1.

The objectives of the European System of Central Banks (ESCB) are defined in the Treaty on the Functioning of the European Union as: “the

primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general

economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty

on European Union.”

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interest of the central bank. Debt sustainability reduces the risk of fiscal dominance and disruptive

crises that threaten price stability

. Fiscal policy that is friendly to public investment and raises potential

output will lower inflation pressure for a given level of demand. Flexibility is important because it allows

the fiscal authorities to pursue their various objectives and to deploy policy in support of the central

bank’s price stability objective. We analyse the trade-off between debt sustainability and flexibility

under the proposed framework.

Third, from the perspective of a specific ECB instrument, the “transmission protection instrument” (TPI)

wascreated in July 2022 to maintain orderly debt market conditions in the face of sharply higher

interest rates. While the TPI is not the only ECB instrument at the intersection of monetary and fiscal

policy,

it is the only one whose eligibility criteria include compliance with the fiscal framework, as well

as debt sustainability. We answer the question whether the changes in the framework would have an

impact on the operation of the TPI, and whether the TPI should be modified to better “fit” the new

framework.

The remainder of this paper is structured in line with these three perspectives. Section 2 analyses the

implications of the proposed framework for the fiscal stance over the coming 5 years. Drawing on the

empirical findings of Section 2, Section 3 takes a view on the design of the proposed fiscal governance

framework from the perspective of the interplay between monetary and fiscal policy. Finally, Section 4

analyses the relationship between the proposed framework and the TPI. Section 5 concludes.

Fiscal dominance describes a situation in which large government debt and deficit prevent the central bank from controlling inflation. In

such a situation, a central bank interest rate increase to tame inflation might result in market pressure on government bond markets, and

the government might become insolvent without central bank financing.

Other instruments include Outright Monetary Transactions (OMT) and all instruments that operate through bond purchases in secondary

markets (which are often called quantitative easing – QE).

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IMPLICATIONS OF THE PROPOSED FISCAL GOVERNANCE

FRAMEWORK FOR THE FISCAL STANCE IN THE EU

The European Commission (EC)’s April 2023 proposal to replace the current EU fiscal framework

requires Member States (MS) to develop medium term fiscal-structural plans, following discussions

with the Commission, that meet two main requirements. Both must “hold in the absence of any further

budgetary measures over a period of 10 years” (EC, 2023a, Article 15) following the end of a 4-7-year

adjustment period:

(a) public debt as a share of GDP must be “put or kept on a plausibly downward path (…) or

stay at prudent levels”.

(b) the government deficit must be maintained or brought below the 3% of GDP reference

value.

Annex V of EC (2023a) defines debt that is “put or kept on a plausibly downward path (…) or stay at

prudent levels” as a debt path that slopes downward (or remains below 60% of GDP if it already meets

the 60% benchmark) both with sufficiently high probability for 5 years after the adjustment period, as

assessed by the stochastic debt sustainability analysis (DSA) of the Commission; and under the

deterministic stress scenarios described in the Commission’s 2022 Debt Sustainability Monitor (EC,

2023c).

In addition, the proposal commits the Commission to several additional conditions both in formulating

a “technical trajectory” that it must put forward as a basis for discussion with MS with debt or deficits

above the Treaty benchmarks of 60% and 3% of GDP, and in its assessment of MS medium-term fiscal-

structural plans. Specifically, it must check: ”whether the fiscal adjustment effort over the period of the

national medium-term fiscal-structural plan is at least proportional to the total effort over the entire

adjustment period” (no-backloading safeguard); “whether the public debt ratio at the end of the

planning horizon is below the public debt ratio in the year before the start of the technical trajectory”

(debt safeguard), “whether for the years that the Member State concernced is expected to have a deficit

above the 3% of GDP reference value, and the excess is not close and temporary”, the fiscal adjustment

is at least 0.5% of GDP (excessive deficit safeguard

), and whether “national net expenditure growth

remains below medium-term output growth, on average, as a rule over the horizon of the plan” (net

The proposal consists of two proposed regulations and one directive. The main reforms are contained in a “Proposal for a regulation of the

European Parliament and of the Council on the effective coordination of economic policies and multilateral budgetary surveillance and

repealing Council Regulation (EC) No 1466/97” (EC, 2023a

) which would replace the “preventive arm” of the current Stability and Growth Pact.

In addition, a “Proposal for a Council regulation amending Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of

the excessive deficit procedure” (

EC, 2023b) would abolish the “1/20

rule” which required MS with debt above 60% of GDP to reduce their

debts by at least 1/20

of the difference between its debt ratio and 60% per year, and refocus the existing “debt-based excessive deficit

procedure” on departures from the fiscal path agreed with the Council under the regulation replacing the preventive arm. However, the

“deficit-based excessive deficit procedure” (EDP) would remain largely unchanged, requiring that “for the years when the general government

deficit is expected to exceed the reference value, the corrective net expenditure path shall be consistent with a minimum annual adjustment

of at least 0,5% of GDP as a benchmark.” Finally, a “Proposal for a Council directive amending Directive 2011/85/EU on requirements for

budgetary frameworks of the Member States” (

EC, 2023c) aims at strengthening national-level independent fiscal institutions and medium-

term budgetary frameworks.

See Articles 6, 12, and 15 as well as Annex I and V of EC (2023a).

We interpret “a minimum annual adjustment of at least 0,5% of GDP as a benchmark” wording of the draft regulation on the excessive deficit

procedure (EC 2023b

) as at least half percent adjustment. In our numerical calculations, we assume exactly half percent when otherwise

adjustment would be less than half percent. However, Pench (2023) argues that the adjustment requirement can be less than half percent,

because this safeguard, as well as the debt reduction safeguard, could be given a subordinated role relative to the sustainability criterion

when the Commission and the Council make an overall assessment of the medium-term plans.

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expenditure growth safeguard, which we interpret as ruling out a decline in the structural primary

balance over the first four years of the adjustment period)

In Darvas, Welslau and Zettelmeyer (2023), we compute the fiscal adjustment implications of these

conditions for all MS with 2024 projected debts or deficits above the reference values (on the

assumption that the first adjustment year under the framework would be in 2025), based on a

replication of the Commission’s DSA methodology, using EC forecasts for growth, market-based

interest rate and inflation expectations, as well as some ancillary assumptions to enable us to apply the

safeguards.

Table 1 summarises the main results. Positive numbers mean an increase in the structural primary

balance, i.e. a fiscal tightening, expressed in percent of GDP. Countries are listed in a declining order of

the fiscal balance forecast by the European Commission for 2024 (column 2). EC projections for fiscal

adjustment in 2023 and 2024 are shown in columns (3) and (4)

. These indicate that the Commission

expects sizeable fiscal consolidation in most EU countries, partly reflecting the withdrawal of COVID-19

and energy crisis support measures, albeit with exceptions (Belgium, Bulgaria, Croatia, Finland, and

Slovakia). The GDP-weighted aggregate impact of this tightening for the euro area countries shown in

the table is close to 0.8% of GDP in 2023 and 0.7% in 2024 (see bottom row).

Columns (5)-(12) show the annual average fiscal adjustment that would be required for the 2025-27

period if the Commission’s proposed framework was enacted in 2024. This depends on the adjustment

period, which is normally four years, but could be extended to seven years for countries undertaking

growth-enhancing structural reforms, including in the context of National Recovery and Resilience

Plans (NRRPs).

The table is laid out in a way that makes it clear which of the requirements of the

framework are driving the results: Columns (5) and (6) show the average annual adjustment for 2025-

28 that would be required by conditions (a) and (b) of the proposed framework, that is, to (a) put or

keep debt on a sustainable downward path, and (b) to lower the deficit to less than 3% of GDP by the

end of the adjustment period and keep it there for at least 10 years. Columns (7) to (12) show the annual

adjustment, separately for the years 2025, 2026 and 2027, which the proposed framework would

require once the safeguards are additionally applied. The need to show each year separately comes

from the excessive deficit safeguard, which applies only in years in which the deficit is still above 3%

Countries and years for which this safeguard is binding are highlighted in orange, countries for which

the debt safeguard is binding in yellow, and countries for which the net expenditure growth safeguard

The main assumption is that the “planning horizon” referred to in the debt safeguard, which is not defined in the proposed regulation, is

four years. In addition, we assume that the total adjustment requirement over the 4-7-year adjustment horizon is broken down into equal

adjustment steps, in structural primary balance terms. This assumption implies that the net expenditure paths automatically satisfy the no-

backloading safeguard; indeed, they go further, as the no-backloading safeguard as currently drafted does not restrict backloading within

either the four-year adjustment period or the first four years and the last three years of the seven-year adjustment period. See Darvas, Welslau

and Zettelmeyer (2023) and Pench (2023) for a discussion.

The source is European Commission (2023d).

Including the remaining euro area countries in the average would somewhat reduce the impact in 2023, to 0.6% of GDP, mainly due to

projected fiscal easing in the Netherlands (-1.9%) and Luxembourg (-1.5%), but leave the 2024 impact unchanged.

The calculations underlying Table 1 use the same growth forecasts to compute fiscal adjustment under the four and seven year adjustment

periods. To the extent that the extension to seven years is determined by the strength of MS plans to raise growth, this could moderately bias

up the adjustment results for the seven-year period shown in the table. However, Article 13 of the draft regulation (EC 2023a)

says that “During

the lifetime of the Recovery and Resilience Facility (…) commitments included in the approved Recovery and Resilience Plan of the Member State

concerned can be taken into account for an extension of the adjustment period.” Given that NRRP investments and reforms qualify for the

extension, and Member States have difficulties even in implementing NRRPs, at least until the end of 2026, it is unlikely that countries would

propose new investments and reforms to obtain an extension. NRRP investments and reforms, however, are already incorporated into the

official growth projections on which the table is based.

In Table 1, this makes a difference only for Poland in 2027.

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is binding in light green. Finally, column (13) shows the average annual adjustment that would be

required, in structural primary balance terms, if the current fiscal framework based on a “Medium Term

Objective” (MTO) were reapplied after 2024.

The main results are as follows.

1. The proposed framework would require continued fiscal adjustment from 2025 until the end of the

four-year planning horizon in 2028, from almost all MS (the only exceptions are Cyprus and Greece,

whose 2024 structural primary balances are projected to already be above the 2028 values

prescribed by the framework).

2. As indicated by the highlights (and by comparing columns (5)-(6) and columns (7)-(12)), the fiscal

adjustment requirements of the proposed frameworks are mostly driven by conditions (a) and (b)

above – that is, the debt sustainability requirement and the requirement that the deficit be reduced

to and remain below 3% of GDP by the end of the adjustment period. There are three exceptions:

o First, for a few countries with projected excessive deficits in 2024, the annual fiscal

adjustment prescribed by conditions (a) and (b) falls short of the 0.5% of GDP required by

the excessive deficit safeguard (Poland and Malta, and additionally Italy, Spain, Hungary

and Romania for the 7-year adjustment period which lowers the average annual

adjustment required by conditions (a) and (b)).

o Second, the debt safeguard is binding for two countries, France and Bulgaria, in both the

4-year and 7-year adjustment periods, and for three additional countries, Belgium, Romania

and Slovakia, in the 7-year adjustment period only. For France, the annual required

adjustment during 2024-28 goes up from 0.8% of GDP (4-year adjustment period) or 0.4%

of GDP (7-year adjustment period) to 1.1% of GDP. For Belgium, the increase is 0.3% of GDP

(7-year adjustment period only).

o Third, the net expenditure safeguard is binding for Greece and Cyprus. In the absence of

this safeguard, these countries would have been able to lower their structural primary

balances from their high projected levels in 2024 without running afoul of either conditions

(a) and (b) not any of the other safeguards.

3. While the proposed system prescribes a significant fiscal tightening, this is not as large as would be

required under the current fiscal rules, if these were to be reapplied from 2025 onward. A

comparison between column (13) and columns (7)-(12) shows that the fiscal adjustment

requirement under the proposed system would be at least 0.2% of GDP per year lower than under

the current system for Cyprus, Greece, Finland, Spain, Italy, Malta, Belgium, and Slovakia. For

Portugal, Germany, Austria, France and Slovenia, it does not make much of a difference (+/- 0.1%

of GDP). Only for Bulgaria would the proposed system require much higher fiscal adjustment than

the current one, on account of the debt safeguard. The difference comes mainly from the fact that

in the current system, higher debt raises the MTO via an ad-hoc formula, while fiscal adjustment

under the proposed system is based on a set of deterministic and stochastic debt projections (with

some ad hoc corrections via the safeguards, as discussed above).

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Table 1: Fiscal adjustment based on European Commission forecasts (2023-24), proposed framework

(2025-28), and current framework (2025-28)

(in structural primary balance terms, expressed in percent of GDP)

Source: authors’ calculations based on Darvas, Welslau and Zettelmeyer (2023), economic growth projections from the European

Commission’s May 2023 forecast, and market-based interest rate and inflation forecasts.

Note: Countries and years for which excessive deficit safeguard is binding are highlighted orange, countries for which the debt safeguard is

binding are highlighted yellow, and countries for which the net expenditure safeguard is binding in light green.

The last line of the table shows the aggregate implications for the euro area fiscal stance, based on the

14 euro-area countries included (88% of the euro area in GDP terms). This implies that the consolidation

forecast by the Commission for 2023 and 2024 would continue during 2025-28, albeit at a slightly

slower pace. The Commission’s DSA and the need to reduce the deficit below 3% imply a tightening

between 0.58% and 0.31% of GDP per year, depending on whether countries are given 4 or 7 years

respectively to adjust (columns 5 and 6). The application of the safeguards bumps this adjustment up

by a notch, to 0.65% and 0.51% percent of GDP, mostly on account of the much higher adjustment for

France (columns 7-12).

The question is whether this fiscal adjustment path would support the achievement of the ECB’s price

stability objective. Most private forecasts and all major official forecasts – by the ECB, the European

Commission, the IMF and the OECD – predict a return to the inflation target in the medium term.

However, these forecasts typically assume that the central bank will do whatever it takes to achieve its

inflation target and thus do not answer the question of whether fiscal policy could contribute either by

accelerating the process or lowering the output costs of disinflation. To take a stab at that question, it

is necessary to look at inflation forecasts together with forecasts for output and the fiscal stance.

The only institution that provides a set of consistent forecasts of these variables over the medium term

(until 2028) is the IMF in the World Economic Outlook. While these forecasts are somewhat dated (April

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PE 747.830 19

2023)

, it is worth asking what they imply if taken at face value. The IMF expects euro-area inflation to

return to very close to the 2% ECB target by 2025 and stay close to the target until the end of the

forecast horizon (Figure 1, Panel A). It also expects the euro area to avoid a recession; indeed, it projects

a recovery of growth by 2025. This said, there is high uncertainty around these projections, indicated

by the shaded confidence bands, which imply a recession probability of 25% in 2026.

Finally, as

regards fiscal adjustment, the IMF expects an adjustment similar to the European Commission in total

in 2023 and 2024, followed by much slower adjustment over the medium term, with the structural

primary balance gradually converging to zero after 2025. Panel A of Figure 1 also shows how fiscal

adjustment presented in Table 1 would differ from that projected by the IMF. Until 2025, the two fiscal

paths more or less coincide. After 2025, however, the fiscal path required by the proposed framework

is dramatically tighter (purple broken line).

Figure 1: IMF projections for the euro area, and adjusted growth projections corresponding

to the proposed new fiscal rules, 2022-2028

Source: IMF World Economic Outlook database and Bruegel calculations.

Note: Structural primary balance is our calculation using IMF data on primary balance and output gap, and the average euro-area budget

balance semi-elasticity to the output gap from Table I.3 (p. 41) of Mourre, G. et al. (2019). We calculated the euro-area average elasticity as a

weighted average of the elasticities of euro-area countries. We did not exclude possible one-off expenditure and revenue items when

calculating the structural balance. “Structural primary balance under new fiscal rules” correspond to European Commission May 2023

forecast for 2022-2024 and our calculations for 2025-2028 by averaging the annual adjustment requirement under the 4-year and under the

7-year horizons (since some countries might opt for a 4-year plan, others for a 7-year plan). In Panels B and C, “GDP growth under new fiscal

rules” is our calculation by adjusting the IMF GDP growth projections with the impact of the difference between the changes in IMF

structural primary balance estimate and the change in our “Structural primary balance under new fiscal rules” estimate, assuming either the

0.75 fiscal multiplier parameter that the Commission uses (Panel B), or a fiscal multiplier of 1.3 (Panel C). In line with the Commission, it is

assumed that the impact of fiscal consolidation on the output gap gradually diminishes in three years. Percentiles are calculated by us

based on IMF historical forecast errors.

Panels B and C of Figure 1 show how GDP forecasts would be affected by faster fiscal consolidation

under the proposed new fiscal rules, using either the (relatively low) fiscal multiplier assumptions of

the European Commission (Panel B), or a somewhat larger fiscal multiplier (see table note). The

consequence would be a somewhat lower output path than that projected by the IMF. At the same

time, the probability of a recession in 2026 rises from 25% in panel A to 30% in panel B and 34% in

panel C. These probabilities are somewhat smaller than the recession probabilities presented in the

most recent ECB forecast, based on ECB growth forecast errors, which are in the order 40% by end-2025

(see ECB, 2023a, Chart 1).

We see two main takeaways in this analysis.

The IMF published an Update to its World Economic Outlook in July 2023, which, however, only provides forecasts for 2023 and 2024.

Confidence bands were calculated using historical IMF growth forecast errors.

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First, by any measure – whether one believes the European Commission or the IMF’s forecasts – the

time where monetary policy and fiscal policy were pushing in opposite directions is over. Fiscal and

monetary policy are now moving in tandem and expected to do so until 2025, by when both the ECB

and the IMF expects that euro-area inflation will return close to the ECB’s 2% target.

Second, if fiscal balances evolve in line with the proposed economic governance reform, monetary and

fiscal policy may well drift apart again from in a few years from now, but in opposite directions

compared to where they were in 2022. If inflation indeed falls back close to 2% by 2025, the ECB will

stop tightening and might even cut interest rates (either in 2025, or perhaps even earlier), while fiscal

policy would continue on a tightening path for several years. This will imply a significant demand drag

on the euro area economy. To the extent that it translates into a drop of inflation below 2 %, monetary

policy will ease, thereby supporting output and avoiding a recession. But if the preceding monetary

and fiscal tightening has already created weaker economic conditions than predicted in the IMF’s

baseline scenario, a recession may ensue. Recent signs of economic weakening in the EU, with

downward revision to growth in both 2023 and 2024 in the European Commission’s September 2023

forecast (European Commission 2023e) relative to its May forecast European Commission 2023d),

suggest that this risk is growing.

Hence the answer to the question of whether the proposed framework would support price stability

objectives over the horizon of its first application is as follows. In the short run, it would not make much

of a difference. But over the medium term, there is a risk that it would induce a fiscal stance that is too

tight from a conjunctural perspective, and requires the monetary authority to offset it. Not surprisingly,

this risk depends on the length of the adjustment period: as the seven-year adjustment period would

spread out fiscal adjustment over more years, and the fiscal drag on growth over the first four years

would be substantially less.

In addition, the total required adjustment might be lower as a result of the growth-inducing reforms that are required to qualify for the

three year extension to the adjustment period. For the reasons explained in footnote 10, this effect is not considered in the Table 1 estimates.

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DOES THE PROPOSED FRAMEWORK OPTIMALLY TRADE-OFF

FISCAL SUSTAINABILITY AND FLEXIBILITY?

As argued in the introduction, fiscal frameworks should seek to ensure debt sustainability while also

giving policy makers flexibility to pursue other objectives. This is both in the general public interest and

in the interest of monetary policy makers, who may require the help of fiscal policy makers in meeting

their price stability objective

Importantly, however, there can be a trade-off between the two objectives. This could arise from the

fact that fiscal authorities may have incentives to overspend, in light of short election horizons, or

perhaps in light of the fact that the electorate itself does not fully internalise the welfare of future

generations. In this case, ensuring debt sustainability may require restricting the flexibility of the fiscal

authority. This is the standard argument for fiscal rules (see, for example, Alesina and Tabellini, 1990).

For similar reasons, governments may prefer current spending to investment spending, since the latter

only partly benefits current voters. Fiscal rules could attempt to correct this bias.

A monetary union with sovereign fiscal policy at the level of Member States complicates this trade-off,

in two respects.

On the one hand, it strengthens the argument for rules that constrain overly expansionary fiscal

policies. Overborrowing by members of a monetary union has stronger negative externalities for other

members than across countries that are integrated only through trade and financial relationships. This

is true not only because financial linkages are tighter in a monetary union, but because a messy default

and/or exit from the currency area can threaten the credibility of the currency union as a whole (the

July 2015 crisis in Greece is a case in point). As a result, fiscal crises will lead to pressure for a bailout

through financial assistance, and possibly pressure for debt monetisation, endangering price stability

in all currency union member countries (Darvas et al, 2018, Bénassy-Quéré et al, 2018, Gourinchas et

al, 2023).

On the other hand, membership in a currency union also strengthens the possibility of a positive

externality associated with expansionary fiscal policy. The central bank may need help in increasing

aggregate demand, as was the case in the euro area between 2013 and 2020, but national policy

makers may not internalise the impact of fiscal policy on the euro area as a whole. As sovereign

countries cannot be forced to incur debt beyond the level that can be justified to national citizens, this

problem can only be solved through a central fiscal capacity (CFC), which can adjust the euro area fiscal

stance to the collectively optimal level.

From the perspective of monetary-fiscal coordination, one obvious problem of the proposed fiscal

framework is the lack of such a capacity. Leaving aside this problem, the question is whether the

framework ensures debt sustainability at minimum cost to restricting the possibility of expansionary

national fiscal policy when this is needed for price (and output) stability reasons. An important corollary

of this requirement is that the framework should not generate rules or incentives that induce

procyclical fiscal contractions in response to a negative output shock.

To answer the question, we need to briefly take stock of the design features that attempt to ensuring

debt sustainability on the one hand while preserving flexibility on the other.

For example, in her 27 July 2023 monetary policy statement, President Lagarde stressed: ” As the energy crisis fades, governments should roll

back the related support measures promptly and in a concerted manner. This is essential to avoid driving up medium-term inflationary pressures,

which would otherwise call for a stronger monetary policy response.”

https:/1/www.ecb.europa.eu/press/pressconf/shared/pdf/ecb.ds230727~9e147b657d.en.pdf

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To ensure debt sustainability, the framework relies on a plethora of commitment devices:

• The main ex ante commitment device is the medium-term fiscal structural plan, which results

in a net expenditure path. This must satisfy not only criterion (a), the debt sustainability

criterion per se, but also criterion (b), the deficit criterion, which is conceptually irrelevant for

debt sustainability, but required by the treaty, and may be effective in disciplining policy

makers in practice (Caselli and Wingender, 2021). Furthermore, the European Commission is

supposed to assess whether the plan also meets three additional safeguards described above

— designed to prevent “backloading”, achieve debt reduction by the end of the planning

horizon, and require a minimum speed of adjustment of 0.5%of GDP per year for countries

whose deficits exceed 3% — and base its recommendation to the Council on this assessment.

• Ex post, the framework envisages four devices (lines of defense, so to speak) to make sure that

fiscal adjustment happens as planned. First, the agreed net expenditure path must be written

into law in every country, resulting in binding medium-term net expenditure ceilings. Second,

if the country violates these ceilings, it might be subject to a disciplining procedure (the “debt-

based” excessive deficit procedure). Third, even if the country does not violate the ceilings, it

could be subject to higher-than planned minimum adjustment if the conditions of the “deficit

based” EDP apply, namely, if its deficit exceeds 3% when its planned adjustment is less than

0.5% of GDP

. Even if the net expenditure path was designed to prevent this, this could happen

ex post as a result of a bad shock (lower nominal output or higher interest rates). And fourth,

fines for excessive deficit would be imposed at an earlier stage, and initially in smaller amounts,

than in the current system.

The framework also embodies three elements that seek to preserve flexibility, promote reforms and

investment, and avoid procyclical fiscal adjustment:

• First, the possibility to extend the adjustment period by three years for countries that put

forward growth-enhancing public investment and reforms. From the perspective of the ECB,

this is desirable because it raises equilibrium interest rates (“r*”), making it less likely that the

economy will return to a regime in which monetary policy is constrained by the zero lower

bound on interest rates.

• Second, the fact that the main commitment device is a net expenditure path, not a deficit path.

Net expenditures exclude items that the fiscal authorities cannot control, including interest

spending, as well as the cyclical drivers of the deficit (revenue and cyclical expenditure

categories such as unemployment benefits). In principle, this means that if the country is hit by

a bad shock, it should not be required to tighten;

• Finally, two “escape clauses”: a general escape clause in which the Council “may adopt a

recommendation allowing Member States to deviate from their net expenditure path, in the

event of a severe economic downturn in the euro area or the Union as a whole, provided it does

not endanger fiscal sustainability”, and a “country-specific escape clause”, where it may do the

same “where exceptional circumstances outside the control of the Member State lead to a

major impact on the public finances of the Member State concerned, provided it does not

endanger fiscal sustainability.”

The question is whether the benefits of the restrictions introduced for the sake of ensuring debt

sustainability justify the costs that they impose on flexibility, and vice versa for the devices that are

See footnote 6 about the ambiguity of whether the minimum half percent adjustment requirement is a hard constraint or not.

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PE 747.830 23

there to protect flexibility. Drawing on the analysis of Darvas, Welslau and Zettelmeyer (2023) and the

results of the last section, we answer this question as follows.

Aside from the lack of a CFC, the main elements of the proposed framework are sound: asking countries

to develop a medium-term fiscal-structural plans consistent with debt sustainability, creating

incentives for reform and public investment, requiring them to write the plan into national law in the

form of a net expenditure path; requiring corrective measures if the plan is violated; and letting

countries off the hook in the event of a major downturn that cannot be addressed through automatic

stabilisers alone.

We also see a rationale for a (properly designed) “no backloading safeguard” that

constrains the net expenditure path beyond what would be required by debt sustainability analysis

alone. The reason is that debt sustainability analysis alone may not put enough structure on the

adjustment path, giving a pass to adjustment proposals that are not time-consistent in light of the

political process. We therefore agree with imposing a no-backloading condition, which rules out net

expenditure paths that seek to leave most adjustments to the last minute.

Second, given its central role, there is a case for reviewing the European Commission’s DSA

methodology, in a way that involves Member States rather than just the Commission alone. While the

methodology is generally both reasonable and rigorous, there is scope for improving it with relatively

little effort (see Darvas, Welslau and Zettelmeyer 2023 for details)

. Furthermore, MS are unlikely to

comply with the implications of the methodology for fiscal adjustment unless they understand it and

agree with it. To make the review as objective as possible, we recommend the establishment of an

independent expert group to conduct the technical review, seeking the views of Commission staff,

Members States, the ECB, the ESM, and the European Fiscal Board (EFB), and submitting a report to the

Council recommending changes. This DSA review will take some time, while the economic governance

review (EGR) should be adopted in the next few months; otherwise, the existing fiscal rules will be

reinstated in 2024. We, therefore, recommend approving the EGR as soon as possible with a clause

requiring the revision of the DSA methodology before the end of 2024, making 2024 a transition year,

and launching the full implementation of the new fiscal framework from the beginning of 2025, based

on the new DSA methodology.

Third, there are several design flaws with the proposed safeguards which should be addressed before

the proposal goes into effect.

i. As currently drafted, the no-backloading safeguard is almost empty, in the sense that it would

not prevent the most common forms of backloading. This is because it requires that “the fiscal

adjustment effort over the period of the national medium-term fiscal-structural plan is at least

proportional to the total effort over the entire adjustment period.” If the “period of the plan” is

four years, this formulation would only ensure that the average adjustment in the last three

years of a seven-year adjustment is not smaller than the average adjustment in the first four

years, but not prevent backloading within the four-year adjustment period, nor within the first

four years and last three years of the seven-year adjustment period.

ii. Both the debt safeguard and the excessive deficit safeguard impose significant additional

restrictions on fiscal policy that cannot be justified with debt sustainability objectives

We have (separately) been arguing for this type of architecture for some time. See Claeys, Darvas and Leandro (2016), Bénassy-Quéré et al

(2018), Darvas, Martin and Ragot (2018), Blanchard, Leandro and Zettelmeyer (2021), Arnold et al (2022).

Technical issues are related to the maturity structure of debt; the interpolation of inflation; not differentiating between the GDP deflator

and harmonised index of consumer prices (HICP); using euro-area inflation expectations for Bulgaria, Czechia, Denmark, and Sweden;

disregarding the sensitivity of interest rates to alternative debt paths; assuming no uncertainty during the adjustment period in the

stochastic analysis; assuming normal distribution of shocks in the stochastic analysis; and a number of other simplifying assumptions. There

are a number of other assumptions as well, which are reasonable, but could be re-examined.

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24 PE 747.830

(particularly if the no-backoading safeguard is fixed). These are particularly apparent in the case

of the seven-year adjustment period. These safeguards prevent the countries to whom they

apply from benefitting from the extension of the adjustment period, namely, to lower the

annual adjustment requirement in exchange for growth enhancing reform or investment. By

doing that, they undermine the intended purpose of the extension of the adjustment period.

The effects can be large. For example, the application of the debt safeguard raises the annual

adjustment requirement for France from 0.8% of GDP with four-year adjustment, or 0.4% of

GDP with seven-year adjustment, to 1.1% of GDP. The impact of the debt safeguard on

Bulgaria’s adjustment requirement is even larger, which is ironic since Bulgaria has one of the

lowest debt ratios in the euro area. The excessive deficit safeguard has smaller effects, but they

apply to more countries. Both safeguards should be abolished or fundamentally redesigned.

If the reason for inserting the safeguards was the lack of trust in the DSA by some Member

States, then a better solution would be the joint review of the DSA methodology by the

Commission and the Member States and codification of the methodology in the Code of

Conduct of the Stability and Growth Pact, as recommended in Darvas, Welslau and Zettelmeyer

(2023).

iii. Consistent with abolishing or redesigning the excessive deficit safeguard, the deficit-based

excessive deficit procedure requires a redesign, because it can induce procyclical adjustment.

Member States that are in compliance with the net expenditure path agreed with the Council

should not be required to undertake a higher adjustment in the face of a shock that puts their

deficit above 3%, so long as the agreed path continues to satisfy the DSA-based requirements

(condition (a)).

Finally, we would have liked to see a greater role of independent fiscal institutions in the process of

activating the escape clauses. If this process becomes political, it could seriously undermine the

discipline that the framework is meant to impart. The participation of independent fiscal institutions

could reduce that risk.

Note that these proposals cut both ways. The recommendations to review the Commission’s DSA

methodology has nothing to do with shifting the weights that the proposal assigns to discipline and

flexibility in one direction or the other; rather, it is about making the framework more efficient in the

sense of increasing its capacity to predict unsustainable debt. Among our three recommendations on

safeguards, the first would make the framework tougher (at an acceptable cost to flexibility) while the

two others would make it more flexible (at acceptable costs to its disciplining function). Finally, the

recommendation on involving fiscal councils is again about increasing the efficiency and the credibility

of the new framework, at no or acceptable cost to flexibility and its disciplining function.

A fundamental redesign would mean (1) defining the safeguards so they do not block an extension of the adjustment period from

translating into lower adjustment requirements (for example, by changing the language such that the debt safeguard applies to the

adjustment period, not the “planning horizon”; (2) introducing an exception for EU-endorsed public investments into the safeguards. In

addition, the debt safeguard should not apply to countries with debt below 60% of GDP.

See also Blanchard and Zettelmeyer (2023)

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REEXAMINING THE TRANSMISSION PROTECTION INSTRUMENT

IN LIGHT OF THE PROPOSED FRAMEWORK

In July 2022, the ECB Governing Council approved the Transmission Protection Instrument (TPI), which

allows Eurosystem secondary market purchases of securities issued in jurisdictions experiencing a

deterioration in financing conditions not warranted by country-specific fundamentals, provided

certain criteria are fulfilled. The declared aim of the new tool is to “ensure that the monetary policy

stance is transmitted smoothly across all euro area countries”, a precondition for the ECB to deliver on

its price stability mandate.

Stripped from ECB terminology, the objective of the TPI is to maintain orderly market conditions in

sovereign debt markets without undermining fiscal discipline and without giving rise to transfers from

the monetary authority (as might arise if the ECB were to purchase sovereign bonds of an insolvent

country). To achieve this, the July 2022 ECB decision set four criteria for the eligibility to the TPI, as

follows

(1) compliance with the EU fiscal framework: not being subject to an excessive deficit procedure (EDP),

or not being assessed as having failed to take effective action in response to an EU Council

recommendation under Article 126(7) of the Treaty on the Functioning of the European Union

(TFEU);

(2) absence of severe macroeconomic imbalances: not being subject to an excessive imbalance

procedure (EIP) or not being assessed as having failed to take the recommended corrective action

related to a Council recommendation under Article 121(4) TFEU;

(3) fiscal sustainability: in ascertaining that the trajectory of public debt is sustainable, the Governing

Council will take into account, where available, the debt sustainability analyses by the European

Commission, the European Stability Mechanism, the International Monetary Fund and other

institutions, together with the ECB’s internal analysis;

(4) sound and sustainable macroeconomic policies: complying with the commitments submitted in the

recovery and resilience plans for the Recovery and Resilience Facility and with the European

Commission’s country-specific recommendations in the fiscal sphere under the European Semester.

These are necessary criteria for eligibility. When these criteria are fulfilled, the ECB will independently

decide whether to conduct TPI operations, by assessing whether “unwarranted, disorderly market

dynamics” arose, following a “comprehensive assessment of market and transmission indicators, an

evaluation of the eligibility criteria and a judgement that the activation of purchases under the TPI is

proportionate to the achievement of the ECB’s primary objective”.

All four eligibility criteria are related to the economic governance review. In this section, we focus on

the aspects most closely related to the reform of the fiscal framework, (1) and (3), and address two

questions. First, would the proposed framework pose any difficulties in applying the two conditions,

relative to the current framework? Second, does the proposed framework create opportunities for

improving the TPI? The answers are no, and yes, respectively.

Source: https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.pr220721~973e6e7273.en.html

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4.1. Would the proposed framework complicate the application of the

TPI?

The short answer is no. Under the proposed framework, condition (1) will continue to be determined

by the Council as before, while condition (3) could be evaluated by the ECB exactly as before, as all the

debt sustainability analysis of the institutions named will continue to be available. Indeed, the DSA of

the Commission may be publicly available with greater frequency than under the status quo (when it

is published once a year), as it plays a critical role in the excessive deficit procedure (see below). Hence

checking (1) and (3) will be no harder, as a result of the proposed fiscal governance reform, than it was

before.

To see how the assessment of condition (1) would work in practice, is it nonetheless worth summarising

how the proposed regulation envisages the opening of an EDP, and whether there is clarity on the

interpretation of “effective action” once a country is under an EDP.

According the proposed “Council regulation amending Regulation (EC) No 1467/97 on speeding up

and clarifying the implementation of the excessive deficit procedure” (EC 2023b), two circumstances

could lead to the launch of an EDP:

• The deficit-based EDP remains unchanged from the current framework. An excessive deficit

exists if the deficit exceeds the 3% reference value, unless the deviation is small and temporary

or caused by exceptional circumstances beyond the control of the government.

• The debt-based EDP is revised. For countries with public debt ratios above 60% of GDP,

deviations from the Council-endorsed net expenditure path will be evaluated. Within this

group, a differentiation is made for countries with “substantial public debt challenges”

and

the remaining countries. For the former, a deviation from the agreed net expenditure path will

by default lead to the opening of an EDP, while for the latter, other factors will be considered

too.

The new debt-based EDP condition can be assessed only after some years the new framework will have

entered into force, so at the possible start of the new framework in 2024, only the conditions for a

deficit-based EDP will be assessed. Table 1 reports European Commission deficit forecast for 2024 and

shows that ten EU countries, of which six are members of the euro area, are expected to have more

than 3% budget deficit in 2024. Among the euro-area countries that suffered high spreads during the

euro crisis in the early 2010s, Italy and Spain are in this group and thus will likely enter an EDP in 2024.

Once in an EDP, a country would remain eligible for the TPI if it takes “effective action” in response to

the Council recommendation. Per Article 126(8) of the TFEU, it is for the Council to establish whether

effective action has been taken. Under the new framework, (Article 3, paragraph 4 of EC 2023b), the

Council would ask the MS to “implement a corrective net expenditure path” that meets the following

criteria.

• It meets condition (a), i.e. “puts the debt ratio on a plausibly downward path or keep it at a

prudent level” as defined by the regulation replacing the preventive arm;

• It ensures that the average annual fiscal adjustment effort in the first three years is at least as

high as the average annual fiscal effort of the total adjustment period.

As explained in the most recent debt sustainability monitor (EC 2023c, p. 11), these are countries which based on the Commission’s debt

sustainability methodology, are assessed as having high fiscal sustainability risks over the medium term. In 2022, this group included Belgium,

Greece, Spain, France, Croatia, Italy, Hungary, Portugal and Slovakia.

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PE 747.830 27

• “For the years when the general government deficit is expected to exceed the reference value,

the corrective net expenditure path shall be consistent with a minimum annual adjustment of

at least 0.5% of GDP as a benchmark.”

Hence, implementation of the requested corrective net expenditure path would constitute effective

action.

In addition, an amendment to Article 8 of the regulation (EC 2023b) lays out the conditions under which

the Council would “abrogate” (end) the EDP, namely “where budgetary forecasts as provided by the

Commission indicate that the deficit has been brought durably below the reference value and, where

the excessive deficit procedure was opened on the basis of the debt criterion, the Member State

concerned respected the corrective net expenditure path set by the Council (…) over the previous 2

years and is projected to continue to do so in the current year on the basis of the Commission forecast.”

Our reading of the proposed regulation is hence that it defines the conditions for compliance with the

EU fiscal framework at least as clearly as the regulation that it replaces. The Council will continue to

decide on the existence of an excessive deficit, and on whether countries in and EDP are taking effective

action. And the criteria for doing so are well described in the regulation, creating predictability.

4.2. Does the proposed framework offer an opportunity for improving

the TPI?

There is an important asymmetry between conditions (1) and (3). In condition (1) (as well as as

conditions (2) and (4)), the ECB delegates the assessment of whether the condition is satisfied to the

Council and the Commission. In condition (3), however, the decision whether a country’s debt is

sustainable is not delegated. While the ECB Governing Council “takes into account” the DSA of the

European Commission (as well as that of the European Stability Mechanism, the International Monetary

Fund and others) as well as the ECB’s internal analysis, it reserves the right to decide any way it wants.

The question is whether there may a case for removing this asymmetry, in either direction. If the ECB

Governing Council gives itself discretionary power to decide on debt sustainability, might it also make

sense to give itself discretionary power to in deciding whether the country’s fiscal policy is appropriate?

Conversely, if the ECB delegates the assessment of all criteria but (3) to Council and Commission, might

it also makes sense to delegate the assessment of debt sustainability?

To begin with the first question, the potential attraction of placing some decision-making power

related to condition (1) into the hands of the ECB is that this might undo some of the less useful, ridigity-

inducing features of the proposed system, such as counterproductive safeguards. In principle, the ECB

might take a narrower view of both the inappropriate fiscal behavior and “effective action” than the

Council, namely, one that is focused only on adherence to a net expenditure path consistent with debt

sustainability (criterion a) while disregarding minimum adjustment of 0.5% when this is inappropriate

in the eyes of the ECB.

The problem of this approach, of course is that it would be highly confrontational. Furthermore, the

ECB’s official opinion on the proposed framework (ECB, 2023b) takes a kinder view of the proposed

safeguards than we have taken in this paper. Hence, the idea that the ECB might use the enormous

power of the TPI to in effect fix some of the problems of the proposed framework is a pipe dream. We

conclude that condition (1) should remain as currently drafted.

That is, it is a sufficient condition for effective action. It may not be a necessary condition, if the Council considers the implementation to be

close enough to the requested corrective path. The proposed regulations do not provide any guidance in this respect.

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28 PE 747.830

Consider now the second question, on whether condition (3) should be aligned with the remaining

conditions in the sense that, rather than taking a discretionary decision on debt sustainability based on

various inputs, it defers to the DSA of the Council and Commission, as implemented under the

proposed framework.

As argued by Claeys and Demertzis (2022), this could be attractive for two reasons. First, the TPI

potentially involves fiscal transfers across euro-area countries. In the absence of a genuine fiscal union,

a decision with large potential fiscal consequences should involve considerable deference to the fiscal

representatives of euro-area Member States, like the Eurogroup (the euro-area finance ministers from

the ECOFIN Council). Second, piggybacking on the Council’s/Commission’s DSA would avoid noise that

could destabilise the debt markets. Markets would know that countries whose debt is found

sustainable by the Commission/Council, and meet the remaining conditions (all of which are

observable), will have access to the TPI. By contrast, under the current system, there will always be

doubt whether the ECB Governing Council ultimately agrees with the Commission’s/Council’s DSA or

not.

From the perspective of July 2022, it is understandable why the ECB did not go this route. First, there

was no mechanism for the Council/Eurogroup to assess the fiscal sustainability of Member States

(except when financial assistance is requested from the European Stability Mechanism, but this is not

a condition for the TPI). The Commission’s DSA analysis did not have a prominent role in the EU

governance framework, and the Commission DSA results were not endorsed by the Council. Second,

the Commission’s methodology was relatively obscure, and – while reasonable – embodied some

doubtful features (see Darvas, Welslau and Zettelmeyer 2023 for details).

In light of the economic governance legislative proposal, these arguments may no longer apply. First,

the status of the DSA methodology has in effect been upgraded: its results will be endorsed by the

Council. Furthermore, in Darvas, Welslau, and Zettelmeyer (2023) and the previous section, we

recommended that there should be a review and approval of the Commission’s DSA methodology

jointly by the Commission and all Member States and that the technicalities of the DSA methodology

should be codified in a document approved by Member States, possibly in the Code of Conduct of the

SGP. The ECB should be given a chance to comment and contribute to the review at the technical level.

Assuming the future fiscal framework encompasses debt sustainability as a necessary condition for

compliance with the fiscal framework and the DSA methodology is collectively reviewed, we would

therefore recommend a revision of the TPI conditions to give greater deference to the future, Council-

endorsed DSA. Specifically, we see two options, the first of which would take an incremental step, and

while second one would be more radical.

The incremental approach would be to change the language of condition 3 in a way that creates the

expectation that the ECB would normally defer to the Council/Commission DSA, without delegating

the debt sustainability decision entirely. For example, condition 3 could read (our addition to the

existing text is in bold):

fiscal sustainability: in ascertaining that the trajectory of public debt is sustainable, the Governing

Council will normally adopt the conclusions of the Council-endorsed debt sustainability

analysis conducted in the context of the implementation of the EU fiscal framework. In

addition, it may take into account, where available, the debt sustainability analyses by the

European Stability Mechanism, the International Monetary Fund and other institutions, together

with the ECB’s internal analysis.

The radical approach would be to either delete condition (3) altogether – since debt sustainability as

per the Council-endorsed DSA is automatically satisfied when a MS complies with the fiscal framework

Achieving the right fiscal-monetary mix (in the context of the economic governance review)

PE 747.830 29

– or maintain condition (3) but link the debt sustainability assessment fully to the Council/Commission

DSA.

The two approaches have different pros and cons.

• The main advantage of the radical approach compared to the incremental one is that it

excludes the possibility of market turmoil linked to the possibility that the Commission/Council

DSA might be rejected by the ECB.

• Against that, there may be a risk associated with the radical approach, namely the possibility

that the Commission/DSA might actually get it wrong.

It is important to emphasise that the independence of the ECB would not be compromised if it

delegates the DSA finding to Council and Commission, since the final decision to activate the TPI

remains entirely in the discretion of the ECB (this decision does not just depend on the four eligibility

conditions, but on the assessment of whether market conditions are justified by fundamentals and

whether the activation of the TPI is proportionate to the achievement of the ECB’s primary objective,

which the ECB does not delegate).

Moreover, if a government introduces fiscal measures

unfavourable to fiscal sustainability after the Council endorsed the national fiscal plan and thereby risks

a deviation from the agreed fiscal path, the ECB will continue to have full discretion in assessing

whether the increased interest rate spread of this country is in line with fundamentals or caused by

“unwarranted, disorderly market dynamics”.

For the same reason, the ECB would not be “stuck” if it were to find flaw with the DSA of the

Commission/Council. While formally deferring to the Council/Commission (i.e. calling debt sustainable

when the Council/Commission does), it could decide not to activate the TPI on the grounds that

secondary market spreads are sufficiently close to fundamentals. This would likely create less market

turmoil than to conclude that, contrary to the views of Commission and Council, the public debt of a

country is not sustainable.

Furthermore, there are several precedents for the delegation of eligibility criteria that address credit risk by the ECB. Under the OMT, the

ECB implicitly delegates the debt sustainability assessment to the European Stability Mechanism (ESM). Under its normal collateral framework,

it delegates to private rating agencies.

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CONCLUSION

This paper analysed how the interplay between monetary and fiscal policy might be affected by the

proposed reform to the EU’s fiscal governance framework, and whether the TPI should be redrafted in

this light. We conclude as follows.

First, from the perspective of its main features, the proposed framework is mostly good news for

the fiscal-monetary policy mix in the euro area. With one notable exception – the lack of a central

fiscal capacity – the basic design elements of the framework are helpful to monetary policy. These

include its focus on debt sustainability; the use of a net expenditure rule to avoid procyclical

adjustment in response to shocks, allowing some flexibility on the timing of adjustment, creating

incentives for growth inducing reforms and investment, and two escape clauses that provide fiscal

policy makers with flexibility to react to large shocks.

Second, the new framework embodies several design features that imply that it is some way off

from striking the optimal compromise between debt sustainability and flexibility.

We propose five amendments:

• The first would strengthen the discipline of the proposal at acceptable cost to flexibility: review

the drafting of the “no-backloading safeguard” to make it more meaningful (that is, give it

more teeth).

• We also offer two amendments that would increase flexibility at acceptable cost to the

framework’s discipline (particularly if our proposal on the no-backloading condition is taken):

(1) abolish or fundamentally review the drafting of the debt safeguard requiring debt to

decline within the planning horizon; (2) abolish or fundamentally review the excessive

deficit safeguard, as well as the definition of effective action under the revised excessive

deficit procedure. The latter should not require a minimum annual adjustment of countries

following a net expenditure path consistent with debt sustainability and the return to 3% by

the end of the adjustment period.

• Finally, we offer two amendments that would improve the effectiveness and efficiency of the

proposed system without necessarily changing the weights that it places on discipline and

flexibility. First, we argue for a review of the Commission’s DSA methodology, to be

conducted by an independent expert group based on inputs from the Commission,

Member States, ECB, ESM, and EFB, with the objective of fixing obvious weaknesses and

turning it into a methodology that is “owned” and can be implemented by all Member States

rather than just the Commission. Since the DSA methodology review will take some time, we

recommend making 2024 a transition year and launching the full implementation of the new

fiscal framework from the beginning of 2025. Second, we recommend involving independent

fiscal institutions (IFIs) in the decision whether to activate the escape clauses, hence

helping to de-politicise these decisions.

Third, we are concerned about the impact of the new framework on the medium-term fiscal

stance during its first application cycle. Given that many euro area countries are starting from high

debt and deficits, the framework will require a large, protracted fiscal tightening. While fiscal tightening

is welcome while inflation is too high, the main impact of the framework will come at a time when

inflation is already expected to be back at target (2025) and the economic cycle may well be much

weaker as a result of the lagged effects of the preceding monetary tightening as well as fiscal tightening

projected for 2023 and 2024. Once in effect, the new framework will require continued tightening in

most euro area member countries, albeit at a somewhat slower pace than both projected in 2023 and

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PE 747.830 31

2024 and required under the current framework. The medium term drag on demand, which should

persist at least until 2028, could complicate monetary policy from 2025 onward, potentially requiring a

return to very low policy rates.

Fourth, the adoption of the new framework represents an opportunity to simplify the eligibility

criteria of TPI. Under the proposal, debt sustainability will become a necessary condition for

compliance with the EU fiscal framework. Furthermore, a review and approval of the Commission’s DSA

methodology jointly by the Commission and Member States, in which the ECB is given the opportunity

to comment and give technical input, should increase the ECB’s confidence in the methodology used

to assess debt sustainability. Once this has happened, the ECB could either remove debt sustainability

as an eligibility condition that must be independently verified (as it is implied by compliance with the

fiscal framework) or delegate the debt sustainability assessment to the Council and Commission. This

would increase the predictability and hence effectiveness of the TPI by eliminating fears that the ECB

Governing Council may not agree with the Commission’s/Council’s assessment of debt sustainability.

Once the eligibility criteria are met, the ECB would independently decide on the activation of the TPI.

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REFERENCES

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and repealing Council Regulation (EC) No 1466/97’, https://eur-lex.europa.eu/legal-

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commissions-fiscal-governance-reform-plan

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Monetary-fiscal interaction:

achieving the right

monetary-fiscal policy mix

in the euro area

Kerstin BERNOTH

Sara DIETZ

Rosa LASTRA

Marie RULLIÈRE

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Abstract

Achieving a balanced monetary-fiscal policy mix in the euro area

is crucial to ensure that monetary policy is able to fulfil its primary

price stability objective. This paper outlines, from an economic

and legal perspective, the interaction between monetary and

fiscal policy in light of the current monetary and fiscal stance and,

in particular, the “quasi-fiscal” effects of some unconventional

monetary policy measures. Since sustainable public finances are

a prerequisite for a price-stability-oriented single monetary

policy, the paper also analyses the EU economic governance

review proposals.

This document was provided by the Economic Governance and

EMU Scrutiny Unit at the request of the Committee on Economic

and Monetary Affairs (ECON) ahead of the Monetary Dialogue

with the ECB President on 25 September 2023.

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PE 747.830 37

CONTENTS

LIST OF ABBREVIATIONS 38

LIST OF FIGURES 39

EXECUTIVE SUMMARY 40

1. INTRODUCTION 41

2. THE JURISDICTIONAL DOMAIN OF MONETARY AND FISCAL POLICY 43

2.1. The price stability mandate of the ECB 43

2.2. Fiscal policies within the responsibility of the Member States 43

3. INTERACTIONS BETWEEN MONETARY AND FISCAL POLICY 45

3.1. Interdependencies and interaction of (conventional) monetary and fiscal policy 45

3.2. The current monetary and fiscal stance 46

4. ECB “QUASI-FISCAL” MEASURES 50

4.1. Legal analysis of ECB “quasi fiscal” measures 51

4.2. TPI and its role in preventing future fragmentation of sovereign bond markets 52

5. THE NEW EU ECONOMIC GOVERNANCE ARCHITECTURE 54

5.1. Legal foundations of the EU economic governance architecture 54

5.2. Proposal to reform the EU economic governance rules 55

6. IMPLICATIONS OF THE ECONOMIC GOVERNANCE REVIEW FOR MONETARY POLICY 57

7. CONCLUSION 59

REFERENCES 60

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LIST OF ABBREVIATIONS

APP

Asset Purchase Programme

BIS

Bank for International Settlements

ECB

European Central Bank

ECJ

European Court of Justice

DSA

Debt Sustainability Analysis

ELA

Emergency Liquidity Assistance

EMU

Economic and Monetary Union

European Parliament

ESCB

European System of Central Banks

European Union

GDP

Gross Domestic Product

HICP

Harmonised Index of Consumer Prices

LOLR

Lender of Last Resort

MIP

Macroeconomic Imbalance Procedure

OMT

Outright Monetary Transactions

PEPP

Pandemic Emergency Purchase Programme

TLTRO

Targeted Longer-Term Refinancing Operations

TEU

Treaty on European Union

TFEU

Treaty on the Functioning of the European Union

TPI

Transmission Protection Instrument

TSCG

Treaty on Stability, Coordination and Governance in the Economic and Monetary

Union

USD

US Dollar

ZLB

Zero lower bound

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LIST OF FIGURES

Figure 1: Government benchmarks, 10-year, yield 47

Figure 2: General gross debt in % of GDP 48

Figure 3: Introduction of quantitative easing from 2014 by the European Central Bank 51

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EXECUTIVE SUMMARY

• While the jurisdictional domains of monetary and fiscal policy are separated – the former within

the exclusive competence of the European Union (with the European Central Bank (ECB) as the

institution entrusted with the conduct of the single monetary policy) and the latter within the

Member States' competences – monetary and fiscal policies are highly interdependent,

interacting in various ways.

• Though there have been tensions throughout the life of the Economic and Monetary Union (EMU),

monetary and fiscal policies have been broadly aligned and mutually supportive at key

episodes in its history. This was also the case during the COVID-19 pandemic.

• However, with the return of inflation in 2021, there is renewed and high level of tension in

the monetary-fiscal policy mix. While monetary policy is tightening, discretionary fiscal support

in the euro area to counter rising energy costs has been substantial in 2022 and remains significant

in 2023. Some of these measures have had a direct dampening effect on energy prices (e.g. indirect

tax cuts or price caps). However, once they expire, inflation is likely to rise again, which could

hamper the ECB's disinflationary efforts.

• Some of the ECB interventions, especially large-scale asset purchase programmes, have

relevant fiscal implications. These “quasi-fiscal” monetary policy measures are characterised by

the fact they materially impact on the fiscal accounts and/or affect other aspects of fiscal policy

such as tax, spending or financing.

• “Quasi-fiscal” monetary policy measures are problematic from a legal point of view since

they partly over-stretch the mandate of the ECB. This could also be the case of the announced, but

not yet activated, new sovereign bond purchase programme, the Transmission Protection

Instrument (TPI).

• T

he proposal for a new EU economic governance framework aims to strengthen national

ownership of fiscal rules. This is an important step to ensure that public finances in the euro area

are sound and do not have to be indirectly addressed by monetary policy measures.

• While the current reform proposal addresses many of the shortcomings identified, too much

discretion remains in the interpretation of the rules by both the European Commission and the

Member States. This might lessen the fiscal discipline and fiscal homogeneity necessary for a

price-stability oriented monetary policy

• In the current inflationary environment, a reduction in fiscal stimulus or more targeted fiscal

support could reduce inflationary pressures. This could allow for a more gradual and moderate

tightening of monetary policy, thereby reducing financial stability and fragmentation risks and

making the use of the controversial TPI less necessary for the ECB.

• The ECB should only resort to “quasi-fiscal” monetary policy measures in exceptional cases

uch as when the interest rate level has reached the zero lower bound or when there are

divergences in government bond yields between Member States resulting from market

speculation that jeopardise a single monetary policy.

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1. INTRODUCTION

The Maastricht Treaty established a division of competences between monetary policy and fiscal policy,

with the former centralised and the latter decentralised. Notwithstanding the formal separation, the

Treaty envisaged some basic forms of coordination (positive integration) as well as some forms of

negative integration or prohibitions (with regard to monetary financing, excessive deficits, bail-out

policies and others).

Although there have been tensions throughout the life of the Economic and

Monetary Union (EMU), monetary and fiscal policies have been aligned during periods in its history.

This was the case during the COVID-19 pandemic. However, with the return of inflation in 2021, tension

in the monetary-fiscal policy mix reappeared. Monetary policy is tackling rising inflation (the primary

objective of the European Central Bank - ECB) by boldly raising interest rates to their highest level in 22

years and by phasing out the Asset Purchase Programme (APP). The ECB also announced a new bond

buying programme - the Transaction Protection Instrument (TPI) - which could be activated at any time

to counter unwarranted, disorderly bond market dynamics as we discussed in our earlier paper.

addition, there is the risk that sharply rising interest rates could trigger a systemic banking crisis, as the

recent turmoil in Switzerland and the US in the spring of 2023 vividly demonstrated.

Meanwhile, public debt levels in several euro area Member States remain very high. Debt reduction is

at the top of the agenda of euro area policymakers in order to create sufficient fiscal room for future

manoeuvring. However, the COVID-19 crisis, the energy price shock resulting from the war in Ukraine

and the rise in the cost of living have prompted euro area Member States to adopt supportive

discretionary fiscal measures.

Several member countries, such as France and Spain, have taken

measures that have had a direct dampening effect on energy price increases. However, once these

measures expire, inflation is likely to rise again in these countries, which could hamper the ECB's

disinflationary efforts.

The ECB cannot solve the current challenges and potential risks alone. Rather, in such an environment,

monetary and fiscal policy must work together in a coordinated manner.

The European Commission

is embarking on a reform of the economic governance framework in the EMU, including a more

country-specific approach within such a regime. The objectives of the proposals

are stronger national

ownership, simpler rules taking account of different fiscal challenges, facilitating reforms and

investments for EU priorities, and providing for effective enforcement.

This paper starts by briefly outlining the legal framework of EMU, which established the separation of

fiscal and monetary competences. Second, we examine the complex interaction between fiscal and

monetary policy in light of the current economic stance. Third, we discuss the “quasi-fiscal” implications

of the ECB's unconventional monetary policy measures, in particular its large-scale asset-purchase

programmes, also known as Quantitative Easing (QE). We go into more detail on their legal basis and

shed light on the Transaction Protection Instrument (TPI) announced in July 2022. Fourth, we consider

See Lastra (2015), pp. 293 ff.

See Bernoth et al. (2022).

For an overview, see Sgaravatti et al. (2021).

It should be noted that also financial supervision and macroprudential policy are important players to manage the challenges ahead.

But this is not subject of this paper.

These proposals would amend both (i) the preventive arm a new Stability and Growth Pact, (ii) the corrective arm to speed up and

clarify the implementation of the excessive deficit procedure and (iii) the Directive on the requirements for national budgetary

frameworks. See also footnote 6.

Proposal for a regulation of the European Parliament and of the Council on the effective coordination of economic policies and

multilateral budgetary surveillance and repealing Council Regulation (EC) No 1466/97, COM/2023/240 final (so called preventive arm

regulation); Proposal for a Council regulation amending Council Regulation (EC) No 1467/97 on speeding up and clarifying the

implementation of the excessive deficit procedure, COM/2023/241 final (so called corrective arm regulation); Proposal for a Council

directive amending Council Directive 2011/85/EU on requirements for budgetary frameworks of the Member states, COM/2023/242

final (so called budgetary frameworks directive).

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the new proposals to reform the EU economic governance rules and their expected effect on monetary

policy. And finally we conclude.

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2. THE JURISDICTIONAL DOMAIN OF MONETARY AND FISCAL

POLICY

The legal framework of EMU, as laid out in the European Treaties (Treaty on European Union (TEU) and

Treaty on the Functioning of the European Union (TFEU)), demarcates the mandate of the ECB and the

separation and different jurisdictional domains between monetary policy and fiscal policy.

2.1. The price stability mandate of the ECB

Monetary policy in the euro area is one and indivisible. It is governed by the Treaty framework, which

clearly establishes the primacy of price stability in the conduct of monetary policy.

As a contributory

task, the ECB should support financial stability.

Fiscal considerations within the broader scope of economic policies may not be targeted as such by

monetary policy, which ought to remain uninfluenced by the fiscal objectives of the individual Member

States. While fiscal policy is still decentralised, monetary policy is the exclusive competence of the ECB.

In order to protect the primacy of price stability in the conduct of monetary policy and to shield it from

political instruction (including fiscal policy considerations), the Treaty grants strong independence to

the ECB.

The Treaties remain silent on a definition or further explanation of what is meant by price stability. The

academic literature has discussed in-depth what was meant by the Treaty founders and resorted, inter

alia, to economic theory (of the time) and the Maastricht-criteria for accession to the euro area to

determine what precisely the term "price stability" entails. In this regard, price stability was interpreted

as aiming at an inflation of close to, but below 2% until 2021; in July 2021 the ECB amended this

interpretation as part of its monetary policy strategy review. On 8 July 2021, the ECB Governing Council

adopted a symmetric 2% inflation target over the medium term, thereby diverging from its previous

interpretation (ECB, 2021a).

2.2. Fiscal policies within the responsibility of the Member States

As stated above, while monetary policy is centralised at Union level and constitutes an exclusive

competence,

fiscal policies (as part of the economic policies) remain the competence of the Member

States. Hence, the jurisdictional domains of monetary and fiscal policy are separated in the Union legal

framework.

Thus, the monetary union and the ECB's monetary policy rests on, and interacts with,

heterogenous economies and fiscal policies of the 27 Member States.

TFEU provides for some coordination of economic policies and sets requirements regarding the fiscal

situation of the Member States to ensure a minimum level of economic convergence.

In practice,

however, the incompleteness of the EMU - also described as an asymmetry underlying the EMU with

centralised monetary policy at Union level and decentralised economic policy at Member State level -

Art. 127 (1) 1, 282 (2) TFEU and Article 2 of the Statute of the European System of Central Banks (ESCB Statute) lay out the ECB's primary

objective to maintain price stability. Only "[w]ithout prejudice to the objective of price stability, the ESCB shall support the general

economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of

the Treaty on European Union" according to Art. 127 (1) 2 TFEU.

Art. 127 (5) TFEU.

Art. 130, 282 TFEU and other provisions.

Art. 3 (1) (c) TFEU.

See Lastra and Louis (2013), pp. 35 ff.

See in detail 5.1. of this paper and Lastra and Louis (2013), pp. 20 ff.

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has been criticised as flawed since the beginning of the EMU.

The insufficient enforcement of the

existing ruleset is also the subject of considerable criticism.

See Hetges (2015), pp. 32 ff.; on the discussion see for example Seidel (2000), pp. 866 f.; Horn (2011), p. 1399; Siekmann (2013), marginal

notes 24 ff.; Lastra (2015), pp. 291 f.; Lastra and Louis (2013), pp. 4 ff.

See Degenhart (2013), pp. 88 ff.; Ohler (2019), pp. 13 ff.; Thiele (2013), pp. 3 ff. with further references; Konrad et al. (2010), pp. 143–171;

Antpöhler (2012), p. 355. In detail on the different forms of economic imbalances between Eurosystem members Smets (2012),

pp. 41 ff.; Lastra and Louis (2013), pp. 35 ff.

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3. INTERACTIONS BETWEEN MONETARY AND FISCAL POLICY

While monetary and fiscal policies reside in different jurisdictional domains, they are highly

interdependent, interacting with each other (see Chapter 3.1.). These interactions should be ideally

mutually supportive and in line with the respective goals and mandate of monetary and fiscal policy.

However, the current monetary and fiscal stance results into a complex monetary-fiscal policy mix (see

Chapter 3.2.).

3.1. Interdependencies and interaction of (conventional) monetary and

fiscal policy

Monetary and fiscal policies use different instruments to influence the economy and achieve their

objectives. Monetary policy instruments can be broadly divided into conventional and unconventional

instruments. In this section we will briefly discuss the interaction of conventional monetary policy

instruments with fiscal policy. In Chapter 4, we focus instead on unconventional monetary policy

instruments and their interaction with fiscal policy, which is why they are also referred to as “quasi-

fiscal policy measures”.

The main conventional monetary policy instrument is the steering of short-term interest rates. By

adjusting interest rates, central banks aim to influence borrowing costs spending and investment

decisions of households and firms, and, ultimately, the price level and inflation, the ECB's primary

objective.

Fiscal policy involves government decisions on taxation and government spending. Through these

instruments, governments influence the level of demand and supply in the economy and allocate

resources to different sectors with the aim to stabilise the business cycle and redistribute income and

wealth. the business cycle and redistribute income and wealth.

Since both monetary and fiscal policies affect the real economy, they inevitably interact. For example,

if the central bank adjusts interest rates to cool or stimulate the economy in order to achieve its price

stability objective, this will also have an impact on the government's debt servicing costs, thusly

affecting fiscal sustainability and the room for manoeuvring. Conversely, the level of government

borrowing affects the demand for credit and, hence, the level of interest rates, thus interacting with the

main instrument of monetary policy. Moreover, public investment and consumption affects aggregate

demand and, therefore, ultimately also the price level. In this way, monetary and fiscal policies can

support or disrupt each other in stabilising the economy and pursuing price stability.

In times of economic contraction and low inflation, coordination of monetary and fiscal policy is not

too difficult. Monetary policy could be accommodating by keeping interest rates low to avoid

burdening governments with high debt servicing costs. At the same time, governments could take

advantage of cheap financing and use fiscal stimulus measures, such as tax cuts and increased

government spending, to boost the economy.

However, it is more difficult to coordinate fiscal and monetary policy in times of economic contractions

when inflation is high, as is currently the case. An inflation-targeting central bank, as the ECB, must

tighten monetary policy by raising interest rates and phasing out asset purchase programmes. These

measures raise the cost of servicing government debt, thus discouraging the issuance of new

government debt. Moreover, government deficits increase as maturing debt has to be rolled over. At

Several studies show that the effectiveness of fiscal stimulus is also dependent on the monetary policy stance. For instance, the fiscal

multiplier turns out to be higher when monetary policy is accommodative or when interest rates have hit the zero lower bound (Klein

and Winkler, 2021).

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the same time, government spending rises as automatic stabilisers operate. If the fiscal room for

manoeuvring is already constrained by high public debt levels, as it is the case in several euro area

Member States, governments may be prevented from further supporting monetary policy through the

use of expansionary fiscal measures. In case financial markets cast serious doubts on the solvency of

governments, governments may even resort to pro-cyclical fiscal policy by cutting government

spending, which would counteract an expansionary monetary policy. Thus, fiscal policy would be

constrained by monetary policy. The awareness that interest rate hikes worsen the debt sustainability

of governments could also lead central banks to be reluctant to raise interest rates further or to do so

by less than necessary - a situation referred to as “fiscal dominance”. In this case, monetary policy would

be constrained by fiscal policy.

When an economy is affected by an economic downturn or an inflation shock in only some sectors, as

was the case with the pandemic and during the current energy crisis, effective monetary and fiscal

policy coordination is particularly important. Monetary policy instruments can be viewed as relatively

blunt tools that affect the economy as a whole, including the general price level. In case of transitory

and sectoral shocks, fiscal policy is better suited to stimulate and support specific sectors and to

support the most affected households and firms (Woodford, 2022). In this case, monetary policy may

best support fiscal policy by keeping general inflation expectations low through a high degree of

credibility.

Thus, these examples illustrate the need for sound and solid public finances and sufficient fiscal room

to manoeuvre in order to ensure effective monetary and fiscal policy coordination and the use of

counter-cyclical fiscal measures as a stabilisation instrument. The EU legal framework does not provide

intensive ex-ante or ad-hoc coordination of monetary and fiscal decision making (see Dall’Orto et al.,

2020; Manzke, 2015). Rather, the Treaties only allow for limited coordination and cooperation (and the

forms of positive and negative integration mentioned in the introduction).

This inter-institutional

cooperation is based on rights of participation, rights to be consulted, and democratic accountability

duties

. In addition, the ECB has a consultative role.

These forms of coordination institutionalise the

exchange of information necessary to conduct monetary and fiscal policies based on a profound

understanding of each other (see e.g. Bodea and Huemer, 2010; Bini Smaghi and Casini, 2002; von

Hagen and Mundschenk, 2002; Beukers, 2013). The Bank for International Settlements (BIS) Annual

Report 2023 considers “the perennial but elusive search for consistency between fiscal and monetary

policy” and talks about the need for a “region of stability”: “the region that maps the constellation of

the two policies that foster sustainable macroeconomic and financial stability, keeping the inevitable

tensions between the policies manageable.”

3.2. The current monetary and fiscal stance

For more than a year and a half now, inflation in the euro area has been well above the ECB's inflation

target. Accordingly, monetary policy in the euro area has switched to a clear restrictive course. The

interest rates on the deposit facility, the main refinancing operations and on the marginal lending

facility have been gradually increased to 4.00%, 4.50% and 4.75% respectively, and quantitative

tightening has been initiated. Despite the current decline in headline inflation, the core inflation rate

remains stably too high and does not yet show any downward tendencies. Therefore, the ECB will

probably remain on a restrictive course for quite some time. There is the risk that sharply rising interest

See No. 12 Resolution of the European Council of 13 December 1997 on economic policy coordination in stage 3 of EMU and on Treaty

Articles 109 and 109b of the EC Treaty, OJ C 35, 2.2.1998, pp. 1–4; see also ECB (2003), pp. 37 ff.; Beukers (2013), p. 1582.

Art. 284 TFEU.

Art. 282 (5), Art. 127 (4) TFEU and Art. 4 ESCB-Statute.

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rates could trigger a systemic banking crisis, as the turmoil in Switzerland and the US demonstrated in

the spring of 2023.

Figure 1: Government benchmarks, 10-year, yield

Source: Eurostat.

Note: Germany, France, Italy, Spain, Netherlands are represented as the largest economies in the euro area, as measured

by their 2021 GDP in US-dollars.

It is important to consider that this monetary tightening has very different regional effects, as interest

rates and risk premiums react differently due to the very heterogeneous public debt levels; they

typically rise more strongly and non-linearly in the highly indebted countries (Bernoth, 2012). Between

2020 and 2021, ten-year nominal government bond yields reached historic lows and were even

negative in the Netherlands and Germany. At the beginning of 2022, even before the ECB's first interest

rate hike in July 2022, yields in the main euro area economies rose sharply at the same time, reflecting

market expectations of ECB intervention (Figure 1). At the end of August 2023, bond yields in individual

countries ranged from 2.48% (Germany) to 4.13% (Italy), remaining relatively stable since the end of

2022. Although long-term government bond yield spreads widened slightly compared to Germany at

the beginning of 2022, risk premiums currently appear to have little impact on bond yields. This is

mainly due to the announcement of the TPI in July 2022. As a result of these rate hikes, the interest-

related costs of public debt servicing have risen since the sharp increase in the key interest rate.

Moreover, the extraordinary fiscal measures implemented by governments to cushion the economic

effects of the COVID-19 crisis have led to a sharp increase in public deficits and a record level of

sovereign debt in most euro area Member States in 2020.

Thus, the public debt in the euro area

reached 97.2% of gross domestic product (GDP) in 2020 before decreasing slightly to 91.5% in 2022.

While all euro area countries saw a rebound in their public debt in 2020, recent developments are

highlighting growing debt disparities within the euro area (Figure 2). Where Estonia's debt-to-GDP

ratio reached just 18.4% in 2022 (up by around 10 percentage points since 2019), Greece's now stands

at 171.3% (down by more than 9 percentage points since 2019). In total, in 2022, only eight countries

Only Germany, Ireland, Latvia, Malta, Netherlands, Austria, and Slovenia did not reach an historic high in their debt-to-GDP ratio in 2020.

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have public debt ratios below 60% and five countries have reduced their debt ratios compared with

2019 despite the significant economic impact of the COVID-19 crisis (Croatia, Cyprus, Greece, Ireland,

and Portugal). The Debt Sustainability Monitor 2022 (European Commission, 2023b), which gives an

insight into fiscal sustainability risk encountered by EU Member States, estimated the fiscal risk to be

overall low in the short-term, before becoming high or medium for most countries in the medium- and

long-term. Especially in an environment of higher inflation, this situation poses the risk of “fiscal

dominance” emerging, compromising the ability of single monetary policy to adequately fulfil its

primary price stability objective.

Figure 2: General gross debt in % of GDP

Source: Eurostat.

Note:

The horizontal line of 60% of GDP indicates the reference value for government debt as specified in the Maastricht

Treaty.

To strengthen the efficiency of tightening monetary policy and to avoid adding upward inflationary

pressures, the euro area fiscal stance has becoming more restrictive since 2023, although there are

significant disparities between countries, as highlighted in the Eurogroup statement of 13 July 2023,

on the fiscal stance for the euro area for 2024 (European Council, 2023). While the emergency fiscal

response measures adopted during the COVID-19 pandemic have already largely expired, falling

energy prices should allow euro area governments to progressively phase out the support measures

implemented to counteract the economic effects of the war in Ukraine (especially high energy costs,

supply chain disruptions).

The upcoming contractionary fiscal impulse in the euro area is warranted to ensure a gradual decline

in deficits and high public debt over time. Both remain well above their pre-pandemic levels, while

rising interest rates will – although only progressively – weigh on the cost of servicing public debts.

Thus, the fiscal strategy of Member States should restore fiscal buffers to secure debt sustainability.

At the same time, fiscal policy measures aimed at increasing economic growth over the medium term

by boosting the supply side of the economy are being implemented in most euro area countries. These

fiscal policies are supported in part by private and public funds but also through the NextGenerationEU

programme, via its core element: the Recovery and Resilience Facility. With this temporary instrument,

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the European Union is providing financial support to Member States to foster investments in ecological

and digital transformation over the 2021-2026 period.

The relation between fiscal policy and inflation is not straightforward. Indeed, the impact of fiscal

measures on inflation depends on various factors, notably the type and the size of the fiscal impulse

(change in government spending or tax rates, discretionary fiscal policies - targeted or not, side effect

on government deficit, demand- or supply-side measures), specific national features (level of debt,

position in the business cycle), the global economic and geopolitical context, and the monetary policy

stance.

Some of the temporary discretionary fiscal measures taken in the euro area at the beginning

of the war in Ukraine to cushion rising energy costs, such as indirect tax cuts or price caps, are estimated

to have contributed to reducing inflationary pressures in 2022 and 2023, although the effect is

mitigated by the discontinuation in 2022 of the subsidies to households and businesses intended to

counter the impact of the health crisis (Bankowski, 2023). However, these direct energy support

measures should increase inflation in 2024 and 2025 as most of them expire in 2023. In addition, direct

measures to support household income adopted by several euro area governments, such as public

sector wage rises, indexation of social benefits to inflation, and cash transfers, will weigh on inflation

with some delay as they are gradually transmitted to households' nominal disposable income and,

therefore, increase aggregate demand.

Although the implementation of the structural supply-side

reforms at the EU level has a stimulating effect on the economy by increasing public expenditure, the

overall impact on inflation in the euro area is likely to be limited in the medium term.

However, given

the complexity and size of the fiscal measures adopted, the ECB needs to closely monitor their impact

on inflation and take them into account in its decision-making.

See Bönke and al. (2023), pp. 296-297 for more details on the NextGenerationEU programme.

See Checherita-Westphal and al. (2023), pp. 15 ff.; See ECB (2021), box 6 entitled “Fiscal policy and inflation in the euro area: a VAR-

based analysis”; See IMF (2023), Chapter 2.

See ECB (2023), box 9 entitled “Update on euro area fiscal policy responses to the energy crisis and high inflation”.

See Bankowski (2022), pp. 33 ff.

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4. ECB “QUASI-FISCAL” MEASURES

The interaction between monetary and fiscal policies is particularly relevant in the discussion of the

ECB's unconventional monetary policy measures, primarily the large-scale asset purchases also called

Quantitative Easing (QE) given their “quasi-fiscal” effects. A central bank activity can be considered to

have a “quasi-fiscal” component or effect if it has a significant impact on the government accounts

and/or affects other aspects of fiscal policy (taxes, spending, financing), either immediately or in the

future. This includes, for example, activities that result in financial losses for the central bank, which

ultimately must be borne by governments in the form of lower dividends or loss compensation. Central

bank activities can also impact fiscal policy if they affect the allocation of resources in the economy and

create distortions, or if they change the structure of government debt or the market for government

securities, thereby reducing the effectiveness of government debt management (Hooley et al., 2023).

During the Great Financial Crisis and the COVID-19 pandemic, the ECB applied a number of

unconventional monetary policy tools to address deflationary tendencies. This involved an

unprecedented expansion of central bank assets with quasi-fiscal characteristics:

• In 2010, the Securities Markets Programme (SMP), replaced by the Outright Monetary

Transactions (OMT) in 2012, was introduced to ease credit conditions by purchasing bonds on

the secondary market.

• The Targeted Longer-Term Refinancing Operations (TLTRO) announced in 2014 (TLTRO I), 2016

(TLRTO II) and 2019 (TLTRO III) provided banks with extended funding opportunities at

favourable conditions linked to the granting of loans to non-financial corporations and

households.

• Since October 2014, massive asset purchase programmes (APPs) have increased the size of the

ECB's balance sheet (Figure 2). In 2020, the ECB implemented another round of quantitative

easing with the Pandemic Emergency Purchase Programme (PEPP) to counter the effects of the

COVID-19 crisis.

On the whole, the unconventional measures were effective at stabilising financial and economic

conditions, easing financial market stress, and, thereby, also smoothing monetary policy transmission

(Cour-Thimann, 2013; Beckmann, 2020; BIS, 2019).

Combined with negative interest rates, large APPs

lowered both interest rates and the cost of borrowing, stimulated bank lending to businesses and

households, and encouraged consumption and economic activity (though the unintended effects of

APPs require further study). The real economy has also been supported through the exchange rate

channel, as currency depreciation induced by the expansion of the monetary base has improved the

competitiveness of businesses and fostered export recovery. In total, unconventional monetary

policies from 2014 boosted annual GDP growth in the euro area by 0.6 pp. and inflation by 0.4 pp., on

average, over the period 2015-2020 (Altavilla, 2021).

However, ECB unconventional monetary policy measures have increased financial risks on the

Eurosystem’s balance sheet (which has expanded significantly with QE), that may result in financial

losses for the ECB and the national central banks and, ultimately, the Member States’ governments and

taxpayers. Moreover, these monetary policy measures have relevant distributional effects which are

traditionally limited to, and characteristic of, fiscal policy (Dossche at al., 2021; Becker at al., 2015;

European Parliament, 2015).

Yet, the ECB has complete operational autonomy in the implementation

See the European Central Bank website for more details on the different monetary policy instruments.

https://www.ecb.europa.eu/mopo/implement/html/index.en.html

See Beckmann and al. (2020), pp. 14-15, for an overview of the range of estimated effects of unconventional monetary policy on GDP

growth and inflation in the euro area from various studies.

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of unconventional monetary policies and there is no involvement of the fiscal authority in their design

and implementation. Thus, in order to minimise these effects, unconventional monetary policy

instruments should only be used for limited periods of time.

Figure 3: Introduction of quantitative easing from 2014 by the European Central Bank

Source: European Central Bank.

Note: The euro area government bond yield benchmarks are calculated on the basis of national bond yields weighted by

outstanding amounts of government debt in each maturity bucket.

4.1. Legal analysis of ECB “quasi fiscal” measures

From a legal point of view, “quasi-fiscal” monetary policy measures are problematic in terms of: (a)

competence, (b) principles underlaying the monetary policy legal framework, and (c) financial and

institutional independence.

First, monetary policy measures are characterised by their primary objective to maintain price stability.

However, the fiscal condition/state of Member States (economic and financial imbalances and

sovereign debt ratios) influence the transmission of monetary policy measures. This notwithstanding,

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the ECB's price stability mandate does not provide the ECB with a competence to address disruptions

of monetary policy transmission that are rooted in the fiscal and economic situation of Member States

and which rest within their jurisdictional domain. While any economic and financial imbalances as well

as sovereign debt ratios inevitably affect monetary policy transmission, the ECB is not competent to

address any causes that directly or indirectly impede its price stability mandate. These causes partly

relate to issues that are firmly rooted in the fiscal and economic situations and within the competence

of the Member States. The ECB only has a secondary or contributory competence to support the

economic policies of the Member States, i.e. the ECB can only support the policies pursued by other

actors and institutions.

Second, while distributional effects of monetary policy measures are inherent to any policy measure,

for example, traditional interest rate policy, selective measures that directly privilege specific market

participants, certain Member States, or certain financial or non-financial institutions, are generally not

foreseen within the EU monetary policy framework. Such measures with highly distributional effects

are only allowed in very narrowly defined cases that rely on monetary reasons and not on economic,

social, or other preferences.

The EU monetary policy framework also rests on the principle that the ECB may only conduct monetary

policy operations with solvent counterparties and on the basis of adequate collateral. Even in crisis

situations, when national central banks act as lender of last resort (LOLR), it is a basic principle that they

can only lend money to credit institutions that are solvent, but experience liquidity problems and only

against sufficient collateral. These preconditions respond to two purposes: (i) to distinguish monetary

policy measures from fiscal measures, since it is the task and the competence of fiscal authorities to

inject capital into insolvent institutions, resulting in direct distribution of resources; and (ii) to safeguard

the ECB from incurring losses, which is important with regard to the ECB's financial and institutional

independence (see also Rogoff, 2021).

The third aspect to consider is that the independence of the ECB cannot be compromised by fiscal and

financial considerations. In a situation of so called “fiscal dominance” and/or “financial dominance”, the

ECB might depart from a monetary policy strategy that might be adequate in terms of price stability.

4.2. TPI and its role in preventing future fragmentation of sovereign

bond markets

In reaction to the fragmentation of the sovereign bond markets in the euro area, the ECB Governing

Council announced its new anti-fragmentation tool, named the Transmission Protection Instrument

(TPI) on 21 July 2022. The TPI aims to ease potential bond market fragmentation with secondary market

purchases of securities issued in jurisdictions experiencing a deterioration in financing conditions not

warranted by country-specific fundamentals. According to the press release, the TPI aims to support

the effective transmission of monetary policy in the case of "unwarranted, disorderly market dynamics

that pose a serious threat to the transmission of monetary policy across the euro area" by selective

sovereign bond purchases (ECB, 2022).

The TPI faces some legal and economic challenges with regard to its conformity with the ECB mandate

and its monetary policy competence, which we analysed in depth in a previous paper.

While the aim

of TPI – ensuring an “effective transmission of monetary policy” – is no doubt a necessary prerequisite

in the pursuit of a price stability-oriented monetary policy, this alone does not suffice to prove that the

Art.127 (1) 2 TFEU states: “Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in

the Union (…)”.

See in detail Bernoth et al. (2022).

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measure falls within the ECB's price stability mandate. Currently, with surging inflation, the ECB is trying

to curb surging inflation by increasing interest rates. This puts a heightened burden of justification on

the ECB to explain how further asset purchases – an expansionary monetary policy – would fit within

the overall monetary policy stance of fighting inflation, should TPI be activated. It is only if market

failures are identified as the cause for the financial fragmentation of sovereign bond yield spreads that

the ECB allowed to take such selective and targeted measures to address these causes.

Fiscal support for highly-indebted Member States that struggle with higher, yet justified, risk premia is

not a task for the ECB and not within the monetary policy domain. It rather falls within the fiscal domain

and within the remit of the competence of the Member States according to the respective democratic

processes in place. Such a decision should be subject to political and public scrutiny. As the ECB stated

with regard to the TPI, the deterioration in financing conditions potentially hampering monetary policy

transmission, which TPI might be able to address, may "not [be] warranted by country-specific

fundamentals" (ECB, 2022). This is in line with the European Court of Justice (ECJ)'s ruling on OMT,

where it made clear that "the programme in question cannot be implemented in a way which would

bring about a harmonisation of the interest rates applied to the government bonds of the Member

States of the euro area regardless of the differences arising from their macroeconomic or budgetary

situation."

Moreover, activation of the TPI requires sound and sustainable budgetary and economic policies, as

stated in the eligibility criteria explained in the press release (ECB, 2022). However, as outlined also in

Bernoth et al. (2022), the institutional structure of the ECB is not well suited to assessing these criteria.

The monitoring of compliance with fiscal rules and the ultimate discretionary decision on whether a

Member State sufficiently fulfils the requirements of sound and sustainable fiscal and economic

policies may expose the ECB to political pressure and threaten its independence. The decision as to

whether the ECB should carry out such an assessment itself or whether this should be the responsibility

of external bodies (e.g. the European Stabilisation Mechanism and the International Monetary Fund)

therefore remains an important question to be clarified.

The ECB has not yet disclosed the method, benchmarks and criteria it will use to assess, whether bond

yield developments are “not warranted by country-specific fundamentals”. The provisions on how the

Governing Council will use the listed eligibility criteria as input to its decision-making process are very

non-specific and non-transparent and therefore allow for a certain degree of discretion.

The potential quasi-fiscal components of TPI and the corresponding legal challenges also become

apparent when considering the balance sheet implications. TPI interventions, if activated, would lead

to a further increase in the size of the Eurosystem's balance sheet if they are not sterilised by the sale of

other assets. If the Member State were not able to pay back its debt, the central bank would incur losses

on its balance sheet.

ECJ, Judgment of the Court of 16 June 2015, Case C-62/14, Gauweiler et al., ECLI:EU:C:2015:400, para. 113

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5. THE NEW EU ECONOMIC GOVERNANCE ARCHITECTURE

Sustainable public finances are considered a prerequisite for a single monetary policy in the euro area

to be able to focus on its primary mandate of price stability, as well as for monetary and fiscal policy to

mutually support each other in their stabilisation function. An adequate governance structure in the

EU should create these conditions.

5.1. Legal foundations of the EU economic governance architecture

The EU economic governance framework, as laid out in the Treaties, provides a system of institutions

and procedures to coordinate economic policies of the Member States (see Art. 120f. TFEU) and aims

to monitor, prevent, and correct problematic economic trends that could weaken national economies

or negatively affect other EU countries. This framework has evolved over time, being and been refined

and reinforced.

The legal framework relies on the TFEU (Art. 120ff., 126 TFEU)

, the Stability and Growth Pact

(see

below), the European Semester (an annual cycle of economic, fiscal, employment and social policy

coordination) and the so-called six-pack and two-pack legislative reforms (additional secondary

legislation to strengthen the Stability and Growth Pact).

The European Commission monitors the

economic development in the euro area in order to detect potential problems and risks for economic

stability and competitiveness. To do this, it conducts regular assessments and forecasts, while also

producing an Annual Sustainable Growth Survey and the Alert Mechanism Report.

Prevention is a key pillar within EU economic governance as it aims to address economic problems

early on and prevent spill-over effects to other Member States. The Stability and Growth Pact (SGP)

plays an important role within the EU's prevention mechanism and requires the Member States to

pursue sound national fiscal policies by setting budgetary targets. The Macroeconomic Imbalance

Procedure (MIP), introduced in 2011 as part of the so called "six-pack" reform of the economic

governance, foresees, in the case of excessive imbalances in the economies of a Member State, that

said Member State is subject to enhanced monitoring and might even face sanctions. In addition, the

Treaty on Stability, Coordination and Governance (TSCG or the ‘fiscal compact’) sets standards for fiscal

policies by limiting the size of the structural deficit that a government may incur to 0.5% of GDP per

year and requires the establishment of automatic policies to correct significant transgressions.

Correction of economic imbalances and enforcement of the existing ruleset with the Excessive Deficit

Procedure (EDP) and the Excessive Imbalance Procedure (EIP) are a crucial part within the EU economic

governance framework.

Under EDP, if a national budget deficit exceeds 3% of GDP or if it fails to

reduce its excessive debts (i.e. is still above 60% of GDP), the Member State must commit to targets to

bring its excessive deficit or debt back down. The EU can also impose sanctions, such as fines that can

reach 0.2% of their GDP, if a Member State persistently fails to take adequate action.

Similarly, under the EIP of the EU’s MIP, a Member State experiencing excessive imbalances can be

required to submit Corrective Action Plans to address its situation and might likewise face fines if they

fail to sufficiently impose corrective measures.

See Lastra and Louis (2013), pp. 35 ff.

See Lastra (2015), pp. 293 ff.

See Lastra (2015), pp. 301 ff.; Lastra and Louis (2013), pp. 55 ff. with further references.

See Lastra and Louis (2013), pp. 66 ff., 144.

See Lastra and Louis (2013), pp. 144 ff.

See Lastra (2015), pp. 293, 298 ff., see also 231 ff.

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5.2. Proposal to reform the EU economic governance rules

The EU fiscal framework has been criticised for being too rigid on the one hand and for not promoting

sufficient convergence on the other, with the result that several EU Member States lack the fiscal

capacity to ensure effective coordination in times of economic downturn. In response to the

inadequacies and complexities of the current economic governance architecture, the Commission in

April this year presented its new package of proposals to reform the EU’s economic governance rules.

The proposed new economic governance architecture aims to strengthen public debt sustainability

while promoting progress towards a green, digital, inclusive and resilient economy and making the EU

more competitive.

The cornerstones of the proposal are stronger national ownership, simpler rules

taking into account different fiscal challenges, facilitating reforms and investments for EU common

priorities, and providing for effective enforcement.

The EU economic governance reform consists of three legislative proposals: (i) a proposal to create a

new regime for the SGP with regard to its preventive aspects (the so called preventive arm regulation)

(ii) a proposal to strengthen the corrective elements of the SGP (the so called corrective arm

regulation)

and (iii) amendments regarding the requirements for the budgetary frameworks of the

Member States.

In particular, the proposal on the preventive arm allows Member States to set their multi-annual net

expenditure path on the basis of reform and investment commitments that they would detail in their

medium-term fiscal-structural plan. For Member States whose government debt is above the 60% of

GDP reference value or whose government deficit is above the 3% of GDP reference value, the

Commission would propose “technical trajectory for net expenditure covering a minimum adjustment

period of 4 years of the national medium-term fiscal-structural plan, and its possible extension by a

maximum of 3 years […]”. as guidance for the multi-annual trajectory for net expenditure

with a view

of maintaining debt levels on a downward path. The extension of fiscal adjustment by a maximum of

3 years would allow for a more gradual adjustment path if countries undertake reforms and

investments commitments in line with EU priorities.

The proposal responds to the long-standing criticism that the current fiscal surveillance indicators are

based on numerical variables that are very difficult to measure in real time, in particular, the structural

balance and potential output variables. This has resulted in the fiscal policy being often pro-cyclical

when it should have been counter-cyclical according to the information available to policy makers in

real time (Bernoth, 2015). Steering on the expenditure side is more transparent and less susceptible to

manipulation (Anderson and Minarik, 2006). Moreover, focusing on a medium-term approach rather

than year-to-year monitoring gives governments more flexibility to respond to unforeseen events and

cyclical fluctuations in public expenditure.

Proposal for a regulation of the European Parliament and of the Council on the effective coordination of economic policies and

multilateral budgetary surveillance and repealing Council Regulation (EC) No 1466/97, COM/2023/240 final; Proposal for a Council

regulation amending Council Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of the excessive deficit

procedure, COM/2023/241 final; proposal for a Council directive amending Council Directive 2011/85/EU on requirements for

budgetary frameworks of the Member states, COM/2023/242 final.

Proposal for a regulation of the European Parliament and of the Council on the effective coordination of economic policies and

multilateral budgetary surveillance and repealing Council Regulation (EC) No 1466/97, COM/2023/240 final (so called preventive arm

regulation).

Proposal for a Council regulation amending Council Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of

the excessive deficit procedure, COM/2023/241 final (so called corrective arm regulation).

Proposal for a Council directive amending Council Directive 2011/85/EU on requirements for budgetary frameworks of the Member

states, COM/2023/242 final (so called budgetary frameworks directive).

Proposal for a regulation of the European Parliament and of the Council on the effective coordination of economic policies and

multilateral budgetary surveillance and repealing Council Regulation (EC) No 1466/97, COM/2023/240 final, Art. 5.

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Moreover, the new proposal foresees that independent national financial institutions should be given

a stronger role in monitoring the implementation by Member States of their national medium-term

fiscal-structural plans.

The proposals allow Member States to have more control over the design of their medium-term plans,

but also foresee a more stringent enforcement regime to ensure Member States deliver on the

commitments undertaken in their medium-term fiscal-structural plans. The excessive deficit procedure

for breaches of the 60% of GDP reference value is strengthened. For a Member State facing substantial

public debt problems, the degree of debt challenge will be considered a relevant factor for the

initiation of an excessive deficit procedure upon departure from the agreed net expenditure path.

Proposal for a regulation of the European Parliament and of the Council on the effective coordination of economic policies and

multilateral budgetary surveillance and repealing Council Regulation (EC) No 1466/97, COM/2023/240 final, Art. 22.

Proposal for a Council regulation amending Council Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of

the excessive deficit procedure, COM/2023/241 final (so called corrective arm regulation).

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6. IMPLICATIONS OF THE ECONOMIC GOVERNANCE REVIEW FOR

MONETARY POLICY

The economic governance review bears overall positive implications for the ECB's price-stability-

oriented monetary policy from an economic and legal perspective, as expressed in an official Opinion

by the ECB of 5 July 2023.

The proposed review establishes rules that monitor and restrict, where

necessary, fiscal deficits and helps to ensure that Member State's fiscal and economic situations can, at

least to a certain degree, converge, thus representing a precondition for a single monetary policy.

Likewise, it is important that national ownership of the framework, by setting national medium-term

fiscal structural plans, is strengthened to avoid situations where – due to a lack of fiscal capacity at the

Union level – the ECB might be de facto forced to address fiscal and economic imbalances in Member

States by means of monetary policy measures, which are outside of its mandate.

In general, rules that help delineate the responsibility of the ECB for ensuring price stability on the one

hand and the responsibility of the Member States for their fiscal and economic situation on the other

are essential for ensuring that monetary policy measures do not have “quasi-fiscal” effects of such a

scale and manner that they actually substitute fiscal measures. Therefore, the Governing Council's

decision to phase out unconventional monetary policy measures of a “quasi-fiscal” nature is welcome

and will help to reduce risks and increase transparency. It will protect the Eurosystem from interest rate

risks on large holdings of securities as policy normalises and will help reduce distortionary effects on

public and private sector assets. This will also reduce reputational risk for the ECB. However, it is worth

noting that the recent process of quantitative tightening has been very gradual and will continue for

several years to avoid market disruption. The ECB therefore faces a difficult trade-off.

This delineation and the avoidance of the wrong type of monetary-fiscal policy mix is not only

important to ensure that the ECB stays within its mandate, as laid down in Art. 127 TFEU, but also to

ensure that the ECB keeps its institutional and financial independence. Economic and fiscal measures

must be taken by the competent and democratically accountable institutions and actors, as they bear

an important social dimension. The existing forms of coordination between the ECB and economic and

fiscal policy makers are important to ensure an adequate level of information and better understanding

between both policy fields.

The current reform of the EU governance framework provides an opportunity to address the

shortcomings that have emerged over the past decades, leading to a situation where optimal

coordination of fiscal and monetary policies has been hampered. A well-functioning EU governance

framework that leads to effective fiscal consolidation and gradual debt reduction in the years ahead,

especially in the highly indebted countries, facilitates the ECB's monetary policy in several respects. In

the current high-inflation environment, a reduction in fiscal stimulus or fiscal support targeted at only

individual sectors in need reduces inflationary pressures (Beyer et al., 2023). This would allow for a more

gradual and moderate monetary tightening, thereby reducing financial stability risks posed by a rapid

and widespread increase in interest rates. Furthermore, fragmentation risks of European bond yields

(and spreads) would be mitigated, making the use of the controversial TPI less necessary for the ECB.

A closer look, however, shows that the current reform proposal, while eliminating many of the

identified shortcomings (see sub-chapter 4.2), still lacks transparency and leaves too much room for

discretion, which may once again open the door to clientelism and endless discussions. For instance,

the proposal says that “The national medium-term fiscal-structural plan shall ensure the fiscal

Opinion of the European Central Bank of 5 July 2023 on a proposal for economic governance reform in the Union (CON/2023/20), OJ C

290, 18.8.2023, pp. 17–25.

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adjustment necessary to put or keep public debt on a plausibly downward path by the end of the

adjustment period at the latest, or remain at prudent levels, and to bring and maintain the government

deficit below the 3% of GDP reference value over the medium term “

How exactly is the "plausible

downward path" defined and how long is the "medium term"?

Moreover, the governments' medium-term fiscal-structural plans, and also the Commission's fiscal

trajectories, are based on medium-term projections of public debt. While the proposal says that the

Commission must disclose the underlying framework for these projections and its results, there is

always a degree of discretion in the assumptions underlying a projection model and its design. The

proposal states that "when Member States use assumptions in their medium-term fiscal-structural plan

that differ from the Commission’s standard medium-term debt projection framework, they should

explain and duly justify the differences in a transparent manner and based on sound economic

arguments. In particular, the debt projections at unchanged policy to be included in the plan should

be consistent and comparable with the Commission projections."

But no one can say with certainty

which model is the right one, and the question is why the Commission does not impose one from the

outset to avoid discussion.

In contrast to the previous governance structure, which was mainly based on negotiations between

Member States, the new proposal places more emphasis on negotiations between the European

Commission and each individual Member State. Whether this vertical structure will improve

compliance, however, is an open question. As Fuest (2023) argues, if countries do not want to comply

with the European Commission's requirements, it will be easy for them to argue, for example, that the

Commission is a technocratic institution with less democratic legitimacy than their national

parliaments.

There is still time to remedy these deficiencies in the coming months, and this should be used to put

EMU on a more stable position in the long term, able to exploit the synergistic effects between

monetary and fiscal policy.

See Proposal for a regulation of the European Parliament and of the Council on the effective coordination of economic policies and

multilateral budgetary surveillance and repealing Council Regulation (EC) No 1466/97, COM/2023/240 final, Art. 6 and 12.

Proposal for a regulation of the European Parliament and of the Council on the effective coordination of economic policies and

multilateral budgetary surveillance and repealing Council Regulation (EC) No 1466/97, COM/2023/240 final, p. 14.

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7. CONCLUSION

The EU Treaties establish a formal separation of competences between a centralised monetary policy

and decentralised fiscal policies. Despite their different jurisdictional domains, fiscal and monetary

policy are highly interdependent. While this close interaction has led to tensions in the past, monetary

and fiscal policy have been largely aligned and mutually supportive during the COVID-19 crisis.

Since 2021 with the return of inflation, tensions are again visible in the monetary-fiscal policy mix.

Indeed, while the ECB started tightening monetary policy in 2022, with the aim of bringing inflation

down to close to 2% in the medium term, most Member States have adopted supportive fiscal

measures designed to reduce the impact of rising energy costs on households and businesses. This

massive fiscal support is expected to lead to inflationary pressures over the next two years (Bankowski,

2023), partly as a result of the withdrawal of fiscal measures with direct dampening effect on energy

prices as indirect tax cuts, but also due to the lagged upward effect on inflation of household income

support measures. On the other hand, the “quasi-fiscal” monetary measures implemented by the ECB

in recent years, especially the large-scale asset purchase programmes, including the announced, but

not yet activated, TPI, have, by definition, a significant impact on the government accounts and/or

affect other aspects of fiscal policy (taxes, spending, financing), either directly or in the future. “Quasi-

fiscal” monetary policy measures are also problematic from a legal point of view since they partly over-

stretch the mandate of the ECB.

The Commission has presented a proposal to reform the EU economic governance framework. The

proposed new framework aims to ensure greater national ownership and simpler rules that account

for the different fiscal challenges, thereby facilitating reforms and investment for EU priorities. While

the proposal addresses many of shortcomings identified, too much discretion is still left to the

Commission and Members States in interpreting the rules.

In the coming years, it will be crucial to re-establish better coordination between monetary and fiscal

policy. This requires sound public finances to provide sufficient fiscal room for manoeuvring. Moreover,

the ECB should only resort to “quasi-fiscal” monetary policy measures in exceptional cases, such as

when the interest rate level has reached the zero lower bound or when there are divergences in

government bond yields between Member States resulting from market excesses that jeopardise a

single monetary policy. The current reduction in the balance sheet of the Eurosystem through the

gradual phasing out of the bond purchase programmes and the TLTROs is therefore to be welcomed.

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Big central banks and big

public debts: The next

challenges

Charles WYPLOSZ

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Abstract

Like most advanced economies, the euro area emerges from a

series of historical shocks with larger public debts, a sizeable

increase in the already large balance sheets of the Eurosystem

central banks, and intensified links between fiscal and monetary

policies. The governments and the ECB must now undo what

they did. Corrective action must not wait, if only because other

shocks may again unexpectedly occur. The paper also presents a

procedure to cut public debts.

This document was provided by the Economic Governance and

EMU Scrutiny Unit at the request of the Committee on Economic

and Monetary Affairs (ECON) ahead of the Monetary Dialogue

with the ECB President on 25 September 2023.

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CONTENTS

LIST OF ABBREVIATIONS 68

LIST OF FIGURES 69

LIST OF TABLES 69

EXECUTIVE SUMMARY 70

INTRODUCTION 71

MACROECONOMIC POLICIES IN THE SHORTER RUN 72

2.1. What went wrong at central banks? 72

2.2. The fight against inflation 73

2.3. Fiscal policies 74

2.4. Interactions between monetary and fiscal policies 76

NEW MONETARY POLICIES 78

3.1. Quantitative easing: when it makes sense and when it does not 78

3.2. Fiscal implications of quantitative easing 78

3.3. Policy implications 80

THE EURO AREA IS SPECIAL 81

4.1. The public debt issue 81

4.2. The conventional strategy 82

4.3. How to reduce public debts 83

4.3.1. The idea 83

4.3.2. How to replace Treasury bonds with central bank bonds 85

4.3.3. Objections and answers 85

CONCLUSIONS 87

REFERENCES 88

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LIST OF ABBREVIATIONS

APP

Asset purchase programme

ECB

European Central Bank

European Union

EMU

Economic and Monetary Union

GDP

Gross domestic product

HICP

Harmonised index of consumer prices

PEPP

Pandemic emergency purchase programme

Quantitative easing

Quantitative tightening

TPI

Transmission protection instrument

United Kingdom

United States

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LIST OF FIGURES

Figure 1: Headline inflation rates 72

Figure 2: Central bank balance sheets (% of GDP) 74

Figure 3: Cyclically adjusted primary budget balances (% of GDP) 75

Figure 4: Inflation and the cyclically adjusted primary budget balances (% of GDP) 75

Figure 5: Public debts (% of GDP) 81

Figure 6: Central bank holdings of central government debts – end 2022 (% of total debt) 84

LIST OF TABLES

Table 1: Primary surpluses in the OECD area (1960-2023) 83

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EXECUTIVE SUMMARY

• Like most advanced economies, the euro area emerges from a series of historical shocks with larger

public debts, a sizeable increase in the already large balance sheets of the Eurosystem central

banks, and intensified links between fiscal and monetary policies. The governments and the ECB

must now undo what they did as they dealt with the shocks.

• As most other central banks, the ECB has failed to manage inflation twice since 2009. First

inflation was too low, now it is too high. The main reason is that central banks did not recognise

the lack of accuracy of their forecasts and of their estimates of the neutral interest rate.

• Inflation targeting remains the right strategy, but its implementation must be amended. This

includes the use of quantitative easing (QE) and quantitative tightening (QT), and the acceptance

that inflation forecasts can become unreliable. This calls for a revision of the monetary policy

strategy, which the ECB has announced for 2025.

• Sustained use of QE over many years has not delivered on its macroeconomic objectives.

Liquidity injections stabilise financial markets when they are hit by crisis and can be used pre-

emptively. This is does justify sustained QE, which amplifies the quasi-fiscal aspects of monetary

policy and strongly affects the behaviour of financial institutions.

• QT must be implemented without delay once financial stability has been restored. Delaying

QT for fear of financial instability is a case of both fiscal and financial dominance. If financial

instability returns during QT, temporary liquidity injections can be used without abandoning QT.

• The interactions between monetary and fiscal policy are well established but have been

overlooked. In particular, the inflationary impact of strongly expansionary fiscal policies has

contributed to the inflation surge of 2021. In general, the respective responsibilities of

governments and central banks must be clarified and central banks ought to recognise the quasi-

fiscal aspects of monetary policy as they reformulate their strategies.

• The remuneration of commercial bank deposits at central banks is a legacy of sustained QE.

Central banks have not signalled whether they intend to retain the abundance of liquidity as a

permanent feature of the interbank markets or whether to re-establish the previous regime of

scarcity. At stake are transfers of income to commercial banks, which ought to be a fiscal decision.

• Large public debts are a source of fragility. The conventional strategy is to pare debts down

through sustained primary budget surpluses. The experience shows that governments are most

unlikely to deliver and that, in any case, it will take decades to achieve the required debt reductions.

• Within the euro area, the existence of very large public debts hampers the transmission of

monetary policy and represent a serious threat. The conventional strategy must be rethought

accordingly.

• Public debts can be reduced by keeping forever the holdings of Treasury bonds on the books

of central banks. This calls for changing how central banks intervene on the interbank markets.

Instead of using Treasury bonds, the central banks can trade in their own bond instruments. This

process is not inflationary and does not entail inter-country transfers. The independent Eurosystem

can guarantee that this procedure is not abused by member governments.

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INTRODUCTION

This paper deals with two specific developments. First, central banks have become too large, in many

ways. They have expanded their mission. Beyond price stability, they have accepted to protect financial

instability, not just in response to crises but also in preventing potential volatility. To that effects they

have experimented with new tools. They have kept their interest rates ‘low for long’, including setting

their policy rates at negative levels. They have massively expanded their balance sheets, abandoning

the previous tradition of enforcing monetary scarcity. They have also intervened in support of banks

and public debts on an unprecedented scale. Second, governments too have become larger. They have

extended subsidies to households and firms as never before in peace time. They have intervened in

specific markets to manage scarcities. Like the central banks, they have accepted many new

responsibilities, including to deal with climate change and to insulate the labour markets from

economic shocks. To that effect, they have used tools like imposing lockdowns, supporting work from

home or not working at all while remaining employed. As a result, they have allowed their public debts

to rise further, reaching levels that are a source of fragility in numerous countries.

Central banks have started to normalise their policies. They have raised their policy interest rates and

started to shrink their balance sheets. In so doing, they exert pressure on highly indebted governments,

which they previously financed indirectly through low interest rates and quantitative easing (QE). Most

governments have started to cut their budget deficits, which had remained large for long, possibly

feeding the inflation surge that started in 2021. The planned reduction of budget deficits may help

central banks as they seek to bring inflation rates back to target, but it makes monetary policy more

difficult to fine tune. These two-way influences raise a number of difficult issues. In most countries,

governments and central banks may cooperate in this kind of situation. Within the Economic and

Monetary Union (EMU), cooperation is difficult because the European Central Bank (ECB) cannot make

arrangements with the governments of 20 member states and also because economic conditions differ

among the member countries (Beetsma et al, 2001; de Grauwe and Yi, 2015).

The next section focuses on the short run in the advanced economies. The next couple of years will be

defined by the fight against inflation and subsequent reduction of the big central bank balance sheets.

While central banks naturally stand at the front, fiscal policies must be adjusted. Governments must

stop feeding price pressure and they need to sustain efforts at stopping the debt build-up in an

unfavourable environment where major new needs have emerged. Looking at the longer run, Section

3 argues that the monetary policy strategy need to be amended. Inflation targeting remains a valid

bedrock, but its implementation has to be corrected. QE has been heralded as a new instrument that

operates as a substitute for interest rates when they reach their lower bounds. It has not worked that

way. QE is an important tool to quell bouts of financial stability, which means that it should not be used

for years on end. Quantitative tightening (QT), the undoing of QE, is necessary, but fraught with risks.

A key risk is its impact on government budgets. Section 4 focuses on challenges specific to the euro

area. The differences in national public debts distort the transmission of monetary policy and, once

again, threaten the financial stability of the monetary union. Large debts are most unlikely to be

significantly reduced in the coming years. This is an issue that is studiously ignored by policymakers.

The paper offers suggestions to tackle that issue.

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MACROECONOMIC POLICIES IN THE SHORTER RUN

2.1. What went wrong at central banks?

In most advanced economies, central banks have good reasons to feel under pressure. They have

become very large but failed to bring inflation up when it was too low. They further failed to detect the

inflation surge when it took off, so they were late to react. Their reaction was standard in the face of

non-standard shocks. Of course, inflation is coming down, but central banks are now different from

what they used to be before the global financial crisis, and they need to adapt or revert.

Up until the global financial crisis, most central banks had adopted the inflation targeting strategy. In

a nutshell, the strategy calls for adjusting the policy interest rate whenever inflation expectations

diverge from the target. For a while, it worked well, but not after 2008 when, as Figure 1 shows, inflation

dipped below target. When interest rates hit the lower bound, QE was invented. A large literature has

tried to explain this ‘inflation puzzle’, producing a long list of potential reasons (e.g. demographic

change, a flat or non-linear Phillips curve, technological change, a very low equilibrium interest rate,

globalisation, and more).

Much the same happened when the pandemic hit and, this time, inflation

surged. This second failure, on top of the first one, represents a serious challenge.

Figure 1: Headline inflation rates (% per year)

Source: OECD.

A natural conclusion would seem to be that we lack a proper understanding of the inflation

phenomenon. A number of commentators have rushed to this conclusion. Adherents of the monetarist

tradition see the inflation surge as a consequence of QE during the pandemic (Issing, 2021). But this

does not explain why QE did not create inflation in 2010s. Others have proclaimed the Phillips curve to

be not just flatter or nonlinear,

or even dead (Cochrane, 2019), but this is not confirmed by a large

amount of empirical work. As recently argued by Bernanke and Blanchard (2023), a textbook summary

of macroeconomic theory provides a convincing explanation of the events of the last quarter century.

Some of the many surveys are Ciccarelli and Osbat (2017), Sánchez and Kim (2018) and Yellen (2019).

If the Phillips curve is flat, economic conditions (the output or the unemployment gaps) do not affect inflation. If it is nonlinear, the effects

of economic conditions become stronger as the gap becomes smaller.

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Central banks have failed for two main technical reasons.

First, their forecasts have not been accurate.

The dynamic stochastic general equilibrium (DSGE) models, which capture the current conventional

wisdom, are unable to account for both the impairment of financial markets that followed the 2008

crisis and for the pattern of household savings triggered by the lockdowns enforced during the

pandemic (Cochrane, 2023). Second, as explained by Gros and Shamsfakhr (2022), these models require

their users to make the crucial assumption of what inflation will be in the medium term? They have

assumed that, by then, inflation would have returned to its target level, which amounted to decide that

the surge would be temporary. They quoted widespread support from private forecasts of

professionals, whose views were shaped by those of the central banks themselves. However, Coibion

et al. (2020) have shown that households and firms, which bargain over wages and set prices

accordingly, hold very different expectations from those of professionals. The inflation targeting is not

to be blamed.

2.2. The fight against inflation

As they realised that their forecasts were seriously misleading because of high uncertainty and

changed circumstances, central banks have suspended forward guidance, the practice of signalling

their intentions over the coming couple of years in order to shape expectations. The shift to rely on

observed/incoming data to make policy decisions undermines inflation targeting, even though

inflation targeting based on misleading forecasts is even worse. Given that monetary policy affects

actual inflation with a long and variable delay, this shift all but guarantees that the anti-inflation stance

will last for too long.

The immediate costs will include a period of below-target inflation and of longer than needed slow

growth, possibly negative growth, along with rising unemployment. Central banks are fully conscious

of this consequence and rightfully argue that it is better to err in this direction than to allow inflation

to remain too high. About a year and a half after policy started to tighten, headline inflation is

unsurprisingly declining and the tightening cycle is visibly coming to its end.

That does not mean that central banks should declare victory. They still face the challenge of coming

to terms with the reasons why they failed to achieve their targets since 2008. In the near term, they

stand to face three main issues:

• They will eventually have to cut their interest rates. Until recently, the conventional wisdom

was that the neutral interest rate – the rate at which monetary policy is neither expansionary

not contractionary – is about 2 to 3% when inflation is at its 2% target. Like much of the pre-

existing conventional wisdom, there is surprisingly little support for this assertion.

• In addition, if inflation undershoots its target, central banks may have to go below the neutral

rate. That means that there is considerable uncertainty on how far down, and how fast, central

banks will have to bring their interest rates. A debate will soon emerge, fed by this uncertainty

and by the fiscal considerations presented in Section 2.3.

Most central banks have started to reduce the size of their balance sheets (quantitative tightening,

QT). As Figure 2 shows, QT is proceeding relatively slowly. If, as they argued during the QE period,

varying the size of balance sheets has a significant effect on inflation, we could have expected them

to combine interest rate increases and QT, perhaps raising the interest rates more slowly and

proceeding faster with QT, as explained in Wyplosz (2023a). The doctrine on QE and QT needs to be

clarified.

President Lagarde has recognised these shortcoming in her speech at the Jackson Hole Symposium on 25 August 2023.

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Figure 2: Central bank balance sheets (% of GDP)

Source: Schnabel (2023).

One possibility is that central banks are concerned with financial (in)stability at a time when rising

interest rates risks stressing banks and financial institutions. Some relevant events have occurred in the

UK, the US and Switzerland but they could be dealt with modest and temporary reversals of QT.

Another concern is that QT involves selling public debt instruments, which makes it more difficult for

government to finance budget deficits and to serve debt. The delicate relationship between monetary

and fiscal policies is examined in Section 2.4 below.

2.3. Fiscal policies

Fiscal policy expansions have been historically strong throughout most of the advanced economies

since 2019, and they are slowly being reversed. This is clearly visible in Figure 3, which displays the

cyclically-adjusted primary budget balances of large OECD countries and the euro area.

The figure

compares the average balance over the pre-Covid period with what happened in the following years.

Although the retrenchment in 2022 and 2023 is large, all the balances are expected by the OECD to

remain in deficit in 2023. There were good reasons for all countries to adopt emergency measures,

although the deficits would have been contained had the measures been carefully targeted toward

the intended beneficiaries. Moreover, when growth strongly resumed after the lockdowns, the

deficits remained large as governments were anxious not to undercut the budding recovery. Yet, the

recovery was brisk, largely because non-targeted subsidies led households to accumulate large

savings that started to be spent once lockdowns ended and the pandemic became less severe.

The purpose of the cyclical adjustment is to measure the discretionary actions of governments since it nets out the automatic effects of

cyclical fluctuations and pre-committed interest payments on the existing debt.

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Figure 3: Cyclically adjusted primary budget balances (% of GDP)

Source: Economic Outlook, OECD.

The role of fiscal policies in contributing to the inflation surge is not always acknowledged, even

though the ECB has repeatedly voiced concern. A good measure of the effect of fiscal policy on the

macroeconomy – aggregate demand and, subsequently, inflation – is the change in the cyclically

adjusted primary deficit. This change represents how much the government voluntarily adds to, or

subtracts from aggregate demand. For each year from 2017 to 2023, Figure 4 plots inflation against the

change in the cyclically adjusted primary deficit, lagged by one year to account for the delayed impact.

Because fiscal policy is but one of the sources of inflation, the link is not tight, yet it is present. More

formal evidence can be found in Bankowski et al. (2023) for the euro area and in Demirel and Wilson

(2023) in the US.

Figure 4: Inflation and the cyclically adjusted primary budget balances (% of GDP)

Source: Economic Outlook, OECD.

Note: The budget measure corresponds to the previous year.

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2.4. Interactions between monetary and fiscal policies

In principle, the separation of tasks between governments and central banks is clear. Central banks are

in charge of inflation. Dealing with the impact of the pandemic and subsequent shocks on households

and firms is the responsibility of governments. Together governments and central banks are

responsible for financial stability. However, these macroeconomic policies are interdependent, a fact

that has long been recognised. It is surprising, therefore, that this interdependence has not been taken

into account to a greater extent by both central banks and governments.

Fiscal expansions were enacted in 2020 during the acute phase of the pandemic. As Figure 3 shows,

the cyclically adjusted primary budgets were pushed into large deficits, with changes ranging from 6%

to 11% of gross domestic product (GDP). The impact on GDP growth was bound to be sizeable, even

though the lockdowns and other health policy measures worked in the opposite direction. With

hindsight, we now know that GDP growth rebounded forcefully in 2020-21, which contributed to the

inflation surge. At the time, there were debates about the impact of the Covid shock, which reduced

both demand and supply, with an uncertain overall effect. Uncertainty also concerned the duration of

the shock and, therefore, the timing and vigour of the eventual recovery. As previously noted, most, if

not all forecasting models were unable to clarify the situation and most central banks did not try to

counteract the impact of the unusually large fiscal expansions.

Clearly, the central banks were facing considerable uncertainty. In such a situation, however, risks must

be balanced. And indeed, there were several risks:

• A clear concern, which central banks shared with governments, was not to undermine the

recovery once the pandemic became less threatening. By early 2021, however, vaccines

became widely available in the advanced countries and the importance of newly-accumulated

household savings suggested the possibility of a strong recovery (Wyplosz, 2021). That, alone,

should have alerted central banks to the need of keeping inflation at the top of their list of

priorities.

• There were widespread fears of lasting “scarring effects” from the pandemic, due to

withdrawals of labour market participations and shifts in consumer behaviours. These effects

could harm the recovery, but since they would mostly contributed to a decline in potential

GDP, they could be inflationary. Dealing with scars and changing behaviour was a responsibility

of governments while central banks had to deal with the inflationary impact.

• Financial stability was another concern. Central banks had learned to quickly inject large

amounts of liquidity. Until the end of 2022, though, there was no sign of instability and they

kept QE going. Then, they gradually stopped QE and started to shrink the amount of liquidity,

which may lead to instability.

• Without a better understanding of why inflation had been too low, central banks in the

developed economies were worried of missing a chance of escaping the liquidity trap.

Indeed, several central bankers suggested that they were willing to overshoot the inflation target as a

way of exiting the too-low inflation period. Thus, it was a calculated risk, but did it consider the

inflationary impact of highly expansionary fiscal policies? No such risk was mentioned as late as

November 2021, when the ECB stated that:

“To support the recovery, ambitious, targeted and coordinated fiscal policy should continue to

complement monetary policy.” (Economic Bulletin 7/2021, ECB, p.3.)

while noting that:

“Inflation is expected to rise further this autumn, but to decline next year. The current increase in

inflation is expected to be largely temporary, mainly reflecting the strong increase in oil prices since

around the middle of last year, the reversal of the temporary VAT reduction in Germany, delayed

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summer sales in 2020 and cost pressures that stem from temporary shortages of materials and

equipment. In the course of 2022 these factors should ease or will fall out of the year-on-year inflation

calculation. Underlying inflation pressures have edged up. As the economy recovers further, and

supported by the Governing Council’s monetary policy measures, underlying inflation is expected to

rise over the medium term.” (Economic Bulletin 7/2021, ECB, p.4.)

Note that the inflationary impact of fiscal expansions is not mentioned. It is only after it started to raise

the policy rates that the ECB stated in August 2022 that:

“Economic activity continues to benefit from the reopening of the economy, a strong labour market

and fiscal policy support. […] Fiscal policy is helping to cushion the impact of the war in Ukraine for

those bearing the brunt of higher energy prices. Temporary and targeted measures should be tailored

so as to limit the risk of fuelling inflationary pressures. Fiscal policies in all countries should aim at

preserving debt sustainability.” (Economic Bulletin 5/2022, ECB, p.3.)

The coordination between monetary and fiscal policies Is traditionally difficult to organise because the

agendas of central banks and governments are rarely aligned. Since 2020, however, the objectives of

both authorities were the same. Both acted forcefully, as if they were alone, and they often failed to

recognise that many of the required actions were of a fiscal policy nature. In the euro area, the existence

of 19 governments

made coordination even more difficult.

Croatia only joined the euro area in 2023.

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NEW MONETARY POLICIES

3.1. Quantitative easing: when it makes sense and when it does not

QE was introduced as a response to having reached the effective lower bound of the key policy interest

rates. Having lost their standard instrument to conduct expansionary policies, central banks hoped that

cash injections would be a substitute instrument. QE worked in two ways. First, on the credit supply

side, it was thought that abundant liquidity would lead to increases in bank lending through a

relaxation of credit conditions at unchanged interest rates. The assumption was that commercial banks

would be eager to find lucrative uses for their abundant deposits at central banks. Second, on the credit

demand side, it was believed that, by absorbing large amounts of public debts at varied maturities, QE

would lower the whole yield curve, thereby encouraging more borrowings by the private sector. Credit

conditions were relaxed and the yield curves became flatter, indeed, but the demand for credit did not

rise enough to generate sufficient growth to raise inflation, the ultimate objective of QE. In the event,

banks found new ways of using their abundant liquidities in other ways than by supplying more credit.

Acharya and Rajan (2022) and Rajan (2023) argue that QE had made some financial institutions

“liquidity dependent”, so that continuing QE during a quiet period may have planted the seeds of

future difficulties:

• Injecting liquidity serves another purpose. It stabilises financial markets during a crisis.

However, if the outcome of QE is to create “liquidity dependence”, the liquidity injections are

not achieving their aim of increasing the resilience of banks.

• Before QE, commercial bank reserves were close to the minimum that they wished – or needed

– to hold. The scarcity of reserves made it possible for central banks to not remunerate bank

deposits. When bank deposits exceed what is desired, central banks must offer remuneration,

close to the policy interest rate in order to pin the interbank interest rate at the policy rate

chosen by the central bank. Section 3.2 examines the quasi-fiscal implication of QE.

• QT is challenging. After successive waves of QE, liquidity is excessive and must be reduced.

However, this process can destabilise banks and other financial institutions. They not only

stand to gradually face tighter availability of liquidity but they may become seriously

constrained inasmuch as they had become “liquidity dependent”. The larger QE has been, the

further QT has to proceed, and the more difficult it becomes.

• Public debts are under pressure. As central banks hold a significant portion of public debts, QT

competes with new debt issuance, be it to finance ongoing budget deficits or to roll over

maturing debt instruments (next section).

The upshot is that the ability of QE to affect aggregate demand is very much in doubt and that liquidity

injections are a powerful tool to deal with financial stability during a crisis. Long lasting QE is largely

useless, and potentially detrimental. “Brief QE” in the form of pre-emptive or emergency liquidity

injections is a key instrument.

3.2. Fiscal implications of quantitative easing

Monetary policy is supposed to be neutral in the sense that it affects only the nominal economy (all

variables expressed in value) not the real economy (all variables expressed in volumes). In practice, this

is not the case, at least in the shorter run when prices and wages are not flexible. For instance, raising

the interest rate does not reduce inflation quickly. It first reduces private spending, it also typically

results in an exchange rate appreciation that reduces exports. The resulting lower aggregate demand

is meant to influence price and wage setters as they contemplate weakening sales and higher

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unemployment. These real effects, however, are expected to gradually disappear as inflation declines

and central banks stop pulling the brakes. Over a business cycle, real interest rates, relative prices and

real wages usually settle back to their long-run trends.

During a liquidity crisis, central banks act as lender of last resort. The well-established practice stands

to encourage financial institutions to take excessive risks if they are certain to receive help in case of a

crisis. This moral hazard is taken seriously by central banks which customarily state that liquidity

injections are a possibility, not a commitment. Financial regulation is also designed to make these

events rare and costly for institutions when they receive support. However, when it is not a particular

institution that becomes illiquid but the whole market, the central bank has no choice but intervene.

These interventions, which can be seen as one-off QEs, distort financial markets but their fiscal

implications are minimal because, by design, they are rare and temporary, and can be reversed once

financial stability is restored. Furthermore, governments can and often do intervene along central

banks with their own subsidies.

Sustained QE, on the other hand, is not neutral. It creates lasting and disturbing links with fiscal policy,

as explained in Hooley et al. (2023).

The most notable effects are:

• By acquiring large amounts of long-term assets, central banks flatten the yield curve, as

previously mentioned. By reducing term premia, this is a distorting subsidy and therefore an

action that belongs to the fiscal authorities. It encourages long-term risk-taking.

• At the same time, the returns from private assets have become significantly higher than the

returns from public debts. This has been explained by investors’ heightened search for safe

assets. By providing investors with large amounts of liquidity through purchases of public

debts, central banks support the safety of the debts and make it possible for

governments to borrow at a discount (Reis, 2021).

• QE typically involves purchases of public debts. In the euro area, the ECB holds some 30% of

outstanding debts (see Figure 6 below). This lightens the borrowing and debt burdens.

Everything else remaining equal, it encourages deficit spending. While help from central banks

to governments may be welcome at times – in 2020-21, the ECB indirectly financed almost all

the member states’ deficits – it should be strictly limited to exceptional situations. QT is a

condition for avoiding fiscal dominance.

• In some countries, as in the euro area, the central bank may also purchase private assets,

typically those that are highly rated. This is another source of distortion. It typically

favours large firms from the industrial sector, with no obvious justification.

• In the euro area, QE benefits more the countries with large public debts. The ECB argues

that it is needed to prevent the kind of segmentation that was observed during the debt crisis

over 2010-2012 and thus to maintain the transmission of monetary policy throughout the

whole area. Special programmes such the Pandemic Emergency Purchase Programme (PEEP)

and Transmission Protection Instrument (TPI) reinforce this aspect. Here again, these

distortions may be highly desirable in specific situations, but QT should undo them when the

need is no longer justified.

• QE reduces the maturity of debts of the overall public sector. Combining balance sheets of

the central bank and the government into an overall public sector balance sheet, QE can be

seen as replacing some long-term debt instruments with very short-term liabilities of the

central bank. Under normal conditions, it is the responsibility of the fiscal authorities to

determine the maturity structure of their debts.

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•

The abundance of liquidity forces central banks to offer interest on bank deposits, as

already noted. Relative to the previous situation, this amounts to transfers to banks.

Whether bank deposits should be remunerated or not is controversial but, in the end, decisions

on transfers should belong to the fiscal authorities, if only because they receive the central bank

profits and therefore end up bearing the costs of interest payments to banks.

• Central banks take on board risky assets, including public debts, all of which are not safe.

While central banks are uniquely apt at absorbing risk (since they can always create money as

needed to guarantee debt service), this is another distortion. Furthermore, if risks materialise

and central banks create money to absorb them, this opens up the risk of inflation, which is

their key responsibility.

3.3. Policy implications

The main message is that the distortionary effects of classic monetary policy wash out over a cycle as

the effects from periods of tightening are compensated by the opposite effects from periods of

loosening. Occasional liquidity injections are not neutral but the effects are limited, while sustained QE

creates a large number of distortions and takes over significant fiscal characteristics. QE of past years

has also left central banks with large balance sheets. Barring any new major shock – a hope more than

a presumption – it is time to envisage the next steps. Two of them, making central banks and public

debts smaller, deserve more attention than they currently attract.

As noted above, prompt QT is the necessary counterpart to emergency QE. According to Figure 2 , QT

is proceeding quite slowly, however.

One reason is the fear that it could usher in financial instability, but QT does not prevent occasional

injections of liquidity when needed.

Another reason is financial dominance. Financial institutions

have adapted to the abundance of liquidity and shares are currently highly valued, although the rapid

rise in interest rates have a depressing effect on share prices. In addition, since banks receive interest

on their central bank deposits, the abundant liquidity can be seen as a subsidy to the whole financial

sector, which naturally wishes that liquidity remains abundant. Governments also benefit from

compressed yield curves, a case of fiscal dominance. All these explicit or implicit subsidies are difficult

to withdraw, especially when they have been in place for a long time.

However, the certainty of QT is crucial to minimise the quasi-fiscal aspects of QE presented in Section

3.2. QT should not be an option to be exercised whenever it seems convenient. This concerns both the

timing and the quantitative objective. Most central banks have now announced a QT schedule in the

form of monthly withdrawals of liquidity over periods of several months. This is an important

commitment, but it leaves out two essential questions: what is the destination, and when can we

expect the destination to be reached? In particular, will the monetary regime remain characterised by

excess liquidity and, therefore, will bank deposits continue to be remunerated at the policy rate? In

order to minimise the risk of instability, financial markets need to know the answers to these questions

ahead of time to make adequate preparations. These are difficult questions, and central banks may not

be able to provide definitive answers. Yet, before the inflation surge, several of them have formulated

monetary policy strategies that now need to be updated. These issues clearly belong to the formulation

of the next monetary policy strategy.

Indeed, occasional and temporary liquidity injections merely slow down the trend of liquidity absorption.

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THE EURO AREA IS SPECIAL

4.1. The public debt issue

As can be seen from Figure 5, the gross public debts of several euro area member governments are

large, exceeding 100% of GDP in six cases, higher than before the sovereign debt crisis. The debt ratio

has declined in only four countries (Ireland, the Netherlands, Germany and Austria), even though

interest rates have been close or below zero during much of the intervening period.

Figure 5: Public debts (% of GDP)

Source: Economic Outlook, OECD.

The debt increases are partly explained by the shocks of the 2020s, when the general escape clause of

the Stability and Growth Pact was activated. However, an effective debt discipline framework would

have led to debt reductions during the good years 2012-19, thus making room for the exceptional

deficits warranted by the recent shocks. This is what happened in the four countries where debts are

lower than in 2009 and in the countries where debts are less than 60% of GDP. These are countries

where debt discipline is practiced, quite independently of the Stability and Growth Pact.

The existence of large differences in public debts directly affects monetary policy. Interest rates on

public debts tend to reflect indebtedness, which affect private borrowing rates. As a result, the single

policy rate set by the ECB does not result in similar borrowing rates across the euro area. Put differently,

the transmission of monetary policy is not uniform across member countries. At worst, as it has been

the case during the debt crisis, suspicions of debt sustainability can lead to very high interest rates for

both the sovereign and the private sector.

This, in turn, translates in divergent national views about the conduct of monetary policy. In the current

tuation of rapid increases of the policy rates, some governments have started to complain, while

others may find that stronger action is needed. Thus, the Italian Prime Minister has warned the ECB

against further interest rate increases (Financial Times, 28 June 2023), as did Ministers from Portugal

and Spain (Le Monde, 4 July 2023). In response, the President of the Bundesbank declared that “the

image of nearing the interest rate peak is actually wrong” (Speech at the Frankfurt Euro Finance

Summit, 3 July 2023).

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4.2. The conventional strategy

Can something be done to directly deal with the public debt situation? The conventional answer is that

sustained primary budget surpluses is the way to bring public debts down and this is the raison d’être

of the Stability and Growth Pact. Unfortunately, this logic is most unlikely to deliver significant debt

reductions. In a recent survey of the historical evidence, Arslanalp and Eichengreen (2023) make two

points:

• Reducing debts through primary surpluses takes considerable times. The evolution of public

debts depends on two factors: 1) the primary budget balance; 2) the difference between the

interest rate and growth, often referred to as r-g. There is considerable uncertainty about the

long-run values of r and g, let alone the sign of r-g. For the sake of illustration, assume that r-

g=0. With primary surpluses continuously at 5% of GDP, bringing the debt from 100% of GDP

to 60% would take 8 years. For surpluses at 3% of GDP it would take 14 years, and it would take

40 years for surpluses of 1%.

• The experience of the last half-century is that sustained, large primary surpluses are very rarely

observed. In modern advanced economies, government budgets are large and include a

welfare state with many entitlements, which create political conditions not conducive to the

conventional strategy.

Table 1 tallies the evolution of primary surpluses over more than eighty years in OECD countries. No

country exhibits an average surplus exceeding 1% of GDP, with two exceptions: Denmark (barely) and

Norway, which is an outlier because of its large income for North Sea gas. Surpluses in excess of 3% or

5% of GDP are very rare. Surpluses in excess of 1% would need to be sustained over decades to seriously

cut debts in highly indebted countries. The last column indicates the largest spans of consecutive

surpluses above 1%. In several cases, they extend over long periods, but never for twenty years or more,

except for Norway and for Belgium.

This evidence confirms the conclusion of Arslanalp and Eichengreen (2023) that large debts are here to

stay. For the euro area, it means a continuing fragility of some public debts, with an underlying risk of

crisis. It also means that the ECB will continue to face contradictory constraints and a challenging policy

transmission process. Slow growth may also characterise countries whose governments are fiscally

constrained. It may also harm progress on climate change, on health policies, on defence and

investment in technological research and development.

The mistaken belief that sustained fiscal retrenchment is the solution means that there is no intention

to directly tackle the debt problem. This is the responsibility of governments, not the ECB. But it directly

affects the ECB in many ways, as previously explained. The following section sketches an explicit

procedure to cut public debts.

Belgium maintained a surplus in excess of 1% for 21 years, from 1987 to 2008. During that time, its debt went from 142% to 103% of GDP.

Today it stands at 105%.

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Table 1: Primary surpluses in the OECD area (1960-2023)

Source: Economic Outlook, OECD.

Note: Sample periods vary across countries. The central and east European countries are excluded.

4.3. How to reduce public debts

4.3.1. The idea

The national central banks of the Eurosystem currently hold a significant share of their respective

central government debts. According to Figure 6, the share is usually ranges between 25% and 30% of

total debt. Debt service on these shares is zero for the consolidated public sector since interest

payments by governments to central banks are returned to governments as profits. In addition, the

debt held by central banks is removed from the financial markets, which reduces their exposure to

market instability and makes the debts safer. “Effective debts”, therefore, are generally 70%-75% of the

corresponding gross debt numbers shown in Figure 5. For example, Italy’s “effective public debt” is

109% of GDP instead of 141%.

The problem is that there is no guarantee that the national central banks will keep forever existing

debts on their books, which implies that the concept of “effective debt” as defined above is misguiding,

This is an updated version of the plan presented in Pâris and Wyplosz (2014).

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but so is the commonly used concept of actual debt, which ignores the economic effect of holdings of

Treasury bonds

by central banks. Behind this confusing situation lies uncertainty about the evolution

of future holdings. QT will certainly reduce debt holdings by central banks, but we do not know how

far it will proceed. Removing this uncertainty may provide a solution of the large debt problem.

Figure 6: Central bank holdings of central government debts – end 2022 (% of total debt)

Source: ECB.

Note: Data for some countries are not available. Not reported countries with very low numbers (Croatia, Cyprus).

If the Eurosystem central banks were to keep the existing amounts of debts on their books forever, this

would be equivalent to a debt restructuring, whereby the correct measure of indebtedness would be

the “efficient debt”. How this can be done requires looking into how central banks routinely manage

the money supply through the interbank market.

For decades, central banks have created money by taking on board (through outright purchases or

repurchase agreements) public debt instruments.

The main reason for using this instrument is that

Treasury bonds are deemed safe. Under this assumption, central banks do not take any risk. In so doing,

the central banks indirectly finance a fraction of the budget but, until QE, in most countries, the

fractions were small. Effective debts were close to actual debts, and the fiscal impact of standard

monetary policymaking was irrelevant.

The link between liquidity provision by central banks and public debt financing can be avoided. As

central banks provide liquidity to commercial banks (by increasing bank deposits), they must be paid

in return. The standard procedure is for the commercial banks to cede Treasury bonds. In other words,

the central banks purchase Treasury bonds. The procedure can be changed, however. Instead of

purchasing Treasury bond, central banks could buy back their previously issued own bonds held by the

commercial banks. Central bank bonds are at least as safe as public debts, both are liabilities of the

overall public sector. Were central banks to adopt this procedure, they could conduct routine monetary

policy operations while keeping the existing public debts on their balance sheets. Promising to keep

existing holdings of Treasury bonds forever would effectively reduce the public debts of governments,

replacing them with central bank debts. It would not change the level of indebtedness of the

This paper does not get into the differences between bonds and bills, using instead the generic term bonds.

The ECB also acquires private assets, which raises another set of questions that go beyond the purpose of this paper.

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consolidated public sector, only its composition, with no impact on the money supply. The interbank

market would use central bank bonds as it presently uses Treasury bonds.

4.3.2. How to replace Treasury bonds with central bank bonds

The problem is that, currently, commercial banks do not hold central bank bonds, which they would

need to hold in sufficient quantity to trade with central banks on the interbank markets. Somehow, the

pump must be primed. Two procedures are possible:

• First, the central bank could buy from commercial banks more Treasury bonds in exchange for

newly issued central bank bonds. This would not affect commercial bank deposits. In order to

separate the procedure from monetary policy through the impact on the yield curve, the

central bank bonds should be of equal maturity as the Treasury bonds that are being swapped.

• Second, the central bank could take advantage of QT, which aims at reducing bank reserves.

This could be achieved by issuing central bank bonds to be paid for by commercial banks with

reserves, without affecting their holdings of treasury bonds.

An objection to the first procedure is that it would increase debt holdings by central banks, which may

be considered as too large. This is a policy choice, which must be agreed upon by the central bank and

its government. An objection to the second procedure is that, for the interest rate on the interbank

market to be equal to the policy rate, central bank bonds will have to serve the same interest as they

offer on bank deposits. Consequently, the banks will consider their deposits and the central bank bonds

as equivalent, just different forms of reserves, and QT will not achieve its aim. A solution is for the newly

issued central bank bonds to have longer maturities than the deposits which are redeemable on

demand. In the end, a combination of both procedures can achieve the desired amount of implicit debt

write-off.

4.3.3. Objections and answers

Neutralising a part of existing public debts by placing them on the books of the central banks is bound

to generate a number of objections. Furthermore, the specifics of the new procedure must be

examined in detail. Some of these questions are dealt with as follows.

a. An inflationary financing of budget deficits?

When a central bank absorbs public debts, it amounts to an ex-post financing of past deficit and the

monetary financing of deficits is normally thought of as a source of inflation. The link is more subtle.

The constant expansion of the money supply to pay for deficits is certainly inflationary because the

reserves of the commercial banks rise, which allows them to keep lending and thus support ever more

demand. In the present case, it is a one-off operation that does not increase bank deposits. If needed,

the existing excessive deposits can be reduced through QT, with central banks issuing their own bonds.

b. Deposits and bonds

Both commercial bank deposits and central bank bonds are liabilities of the central bank and, as already

explained, they must be remunerated at the same rate as the policy interest rate. If they are seen by the

commercial banks as equivalent financial instruments, which constitute their reserves, open market

operations where one instrument is swapped against the other would have no effect at all. As noted

above, the central bank bonds could be of longer maturity than the deposits. Another solution would

be that the required reserve requirements, which cap the lending capacity of banks, exclude central

bank bonds from being counted as reserves.

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Inter-country transfers

Within the monetary union, low-debt countries sternly oppose any procedure that could imply

transfers to high-debt countries. This is not an issue here since monetary policies are carried out by

national central banks, which hold Treasury bonds issued by their own governments. Replacing

national Treasury debt with national central bank debt would occur exclusively at the national level,

thus preventing any transfer between countries.

d. Moral hazard

If it is easy for a central bank to reduce the “effective debt” of the government, it would seem to create

a major source of moral hazard. Since both Treasury and central bank bonds are a liability of the

consolidated government, there is indeed a risk that some governments will keep running budget

deficits and raise their debts, with the procedure being repeated again and again. This calls for solid

safeguards, which already exist. Within the euro area, national central banks operate under the control

of the ECB. For that reason, their interbank interventions are carried out on behalf of the ECB and they

cannot monetise the debt unless they are instructed to. The ECB will have the authority to determine

the size of the initial debt write-downs and any other increase of national Treasury bond holding by

the national central banks. It is worth recalling that the Treaty on the Functioning of the European

Union requires that the ECB and all national central banks be independent, which forbids them from

taking orders from governments.

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CONCLUSIONS

The euro area emerges from a series of historical shocks with 1) much larger public debts, 2) increased

central bank balance sheets of the Eurosystem central banks, and 3) intensified links between fiscal and

monetary policies. While the actions that led to this situation are justified by the urgent needs to deal

with the shocks, their legacy is a source of undesirable economic and political distortions. The

governments and the ECB must now work toward facing these consequences. Public debts must be

reduced where they are dangerously large – as seen in

Figure 5 - and the ECB must promptly reverse

QE. Moving in this direction will go a long way toward minimising the quasi-fiscal implications of

monetary policy. Corrective action must not wait, if only because other shocks may again unexpectedly

occur.

The need to shrink central bank balance sheets is well understood and indeed QT is underway.

However, the strategy has not been spelled out in detail and the speed is not well adapted to a deep

retrenchment. Monetary policy has shifted from bank reserves being intentionally kept scarce to

abundant. Beyond consequences on the functioning of the financial system and, perhaps, the

overvaluation of various assets, abundant bank reserves must now be remunerated, which is a quasi-

fiscal issue. Is this new modus operandi destined to be permanent or does the ECB, and other major

central banks, intend to return to reserves scarcity? The answer to this question should determine the

speed of QT, which currently seems to be calibrated by fears of financial instability.

Much of the QE of the 2010s had not been significantly undone by the time the new shocks of the 2020s

hit. Similarly, the already large levels of indebtedness of some governments have not been reduced

generally by the time they had to be raised again. The idea that fiscal discipline, prompted by the

Stability and Growth Pact, will bring the large debts down to safe level assumes that the process can

be spread out over a very long time, to be measured in decades. Time, however, is a constraint that

need to be recognised. The European authorities, the ECB and national governments, must find a way

of quickly cutting public debts down. This paper suggests changing the time-honoured monetary

policy practice of dealing on the interbank markets with Treasury bonds. Instead, national banks can

issue their own debt instruments and keep the public debt that they currently hold on their balance

sheets for ever. In this way, the amounts of public debts held by the private sector can be reduced

significantly.

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An effective policy mix for

the EU’s post-pandemic

challenges

Paolo CANOFARI

Giovanni Di BARTOLOMEO

Marcello MESSORI

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Abstract

The geopolitical and economic shocks, due to the Covid-19

pandemic and the war in Ukraine, represent a structural shift for

the European Union (EU) economy. The euro area needs to deal

with an ongoing inflation process and the EU needs to radically

transform its production model to avoid a lasting decline. An

expansionary centralised fiscal capacity, grounded on the

production of public goods, and a related common industrial

policy are required to allow for this structural change. In the

meantime, it is necessary to bring the excessive inflation process

under control. These two contrasting problems create a policy

dilemma. A restrictive monetary policy backed by national fiscal

actions and a temporary central fiscal initiative are inadequate to

overcome this dilemma. Hence, we propose an innovative policy

mix to address the problem.

This document was provided by the Economic Governance and

EMU Scrutiny Unit at the request of the Committee on Economic

and Monetary Affairs (ECON) ahead of the Monetary Dialogue

with the ECB President on 25 September 2023.

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CONTENTS

LIST OF ABBREVIATIONS 94

LIST OF FIGURES 95

EXECUTIVE SUMMARY 96

1. INTRODUCTION 97

2. RECENT EVOLUTION OF THE EU POLICY MIX 99

3. ONE DISEASE AND TWO REMEDIES: A SIMPLE GRAPHICAL ILLUSTRATION 103

4. THE FISCAL NEEDS: SHOULD THE EU WAIT FOR ITS TRANSITION? 108

4.1. Towards a new EU production model 108

4.2. The role of European public goods 109

4.3. The policy mix and social cohesion 111

5. CONCLUSION 114

REFERENCES 115

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LIST OF ABBREVIATIONS

APPs

CFC

Asset Purchase Programmes

Central Fiscal Capacity

ECB

EPGs

European Central Bank

European Public Goods

European Union

GDP

NATO

NGEU

NRRPs

RRF

SGP

USSR

Gross domestic product

North Atlantic Treaty Organization

Next Generation EU

National Recovery and Resilience Plans

Recovery and Resilience Facility

Stability and Growth Pact

Union of Soviet Socialist Republics

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LIST OF FIGURES

Figure 1: The standard strategy 104

Figure 2: The innovative strategy 105

Figure 3: Dynamic comparison between the two strategies 106

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EXECUTIVE SUMMARY

• The impact of the recent geopolitical and economic shocks implies a structural shift for the

European Union (EU). The euro area must deal with an ongoing inflation process and the EU

should transform its production process to improve convergence within the area and strengthen

its international role.

• European institutions must therefore solve two problems that, at first sight, have contrasting policy

implications: an expansionary centralised fiscal policy grounded on European public goods

(EPGs), and a common industrial policy to achieve a structural change; and a restrictive monetary

policy backed by appropriate national fiscal actions to bring the excessive inflation process

under control. This leads to a policy dilemma that requires a solution.

• A conventional monetary strategy views excessive inflation rates as the primary short-term

problem. As a result, restrictive monetary and national fiscal policies are currently needed,

whereas an expansionary centralised fiscal capacity would tend to interfere with this restrictive

policy stance. Hence, the centralised fiscal policy should be deferred to a medium to long-term

horizon when inflation rate is stabilised at its 2% target.

• The solution for the policy dilemma cannot be the overcoming of the excessive inflation, first, and

then the implementation of structural changes. Addressing excessive inflation is essential, but the

EU should not delay modernising its production model while waiting for inflation to stabilise.

Prompt modernisation policies are essential due to the changing global landscape and the EU’s

consequent high risk of becoming a follower in the transition.

• To identify a better solution, we suggest an innovative strategy to manage the policy mix that

does not mainly rely on monetary policy. The main features of this innovative strategy emerge

from a comparison with the conventional policy strategy, illustrated above.

• An innovative strategy does not deny that centralised fiscal policies can have an undesired short-

term inflationary impact. However, it stresses the costs of postponing structural changes. Hence, it

suggests a policy mix based on moderately restrictive monetary and national fiscal policies

and an expansionary centralised fiscal capacity focused on the production of EPGs to increase

the supply side more than the demand side.

• This innovative policy mix would decrease the recession risk and would allow the EU to reshape its

production model; moreover, it would overcome the excessive inflation rates even if at the cost of

postponing the inflation adjustment required to hit the European Central Bank’s (ECB) target. This

short-term cost can be more than compensated by the positive ‘real’ outcomes.

• This policy mix can be effectively implemented within a supportive economic governance

framework. Hence, the interplay between this policy mix, the role of the ECB, and fiscal regulatory

reform should not be underestimated.

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INTRODUCTION

The era of great moderation has long ended, ushering in a period of repeated shocks and profound

changes in which economic areas unable to positively react are at risk of losing their positions in the

international markets. This risk specifically applies to the European Union (EU), which suffered a second

long recession (2011-2013) after the international financial crisis (‘double dip’), recorded a moderate

recovery in the period 2014-2018, and was severely hit by the pandemic shock (2020-2021) after having

entered a phase of stagnation (2018-2019). Unlike the pro-cyclical response to the 2007-2009 crisis, the

EU’s economic policy reaction to the pandemic shock was effective and allowed its member states to

overcome the worst depression of the last two centuries in just a few quarters. However, the

bottlenecks on the supply side, due to the persistent post-pandemic breaks in the global value chains,

and the geopolitical and economic shocks triggered by the Russian invasion of Ukraine have

determined structural shifts, bringing the EU to a crossroads. The EU must address the economic and

social consequences of the ongoing excessive inflation and stagnation by implementing a long-term

transformation. The change of its considerable but mature production model is at stake (see Buti and

Messori, 2023). This change is necessary for the EU’s economic and social system to avoid the decline

of its role in the international markets and for the EU member states to avoid increasing divergences

among them.

This structural challenge implies that the EU policymakers are facing a dilemma in the short term. On

the one hand, if the European Central Bank (ECB) takes full responsibility for bringing the excessive

inflation rate under control in the euro area, freezing aggregate demand through restrictive monetary

policies backed by national fiscal restrictions will be unavoidable.

On the other hand, to cope with the

needed structural changes, it is urgent to implement fiscal policies that support innovations and the

restructuring of the EU production model. The apparent conflict between the battle against inflation

and the supply of new monetary resources for an economic transformation cannot be solved by

postponing the modernisation of the EU economic model and waiting for the stabilisation of inflation

rates to the 2% target. In a progressing world, the choice to wait would imply that the EU economy is

transitioning from a leading to a follower position. Hence, designing a policy mix apt to meet the EU

specificities becomes necessary. This policy mix should be able to combine a gradual but effective

reduction of excessive inflation, on the one hand, and an economically innovative and ‘green’ transition

based on an expansionary central fiscal capacity (CFC) and a new European industrial policy, on the

other hand.

Our paper aims to clarify the complexity of this policy mix, showing that it can be effective to combine

fiscal and monetary policies characterised by different stances. Specifically, the reduction of excessive

inflation rates in the euro area can be harmonised with financial support to innovations and

restructuring of production activities, if two conditions are met. First, it is necessary that the CFC has a

more significant expansionary impact on aggregate supply than on aggregate demand. Second,

monetary policy should become moderately restrictive, and the national fiscal policies gradually adjust

their main imbalances. The implementation of this policy mix represents, however, a challenge.

The ECB is concerned that the combined stances of the fiscal policies hinder the effectiveness of

monetary policy in curbing excessive inflation in the euro area because of their possible expansionary

These national fiscal restrictions are not only aimed at supporting the monetary policy stance but, at least in the EU countries with high

public debt, they are also imposed by the phase-out of the previous safety net for the allocation of public bonds in the financial markets. This

safety net was, in fact, based on the ECB’s asset purchase programmes (APPs).

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effects on aggregate demand.

This position is understandable, but it is partial because it neglects the

origins of the current euro area inflation process: a negative supply shock due to bottlenecks in the

availability of raw materials and other crucial inputs of production. A restrictive monetary policy that is

left alone can control this inflation process through its standard action: a reduction in aggregate

demand to match the constrained aggregate supply. This impact has an unpleasant side-effect in the

EU, that is it dramatically increases the probability of a recession. Conversely, as recently stressed by

Draghi (2023) and recognised by ECB President Christine Lagarde herself (2023b), an expansionary CFC

acting on the supply side more than on the demand side should supplement and partly replace the

monetary policy’s restrictive measures, thus mitigating the recession risks. In the meantime, such a

European fiscal policy should support innovative changes in the EU production model.

Lagarde’s original concerns should not be overlooked. However, if it is recognised that policy

coordination does not require uniform policy stances, it will follow that a compelling policy mix can

utilise different tools in different ways to achieve multiple objectives. In the case under examination,

an expansionary CFC and the related new EU industrial policy can promote innovation, green

transition, and labour productivity; moreover, these policies can help restrictive monetary and national

fiscal policies to contrast excessive inflation rates and make national public debts sustainable. Hence,

a heterogeneous policy mix can reduce economic instability and enhance sustainable long-term

development.

The rest of the paper elaborates on the last statements. Section 2 examines the shifts in the EU’s recent

policy mix. Section 3 provides a concise theoretical outline of our approach. Section 4 focuses on the

policy conditions that ensure sustainability within a restricted fiscal scope for implementing the

transformation of the EU production model. Section 5 concludes the paper.

In this respect, the President of the ECB (see for instance: Lagarde, 2022) has reiterated that: “Euro-area member states should back the

ECB’s monetary policy by adjusting their increased public balance disequilibria.”

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RECENT EVOLUTION OF THE EU POLICY MIX

The pandemic shock has caused a break in the EU’s combination of monetary and fiscal policies. In the

previous period (2011-2018), monetary policy in the euro area was the only tool to contrast the

economic recession (2011-2013), overcome the risk of deflation (2013–2014), and support a moderate

expansion (2015-18). Throughout the entire 2011-2018 period national fiscal policies were restrictive

or neutral, mainly due to the severe and pro-cyclical revision of the Stability and Growth Pact (SGP) at

the recession’s peak in the euro area (2011-2013). Moreover, after the Commission’s initiative to

introduce some flexibility in the new SGP (mid-January 2015), the stances of the national fiscal policies

followed divergent paths and became even more distortionary. Euro area countries characterised by a

high public debt to Gross Domestic Product (GDP) ratio, such as Italy and France, implemented

expansionary fiscal policies centred on current spending, whereas countries with a low public debt to

GDP ratio (such as Germany) continued implementing restrictive fiscal policies. The result was an

ineffective policy mix that stimulated the ECB to play a substitute role for fiscal policies. In El Erian’s

brilliant expression, monetary policy became “the only game in town.”

It could be maintained that, in taking such actions, the ECB exceeded the boundaries of monetary

policy and adopted quasi-fiscal measures. This interpretation would be inconsistent with the ex-post

legitimisation of the Outright Monetary Transaction and the Asset Purchase Programmes (APPs) by the

European Court of Justice. Nonetheless, even if the ECB acted within its mandate, it should be

acknowledged that monetary policy became the only anti-cyclical policy tool due to an ineffective

policy mix implemented in the EU, and specifically in the euro area, from 2011 to 2019 (see Bartsch et

al., 2021; and Buti and Messori, 2021a).

The EU’s response to the pandemic shock led to a new policy mix. This shock resulted in a temporary

yet dramatic break of many macroeconomic activities, leading – in the first half of 2020 – to the worst

depression of the past two centuries. Consequently, the search for economic stability and recovery

required a mix of expansionary policy tools in the EU and euro area, both at centralised and national

levels. The ECB’s monetary policy became ultra-expansionary by strengthening the APPs through

emergency programmes and increasing the amount of liquidity pumped into the economic system

through the banking channels. These monetary initiatives built a safety net for the allocation of public

bonds in the financial markets, thus allowing for expansionary national fiscal policies even in euro area

countries with high public debt stocks. The result was a massive transfer of public resources to

households and firms to offset the fall in income and widespread bankruptcy in ‘real’ and financial

activities. Moreover, in the summer of 2020, temporary centralised fiscal policies were agreed by EU

leaders, notably Next Generation EU (NGEU) and—mainly—its principal economic programme: the

Recovery and Resilience Facility (RRF).

The implementation of the RRF via the National Recovery and Resilience Plans (NRRPs) began in the

second half of 2021 and will continue until mid-2026. Let us assume that the NRRPs meet their

quantitative and qualitative targets. Thus, centralised fiscal policies will remain expansionary over the

next three years, especially for EU countries with more significant NRRPs in terms of their fund

allocations, such as Italy. Moreover, in February 2022, another dramatic exogenous shock hit the EU:

Russia invaded Ukraine. The unexpected war at the eastern borders of the EU, the consequent energy

crisis, and the dramatic acceleration of the technological and geopolitical conflicts between the United

States and China have required substantial public transfers to households and firms.

In the same period, the euro area recorded an acceleration of the inflationary process that had already

started at the beginning of 2021 and of the excessive inflation rates that became persistent since July

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2021.

The average headline inflation rate soared above 10% in October 2022 and remains significantly

over 2% even in September 2023. Given its primary objective and target, the ECB was constrained to

curb excessive and persistent inflation rates by implementing a restrictive monetary policy. The

monetary tightening in the euro area started in March 2022, intensified from July 2022 to April 2023,

and is still currently being pursued (September 2023). This restrictive monetary stance has also led to a

gradual reduction in the safety net provided by the ECB to national fiscal policies by a reduction of its

balance sheet.

The previous description shows that, from March 2022 to September 2023, the ECB’s monetary policy

tightening and its gradually restrictive impact on national fiscal policies have been – at least – partially

counterbalanced by an expansionary CFC due to the progressive implementation of NRRPs, and by

new national fiscal transfers to households and firms due to the war emergency and its medium-term

impact. The evidence in the euro area shows that core inflation has still not been significantly reduced

in several member states. In contrast, since the last quarter of 2022, Germany and other euro area

countries have been experiencing a recession or stagnation (see Eurostat, 2023). The most credible

forecast is that, despite the short-lived resurgence of traditional services (notably tourism), either

stagnation or recession will affect the remaining part of the euro area in the second half of this year

and the early part of 2024 (see European Commission, 2023). Hence, the economic perspectives in the

euro area are gloomy: a persistent excessive inflation rate and a recession that is a high risk of

stagflation.

At first sight, this situation implies that economic policy faces an unsolvable puzzle. If left alone to bring

the excessive inflation under control, the ECB must continue the implementation of a restrictive

monetary policy. On the contrary, fiscal policies should strengthen their expansionary stance to reduce

the probability of a recession or persistent stagnation in the EU. Hence, taken separately, monetary

policy and fiscal policies interfere with each other. Thus, there is a high probability that both these

policies become ineffective in the achievement of their specific goals, worsening the serious problems

characterising the EU economy.

This dramatic puzzle could have a positive solution if a compelling policy mix were adopted. It appears

as a dead end only because European institutions have failed to learn the lessons from the policy

response to the pandemic shock. However, this methodological lesson should not be oversimplified in

two ways. First, it does not imply that the interplay between monetary and fiscal policies should always

be expansionary regardless of the economic cycle’s phase. Second, as we mentioned above, it does not

mean that a compelling policy mix necessitates a uniform stance across various policy tools. The

methodological break, which allowed an appropriate policy response to the pandemic shock, conveys

a more instructive and complex message: an effective policy mix should integrate various policy tools

targeting different goals and promoting sustainable economic development over the medium to long

term.

To assess the implementation of this methodology, a preliminary analysis of the macroeconomic

situation and its main determinants is required. In the case of the euro area, the excessive inflationary

process was triggered by supply bottlenecks coming from the breaks in the global value chains due to

the pandemic shock (e.g., Canofari et al., 2022). When the peak of the pandemic was overcome, and

aggregate demand recorded a partial rebound thanks to the availability of generous public transfers

at the beginning of 2021, the supply constraints led to increases in EU prices. Then, the Russian invasion

of Ukraine exacerbated supply shortages in several strategic sectors (typically energy, food, and raw

Here, we take for granted that the ECB cannot redefine its quantitative target (an inflation rate equal to 2%) for its primary objective of price

stability. A discussion on the recent redefinition of this target is offered in Benigno et al. (2023a).

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materials for innovative productions). Hence, even if some of the global value chain disruptions were

gradually reabsorbed and inflation spread throughout the euro area economy (recall the current

downward stickiness of the core inflation), it remains true that excessive inflation originates from a

negative gap between aggregate supply and aggregate demand triggered by binding constraints in

the former.

It is well known that the ECB’s mandate is to pursue price stability, and that monetary policy can directly

influence only the demand side. In other words, an anti-inflationary monetary policy must reduce

aggregate demand. However, this strategy is not compliant with the new methodology of the policy

mix defined as a response to the pandemic. In this last perspective, price stability should not be

pursued by worsening production stability and compromising medium-term economic development.

In the case of the current euro area inflation process, a more effective possibility, compliant with the

new methodology of the pandemic policy mix, could be exploited. We are referring to a combination

of policies able to produce a positive supply counter-shock and harmonise aggregate demand with the

consequent less constrained and less stagnating aggregate supply.

In principle, designing such an appropriate combination of policies is easy. A positive supply counter-

shock should be based on a CFC aimed at expanding the EU activities through the production of

European Public Goods (EPGs) without immediately supporting the corresponding aggregate demand.

EPGs must be financed and produced at the EU level (Buti et al., 2023). The recourse to a subset of EPGs,

such as the production and utilisation of centralised energy storages in partial substitution of the

national race to buying up new flows of energy (as happened in the summer of 2022), would weaken

the EU’s supply bottlenecks even in the short run.

From a more general point of view, the same result would apply to the outcomes of a new EU industrial

policy aimed at supporting the green transition and innovative trajectories in digital and artificial

intelligence. In this setting, even national initiatives financed by the RRF could contribute to overcome

supply bottlenecks at least in the medium term. Moreover, national fiscal policies could gradually

adjust the disequilibria in the public balance sheets without increasing the risk of recession. However,

it is worth emphasising that a positive supply shock created by centralised fiscal policies could suffer

from severe lags. A subset of EPGs can support the supply side more than the demand side in the short

term; however, the production of other EPGs can have a short-term inflationary impact because

innovations require restructuring processes that support aggregate demand and decrease “old”

activities in the short term, thus increasing aggregate supply and labour productivity only in the

medium term.

The difficulties in the practical implementation of an effective policy mix could be mitigated if this set

of policies were able to anchor at least short-term inflation expectations to the medium-term target

thanks to its announced and credible medium-term impact on the supply side.

In any case,

appropriate EPGs and a new centralised industrial policy can build a policy mix in the current phase of

the euro area aimed at controlling the excessive inflation rate without putting all the burden on

monetary policy and hindering medium-term sustainable growth. Combining an efficient and

expansionary CFC that supports the net expansion of the supply side, a monetary policy with a

moderately restrictive stance, and national fiscal policies aimed at gradually adjusting the main public

imbalances could decrease inflation rates without causing stagflation or recession in the EU economy.

See Section 4.3.

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The appropriate methodology of this new policy mix could be specified by describing the different

subsets of EPGs and the strong relations between EPGs and the EU’s industrial policy.

Here, we do not

follow these complex paths, which would be only indirectly related to the main topic of this paper. It is

sufficient to stress two further points that strengthen the interaction between EPGs and centralised

industrial policy as crucial components of the new policy mix apt to implement the transformation of

the EU production model.

1. The EU’s main economic disequilibria (including an excessive inflation rate) are structural and

depend on the obsolescence of the EU production model, characterised by an export-oriented

manufacturing sector and widespread low-quality services confined to ancillary duties. The

EU’s medium-to-long term economic growth cannot be based on the current specialisation in

mature technologies and driven by the external demand. The production of appropriate EPGs

and the implementation of an efficient centralised industrial policy are required to change this

old production model through green and technological transitions. These innovative

improvements are necessary for the EU to reduce its gaps with the United States and China in

the digital sector and artificial intelligence, but also to keep the EU’s comparative advantages

in terms of regulation and low environmental impact.

2. The allocation of European industrial policy resources should result from a complex and

dynamic combination of centralised options, market signals, and widespread guidance.

Consequently, the production of EPGs and a centralised industrial policy could also play a role

of guidance for corporate innovations and reorganisations, facilitating the creation of

transnational companies in the EU’s single market. The existence of genuinely European

productions would weaken nationalistic debris and facilitate the balance between such signals

and centralised options.

It is worth underlining that the change in the EU production model cannot be postponed. If the EU

delayed the modernisation of its production model, it would become a follower rather than a leader in

the new economic landscape, in which other economic areas have initiated their radical

transformations.

Let us just mention that the EU might not be able to bridge the technological gaps with the other main international players solely through

public and private investments and R&D incentives, partially financed at a central level. Centralised efforts, based on market signals (see

below), to establish global businesses in high-tech activities are also essential; and this is the duty of an effective European industrial policy.

In this perspective, a centralised industrial policy includes initiatives to improve competition in the EU markets. The lack of robust evidence

weakens the statement that the current excessive inflation rates in the euro area are mainly due to widespread increases in firms’ profit

margins. However, we believe that more competition would contribute to overcoming some of the supply constraints and to limiting price

increases. This topic will be partially addressed in Section 4.3.

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ONE DISEASE AND TWO REMEDIES: A SIMPLE GRAPHICAL

ILLUSTRATION

The considerations developed in the previous section suggest that a compelling EU policy mix, based

on a CFC and—mainly—on the production of EPGs, can support a transition to a new EU production

model through green investments and digital innovations and, at the same time, bring the euro area’s

excessive and persistent inflation rates under control (see Buti and Messori, 2022b and 2023). Various

economists have criticised this statement (e.g., Schnabel 2023). Hence, further specification is needed

to fill the possible gap between our previous theoretical outline and its efficient implementation.

This section illustrates some issues concerning the current phase in the euro area and the EU at large,

as depicted above. Specifically, we analyse the feasible alternative ‘policy mix’ allowing the transition

to innovative production changes in the context of high inflation rates (see also: Buti and Messori,

2022a). To simplify the matter, we consider two contrasting policy strategies:

1. A conventional or standard strategy views excessive inflation rates as the primary short-term

problem. Hence, the current euro-area economic phase requires a strong demand contraction

led by restrictive fiscal and monetary policies. An expansionary CFC to support supply should

be deferred to a medium-to-long term horizon when excessive inflation is expected to be

brought under control.

2. An innovative strategy instead does not defer the expansionary CFC to support supply to a

medium-to-long term horizon and calls for less restrictive fiscal and monetary policies in the

short run. Combining a moderately restrictive monetary policy, consequent national fiscal

policies and an expansionary CFC can smooth the inflationary process and decrease the

recession risk at the cost of suffering a temporary increase in inflation rates.

In the following, we elaborate on the two strategies. It is worth noting that the standard strategy

emphasises that expansionary centralised fiscal policies, aimed at supporting the supply more than the

demand side, achieve the opposite result. In the short term, these policies imply a production

restructuring and a decrease in the economic activity, thus increasing the negative gaps between

aggregate supply and aggregate demand and strengthening inflationary pressure. The innovative

strategy maintains, instead, that expansionary centralised fiscal policies can achieve the desired result

even in the short term. If supply-side fiscal policies were immediately effective, they would lead to a

costless reduction of inflation.

The considerations, developed in Section 2, state that our preferred

strategy is the innovative one. However, the relative effectiveness of these two strategies can be better

appreciated if we exclude the case where the short-term counter-supply effects of the EPGs are

positive. Hence, in what follows, we maintain that the reallocation due to the production of EPGs can

reduce the aggregate supply in the short term, leading to an undesired short-term inflationary increase.

The comparison of the two distinct strategies can be analysed using a simple Aggregate Demand–

Aggregate Supply (AD-AS) representation. Figure 1 shows the impact of the standard disinflationary

approach, while Figure 2 depicts the impact of the innovative strategy. In both figures, we assume a

structural and permanent negative supply shock, which shifts Long-run Aggregate Supply (LAS) and

the short-term Aggregate Supply (AS) leftwards, moving the equilibrium of the economy from point E

to point A. The permanent supply shock combines geopolitical and economic changes. The latter

include the irreversible components of the energy crisis triggered by Russia’s aggression and the

structural impact of the pandemic crisis on global value chains.

This is the benchmark case analysed by Buti and Messori (2022a).

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Let us start by exploring the disinflationary strategy illustrated in Figure 1. In point A, the economy

experiences high inflation. The standard strategy attributes priority importance to price stability.

Hence, in the short term, it implements a stringent monetary policy and constrains domestic fiscal

policies to adjust their main imbalances, keeping any potential CFC unchanged. The consequent severe

restriction in the policy stance leads to a downward shift in the aggregate demand (from AD to AD’).

This policy mix swiftly brings prices back under control but at the cost of exacerbating the recession

(point B).

Figure 1: The standard strategy

Source: Authors’ elaboration.

These textbook effects have been extensively studied and examined in concrete cases. Following a

painful disinflation phase, the economy gradually returns to its long-term equilibrium (point C).

However, in point B, the primary goal (price stability) of the conventional strategy has been met. Hence,

it becomes possible to start the long-term implementation of a supply-side counter-shock via an

expansionary CFC to ease economic recovery. In our previous reading of the EU’s economic problems,

the medium-term delay is enough to make the CFC ineffective in boosting the long-run aggregate

supply determined by the structural shock. The economy is trapped at point C, which remains on the

left of the original long-term equilibrium (point E).

In this perspective, the EU economy risks being

constrained in a follower role compared to areas that have already transitioned to a new production

model.

We now look at the innovative strategy, represented by Figure 2. This strategy responds to the initial

negative supply-side shock by implementing an expansionary CFC based on the production of EPGs as

well as on restrictions of the monetary policy and of the related national fiscal policies that are more

moderate than those associated with the standard strategy. These initiatives have two consequences:

Although delayed, the medium-term beginning of a supply counter-shock could determine a downward shift of AS’ crossing a demand

curve between AD and AD’ at the right of point C. However, this more realistic but complex representation would not substantially change

our interpretation.

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1. The original leftward shift in the aggregate supply (from AS to AS’) is worsened by a further

short-term leftward shift to AS” due to the cost of implementing sectorial reallocations to

produce EPGs;

2. The downward shift in the aggregate demand is such that AD’’ is moderate compared to the

previous case (AD’ in Figure 1

Thus, the innovative policy mix leads to a short-term economic equilibrium represented by point D (in

Figure 2), which remains on the right of point B in Figure 1.

This means that point D attenuates the

recession with respect to the conventional strategy; however, D will be incompatible with price

stability, even if it mitigates the inflation rate relative to point A thanks to the restrictions of monetary

and national fiscal policies.

Figure 2: The innovative strategy

Source: Authors’ elaboration.

As long as the production of EPGs proves effective in enhancing a positive counter-shock in the

aggregate supply, there is a medium-term rightward shift of AS” and the LAS’ shifts to LAS. Moreover,

the aggregate demand gradually returns to its long-term equilibrium. Hence, if the counter-shock were

sufficiently important for absorbing the initial structural shock through the implementation of

restructured productions, the innovative policy mix would move the economic equilibrium to the right

until reaching point E of Figure 2. At this point, the new production model meets its long-term

equilibrium.

To ease the comparison, point B – as determined in Figure 1 – is reported in Figure 2.

It is worth noting that the new long-term equilibrium could be also met at the right or the left of point E. The long-term equilibrium of the

innovative policy strategy would be in a point at the right of E, if the production of EPGs and the related industrial policy led to an innovative

production model characterised by higher labour productivity with positive medium-term impact on the aggregate demand. However, this

same equilibrium could also be in a point at the left of E because the positive supply counter-shock was not able to fully compensate the

initial structural shock despite productivity improvements. In Figure 2, for the sake of simplicity, we assume a perfect compensation

(enhanced productivity included).

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At least two caveats regarding the innovative strategy deserve close attention.

First, the fiscal policies associated with CFC must be thoughtfully designed and efficiently executed,

because they should contend with the concurrent innovations implemented in other international

areas. The challenge lies in ensuring that the related policy mix is effective with respect to the EU’s

internal goals as well as to the evolution of international competitiveness.

Second, national fiscal policymakers should avoid the temptation of utilising an appropriate CFC to

hide the expansion of their domestic fiscal policies. Maintaining an efficient relation between these two

levels of fiscal policies is crucial. The production of EPGs is envisaged as an instrument to drive

innovation and structural changes, while domestic fiscal policies are critical to pursuing fiscal

sustainability. The innovative policy mix will be effective if there is a balance between the stances of

the different policies. As our analysis points out, the current phase of the EU economy requires that the

stance of the national fiscal policies (mainly, in countries with high public debt) is harmonised with that

of the monetary policy, so that the pressure on sovereign debts is not exacerbated and the expected

impact of the ECB policy is not distorted.

The preceding pedagogical illustration of the two policy strategies is static and could be extended by

considering the different dynamics implied. Without going into complex analytical details, we offer a

rough comparison of the dynamic impacts that characterise the conventional and the innovative

strategy, respectively, using Figure 3. Panel (a) of this figure illustrates the evolving trend of the inflation

process that derives from each of the two strategies. Panel (b) compares, instead, the different results

with respect to output. The conventional approach leads to a more rapid decline in the inflation rate,

which reaches its target in the short-to-medium term; however, the cost of this adjustment is a more

severe recession and a recovery that is quite rapid but largely insufficient to reach the original long-

term equilibrium path. The innovative strategy implies that the average inflation rate takes more time

to stabilise, and the economy takes more time to reach its long-term equilibrium; however, the short-

term economic recession is milder, and the long-term equilibrium path matches the original potential

output.

Figure 3: Dynamic comparison between the two strategies

Source: Authors’ elaboration.

Note: The figure is clearly evocative to drive the reader into the adjustment dynamics. The word ‘steady’ stands for the

long-run equilibrium in Figures 1 and 2, i.e., the steady state.

Inflation

standard innovative strategy

100

103

Output

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Figure 3 offers qualitative indications with a more precise quantitative assessment expected from the

models.

Nonetheless, this figure is sufficient to highlight that the two policy strategies have different

trajectories that lead to different results. The comparison of these respective results is not easy to do.

How can we compare the cost of a slower recovery to that of a deeper recession? How can we compare

the cost of a more persistent excessive inflation to that of long-term growth below the potential?

Different EU policymakers do not share a common preference ordering relative to the pros and cons of

economic growth, recession, excess inflation, and so on.

Here, we do not directly address these questions, which need – as a preliminary step – quantifications

based on a common unit of measure. However, two points should be made. The first is that the

quantifications should consider the different horizons (short and long term) of the relative economic

and social variables. The second is that the quantifications should consider the different risks involved

in the two policy strategies. On the one hand, the standard strategy has a more predictable impact,

whereas the innovative one has higher risks; on the other hand, the innovative strategy can allocate a

significant part of these risks to the EU, whereas the standard one is based on more traditional tools.

Our analysis cannot state that one of the two strategies dominates the other in the EU. However, an

uncontroversial hierarchy between the two strategies arises if we adopt a specific perspective. The

deep recession and low potential growth do not ease changes in the EU production model. If the ECB

is left alone in facing an excessive inflation rate in the short term, its increase in policy interest rates and

its reduction of liquidity supply will make the financing of public and private investments as well as the

green and digital transitions more costly and their implementation more difficult (Lane, 2023). These

constraints will become even more binding if two additional aspects relating to expectations are

considered. First, the restructuring of production processes and innovative choices, required by the

transitions, become riskier in a recessionary setting due to worsening expectations. Second, as stressed

above (see Section 2), the policy mix designed by the innovative strategy can strengthen the anchorage

of inflation expectations to the medium-term target thanks to its announced and credible medium-

term impact on the supply side. Hence, in our setting, the innovative policy strategy dominates the

conventional one.

In the next section, we will offer additional qualitative considerations. A quantitative assessment is, however, beyond the scope of the

present paper.

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THE FISCAL NEEDS: SHOULD THE EU WAIT FOR ITS

TRANSITION?

4.1. Towards a new EU production model

The euro area has experienced a significant slowdown in productivity growth since the international

financial and ‘real’ crises (2007-2009).

The underlying causes of this sluggish performance can be

traced back to different factors, some with long-standing structural roots. Here, referring to a few main

determinants linked to the euro area’s policy mix will suffice.

Unlike the expansionary policy reaction in the United States, the European institutions responded to

the 2007-2009 crisis by adopting a swinging monetary policy and strengthening the central fiscal rules.

The aim was to constrain those EU member states with a high public debt-to-GDP ratio and harmful

imbalances in their current accounts to adjust their internal and external disequilibria. To pursue these

goals, the euro area’s weakest member states had to implement restrictive, and hence pro-cyclical,

fiscal policies implying a dramatic compression of wages and internal aggregate demand. On the one

hand, this policy mix led to sovereign debt and banking crises in the euro area, which flowed into a

new economic recession (2011-2013) and a high risk of deflation (2013-2014).

On the other hand, this

policy improved the area’s short-term competitiveness in international markets without increasing

long-term labour productivity.

Then, from mid-2015 to the end of 2018, the euro area recorded a

weak recovery due to an unconventional and expansionary monetary policy and a more flexible

definition of central fiscal rules (see Rostagno et al., 2021). In any case, even in that last period the

monetary policy remained the main responsible for the anti-cyclical initiatives. Hence, differently from

the United States and China, euro area economies were unable to lead critical innovative trajectories,

and their productivity dynamics continued unsurprisingly to be weak.

The new expansionary policies implemented in response to the pandemic crisis in the spring of 2020

resulted in further exceptional monetary and fiscal measures, including a temporary CFC. This new

policy mix was able to confine the worst depression of the last two centuries to the first half of 2020.

However, due to the binding supply bottlenecks and the need to support the income of firms and

households hit by the economic lockdown, it did not aim at relaunching the EU medium to long-term

economic growth. This relaunch became the main objective of the EU policy mix since mid-2021, when

the NGEU started the implementation phase through its main programme (the RRF) and the related

NRRPs.

The three pillars of the RRF (the green and digital transitions and social inclusion) showed that the EU

economy had a relatively strong position in terms of environmental impact and social welfare but was

suffering technological gaps with the United States and China (see Buti and Messori, 2021b, Figures 3

and 4, and Table 1). These gaps were so significant that they hindered the reproduction of the strong

points. Energy-intensive and export-driven productions have characterised the EU economy model

centred on solid but mature technologies in its most competitive sector, i.e., manufacturing. The

services sector has become large but with broad pockets of inefficiency and an ancillary position with

respect to industry. The consequent lack of innovation in the EU economy has increased its risk of

The decline in productivity dynamics is evident across various measurements, including output per work hour (a proxy of Marginal Labour

Productivity) and Total Factor Productivity.

The ‘doom-loop’ between banking and the sovereign debt crisis in the euro area has been analysed by several authors (for instance: De

Grauwe and Ji, 2013; Sapir et al., 2014). An assessment of the risk of deflation is offered by Canofari and Messori (2015).

See Esposito and Messori (2018). It should be recalled that Ireland is an exception. This country utilised the European aid program, required

to handle the impact of the ‘doom-loop’, to implement innovative investments and to structurally increase its labour productivity.

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falling short of the evolving international technological frontiers. The programme proposed by the new

Commission at the end of 2019 that focused on green and digital investments was the first attempt to

upgrade the EU production model.

The implementation of the RRF since 2021 and its three pillars have put in motion a “growing machine”

for the relaunch of the EU economy in the long term (Padoan, 2023). However, only the unexpected

persistence of supply bottlenecks and the Russian invasion of Ukraine with the consequent energy

crisis have made it evident that the EU’s economy was losing its international competitiveness and

needed a new and innovative production model and not just an upgrade (see Buti and Messori, 2023).

This acknowledgment has highlighted that the green and digital transitions and improvement in social

inclusion can be achieved in a time largely beyond the end of the RRF (mid-2026) and that radical

economic changes cannot be supported only by a temporary, even if significant, CFC. The construction

of a new EU production model requires an innovative industrial policy, centralised at the EU level and

aimed at incentivising efficient public and private investments. Here, it would be inappropriate to go

into the details of the possible features of this new European industrial policy. It suffices to emphasise

that public and private investments should be financed by a permanent and significant CFC and by

mobilising vast private financial wealth.

In such a framework, the centralised fiscal policy should be expansionary, and the liquidity in circulation

should be abundant. Implementing these policies would have been highly ambitious at the beginning

of 2021, when the euro area economy was in a low-inflation and starting-recovery phase. It has become

a dramatic challenge today. As showed in Benigno et al. (2023b) and mentioned in the previous

sections, the price index started to pick up in the euro area during the first quarter of 2021 and the

inflation rate has exceeded the 2% target since July 2021. The ECB changed the stance of its monetary

policy in March 2022 and implemented a dramatic sequence of policy interest rate increases from July

2022 to September 2023 accompanied by a more gradual but severe reduction in liquidity supply. At

mid-September 2023, there is a high probability that these monetary policy decisions will lead to an

economic recession in a euro area already in stagnation (see European Commission, 2023).

In the current framework, it is understandable that the ECB is concerned about again being “the only

game in town” able to bring the excessive inflation rate under control. The considerable risk of a

persistent recession in the euro area weakens the willingness of many national policymakers to reverse

the stance of their expansionary fiscal policies implemented in the post-pandemic phase. Specifically,

in countries with high public debt stocks, the attempt is to use the RRF resources to overcome the lack

of space in the national fiscal policies due to the restrictive monetary policy implemented by the ECB.

4.2. The role of European public goods

EPGs are pivotal for implementing the triple transition (green, digital, and social) as the way to change

the EU production model, to increase sustainable growth within the area, and to enhance European

competitiveness in international markets. Being centralised projects with common funding, the EPGs

are a specific component of the CFC; however, they offer a less controversial option due to their

potential to weaken the “net balance” narrative among EU countries and to reduce tensions between

creditors and debtors (Buti et al., 2023.) The vital role played by the EPGs in the EU evolution has

become clear in the economic aftermath of the Russian invasion of Ukraine. However, the importance

of their production was already raised when the RRF’s potentials were hampered by the national

utilisation of the EU funds.

Buti et al. (2023; see also: Fuest and Pisany-Ferry, 2019) identify six priority areas for EPGs: digital

transition, green transition and energy, social transition, raw materials, security and defence, and

health. These areas address crucial EU challenges such as the aims of achieving climate neutrality,

reducing technological gaps, enhancing education and re-skilling, and bolstering open strategic

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autonomy. It follows that a moderate stance is necessary to finance, produce, and deliver adequate

EPGs in a period characterised by a restrictive monetary policy. As already stressed, the implementation

of EPGs also requires a permanent CFC and appropriate European technical vehicles. As Buti et al. (2023)

point out, the intrinsic links between a permanent CFC, effective European vehicles, and the availability

of EPGs raise legal, technical, and institutional problems. It is sufficient to recall that the current

European Treaties do not leave an adequate space for centralised fiscal policies. Consequently,

European institutions face difficulty in planning increases of “own resources” to strengthen the

production of EPGs. Moreover, EU programmes such as the Connecting Europe Facility, InvestEU, and

the Innovation Fund can ease the delivery of EPGs, but they require significant improvement and

redesigning.

Here, we briefly examine three key sectors in which the availability of EPGs is clearly required for

implementing innovations that – in their turn – are essential parts of the new EU production model,

and for strengthening the social cohesion within the area. These sectors are defence (entirely reliant

on public spending), climate transition (where resources come from the public and private sectors at

roughly a one-third/two-thirds ratio), and digital transition (primarily private-driven, yet involving

important public resources).

Let us address at some length the financial aspects of the green transition. The European Commission’s

central scenario suggests that achieving a 55 per cent reduction in greenhouse gas emissions by 2030

would require about €360 billion in total investments (both public and private) for energy and

transportation (European Commission, 2020a). These financial resources are equivalent to around 2 per

cent of the EU’s GDP per annum. Moreover, additional and significant investments and related financial

resources will be required beyond 2030 to achieve net-zero emissions by 2050. Finally, additional

expenses derive from eliminating any dependence on Russian fossil fuels by 2027. According to the

REPowerEU Communication (see European Commission, 2022), the EU’s geographical reallocation of

its demand for fossil fuel will require substantial investments.

European and national regulations, centralised and decentralised taxation policies, carbon pricing,

subsidies and non-pecuniary incentives for private investments can help reduce the burden for the

public sector. However, in various cases (for instance, energy-network externalities and informational

inefficiencies), private investment cannot integrate the public one. Current projections suggest that

the contribution of the public sector to the EU’s overall climate investments should amount to about

one-third, with additional investments of around 0.6 to 1.8 per cent of EU’s GDP needed and still not

covered.

The EU’s multiannual financial framework and NGEU fail to address this funding gap; and

the declining private investments are largely insufficient to solve or even to mitigate the problem.

The implication is that addressing the impact of climate change in the EU will lead to heavy

consequences in terms of CFC and national debt sustainability. As Zenios (2021) outlines, there will be

a need for dramatic improvements in public investments. To avoid unsustainable increases of public

expenditures and borrowing costs in the most fragile EU member states with negative consequences

in terms of economic stability and growth, the production of appropriate EPGs will become crucial. The

latter could fill a large part of the gap. Leaving aside the other difficulties that hinder this production

and delivery, two necessary conditions directly relate to our topic: an effective policy mix and an

accommodating monetary policy. In this respect, the innovative policy strategy discussed in Section 3

becomes fundamental.

Let us now outline some problems relating to digital transition by focusing again on the funding gap.

The European Commission has calculated an investment gap for digital transformation of €125 billion,

The reference is to Eurostat (2021)

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equivalent to 0.9 per cent of GDP per annum (European Commission, 2020a). A large portion of this

funding requirement should be met by the public sector. In this respect, it must be recalled that,

according to the EU Digital Compass 4 strategy, the EU’s goal is to achieve the 100 per cent online

provision of essential public services by 2030 (European Commission, 2023a). Moreover, the

involvement of the public sector is crucial in enhancing digital skills, promoting digital inclusion, and

facilitating the digitalisation of small- and medium-sized firms. Finally, several EU countries with

substantial public debt exhibit subpar performance in digital public services and digital skills. This

picture is worsened by the fact that the NGEU programmes are planning to cover a small fraction of

these investment and financial gaps (Darvas and Wolff, 2021.) Hence, even in this case, the EPGs and –

consequently – an effective policy mix and an accommodating monetary policy should play a

substantial role. In this respect, the innovative policy strategy is again crucial.

As far as defence is concerned, it is necessary to recall that in 2006 the defence ministers of the North

Atlantic Treaty Organization (NATO) committed to allocating a minimum of 2% of their respective

countries’ GDP to defence spending. In 2014, Russia’s annexation of Crimea and the Middle East turmoil

prompted a new engagement: countries falling below the 2 per cent threshold pledged to reach this

target within a decade. As of 2021, Eurostat data reveals that the average defence spending in the EU

stood at 1.3 per cent of GDP, with only Greece, Latvia, and Estonia meeting the 2 per cent

requirement.

NATO’s data (NATO, 2023) slightly varies from Eurostat’s, indicating that even Poland

surpassed the 2 per cent mark in 2021. However, the crucial factor is that the more recent and partial

data (2022), as well as the announced ambitious national plans, indicate that defence spending in the

EU continues to grow. The persistent war at the eastern borders of the EU implies that this growing

trend will further strengthen in the near future. Hence, it is urgent to start the centralisation of

European defence to effectively allocate the growing public spending. In this respect, EPGs should play

a fundamental role.

Despite the ongoing challenges and difficulties, the transformative potential of EPGs to shape EU

economic dynamics underscores their importance for EU institutional evolution. As shown in the

previous Sections, the policy mix and monetary policy have the decisive duty to support the production

of EPGs, and, in this respect, the innovative policy strategy appears to be the dominant strategy.

4.3. The policy mix and social cohesion

The rise in energy and import goods prices has adversely impacted real incomes, leading to recent

bargaining between firms and employees about a fair distribution of the losses. Firms are inclined to

raise their prices to safeguard their profit margins, while workers consider higher wage claims to offset

the erosion of their purchasing power. These dynamics can play a role in driving inflation. If each party

unilaterally tried to compensate for their specific income losses, the interconnectedness of expanding

profit margins, increasing nominal wages, and surging prices could fuel a continuous price hike. The

ECB President has warned against the potential risk of the above-described “tit-for-tat” game between

firms and workers, as this interaction would interfere with the ECB’s 2% inflation target.

Lagarde

emphasised that this risk justifies a long-term monetary tightening strategy to maintain economic

equilibrium during downturns and anchor expectations.

See Darvas and Wolff (2022); and Baccianti (2022).

This section is largely based on Ciccarone and Di Bartolomeo (2023).

Lagarde (2023b).

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The risk of escalating social disputes, particularly against the backdrop of increasing income inequality,

is substantial.

Due to differences in production methods, labour market setups, and industry

strategies among EU countries, these disputes could have varying national impacts and cause further

strain on EU integration. The potential monetary tightening threatened by Lagarde could be less

effective or even distortionary in this setting. Anchoring expectations is a necessary but insufficient

condition to ensure monetary stability. Social agreement on income distribution grounded on income

policies is also required. Hence, it is crucial to understand that the ECB’s stabilisation strategy

fundamentally depends on a consensus about income distribution. In the presence of inflation, income

distribution is altered between those who can and those who cannot adjust the price of their goods or

services upward. The assignment of the concept of ensuring monetary stability to central banks arises

precisely from the desire to prevent income redistribution ‘through inflation’, not determined by

elected public authorities. With zero inflation, in the absence of such government measures, the

distribution is maintained only if there is consensus on it; otherwise, price-wage spirals are triggered.

In this context, Ciccarone and Di Bartolomeo (2023) recently revisited Tarantelli and Modigliani’s

proposal for managing inflation during the 1980s. Tarantelli and Modigliani were aware of the link

between ‘programmed inflation’ as an anchor of expectation and the social conflict related to income

distribution. In fact, according to Ciccarone and Di Bartolomeo (2023), the most ground-breaking facet

of their proposal was not merely the predetermination of inflation or the portrayal of unions as

proactive economic agents. Instead, it was the visionary realisation that steering inflation toward a

predetermined target requires a coordination mechanism fundamentally distinct from those

subsequently identified by theoretical frameworks incorporating rational expectations.

Tarantelli and

Modigliani’s proposal suggests that coordination elements

can skilfully guide expectations in systems

where the assumption of rational expectations cannot be invoked.

100

This idea aligns with the

Keynesian perspective that institutions, conventions, and social agreements can act as tools to

orchestrate the choices of economic actors, even when they might be unstable. When paired with

businesses setting prices based on forecasted inflation, this coordination ensures that actual inflation

matches the target.

In contemporary economies, the central bank’s inflation target has taken on a role akin to the one

Tarantelli and Modigliani assigned to the predetermined inflation rate agreed upon by social partners

and the government. However, this substitution will be robust only if it is supplemented by an income

distribution agreement. For an extended period, the concept of inflation targeting excluded the

possibility of incorporating social agreements to manage inflation. We posit that the significant

fluctuations in current inflation rates (unprecedented in the euro area) and disparities in income

distribution could trigger dynamics that monetary policy alone cannot handle. In the euro area, the

unique monetary policy has asymmetric impacts because countries vary in production structure and

labour relation types.

Some firms attempted to push profit margins beyond what increased costs should justify, aiming to offset past losses (from events such as

the pandemic). However, while firms can adjust prices quickly, in euro area countries wage changes often require lengthy negotiations. During

inflationary periods, this mismatch can initially cause a steep drop in real wages, potentially prompting workers to seek hefty wage raises

later.

These frameworks underpin the anti-inflationary monetary policies anchored to rigid rules, central bank transparency, reputation, and

similar tenets, progressively applied globally since the 1980s. Especially within inflation targeting regimes, an optimally devised monetary

policy poses a credible threat to the private sector, compelling it to endure high interest rates, engendering unemployment and adverse

production gaps until the expectations of both workers and firms align with the target.

Such as planned (low) inflation and negotiated (low) wages.

100

Either due to the absence of objective probability distributions concerning significant events (Knight, 1921; Keynes, 1921) or owing to their

non-stationarity over time.

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It is paramount to recognise that the current economic landscape significantly diverges from that

observed by Tarantelli and Modigliani.

101

In addressing inflation and income distribution conflicts, a

policy adaptation of Tarantelli and Modigliani’s approach should have supported a social agreement

aligning wage moderation with improved public services and workers’ involvement in policy decisions.

Nonetheless, their proposition could still hold pertinence within the present circumstances. Today, a

policy adaptation of their approach could be based on the production of specific EPGs and appropriate

and centralised social protection during the transition to a new EU production model. Even in this case,

the aim would be to prevent wage-price spirals and favour more stable economic conditions. However,

these new income distribution agreements also have consequences for selecting an effective policy

mix and monetary policy strategy.

It is increasingly acknowledged that the unavoidable one-size-fits-all approach of the ECB’s monetary

policy tends to favour euro area countries with more flexible labour markets. However, a well-

structured social agreement could counteract this conclusion. Let us assume that the main results of

the social agreement are an additional production of EPGs and stronger social inclusion during the

green and technological transitions in exchange for wage moderation. These results would lead to at

least three achievements in terms of an effective policy mix: they can incentivise CFC and protect low

income, thus mitigating the positive supply counter-shock, bringing under control the possible source

of inflationary pressure, and supporting the implementation of the EU production model; they can

reduce national policymakers’ aversion to adjusting the disequilibria in their public balance sheets;

they can avoid excessive monetary policy restrictions because the ECB would not be left alone in

handling an excessive inflationary process.

In short, the previous analysis shows that introducing a social coordination mechanism in the policy

mix strengthens the dominance of the innovative policy strategy over the conventional one.

101

Their socio-economic context was that of the mid-1980s. At that time, the objective to keep inflation low to bolster the competitiveness of

domestic production clashed with two opposite positions: the endeavours of trade unions to uphold workers’ purchasing power by increasing

nominal wages and businesses’ efforts to determine prices ensuring profit margins congruent with those of their international competitors.

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CONCLUSION

The structural shift of the EU economy, driven by the geopolitical and economic shocks triggered by

the war in Ukraine, requires the attention of the EU institutions. A strategic approach is essential as the

EU faces ongoing inflation and the necessity of transforming its production model to prevent a

prolonged decline and avoid social contrasts in the context of increasing inequalities within and

between generations. This task calls for an expansionary centralised fiscal policy coupled with a

common industrial strategy, while addressing inflation concerns through moderate restrictive

monetary measures and fiscal interventions. In the present paper, we have presented an innovative

policy mix to navigate the complex landscape created by this challenge.

Our innovative perspective acknowledges the potential short-term inflationary effects of centralised

fiscal policies but highlights the capacity for producing specific EPGs to affect aggregate supply, even

in the short run. Additionally, in cases where the CFC and production of EPGs drive transformative

restructuring accompanied by temporary reductions in the activity level for green and digital

transitions, the medium-term outcome will still be an expanded aggregate supply. Combining a

moderately restrictive monetary policy, gradual national fiscal adjustments and an expansionary CFC

makes it possible to mitigate inflationary pressures, reduce recession risks, manage the side effects of

a temporary inflation surge, and support long-term sustainable growth.

In conclusion, the imperative to reshape the EU production model underscores the need for a well-

balanced policy mix. It is crucial not to rely solely on monetary policy. This justifies our preference for

the innovative policy strategy outlined above. The resulting policy mix, focusing on EPG production,

moderately restrictive monetary measures, and tailored national fiscal adjustments can be effectively

implemented only within a supportive economic governance framework. The interplay between this

policy mix, the role of the ECB, and the impact of fiscal regulatory reform should not be underestimated,

though specific details are beyond the scope of this paper.

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Fiscal adjustment supports

the fight against sticky

inflation

Daniel GROS

Farzaneh SHAMSFAKHR

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Abstract

Fiscal policy becomes less potent in affecting output in an

inflationary environment. As the economy nears full employment

an increasing part of any fiscal stimulus either crowds out other

expenditure or leads to higher prices. This reinforces the case for

an accelerated reduction in deficits, especially through the

termination of energy subsidies that are no longer appropriate as

energy prices have returned to pre-war levels.

An unintended (but predictable) consequence of the past bond

buying schemes of the ECB (PSPP and PEPP) is that the net

income of the Eurosystem is likely to fall by about

EUR 70–80 billion, or 0.5–0.6 % of GDP, making the fiscal

adjustment harder.

This document was provided by the Economic Governance and

EMU Scrutiny Unit at the request of the Committee on Economic

and Monetary Affairs (ECON) ahead of the Monetary Dialogue

with the ECB President on 25 September 2023.

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CONTENTS

LIST OF ABBREVIATIONS 122

LIST OF FIGURES 123

LIST OF TABLES 123

EXECUTIVE SUMMARY 124

INTRODUCTION 125

FISCAL POLICY AWAY FROM THE LOWER BOUND 127

2.1. A simple framework 127

2.2. Empirical estimates of changing multipliers 128

A STEEPER PHILLIPS CURVE? 129

3.1. The renaissance of the Phillips curve 129

3.2. Can fiscal policy shift the curve? 130

THE FISCAL COST OF CENTRAL BANK BOND BUYING 132

MONETARY POLICY AND THE (NEW?) ECONOMIC GOVERNANCE FRAMEWORK 135

CONCLUSION 137

REFERENCES 138

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LIST OF ABBREVIATIONS

ECB

European Central Bank

EMU

Economic and monetary union

PEPP

Pandemic emergency purchase programme

PSPP

Public sector purchase programme

SGP

Stability and Growth Pact

TLTRO

Targeted longer-term refinancing operations

Quantitative easing

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LIST OF FIGURES

Figure 1. IS LM illustration 127

LIST OF TABLES

Table 1: Income/losses of QE- major central banks (% GDP) 133

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EXECUTIVE SUMMARY

• Fiscal policy in the euro area is still projected to be slightly expansionary, with the

structural primary balance remaining in deficit (1 % of GDP in 2023 and projected to be

1.5 % in 2024). This is about 2 percentage points below the surplus of 1 % of GDP in 2018.

• The pre-pandemic benchmark is approximately equivalent to the requirement to put debt

levels on a sufficiently declining path, as required by the proposed new governance rules.

• Accelerating the move towards this benchmark would make a material contribution to

bringing inflation back under control.

• Fiscal policy adjustment should be less costly in terms of lost output or higher

unemployment than during the period of low inflation, because any increase in demand

will lead to higher interest rates, which will crowd out other expenditure.

• Moreover, a key economic parameter, the Phillips curve, is likely to have become steeper,

implying that any small reduction in output might lead to a large reduction in inflation.

• Lowering inflation is not the primary aim of fiscal policy, but at the present junction fiscal

retrenchment will support monetary policy. An acceleration of the primary balance

reduction planned for 2024 would thus be appropriate.

• The ECB’s quasi-fiscal operations (i.e. the public sector purchase programme and the

pandemic emergency purchase programme) are now having unintended fiscal

consequences, as the Eurosystem is likely to incur considerable losses that will ultimately

have to be borne by national treasuries, creating a substantial fiscal headwind.

• The sharp increase in the volatility of interest rates over the last few years, which is likely

to continue, suggests that it will not be sufficient to set a path for net primary expenditure

to reliably achieve the desired reduction in debt ratios. This uncertainty about the path for

the debt ratio is particularly high for highly indebted countries, i.e. those for which a reduction

in the debt ratio is most important.

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INTRODUCTION

The ongoing discussion about reforms to the economic governance framework coincides with the

emergence from a double crisis and a sea change in the conditions under which fiscal policy impacts

the economy.

Fiscal policy has been in crisis-related challenges since 2020, with the rules of the Stability and Growth

Pact (SGP) suspended first because of the COVID-19 crisis and then because of a sharp peak in the

energy crisis following Russia’s invasion of Ukraine. With energy prices back to pre-war levels and the

economy having recovered from the COVID-19 recession, one can no longer argue that extraordinary

circumstances require large deficits. As Thygesen et al. (2023) argue, ‘it is time to put the fiscal

toothpaste back in the tube’

102

Of course, the average deficit numbers hide large differences across member countries and a return

to the status quo ante is not necessarily the main argument for why the present level of deficits is not

appropriate. Under the existing rules, Member States would have to start reducing debt levels in 2024

by one twentieth of the distance to the 60 % of GDP reference value. Under the proposed new rules,

the required adjustment still be substantial for at least some cases. The Commission has not published

the parameters it would suggest to individual Member States under its own proposal, but existing

simulations (Zettelmayr et al., 2023) indicate that just to stabilise the debt ratio, highly indebted

countries like Italy and Spain would have to improve the primary balance over and above the value

planned for 2024 by over 1 point of GDP. The more relevant comparison for macroeconomic policy is

with the 2023 value. If the aim is to reduce the debt ratio by at least 1 percentage point annually, the

required adjustment relative to 2023 would rise to over 3 percentage points for Italy and Spain. Even

Germany would then have to reduce its primary deficit by about 1% of GDP

103

Debt levels have diverged over the past decade, with approximately half of all euro area countries

keeping their debt-to-GDP ratios below or close to the 60 % reference value. These countries would

not be required to reduce their deficits, but many of them are doing so anyway. The result is that the

average fiscal contraction of the euro area as a whole would still amount to close to 2 % of GDP, close

to what it was in the years immediately before the COVID-19 period.

104

These adjustments will not be required immediately. Under the proposed new fiscal rules, the overall

adjustment is likely to be spread over several years.

But the environment for fiscal policy is now very different from the pre-COVID-19 period. The gradual

adjustment rules of the past (about a 0.5 percentage point annual reduction in the deficit) may thus

no longer be appropriate. There are two related reasons why the trade-offs facing fiscal policy have

changed.

First of all, interest rates are no longer glued to the lower bound. In the standard IS-LM framework

used to analyse the effectiveness of fiscal policy, this implies that the impact of a fiscal adjustment on

output should be smaller because it will be partially offset by the negative impact of higher interest

rates on investment and other interest-sensitive expenditure.

Second, there is evidence that the relationship between unemployment and inflation has changed.

Some researchers find that the slope of the Phillips curve has increased, implying that even a relatively

small impact of a fiscal retrenchment might have a significant impact on inflation.

102

See https://cepr.org/voxeu/columns/putting-fiscal-toothpaste-back-tube-its-time-normalise-euro-area-fiscal-stance-2024

103

See https://www.bruegel.org/policy-brief/longer-term-fiscal-challenges-facing-european-union

104

https://www.consilium.europa.eu/media/65609/2023-06-21-efb-assessment-of-euro-area-fiscal-stance-final_0.pdf

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Taken together, these two effects imply that the output cost of the fiscal adjustment required to return

to the pre-COVID-19 stance, which had put the debt ratio on a slowly declining path, should be

relatively small, but could still have a significant impact on inflation.

It follows that fiscal and monetary policy should now move in the same direction. However, the

required fiscal adjustment may be larger than appears at first sight because of the unintended costs

of the ECB’s past quasi-fiscal operations of the ECB (the public sector purchase programme (PSPP) and

pandemic emergency purchase programme (PEPP)).

The remainder of this contribution is organised as follows: Section 2 shows why the transition away

from a ‘low-for-long’ period should reduce the multipliers, i.e. reduce the potential output cost of a

fiscal adjustment. Section 3 discusses the recent evidence that the Phillips curve has become steeper.

Section 4 provides some illustrative calculations of the fiscal cost of the ECB’s past bond buying in the

new environment of normalised interest rates. Section 5 concludes.

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FISCAL POLICY AWAY FROM THE LOWER BOUND

2.1. A simple framework

During the low-for-long period, when interest rates were stuck at the lower or zero bound, fiscal policy

seemed to have become the main countercyclical instrument. The usual argument that a higher deficit

leads to higher interest rates, which then crowd out other expenditure, no longer seemed to hold. In

the standard, if dated, IS-LM framework that economists often use to describe the impacts of fiscal

and monetary policy, this corresponds to the situation depicted below, a very flat (horizontal) LM

curve. Figure 1 illustrates this using an LM curve that is horizontal for large negative values of the

output gap.

Figure 1. IS LM illustration

Source: Authors’ own elaboration.

Note: Output gap is the difference between actual GDP and potential GDP. The arrows illustrate the change in

the output gap after IS curve shift, from IS ZLB to IS ZLB2, and from IS to IS2.

A fiscal expansion, i.e. a higher deficit, would shift the IS curve to the right. It is apparent that when

the economy is at or close to the zero/lower bound, a fiscal expansion has a greater impact on output

than when the economy is far away from the zero lower bound (ZLB). This is shown in Figure 1, which

depicts a (horizontal) shift in the IS curve of the same amount for these two cases.

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0

4,5

-2,5

-2,3

-2,1

-1,9

-1,7

-1,5

-1,3

-1,1

-0,9

-0,7

-0,5

-0,3

-0,1

0,1

0,3

0,5

0,7

0,9

1,1

1,3

1,5

1,7

1,9

2,1

2,3

2,5

INTEREST RATE %

OUTPUT GAP%

LM IS ZLB IS ZLB2 IS IS2

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2.2. Empirical estimates of changing multipliers

There have been extensive efforts to estimate the size of fiscal multipliers in different circumstances

(see de Rugy and Salmon (2022) for an exhaustive survey of multiplier estimates over the last two

decades). Some contributions distinguish between the multiplier effect of different fiscal instruments

such as government spending, taxes and transfers (Forni et al., 2009; Eggertsson, 2009; Coenen et al.,

2012, Barrell et al., 2012). Several studies have investigated the cyclical variation of fiscal multipliers

(Berge et al., 2021).

Following the prolonged period of low interest rates, a large body of literature has discussed the

impact of fiscal policy during episodes of zero/lower bound nominal interest rates. Consistent with

theories, many find a larger value of the government spending multiplier with interest rates at the

zero/lower bound than in normal times (to name a few, see Christiano et al., 2010; Klein and Roland

Winkler, 2019; Di Serio et al., 2020).

The use of asset purchases and other non-standard policy instruments led to a situation (mostly in

advanced economies, including the euro area) that has been called a persistent ‘liquidity trap’, where

the further monetary expansion no longer stimulated the economy and fiscal policy became the main

countercyclical instrument (Gopinath, 2020).

More recent analyses based on state-of-the-art macroeconomic models confirm the higher

effectiveness of fiscal spending in boosting economic activity in a liquidity trap (Michau, 2019;

Lemoine and Lindé, 2023). During the COVID-19 pandemic, interest rates remained at the lower bound

(and central banks intensified the use of expansionary non-standard policies, but the massive fiscal

stimulus packages deployed by governments did not seem to have a major effect on output. This was

to be expected given the sectoral nature of the COVID-19 recession and recovery (Capolongo and

Gros, 2020)

105

See https://www.europarl.europa.eu/cmsdata/211390/2_CEPS%20final.pdf

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A STEEPER PHILLIPS CURVE?

The Phillips curve theory suggests a trade-off between the rate of change of wages (and prices) and

the employment level. The theory was first introduced by William Phillips in 1958 based on empirical

observations of wages and unemployment in the UK, where he identified an inverse relationship

between the two variables. The underlying intuition is that when the economy is experiencing a

period of strong growth and there is a high demand for labour (unemployment is very low), wages

tend to be bid upward rather rapidly, pushing firms to increase prices, and vice versa (Phillips, 1958).

The occurrence of stagflation in the 1970s, with high levels of both inflation and unemployment,

however challenged the validity of the original Phillips curve concept and motivated the refinement

of the theory over time. Lucas (1972) proposed the new classical version of the Phillips curve

incorporating the role of rational expectations into the analysis. Keynesian economists of the 1960s

exploited the concept of the Phillips curve, reasoning that policymakers could reduce unemployment

by accepting higher inflation or vice versa. Lucas argued that if policymakers attempt to exploit the

Phillips curve trade-off by creating surprise inflation, individuals would adjust their behaviour and

factor in the expected inflation. As a result, any short-term reduction in unemployment achieved

through surprise inflation would be temporary, leading to higher inflation expectations and no long-

term reduction in unemployment, resulting in a breakdown of the Phillips curve relationship.

The relationship between inflation and unemployment has become more complex over time in view

of the strength of the labour market. Historically low unemployment, and core inflation remaining

persistently below the target preceding the COVID-19 crisis led to a discussion about whether the link

between output or unemployment and inflation had disappeared. Mishkin et al. (2019) thus asked

whether the Phillips curve was dead

106

. In the euro area, the ECB examined over 500 specifications of

the Phillips curve in 2019 using different measures of inflation (wages, core, headline, etc.) and

different slack measures (output gap, unemployment, etc.) and arrived at the conclusion that the

Phillips curve was alive

107

Using regional data from the US, Mishkin et al. (2019) reported that in tight labour markets the Phillips

curve may be subject to important nonlinearities. Also, Hooper et al. (2020) suggested an emergence

of nonlinear dynamics in the Phillips curve. This implies that the relationship between inflation and

unemployment may not be a simple linear trade-off, as suggested by the original Phillips curve theory

(Hooper et al., 2020).

3.1. The renaissance of the Phillips curve

The pandemic entailing significant supply and demand shocks with the corresponding

unprecedented monetary and fiscal policy responses – introduced new dynamics and challenges to

the applicability and predictability of the traditional Phillips curve, as a consequence of higher

inflation expectations, supply shocks and structural changes (Ari et al., 2023). So the linear Phillips

curve with anchored expectations failed to predict the surge in inflation following the pandemic

(Gopinath, 2022).

The key issue for the ECB at present is not so much whether a fiscal adjustment would have a large

impact on output, but whether it would have a large impact on inflation. This in turn depends on the

106

See https://cepr.org/voxeu/columns/phillips-curve-dead-or-

alive#:~:text=Figures%201%20and%202%20show,inflation%20to%20tight%20labour%20markets

107

See https://www.ecb.europa.eu/pub/economic-bulletin/articles/2019/html/ecb.ebart201904_02~d438b3e4d4.en.html#toc5

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relationship between output or employment and wages (Schanbel, 2023). A key question is whether

the slope of the Phillips curve has increased (again) over recent years.

The present combination of high inflation and low unemployment suggests that the Phillips curve is

not dead (Baba et al., 2023). Moreover, unemployment has declined only marginally over the last year,

while inflation has shot up and remained high despite now-falling energy prices. This suggests that

the slope of the Phillips curve may have increased, implying that even a relatively small change in

demand could have a significant impact on inflation. Even a small negative impact of fiscal adjustment

on demand could provide considerable support for the ECB’s fight against inflation.

More recently, Chai Dao et al. (2023) present further evidence of nonlinearities in the slope of the

Phillips curve. They measure the Phillips curve as the unemployment-inflation trade-off, which is

slightly different from the growth-inflation relationships used in the ECB’s evaluations. They argue that

the slope of the euro area curve has roughly doubled relative to the pre-pandemic years. The increase

in the slope of the US curve is even greater. An important aspect of their findings is that one should

use the pre-2019 estimates as a benchmark rather than the 2022 estimates.

Chai Dao et al. (2023) report the following results:

“the slope of the US relation is about –0.3 at 8 percent unemployment but steepens

to –2 at 3.5 percent unemployment. … The euro area might have a similarly steep part

of the curve, but this remains uncertain as there has not yet been sufficient overheating

to reveal it. A further implication is that policy tightening that cools demand can

potentially achieve larger inflation reductions in a more overheated economy.“

One important use of the Phillips curve is in forecasting inflation – a key issue for the ECB. Its own

analysis (Bańbura and Bobeica, 2020) concludes that some specifications of the Phillips curve could

help forecast inflation, potentially also including nonlinear aspects

108

Taking into account today’s probably much larger impact of a slowing economy could be important

for the ECB in calibrating its own policy.

3.2. Can fiscal policy shift the curve?

Most modern economic models do not treat the Phillips curve as a simple relationship between some

measure of inflation and some measure of economic slack. A key third ingredient is the expected

inflation rate. Actual inflation is thus understood as the result of two elements, namely expected

inflation and the degree of economic slack (e.g. the unemployment rate). Various models and

approaches differ mainly in terms of what determines expectations of inflation. We do not want to

enter into this debate of rational versus adaptive, versus static expectations

109

The evidence presented in the previous subsection on the slope of the Phillips curve referred to the

magnitude of the impact of a change in unemployment on inflation, given inflation expectations.

There is also some evidence that fiscal policy may influence inflationary expectations and shift the

curve. This could mean that contractionary fiscal measures may reduce the expectations of inflation

by firms and households (at any given level of economic slack) and indirectly curb inflationary

pressures to a significant extent. Łyziak and Mackiewicz-Łyziak (2020) find that economic agents

reduce their inflation expectations in response to a more sustainable fiscal policy. Similarly, Grigoli and

Sandri (2023) find that high public debt has stagflationary effects, with weaker economic activity and

108

See https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2471~fc87caada8.en.pdf; for the US see

https://www.nber.org/system/files/working_papers/w31197/w31197.pdf

109

For a very recent discussion, see a long blog post by J. Cochrane https://johnhcochrane.blogspot.com/ (28 August 2023).

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higher inflation. Increasing government spending and higher interest rates on sovereign debt have a

similar effect according to Coibion and Weber (2021). The inflation expectations channel and the pass-

through from fiscal policy to inflation, have also been documented based on a natural experiment

(D’Acunto et al., 2016).

The evidence that in some circumstances a fiscal policy that becomes more sustainable shifts the

curve is still tentative. If confirmed, it would provide another argument to accelerate the reduction in

deficits.

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THE FISCAL COST OF CENTRAL BANK BOND BUYING

When inflation and interest rates increase, central banks ordinarily profit because they pay no interest

on cash and have investments whose yields rise along with interest rates. This is known as seigniorage

income, which ultimately accrues to national treasuries. In recent decades, the ratio of cash holdings

to GDP has grown in most countries

110

, thereby increasing the base for seigniorage. For example, in

the euro area, the amount of currency in circulation – almost EUR 1 600 billion

111

– is now worth about

12 % of GDP. At the present deposit rate, the ECB (the Eurosystem, to be precise) should be earning at

least 3.75 % on the assets that are the counterpart of this EUR 1 600 billion. Its seigniorage revenue

should therefore be EUR 60 billion, or 0.45 % of GDP. For the US, the theoretical seigniorage revenue

is similar as a proportion of GDP because the policy rate is higher, although the cash-to-GDP ratio is

somewhat lower at 9 %. On the over USD 2 200 billion outstanding, the Fed should now be earning

5.5 %, resulting in seigniorage revenues of USD 120 billion, or about 0.5 % of GDP

112

But this time is different. Central banks are now taking losses from the large amounts of bonds they

have bought over the past nearly 10 years of low inflation. Central banks bought long-term bonds

during their various quantitative easing (QE) operations because they wanted to alleviate private

investors from the interest rate risks inherent in holding long-term bonds. The stock of bonds on the

balance sheets of central banks is generally low yield and long term.

For this part of their balance sheet, the impact of rising rates on central bank accounts is the opposite

of that of seigniorage: as policy rates rise, central banks must pay more on their liabilities to banks

than they earn on the stock of bonds.

113

When the stock of bonds held under QE is larger than the cash in circulation (which is the case for

most large central banks that engaged in QE), these losses are larger than the seigniorage revenues,

leading to unprecedented overall losses for the central banks concerned. If one wants to calculate the

impact of higher interest rates due to past QE, one should look at the change in the net revenues of

central banks.

The deterioration of the profit and loss accounts of the major central banks is impressive.

In the US, the quarterly net income of the Federal Reserve went from a profit of USD 32 billion in Q1

2022 to a loss of USD 28 billion in Q1 2023, a reduction of USD 60 billion per quarter or USD 240 billion

annually, which is equivalent to about 1 % of US GDP.

114

In the UK, the losses for the Bank of England will be particularly severe because the cash-to-GDP ratio

in the UK is only 4 % and the accumulated bond purchases amounted to about 40 % of GDP by the

end of 2023. Accordingly, the Bank of England will need transfers from HM Treasury of about GBP 40

billion, or around 2 % of GDP, as long as interest rates remain at their present levels.

The Bank of England also provides an estimate of the total cumulative fiscal cost of its QE operation,

including past gains, which of course depends on future interest rates

115

. The estimates range from

110

As an aside, one should note that this fact is difficult to reconcile with the widely-held proposition that cash is disappearing, which

constitutes one of the key arguments for the digital euro project of the ECB.

111

https://www.ecb.europa.eu/stats/policy_and_exchange_rates/banknotes+coins/circulation/html/index.en.html

112

Authors own calculations.

113

Gros (2016) shows that one could consider QE operations as the investment arm of central banks, with all the attendant risks involved.

114

Federal Reserve Banks Combined Quarterly Financial Report, https://www.federalreserve.gov/aboutthefed/files/quarterly-report-

20230818.pdf

115

For an in independent source of the cost of QE, see https://www.niesr.ac.uk/news/ongoing-costs-quantitative-easing

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over GBP 100 billion to GBP 200 billion, or between 5 % and 10 % of UK GDP. Over the next 3 years,

the Bank expects transfers from HM Treasury of GBP 40 billion, or close to 2 % of UK GDP.

116

For the euro area, the accounts of the ECB and those of the 20 national central banks that conduct the

euro area’s monetary policy are too opaque to provide a similarly simple indication of the fiscal cost

of (past) bond buying, but the overall numbers lead to a similar result: holding bonds worth close to a

third of GDP that yield nearly nothing will lead to a cost of about 1 % of GDP when the ECB has to pay

banks 3.75 % to hold their excess reserves (Gros and Shamsfakhr, 2022).

The loss to the Eurosystem as a whole will be smaller than this amount, because 40 % of this loss will

be offset by the increased seigniorage revenues mentioned above, but 0.6 % of GDP is still relevant,

corresponding to the annual adjustment effort required under the (old) fiscal rules. Furthermore, the

ECB has recently lowered the interest it pays on required reserves to zero.

117

This will have only a small

impact on the losses of the Eurosystem, but shows what steps the ECB is taking to reduce losses.

What is more, the ECB and many national central banks have large reserves that can now be used to

offset some of these losses and spread them over time. However, these accounting adjustments do

not change the underlying fact that the national central banks in the euro area, which receive the bulk

of the so-called monetary income, will have to reduce or even stop their transfers to national treasuries

for some time.

Table 1 below shows in the first column the net income, or rather the expected loss, of the three major

central banks in 2023. The second column then shows the change in the net income between 2022

and 2023. This difference reveals the loss incurred by the existing stock of low-yielding government

debt on the balance sheets of these central banks. As argued above, an increase in inflation should

normally lead to higher central bank profits. But massive QE has completely reversed this.

Table 1: Income/losses of QE- major central banks (% GDP)

Absolute loss 2023

Change in income from 2022 level (p.p.)

US Federal Reserve

0.5

1.0

Bank of England

1.9

Eurosystem

0.7

0.6

Source: Own calculations based on ECB, BoE and Federal Reserve data.

Note: The forecast for euro area GDP in 2023 is taken from the European Commission.

The losses for the Eurosystem would be even larger had the ECB not made an unprecedented

unilateral change to the terms of its long-term lending in late 2022. Back in 2020, the ECB wanted to

entice banks to take up its ‘targeted long-term operations’ (TLTRO) by promising them a rate of minus

1 % if banks expanded their loan books. This seemed aggressive, but barely justifiable, when inflation

hovered close to zero and no end seemed in sight for the negative interest rate policy. Yet, by late

2022, with inflation out of control and the ECB needing to raise its own rates quickly, the cost of this

promise had become clear. The ECB then simply decided to unilaterally change the terms on the

TLTROs, arguing that this ”drastic change in circumstances could not have been foreseen”.

118

116

Asset Purchase Facility Quarterly Report - 2023 Q2, https://www.bankofengland.co.uk/asset-purchase-facility/2023/2023-q2

117

https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.pr230727~7206e9aa48.en.html

118

https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32022D2128

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The cost estimates presented here can only be approximations of the order of magnitude, as the exact

details of the holdings are not known. The key point is that, as the stock of PSPP and PEPP holdings

will diminish only in homoeopathic doses, these costs are likely to continue for as long as the ECB

keeps interest rates at current levels (Gros and Shamsfakhr, 2023).

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MONETARY POLICY AND THE (NEW?) ECONOMIC GOVERNANCE

FRAMEWORK

Before entering into a discussion of the Commission proposals for a new economic governance

framework, it is useful to consider the history of the euro area’s fiscal rules.

The basis of the Maastricht consensus was that monetary policy would be unified only through EMU

and that the ECB would aim solely at price stability as its overarching mandate. The purpose of the

fiscal rules first enshrined in the Maastricht Treaty was mainly to prevent ”gross errors” and to avoid

pressure on the ECB from highly indebted countries. This was also the main reason why the deficit and

debt ”reference values” were included in the Treaty. These fiscal rules represent the only link between

fiscal and monetary policy. Sound public finances facilitate a monetary policy that can pursue price

stability without having to fear financial instability arising from the debt problems of individual

Member States.

The SGP operationalised the meaning of ”reference values” for fiscal policy oversight after the start of

EMU in 1999. The Pact specified that Member States should aim for a balanced budget on average

over the cycle. The purpose was to allow countercyclical policies in a recession, when the fiscal deficit

could move from balance to a maximum of 3% of GDP. The 3% limit, which was lower than the actual

value at the time of the negotiations in Maastricht, was chosen because it was thought that it would

only be reached in the event of a very deep recession. With an elasticity of the deficit relative to growth

of about 0.5, growth would have to fall by 6 percentage points below trend before countries would

see the deficit increase above 3% of GDP – provided of course that they started from a balanced

budget in cyclically normal times.

In addition, the SGP introduced an escape clause (“exceptional circumstances”) that allowed larger

deficits in the event of a severe downturn. To ensure compliance with these rules, the Pact created an

elaborate ”excessive deficit procedure” with a number of escalation stages, finally including fines for

Member States that persistently run excessive deficits.

As is well known, the SGP did not survive contact with reality. (Most) Member States did not run

balanced budgets in favourable times during the first years of EMU and thus ran into higher deficits

when the first downturn came in 2001-2002. In late 2003, the proposal of the Commission to launch

an excessive deficit procedure against France and Germany was met by opposition of the three largest

EMU Member States. This episode showed the fundamental problem with the enforcement of fiscal

rules in the euro area. Member States are always very reluctant to impose harsh measures on their

peers because they might need their votes for something else in the future.

Subsequent rounds of reforms confirmed this Achilles heel. In 2005, the Pact was made more

”intelligent” by referring more to cyclically adjusted deficits; but it also became more complicated.

This was not the last reform. The 2011 reform even attempted to overcome the enforcement problem

with the reverse majority voting system, under which a Commission proposal within the excessive

deficit procedure could be overruled by Member States only with a two-thirds majority in Council.

However, this only shifted the problem on the Commission, which then became more reluctant to

propose fines.

During calmer times after the financial and public debt crises of 2007-2012, Member States made little

progress in reducing debt levels. Some countries, in the first instance Italy but also Spain (Greece being

a special case because it was under a macroeconomic adjustment programme) caused continual

frictions with requests for more flexibility under the rules formally in force then. The limits on debts

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and deficits were then suspended in 2020, as envisaged by the rules, when COVID-19 led to a severe

downturn.

The Commission has since proposed new rules that concentrate squarely on the sustainability of debt

levels. In principle, this is exactly the problem identified by Maastricht (and which materialised during

the euro debt crisis). At the same time, the new rules would require much less adjustment than the

old ones. Moreover, the basis for the new rules should be tailor-made paths for fiscal policy negotiated

individually by Member States with the Commission. The Commission maintains that this will create

more national ownership, solving the enforcement problem.

The new proposed rules, if adopted, would not require major immediate adjustments in fiscal policy.

They would therefore not influence monetary policy, at least not in the short term. The medium- to

long-term effect of the new rules all depends on their success in ensuring the sustainability of public

finances. Whether this will be the case is impossible to say at present. The main argument put forward

by proponents of the new rules is that Member States will be much more likely to follow less

demanding adjustment plans negotiated with the Commission than to comply with the more

demanding existing rules. There is no objective basis for or against this argument. It remains a hope

and only experience will show.

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CONCLUSION

Fiscal and monetary policy should now work in the same direction.

There is no need for formal coordination. The ECB remains fully responsible for combatting inflation

and the overall stance of fiscal policy should mainly be geared towards maintaining sustainable debt

ratios and be countercyclical. At present, these two requirements coincide.

The 2024 budgets presented by Member States envisage a reduction in deficits of about 0.5 % of GDP.

This gradual path of adjustment should be accelerated, given that at the present juncture a stronger

adjustment will also help to reduce inflation. Achieving this acceleration of adjustment will be made

harder by the unintended fiscal costs of the PSPP and PEPP.

It is a different question whether the still large stock of government debt held in the Eurosystem

influences the level of interest rates and keeps them lower than they otherwise would be.

119

The

argument made is simply that the sharp increase in interest payments on reserves makes the

necessary fiscal adjustment more difficult.

The European Commission has underpinned its reform proposals for economic governance, inter alia,

with the assertion that imposing the existing rules in 2024 would require excessive adjustment.

Irrespective of the validity of this assertion in normal times, the call for softer fiscal rules comes at a

very inopportune time. The present situation of sticky (core) inflation and full employment provides

the ideal backdrop for decisive action to put debt on a plausible and sustainable downwards path.

Moreover, the ongoing discussion on the reform of the SGP has created an incentive for (highly

indebted) Member States to keep their deficits elevated this year, because this provides a higher

watermark from which the adjustment plans that would have to be negotiated/agreed under the

proposed governance framework would depart. The 4-7 year time horizon envisaged for the

adjustment plans would presumably take as their starting point the debt level at the end of 2023, with

little pressure to reduce debt even by 2027 under the 4-year horizon, or by 2030 if the country fulfils

the conditions for this extension. It is thus likely that this optimal moment for fiscal adjustment will be

missed.

119

https://www.niesr.ac.uk/news/ongoing-costs-quantitative-easing

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Alignment of monetary and fiscal policies has proven to be decisive for the euro area's ability to

withstand successive crises over the years. Today, the European Central Bank (ECB) continues its

fight against inflation by implementing a monetary policy tightening unprecedented in pace and

scale. At the same time, after allowing for some deviations from regular budgetary rules with the

activation of the general escape clause in 2020, the EU is set to reapply its fiscal rules fully from 2024.

In addition, co-legislators are currently discussing the proposed legislation by the European

Commission for the reform of the economic governance framework. Five papers were prepared by

the ECON Committee’s Monetary Expert Panel, discussing the interaction between monetary and

fiscal policies in the euro area.

This document was provided by the Economic Governance and EMU Scrutiny Unit at the request of

he Committee on Economic and Monetary Affairs (ECON) ahead of the Monetary Dialogue with the

ECB President on 25 September 2023.