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Germany Versus the ECB

With the German economy close to recession, European Central Bank President Mario Draghi has rightly urged eurozone governments to provide more fiscal stimulus. And acknowledging the interaction between fiscal and monetary policy would leave critics much less room for ECB-bashing.

CAMBRIDGE – Over the past couple of months, the German debate over fiscal and monetary policy has taken an interesting turn. Old, deeply ingrained economic dogmas, including that the public sector must strive to generate a fiscal surplus regardless of macroeconomic conditions, are being reappraised, at least by some.

The economic situation is changing rapidly for the worse. The German economy – long the engine of eurozone growth – is undeniably sputtering. Powerful underlying currents are contributing to the slowdown. As a result, there is a high probability of a typical German recession (in terms of depth and duration), if not worse.

The main headwind, of course, is the uncertainty emanating from the highly contentious global trade environment. This is particularly threatening for open economies like Germany and its neighbors, which are deeply integrated into its manufacturers’ value chains.

Rising global trade tensions will hit Europe both ways: indirectly – through the China channel – and directly, for example through announced US tariffs, following the recent World Trade Organization ruling regarding state aid to European aerospace group Airbus. Tit-for-tat retaliation by the European Union against US subsidies for Boeing, probably endorsed by the WTO, will be the logical response.

Gone are the good – or, for some, bad – old days of multilateral trade agreements. Today, tariff and non-tariff barriers are in vogue again, partly because large bilateral trade imbalances, beyond a certain level, inevitably seem to trigger a reflex among some policymakers to shield domestic markets for the benefit of home producers and their employees (often regionally concentrated). Trade, not unlike technological disruption, has redistributive consequences which policymakers ignore at their own peril, and therefore implies a need for adjustment and structural change.

Hence, Germany’s persistently large current-account surpluses, long more than 6% of GDP, are causing increasing tensions with other “over-importing” countries, notably the United States, which must run commensurately large, offsetting current-account deficits.

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Given the high risk of recession in Germany, the seemingly obvious response would be to use both fiscal and monetary policy – the two macroeconomic “handmaidens,” as the US economist Arthur Okun described them – and account for the impact of both.

Fiscal and monetary policy inevitably interact to influence economic activity in what the economist James Tobin called the “common funnel.” The economic policy debate in the eurozone often ignores this interaction. Acknowledging it, however, would leave critics much less room for ECB-bashing.

In a federal state, the uppermost level of government, often responsible for the bulk of public expenditures, is typically charged with implementing fiscal policies to counteract a slowdown. These stabilizing measures can be automatic, as budget revenues and expenditures fluctuate with the economic cycle. Or they can be active, intentionally boosting domestic demand with the aim of getting the economy back on track. Meanwhile, the second handmaiden adjusts policy rates and/or access to funds in pursuit of the same stabilization objective.

This is where eurozone-specific factors complicate things. The EU (and, even more so, the eurozone) is more than a confederation, but much less than a federation. Thus, the mechanics of the common funnel are different. In theory, eurozone member states, being monetary sub-sovereigns, should perform the fiscal stabilization function. But in practice, they do not, either because they are restricted by the quasi-constitutional rules of the EU’s “fiscal compact,” or because their vulnerable public-sector finances leave them constrained by debt markets. Other eurozone governments, meanwhile, may see no need for counter-cyclical fiscal measures, even though they have the fiscal space to introduce them.

This puts most of the stabilization burden on the European Central Bank – which does not have a mandate to smooth output. The business cycle influences the central bank’s policy only indirectly, via its effects on consumer prices.

But the ECB has almost exhausted its unconventional monetary policy tools, such as large-scale securities purchases and negative interest rates. While bringing evidence to bear on these tools’ net benefits, the ECB has acknowledged their potential negative side effects, such as their potentially adverse impact on the resilience of the eurozone’s banking and insurance sectors. ECB President Mario Draghi has therefore rightly called on national governments that have room for maneuver to shoulder some of the stabilization burden by providing fiscal stimulus.

Not doing so paints the ECB into a corner and erodes its independence, as does not addressing the overcapacity in Europe’s banking industry. This is the remit of fiscal policy and would come with budgetary consequences. Sadly, essentially forcing the ECB to use its balance sheet (providing liquidity for ever longer periods to deal with solvency issues) is incomparably more attractive for many national politicians. It also makes bashing the central bank much easier.

The good news for the ECB is that policymakers, including in the frugal Netherlands, are at least discussing counter-cyclical fiscal policies again. Obviously, reasonable people can have different views. Indeed, most of the proposals to handle downturns have always been two-handed, and now the balance finally seems to be shifting in the eurozone.

But the policy debate must become less macro and more concrete. Given their respective national versions of welfare capitalism, eurozone member states have relatively strong automatic stabilizers, much more so than in the United States. Moreover, some countries are quite decentralized fiscally. This is particularly true of Germany, where much of the net disinvestment in public infrastructure – which shows up in aggregate public-sector budgets as savings or as a schwarze Null balanced budget – is the result of a fragile and highly unevenly distributed revenue base within the third fiscal tier (municipalities). Although they follow economically sensible “golden rules” by separating current and capital budget accounts, many municipalities are cash-strapped. To address the German “fiscal space” problem, therefore, one must drill much deeper.

Finally, a reasonable (in terms of size) automatic stabilizing capacity is needed at the eurozone level. While the eurozone’s Budgetary Instrument for Convergence and Competitiveness is a start, it is far from sufficient. And, of course, it should not involve a budget line item for “stabilization,” but rather a real, democratically legitimized transfer of public-sector national responsibilities and sovereignty.

Unfortunately, current politics in eurozone member states, including France and Germany, is much more inward-looking. This will leave the eurozone, and particularly its weaker members, continuously vulnerable.

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