ECB meeting: now, fiscal policy has to play its part

Moreover, the ECB announced new liquidity tools and long-term loans, at full allotment and preferential rates to support refinancing for small and medium-sized enterprises (SMEs). In detail:

• the ECB will be temporarily conducting additional longer-term refinancing operations (LTROs) to provide immediate liquidity support to the Eurozone financial system;
• the ECB’s banking supervision will provide temporary capital and operational relief in reaction to the coronavirus outbreak; and
• the ECB is supporting the decision by the European Banking Authority (EBA) to postpone the 2020 stress test so that banks can focus on business.

Importantly, ECB President Christine Lagarde stated that “ambitious and coordinated fiscal policy” is required, as the response to such a crisis should be fiscal first and foremost. 
On the economic outlook, the coronavirus strongly impairs the Eurozone growth outlook, with risks clearly pointing to the downside. The virus spread is a major shock at a time when the economy was already going through a bout of weakness. Easy financial conditions, fiscal stimulus, and containment and recovery from the pandemic should help the economy regain traction. Inflation trends remain a concern, especially in light of the huge oil price drop, as the five-year forward euro inflation swap has dropped below 1%. The ECB believes it is very likely that inflation will be lower than its most updated forecasts.

Monetary and fiscal policy beyond the short term

Do you expect CBs to move even further on the unconventional front?

Not necessarily, as the role and impact of fiscal policy should not be underestimated. The epidemic crisis has gone from being localised and temporary to being global and to lasting for a much longer period than initially expected. The initial supply shock gave rise to a demand shock whose magnitude is increasing on a daily basis, with historic prevention measures put in place. There is now a risk that the global economy could plunge into a recession as severe as that seen in 2008-09. However, the roots of the current crisis are very different from the 2008-09 Great Financial Crisis or the Eurozone sovereign debt crisis of 2011-12: it is a real economy crisis first and foremost and does not originate from the financial sector. Admittedly, the fall in economic activity may temporarily be even more pronounced. However, macroeconomic stabilisation measures are straightforward to design and are not the sole responsibility of monetary policy. Governments have become aware of the seriousness of the situation following the coronavirus spread, as evidenced by the conclusions of the special European Council held on 10 March, with the Heads of State firmly committing to taking the necessary measures to ensure that the short-term economic shock – which is inevitable and could be severe – does not undermine the medium-term growth potential of economies. To do so, they need to free up fiscal resources in order to guarantee access to health care, help companies in difficulty to avoid a cascade of bankruptcies, and compensate employees who will be forced into temporary unemployment. In exceptional circumstances, the Stability and Growth Pact (SGP) provides for a temporary relaxation of the budgetary rules and there is in practice no limit to what governments can do in the short term, at least if the shock is temporary. The statements made by French President Emmanuel Macron on 11 March are clear in this regard (e.g., temporary easing in corporate taxation, compensation for temporary unemployment, and an increase to healthcare spending). However, this does not mean that the ECB has no role to play. For fiscal policy to be truly effective, it has to be accompanied by persistently accommodative monetary policy, which so far has been the case. Since the sovereign debt crisis, the ECB has equipped itself with many unconventional tools. Provided that governments announce substantial and credible plans, Ms Lagarde made it clear that the ECB could do more. The ECB will have to do everything it can to prevent the current crisis from leading to a solvency crisis. The expansion of the ECB balance sheet has no limits when it comes to maintaining financial stability. If governments act in line with their commitments, the ECB will guarantee lower-cost financing, which would ultimately allow economies to weather the storm by limiting losses. The budgetary bill will be high – probably around EUR 200Bn at the EU level, which is the same amount as the stimulation plan proposed in November 2008 by the European Commission. Decisions will be taken at the country level. In the event of an uncontrolled rise in Eurozone interest rates (e.g., if QE is not sufficient), a weakened state may resort to a financial assistance programme via the ESM or activate the ECB's Outright Monetary Transactions programme. The tools are sufficient in the context of a temporary shock, lasting a few months. It is only in the case of a very long-lasting shock that other monetary policy options should be considered (e.g., equity purchases, ‘helicopter money’).

What could be the long-term consequences of these moves?

Ultimately, the countries in crisis will emerge with significantly higher stocks of public debt and the ECB's balance sheet will grow significantly. For countries to remain solvent, interest rates will have to remain low – that is, below nominal GDP growth. Sooner or later the problem of debt sustainability will return to the forefront in countries where potential growth is low. On the other hand, the size of a CB’s balance sheet is not in itself a problem. The ECB has fallen into a ‘QE trap’ from which it will be even more difficult to emerge without threatening the solvency of some states. This could pose a problem in the medium to long term, especially if inflation resurfaces. In the longer term, this crisis should lead governments to rethink Europe's budgetary and fiscal architecture. It is typically while dealing with situations of this magnitude that the EU would need to equip itself with a significant stabilisation budget. The need to create a European financing instrument could also come back on the table.