In the face of large shocks, countries need to engage in debt financing in order to implement targeted fiscal policies and support aggregate demand. This requires coordination between fiscal and monetary policy. Unfortunately, in the euro area, fiscal and monetary policy coordination is not working. Everybody wants it – in particular, countries which object to extraordinary action by the ECB – but the reality is that the Economic and Monetary Union (EMU) does not have an instrument to achieve it except for soft coordination at the level of the euro area. Therefore, calling for fiscal policy to do its part today is an almost empty statement. The scope for national fiscal policies is limited by the consequences they have for risk premia, which in turn is linked to pre-existing fragilities in their public finances and their financial sector soundness. Relevant fragilities today are also related to the quality of the national health services. This implies that if the EMU wants to collectively support the aggregate demand of the EU, by targeting a certain level of nominal GDP, the only viable approach is through monetary policy.
ESM as fiscal authority
Unlike ten years ago, we have an institution today which can be adapted to deliver the coordination needed in the present dramatic circumstances. An example on how this can be achieved – within the remit of the European Stability Mechanism (ESM) mandate – is in the proposal by Bénassy et al. (2020). But to be really effective in crisis times, the ESM needs to move from a backstop institution that can provide emergency loans to single countries based on conditionality to a fully-fledged fiscal institution that can provide emergency loans to all countries in response to a common shock.
Moreover, there is a fundamental difference in the capability of the fiscal authority (the ESM) and the monetary authority (the ECB) to act in a timely way. While the ESM operates via an unanimity requirement, the ECB does so with majority voting (see below). In time of emergency, it is inevitably the monetary authority that will act.
Monetary policy can achieve a lot by itself since it can engage in quasi-fiscal measures and mimic what can be achieved by a pure debt-financed fiscal policy or a coordinated fiscal policy.1 From a governance point of view, however, this is not desirable. It poses a problem of legitimacy since the central bank does not directly respond to taxpayers and implies a lack of response by the political authorities. Ultimately, this would harm its effectiveness. Central banks are powerful institutions but their power is linked to their credibility, which in turn is based on their political backing (Goodhart 1998) as past financial crises have demonstrated (Pill and Reichlin 2016, Reichlin 2019).
Decision making is imbalanced
Under the Maastricht Treaty, the ECB Governing Council takes monetary policy decisions by a simple majority of the votes cast by the members. Since the entry of Lithuania as the 19th member of the euro area in 2015, there have been two groups with rotating voting rights. The first group consists of the five governors of the largest member states, who share four voting rights. The second group consists of all other governors, who share 11 voting rights. So the larger countries have slightly more votes, but the basic rule is still majority voting.
Under the ESM Treaty, the Board of Governors takes important decisions by mutual agreement, which means unanimity. There is an emergency voting procedure if the European Commission and the ECB conclude that a failure to urgently adopt a decision would threaten the economic and financial sustainability of the euro area. However, this procedure needs a qualified majority of 85% of the votes cast. This gives Germany (with 27% of votes), France (20%) and Italy (18%) de facto veto power.
The decision-making procedures are imbalanced for two reasons. First, decision making by unanimity (or very high qualified majority voting) for joint assistance to one or more countries is very inefficient. In the case of bank bailouts, Schoenmaker and Siegmann (2014) find that majority and qualified majority voting rules come close to the efficiency of a bailout mechanism with a supranational authority. By contrast, they find that unanimity voting is not efficient, as one country is enough to block a proposal.
Second, the imbalance between the ECB (majority voting) and ESM (unanimity voting) means that the ECB ends up taking the necessary steps each time. That happened during the euro area crisis and now again in the COVID-19 crisis. This leads to an imbalanced fiscal-monetary policy mix, with too much monetary stimulus and too little fiscal stimulus (and legitimisation). This makes the EMU vulnerable and at a disadvantage with respect to countries such as the US and the UK, where the Treasury and central bank can put a timely and comprehensive macro package together. The Global Crisis was the first lesson, the COVID-19 pandemic is the second and it is likely to be a painful one if something is not done.
Appropriate fiscal and monetary policy coordination is needed for effective crisis responses. The way forward for the euro area is to broaden the mandate of the ESM from conditional emergency loans to single countries to emergency funding for all participating countries. Next, decision-making rules should be harmonised. Such rules need to move to majority or light qualified majority voting rules to be effective. We define effectiveness as being able to formulate and execute crisis management responses that are large enough and timely. Unanimity or high qualified majority voting rules create a situation where one member can unduly delay or block crisis responses.
Bénassy-Quéré, A, A Boot, A Fatás, M Fratzscher, C Fuest, F Giavazzi, R Marimon, P Martin, J Pisani-Ferry, L Reichlin, D Schoenmaker, P Teles and B Weder di Mauro (2020), “A proposal for a Covid Credit Line”, VoxEU.org, 21 March.
Goodhart, C (1998), “The Two Concepts of Money: Implications for the Analysis of Optimum Currency Areas”, European Journal of Political Economy 14: 407-432.
Pill, H and L Reichlin (2016), “Exceptional policies for exceptional times: the ECB’s response to the rolling crises of the euro area”, in H Badinger and V Nitsch (eds), Handbook of Economics of European Integration, Routledge.
Reichlin, L, A Turner and M Woodford (2013, reprinted 2019), “Helicopter money as a policy option”, VoxEU.org, 23 September.
Reichlin, L (2019), La Banque centrale européenne et la crise del’euro, Collège de France.
Schoenmaker, D and A Siegmann (2014), “Can European Bank Bailouts Work?”, Journal of Banking & Finance 48: 334-349.
1 For more on this point see the discussion in Reichlin et al. (2013).