Lucrezia Reichlin
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Lucrezia Reichlin: The eurozone is facing a fundamental policy asymmetry: the monetary authority is federal, whereas fiscal policies are national. In crises, the European Central Bank plays a disproportionate role in the adjustment. This is ineffective, especially when interest rates are at their effective lower bound. And it may lead the ECB to do too much, raising questions about its legitimacy, as exemplified by the German Federal Constitutional Court’s recent ruling against the ECB’s pre-pandemic asset-purchase program.

A shared fiscal mechanism would reduce vulnerability to sovereign risk in debt issuance, and help to ease the constraint on using fiscal accommodation to respond to large shocks. In an ideal world, this could be achieved by a stabilization fund issuing non-defaultable debt such as Eurobonds or some hybrid instrument backed by a pool of eurozone sovereign bonds.

There are various ways such a fund could be designed; but, fundamentally, it would require a degree of risk-sharing that national governments are not yet prepared to accept. This is understandable: a higher degree of political union would be essential for such a fiscal mechanism to have the needed legitimacy. So, for now, there is little chance that it will be implemented.

Nonetheless, there is some degree of risk-sharing and flexibility in the pandemic-response mechanisms that have been implemented: the European Stability Mechanism’s special credit line for health-related expenses and the European Commission’s credit line for temporary support to mitigate unemployment risks. Moreover, fiscal rules have been temporarily relaxed, and a recovery fund is under discussion. So, in the end, we will make some progress via existing institutions. It will be insufficient, but it will be progress.

LR: In a monetary union, a mechanism to limit these externalities is needed. But it must work in both directions: deficits and surpluses. Crises demand coordinated counter-cyclical fiscal policy. A common fiscal capacity is essential to enable such a policy, including by ensuring that highly indebted countries are not constrained in their ability to use budgetary measures to support demand. In other words, in such situations, countries must be able to run fiscal deficits without risking a debt crisis.

But this cannot work if countries are allowed to build up huge amounts of debt in normal times. That is why Europe also needs a framework that limits moral hazard in normal times, though I think that the current fiscal rules do not work.

LR: A new governance framework must be based on the recognition that a monetary union requires common fiscal capacity (as mentioned above) and a banking union, with tools for crisis prevention and management. The EU would also need to broaden its currently narrow interpretation of the principle of subsidiarity. Many of the problems the EU faces today – refugees, climate, health, foreign policy, and defense – demand common responses. But implementing such responses will be impossible without new institutions and a higher degree of political integration.

The COVID-19 crisis has been divisive in many ways, but it has also stimulated debate that, among other things, has elevated the role of the European Parliament. This might be the moment to launch the kinds of fundamental discussions that would lead to necessary EU treaty revisions. But real change will be possible only if civil society is on board – an outcome that will depend on whether the EU proves itself during this turbulent time.

LR: The COVID-19 crisis has laid bare our lack of resilience, not only in terms of health, but also with regard to the environment and social protection. Given this, the EU needs to invest not only in supporting economic recovery, but also in building a more resilient society based on our core values.

Despite European countries’ shortcomings, they lead the world in terms of social protection and individual rights. They should build on these strengths, in order to create fairer, smarter, more sustainable societies. Every aspect of the EU’s pandemic-response strategies should be designed with an eye toward those goals.

BY THE WAY. . .

LR: I agree that deflation is a likely scenario. If this prediction comes to pass, Europe will need a very proactive monetary policy, with the ECB possibly expanding its toolkit even further, along with coordinated fiscal policy and a growth agenda. But we must remain vigilant, because the combination of low productivity (a possible consequence of this crisis) and some pent-up demand could trigger inflation at some point. That is not my prediction, per se, but it is a possibility.

LR: The migration challenge is far from over. On the contrary, as the crisis takes its toll on poor countries, I expect more migration in the future. The need for a common European response to this issue will thus only grow. Whether or when we get one will depend on how EU leaders manage the crisis at home. Effective coordination there could translate into more cooperation elsewhere.

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LR: One thing it has not done is enabled us to make accurate forecasts during the COVID-19 crisis. The unique conditions created by lockdowns mean that any forecasting model relying on past correlations is bound to be grossly wrong. This is a situation of so-called Knightian uncertainty, when even well-informed forecasters and policymakers struggle to agree on probabilities for the possible future paths of events.

While new datasets with timely information could help us to assess the likely extent of the crisis or its distributional consequences, it is difficult to translate this into an accurate forecast of GDP growth. What we can do, however, is construct scenarios based on a combination of models and judgment.

There is also a lot of fresh research into potential new models and approaches to analyzing data, say, by looking at network structures in productive activities or studying the interaction between the economic and epidemiological cycles. But it is still too early to say whether they will be good forecasting tools.

LR: Do not be afraid, and think outside the box. In this moment of radical change, new ideas will be rewarded.