Heading into another discouraging year of weak growth and inflation and rising populism, the euro area needs a dramatic change of course—not only in its current policies but also in the rules holding it back. The European Central Bank (ECB) sees the recovery as "fragile" and with downside risks, projecting the unemployment rate to remain above 10 percent, and inflation below 2 percent, until at least 2018. Yet another round of monetary easing is coming. It is time to acknowledge that, while monetary policy has been effective, it is not enough.
Europe needs a large fiscal stimulus in the form of a multiyear public investment program, facilitated by revamping the fiscal rules that limit countries from incurring debts to finance public investment. Combined with the issuance of my proposed Stability Bonds to ensure the smooth financing of euro area budgets, this package will catalyze private investment and boost growth, reduce inequality, buy political goodwill for reforms, and create the conditions for fiscal policy to be able to cushion the next recession. The refugee crisis provides the perfect trigger to start this new fiscal policy. Doubtful politicians should consider it an investment to save Schengen that will reap large long-term benefits.
The Stability and Growth Pact (SGP) was created for a world that no longer exists. It was designed for a world of positive interest rates and 2 percent inflation, where monetary policy would be able to cut rates aggressively during recessions while fiscal policy would focus on long-term sustainability. In that world, a smaller fiscal deficit was always preferred, and there was no need for a European fiscal policy. All that was needed was that each country put its fiscal house in order. The fiscal rules were designed in an asymmetric fashion: Member states can be forced to tighten fiscal policy but can't be forced to ease fiscal policy.
That world is ancient history. Interest rates and inflation are zero, and not expected to normalize for many years. When the next recession hits, the ECB won't be able to cut rates to cushion the blow. As a result, the recession will be longer and deeper and will reduce potential growth.
This is not a certainty, but European policymakers must buy insurance against it, acknowledge that fiscal policy has to be the main economic policy instrument, and act now. A more active fiscal policy framework will have three added advantages: create a fiscal stimulus now to boost demand and reduce the damage to potential growth; create a policy mix better able to reduce income inequality; and increase the neutral interest rate, facilitating the action of monetary policy.
The current strategy of using the flexibility allowed by the SGP is inefficient, as it implies a fiscal expansion in countries that are growing at capacity and don't need it, and a fiscal contraction in countries that have a large output gap and need stronger growth. At the same time, the reluctance to abandon the rules is understandable, given the peculiarities of euro area governance.
Two changes can lead to a better fiscal policy. First, exempt public investment from the SGP debt and deficit targets. Public investment must be defined not just as bricks and mortar but as activities that boost potential growth, including those related to the refugee crisis and the improvement of security frameworks. Europe suffers from underinvestment, and needs to boost potential growth to offset the negative impact of population aging. The so-called Juncker plan is a good step but too small to make a difference. A large, multiyear public investment program would boost confidence in the euro area's future, catalyze private investment, and buy goodwill for reforms. To avoid wasting resources into "white elephant" projects, the Eurogroup should approve national annual public investment plans.
Second, the euro area should start creating a European fiscal policy. It's contemplated in the Five Presidents Report as a medium-term action, but it should start now. One option is my Stability Bonds proposal: bonds issued by a European Debt Agency to finance the debt of euro area countries up to 25 percent of GDP, backed by tax revenues. These bonds could finance the public investment plan proposed above and eventually fund the core operations of national governments, thus creating much needed space for fiscal policy. They would create a European safe asset and ensure that fiscal policy doesn't have to be tightened during recessions. The Stability Bonds would be senior to national bonds, constraining moral hazard.
European policymakers are logically wedded to the current fiscal policy structure. They created it, have spent political capital defending it, and modifying it may feel like admitting defeat. But it is time to break away from that groupthink trap, move forward, and adjust to the new economic and political reality. More of the same won't do it.