The economic policy response to the Covid crisis avoided a euro area financial crisis. Looking ahead, in the short run, the key issue is the pace of withdrawal of fiscal stimulus. The right approach seems to follow a state-contingent strategy, guided by unemployment, inflation and output gap data. Over the medium term, the reforms supported by the NGEU remain critical. To succeed, adequate country ownership, rather than the pure conditionality mechanisms, is necessary. Reducing public debt ratios over the medium term at a sufficient speed will require that the growth of primary spending remain below the (higher) potential growth rate, to be achieved through the reform process. Over the longer term, the priorities are the creation of a central fiscal capacity, the strengthening in the enforcement of fiscal rules in good times and the completion of banking and capital market unions.
This paper was prepared by the Economic Governance Support Unit (EGOV) at the request of the Committee on Economic and Monetary Affairs (ECON).
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Executive Summary
Economic policies in the euro area responded to the economic crisis causes by the Covid medical emergency better than in previous crises. The medical crisis and the inevitable decline in GDP due to the direct and indirect effects of the lock downs were not compounded by a financial crisis that would have been disastrous not only for countries more exposed to adverse market reaction, but also for the whole area. This said, the crisis caused a further sharp increase in public debt ratios and deepened the already large difference between debt ratios in Northern and Southern European countries. Lowering debt ratios and fostering fiscal convergence will be important over the coming years, but monetary and fiscal policies will need to be managed carefully to avoid an unnecessary delay in the economic recovery. Moreover, the crisis has been addressed through ad hoc solutions, albeit innovative ones, such as the Next Generation European Union (NGEU) program. This raises the question of which institutional and governance changes would be appropriate over the medium term to strengthen the ability of the euro area to enhance its resilience and confront new crises more easily on a permanent basis.
Three features have stood out with respect to macroeconomic developments in the euro area after the beginning of the Covid pandemic:
• The decline in GDP was generally stronger in Southern European countries than in Northern European countries, as the former were generally hit harder by the Covid pandemic.
• The deterioration of the fiscal accounts also differed markedly across euro area member countries, with, again, stronger negative consequences for Southern Europe.
• In contrast, differences in accessing financial markets, as measured by the movement in interest rate spreads, declined.
Moving to the medium-term perspective, the analysis furthermore focuses on the key challenges faced by by the Recovery and Resilience Facility (RRF) and by the other tools set up by the European Union to improve the area’s medium-term growth performance. Additionally, it is reported that the evolution of public spending will need to be kept under scrutiny (unless compensating measures are taken on the spending side) as part of a strategy to lower public debt ratios through growth. The post-Covid rebounding of economic activity starting from a situation of depressed economic activity will of course imply a decline in the primary spending-to-GDP ratio, the usual effect of letting the automatic stabilisers operate during a recovery phase.
Lastly, the paper analyzes the priorities for the EMU governance reform, finding that improving economic policy governance in the euro area requires a central fiscal policy, a greater enforcement of fiscal rules and a more pronounced level of integration both in the banking market and the capital market.
