The eurozone needs a common fiscal framework
Given the fragility of the eurozone economy, it is natural to think about the policy response to the next serious economic downturn or recession.
In the wake of the 2008 global financial crisis and the subsequent sovereign debt crisis, the ECB had to do all the heavy lifting, resorting to unconventional measures. It brought the deposit rate into negative territory in mid-2014 and started an asset-purchasing programme at the end of 2014.
Presently, it looks like the ECB has reached its limits, despite reassurances that its toolbox is still plentiful. Both negative rates and quantitative easing (QE) have significant drawbacks. There are limits to how low negative rates can go and they have a negative impact on bank profitability, which could impair the transmission mechanism of monetary policy in a context where credit provisions typically go through banks.
At the same time, it looks like QE is affected by the law of diminishing marginal returns: successive rounds of QE (in the US and elsewhere) had a weaker impact on financial markets and the real economy. And for the ECB, QE has probably hit its political constraints.
In other words, there is only one credible response to the next downturn – and it must come from fiscal policy, especially in a context where shocks are usually asymmetric across countries (another limit of monetary policy is its one-size-fits-all feature). Alas, there is no common fiscal framework in the eurozone to respond to such situations.
A common fiscal framework is necessary to complete and underpin the monetary union, but it will not be easy to achieve as different countries have different fiscal spaces. And the availability of fiscal transfers within the union poses moral-hazard issues.
The debate about the eurozone budget has been ongoing at least since the eurozone debt crisis, and it has gained further traction in recent years. However, recent progress has been limited. After a long and uninspiring tug of war between Germany and France, the two countries agreed to the concept of a small budget in June 2018.
Last December, eurozone leaders agreed to create a eurozone budget as an instrument for convergence and competitiveness of the bloc. However, its size and structure will be determined within the constraints of the wider EU Multiannual Financial Framework (MFF).
While the features of such a budget should be agreed by June, a delay to its implementation looks likely.
Indeed, the debate has quietened recently, at least publicly. Other issues, such as migration, have dominated the agenda and, more importantly, European elections are approaching, which has shifted the focus to campaigning and preparing the ground to decide who will occupy the EU’s top positions.
But there are some known obstacles: the European Council and the current European Parliament are struggling to agree on the MFF. Any delay to the MFF has a knock-on effect on the eurozone budget. For now, it looks unlikely that the net MFF will be approved before summer – and what’s more, the modalities of funding are controversial.
The impact of the European elections
As mentioned, Europe has been no stranger to the trend of rising populism. For example, the anti-establishment Five Star Movement and the right-wing League formed a coalition government in Italy in June 2018, while the far-right Alternative for Germany party made its debut in the German Parliament following the 2017 election.
Indeed, the last two recessions in Europe occurred in quick succession and were followed by slow and uneven recoveries. Undoubtedly, these economic conditions have taken their toll on the reputation of the EU project – in particular concerning its ability to deliver prosperity.
In addition, the fact that national governments have tended to blame European institutions for domestic issues has not helped.
These factors, together with the fact that European elections traditionally attract the protest vote, suggest that populist parties are likely to enjoy significant advances in the elections next month.
A recent analysis by JPMorgan (see Chart 7), which is based on national polls, shows that if the European populists joined forces they would form the largest parliamentary group, with 191 seats in the 705-seat European Parliament. That compares to 140 seats in the 2014 European Parliamentary elections (all figures exclude UK parties).
Chart 7. Polls suggest populist parties will gain 50 more seats than in the 2014 European Parliamentary elections
Source: JPMorgan as at March 2019.
However, European populists are characterised by a high degree of fragmentation. National populist parties are spread across most of the nine European parliamentary groupings, including the largely mainstream European Popular Party. Importantly, while they all agree on the principle of repatriating sovereignty from the EU back to the nation state, they have no consistent views on other issues and policies.
Our bottom line is that the three mainstream parliamentary groups – the Popular Party, the Socialists & Democrats and the Liberals – will probably maintain control of the European Parliament. In turn, they will be able to decide the distribution of the EU top jobs. But they will need to cooperate.
Nonetheless, populist parties will probably gain enough power to disrupt decision-making processes, eroding the functioning of European institutions from within. In addition, mainstream parties may be tempted to pursue populist themes in an attempt to redeem support. These developments would hinder the already challenging process of integration, undermining the bloc's ability to combat the next downturn.
The ability of the eurozone to tackle the next downturn or recession will depend on whether the next Parliament can advance the ongoing reform process and strengthen the EU project. In this respect, the elections on 23-26 May are crucial.