At the end of his tenure former European Central Bank president Mario Draghi warned that easy monetary policy “may have to last a long time if there is no support from fiscal policy.” New president Christine Lagarde, who speaks later this week, has also supported the call for fiscal expansion, urging governments to use the fiscal capacity available to them.
But significant fiscal expansion appears unlikely in the Eurozone.
In the Eurozone, the Maastricht Treaty limits fiscal deficits to 3% of GDP, so the scope for stimulus in the region is currently limited. The region’s largest economy, Germany, does have the space to provide stimulus within this restriction, but it appears committed to its constitutional debt brake and its balanced budget stance for 2020. Earlier this year, Finance Minister Olaf Scholz said that “we are in a position to counter an economic crisis with many, many billions of euros, if one actually breaks out in Germany and Europe.” But this merely confirms that fiscal policy will be reactive, rather than proactive, and the “many, many billions” was later confirmed to be EUR 50bn, equivalent to just 1.5% of German and 0.4% of Eurozone GDP.
EU officials are considering ways to adjust the Stability and Growth Pact rules, but radical change is unlikely, not only because of political resistance, but because deficit spending frameworks such as promoted by Modern Monetary Theory (MMT) are not appropriate for a region like the Eurozone. Under MMT, budget deficits are not considered a sign of excessive spending – inflation is – so running a bigger budget deficit doesn’t matter until the economy’s available resources are used up and inflation increases. The central bank’s role in this framework is to be closely aligned with the government, by providing the money to be spent – for example via buying government bonds.
MMT rests on the crucial assumption that governments cannot default on their own “sovereign currency.” But the Eurozone is different from the “one country – one currency” regime assumed by MMT. While they all use the euro currency, member countries remain fiscally independent, and their debt ratios and deficits differ greatly. Member states can’t independently print euros or issue unlimited amounts of debt. For example, Greece's default on its domestic currency debt in 2012 and its introduction of capital controls in 2015 exemplified how the euro, for any individual member state, can turn into something similar to US dollars for a developing country: a currency that you cannot print.
Draghi’s warning that easy monetary policy will have to last a long time appears more likely to prove true than his calls for greater fiscal expansion. Our view is that rates will indeed remain “lower for longer,” and this underpins our focus on allocating our tactical risk budget more toward yield investments than growth. We hold an overweight in EM USD-denominated sovereign bonds, and in the Indian rupee and Indonesian rupiah versus the Australian and Taiwan dollars in our FX strategy.
Read more in our recent report: Global sovereign monitor: Do fiscal deficits matter at all?
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