Fiscal policy to the rescue in the Eurozone

Growth in the Eurozone could be derailed in the coming quarters, and such a slowdown would trigger a new phase of expansionist fiscal policy. The size and the effectiveness of the next round of stimulus, however, remain uncertain, and some European governments will have little incentive to act.

In coming months, Eurozone growth could slow more sharply than commonly expected. We can identify six main risk factors that could negatively affect growth:

A tariff shock hitting the European manufacturing sector, especially the German automotive industry that represents about 14 percent of German GDP, if there is no agreement between the US and the European Union on auto imports by December 11; The lasting consequences of the economic slowdown in China and the credit crunch in Turkey which have already hurt German exports since the end of 2018. Pessimism among EU consumers; The likelihood of a no-deal Brexit on October 31; Higher risk of recession in the US in 2020; and Rising tensions between the US and Iran that could lead to disruptions in the global oil market.

If one or more of these risks materialises, which is more than likely in our view, growth in the Eurozone would be at risk of derailing, which would push policymakers to intervene to support demand and investment. We believe that the conditions are already in place for fiscal stimulus in the euro area for the following reasons:

Interest rates are structurally extremely low. In other words, the cost of debt is low so it reduces the urgency to reduce debt.

There is little room left for monetary policy. The European Central Bank is confined to the zero lower bound, which means that lower rates have less positive effect than in the past, as they are already very low or negative. The ECB could resort to a new round of quantitative easing, in case of an economic downturn or de-anchoring of inflation expectations, as early as 2020, but to be effective, it will need to wield a more massive bazooka than in 2015, and the effects are still uncertain. What we know with more certainty is that QE tends to be associated with negative distributional effects (exacerbation of wealth inequality) that can only be mitigated by fiscal redistribution.

Over the past few years, the economic literature and prominent scholars have paved the way for expansionist fiscal policy. In the US, Modern Monetary Theory proposes to finance a Green New Deal and full employment by increasing the deficit and using the central bank to pay off debt by printing more money. MMT is attracting more and more attention in Europe, including among populist parties, but also beyond, and will certainly be part of the conversation in upcoming elections.

Investment to finance clean energy transition is gaining strong support among European citizens, as shown by the victory of Green parties in the latest EU parliamentary elections.

Source from: The Peninsula