International financial regulators are busy editing their rulebooks. Some will argue that they need to rewrite their handbooks on how to deal with massive fiscal challenges that were already threatening financial markets pre-COVID and now look unsurmountable.
So are we assisting to the burying of the doctrine of austerity? The last major global crisis saw countries like Greece accepting humiliating conditions set up by the ECB, the EU and the IMF in return for much-needed financial support to avoid a sovereign bankruptcy. Greece saw its GDP shrink by 25 per cent as a result of the austerity regime imposed by the IMF that today admits that its austerity prescription was far too harsh.
A decade of austerity for countries like Italy and Greece has only served to boost populist parties as traditional politicians could no longer project themselves as good managers of the economy. The pendulum now seems to be reaching the opposite end of its swing range.
The European Commission has published the fiscal deficit projections of the 19 eurozone bloc. In 2020, these states are expected to register a fiscal deficit of €1 trillion or 8.9 per cent of the bloc’s GDP. 2021 should be better for fiscal management but still quite depressing. Next year the eurozone countries are expected to have a deficit of six per cent of GDP.
So why are financial markets so sanguine about the present fiscal situation? In 2010, financial markets went in a downward spiral when the extent of the sovereign debt crisis became evident. Yet the fall in GDP at that time was about 6.6 per cent. The world’s central banks did the heavy lifting to prevent a recession turning into a depression a decade ago.
The current recession will continue to underline the deep divide in the public finances of euro area members
A loose monetary policy that has pushed interest rates to all-time lows and a commitment by central banks to buy sovereign debt of economically distressed countries like Italy and Spain saved the EU from a major depression. Little or no success has been achieved, however, in promoting frugality in those member states where national debt and budget deficit levels are unsustainable.
The onset of COVID-19 saw regulators change their narrative on the remedies for unsustainable public finances in the weaker countries. Jay Powell, the chairman of the US Federal Reserve, now projects himself as the cheerleader of central bankers, urging governments to use fiscal tools to avoid a global depression.
Christine Lagarde, president of the ECB, argues that “it is clear that both fiscal support and monetary policy support have to remain in place for as long as necessary and ‘cliff effects’ must be avoided. Otherwise, we risk hysteresis in the labour market, an unnecessary loss of viable businesses and greater inequality”.
The burying of the austerity doctrine does not come without risks. The most significant risk is that it will encourage profligacy.
There are already some worrying signs that this may already be happening.
In Italy, for instance, the political debate on whether the country should borrow under the European Stability Mechanism (ESM) facilities rages on. Both government and opposition parties fail to agree among themselves on the appropriateness of this source of financing. Money under the ESM comes with conditions that politicians fear will enrage already depressed voters.
Using the recovery fund of the ESM funds to finance wasteful projects will only prolong the deep recession which the eurozone is facing. In Italy, for instance, some politicians have revived the idea of building a bridge to connect Sicily to the mainland – a concept often resurrected by Italian politicians when they want to shy away from addressing the countries’ structural weaknesses.
If profligacy creeps in the use of money borrowed by distressed states, financial markets may once again lose trust in the ability of political leaders to manage their economies. Next time round, central banks’ intervention may not be enough to calm investors’ nerves.
The eurozone faces yet another existential challenge. The current recession will continue to underline the deep divide in the public finances of euro area members. The mutualisation of the debt of eurozone member states remains a distant objective even if the EU will be assuming some debt to finance the economic recovery in the Union.
Former ECB president Jean-Claude Trichet did not mince his words in an interview on CNN when he said that the government should spend as much as necessary to help their economies recover. But they also run the risk of financing the wrong projects, thereby wasting an opportunity to boost growth prospects.