Fiscal Forward Guidance

We explore this week the possible “exit strategy” from the ongoing extraordinary fiscal and monetary stimulus. Drawing on Olivier Blanchard’ recent research, we argue that the current EU fiscal surveillance framework may be ill-suited to guide governments through an optimal path for a fiscal consolidation which would ensure public debt sustainability while preserving the economic recovery. However, Blanchard’s favoured solutions – moving to a discretionary assessment by the Commission with strong enforcement power or using the ECB’s existing OMT framework – do not seem politically feasible to us, at least not without going first through a painful phase of volatility and tension on sovereign spreads. We continue to think that voluntary “fiscal forward guidance”, i.e. ex ante commitments by governments to start tightening fiscal policy once certain numerical thresholds are met on the recovery (e.g. unemployment falling below a pre-set level) would offer enough visibility for the ECB to map their own normalization while minimizing the risks of market turmoil. There is no perfect system, if only because fiscal policy remains essentially the product of democratic decisions while monetary policy is a technocratic one, and we would expect quite a lot of noise on the route to exit, but the conversation at the institutional level needs to start before the pandemic emergency is over.

Meanwhile, as we write a deal has yet to be agreed between the UK and the EU. For all the drama around this “race against time” to provide some organized framework around the UK/EU economic relationship, the low-quality Free Trade Agreement which is being painfully negotiated would still be one of the worst arrangements among all those which were thinkable after Brexit. An FTA will be far from providing “frictionless trade” between the EU and the UK, which was the British government’s initial objective immediately after the referendum. It would obviously be better for the UK – and to a lesser extent the EU – if a deal was struck, to avoid customs tariff being slapped (the extension of the UK tariffs on food imported to the UK could raise the overall consumer price level by 0.5% immediately), but even with an FTA the damage will be significant. We remain baffled that the negotiation is still hinging on fishing, which contributes 0.1% to the British GDP, while any attempt to secure the position of the UK financial services in the EU has been abandoned months ago (this industry contributes about 10%). Politics has its reasons, and its economic costs.