Via Financial Times

We are on the cusp of another economic policy error in the eurozone. Its roots lie in a mixture of complacency about coronavirus and a deep-seated belief that monetary policy has no ammunition left when interest rates are negative and that fiscal policy is, by nature, constrained.

It is comical, yet consistent with the observation above, to hear European policymakers reiterating that they are waiting and monitoring the situation. Eurozone finance ministers could not agree on a co-ordinated policy response when they held a telephone conference last week. And the G7 industrialised nations only managed to agree — guess what — to monitor the situation. Even Christine Lagarde, president of the European Central Bank, felt the need to issue a statement saying that she, too, was “closely monitoring developments”.

There is still a lot we do not know about Covid-19. But we know what we need to know for an economic policy response. The UK government’s medical advisers, for example, have calculated that, with existing measures, the greatest increase in the number of cases will occur in April, with a peak in May or June. This implies economic disruption lasting at least into the summer.

The timeline should be broadly the same for the eurozone, with the spread of the virus peaking a little earlier in Italy, where it started earlier. The direct impact on the eurozone economy is, therefore, a hit to supply chains and to consumption for two or three quarters. This is a foreseeable and probably significant economic shock, very different in effect to Sars and other viruses of the recent past.

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In an ideal world, eurozone governments would co-ordinate fiscal policy with each other and also with the ECB. But there is no sense of urgency. In Germany, for example, a survey found that 66 per cent of the population think the situation is under control, while 76 per cent are not greatly concerned about becoming infected.

For as long as such delusions persist, there will be no public pressure for immediate government action. Germany has announced a fiscal stimulus of a magnitude of 0.008 per cent of gross domestic product. If there is no political pressure for a domestic stimulus, then there will be no support for a co-ordinated response either.

What about monetary policy? During the eurozone crisis, the ECB was the only functioning institution of the EU. A combination of negative interest rates, quantitative easing and liquidity policies prevented the eurozone from falling into a depression. The ECB managed to ringfence the banking sector and the money markets. And it managed to compensate, in part, for the lack of a mutualised safe asset. But most important it was able to neutralise the effects of austerity, the biggest economic policy error of our times.

Monetary policy is still the only game in town. It would be delusional to think it has no effect. For example, the rise in the euro’s exchange rate since the middle of February stemmed from the expectation that the US Federal Reserve would cut interest rates more aggressively than the ECB. The exchange rate is one of several channels through which monetary policy affects the economy.

The big question for the ECB now is whether it continues to do “whatever it takes” to support the eurozone economy when others do not, or whether it reverts to the mindset of 2011 or earlier. During that era, policymakers prided themselves on keeping calm in the face of adversity.

Ms Lagarde has talked a lot about green finance and tackling climate change. Important as these issues may become in the future, I wonder whether this focus has become too much of a distraction from the more urgent task at hand. The ECB should not only be discussing whether it ought to encourage banks to maintain credit flows to small and medium-sized companies. It should also be dealing directly with the economic shock from coronavirus that lies ahead.

The US, China, Japan and the UK are, at present, more likely to take effective action than the eurozone. The right policy will, this time, require a significant fiscal component. And it will take more than an Italy-only fiscal injection of 0.3 per cent of GDP. The whole of the eurozone will need a stimulus of at least two or three times that size. My expectation is that eurozone policymakers will act eventually, reluctantly and insufficiently.

The result of the collective brain fog in Frankfurt and Brussels would be entirely negative: another policy-induced recession that will last longer than it should.