Simon Wren-Lewis has a typically thoughtful post on the European Commission’s approach to fiscal adjustment as set out by Buti and Carnot in a post linked to by Philip a couple of weeks back. In the context of the zero lower bound constraint on monetary policy, it is hard to disagree with him on the inappropriate aggregate stance of eurozone fiscal policy.
But I think his discussion neglects an important second dimension of the challenge faced by the Commission (and indeed the ECB). In addition to being in recession, the fiscal lender of resort (LOLR) function is still a work in progress. This function has come a considerable way since early 2011, when a hard line on official creditor seniority, and the threat of a low trigger for PSI in future bail out programmes, pushed Ireland and Portugal – followed not far behind by Italy and Spain – deep into “bad equilibrium” territory. (Some thoughts from the time here.) In strengthening the lender of last function, the Commission is constrained by the concerns of stronger countries about the fiscal risks they are taking on, which they see as further aggravated by moral hazard.
(Sometimes I do wonder if the reluctance on LOLR can be fully explained by conflicting interests. Although it relates more to banking side, the recent comments – even if partially retracted – by the new Eurogroup head does give cause for concern about the appreciation for the importance of the LOLR for avoiding a serious escalation of the eurozone crisis.)
The Fiscal Treaty, for example, must be seen as part of the quid pro quo for developing the LOLR. The ESM – absent some of the more damaging elements of the original proposal – and the ECB’s OMT programme would be unlikely without the strengthening of the rules-based framework. This must be balanced by the Commission against unwelcome implications of the rules for the aggregate fiscal stance.
Given their advocacy for a strengthened LOLR, I do think the Commission sometimes gets a bum rap.