A Pragmatic New European Leadership Team Could Supply Tools to Face the Next Downturn

July 10, 2019 1:15 PM

After a turbulent year of predictions that extremism was on the rise, the European Union (EU) has ended up with a capable and pragmatic leadership team, committed to continuing the continent’s economic reform processes, institutional deepening, and support for the global multilateral institutions and trading system. The team was completed in early July with the election of David Sassoli, the center-left Italian politician, as the new European Parliament president.  His selection makes it likely that the European Parliament will endorse the entire personnel lineup.

Others in that lineup include Ursula Von der Leyen, the German center-right defense minister (and ally of Chancellor Angela Merkel), as the new president of the European Commission and Charles Michel, Belgium’s liberal prime minister (and confidant of President Emmanuel Macron of France), as the new president of the EU Council. The center-left Spanish foreign minister Josep Borrell will become the new EU high representative for foreign affairs, and most surprisingly, Christine Lagarde, managing director of the International Monetary Fund, will become the next president of the European Central Bank (ECB).

This complex outcome promotes two women to the EU’s most important jobs for the first time and installs a triumvirate of a president and two Council-appointed vice presidents at the European Commission. The presence of a center-right German as head of the Commission, just as the next seven-year EU budget is being negotiated, may increase the chances of extra German funding approved by the Bundestag.

Pragmatism and the willingness to think beyond traditional institutional silos will be required if Europe is to continue its strong economic performance. But the new European leadership team will face two main economic problems.

Lagarde, for example, will likely inherit a new monetary stimulus program likely to be launched by Mario Draghi before his departure on October 31. Lagarde thus will become president of the ECB at a time of short-term policy interest rates at zero and below, more quantitative easing in the pipeline, and long-term euro area interest rates at historical often negative lows. Despite this stimulus, the ECB still faces difficulties meeting its inflation target of “close-to-but-below 2 percent” just as it runs out of monetary policy ammunition. Given the north-south divide in the euro area and the lack of policy space in many Southern members, a euro area deflationary stagnation may be hard to avoid when the next downturn hits the euro area.

Moreover, the new leadership team’s fiscal policy options are limited by the new euro area Budgetary Instrument for Competitiveness and Convergence (BICC), which is intentionally designed without meaningful funding options and a countercyclical stabilization function. The euro area thus lacks a fiscal policy instrument when its next downturn hits, even if trade-dependent Northern members like Germany and the Netherlands could run deficits in the face of a slump arising from a shock to global trade[1].

Yet the fact that two former center-right finance ministers lead the ECB (Lagarde as president and Spain’s Luis de Guindos as vice president), with the European Commission headed by a center-right German president with a likely liberal vice president for economic affairs in Margrethe Vestager, the current European commissioner for competition, could produce an adequate macroeconomic response to a future downturn, if member states are unable or unwilling to stimulate adequately.

The ECB is institutionally independent from Europe’s elected governments, making the explicit coordination of fiscal and monetary policies (as is the case in Japan with Abenomics) impossible. But installing two former politicians to head the central bank can help create a modus operandi between fiscal and monetary authorities. Monetary policy traditionalists might consider such coordination heresy. But relying on just another standard monetary policy response to the next downturn is a path to impotence, irrelevance, economic stagnation, and a possible political demise of the European project. Facing that danger, Lagarde is likely to leave no stone unturned to avoid such possible economic stagnation and will be credible at selling new policy initiatives in Berlin and The Hague. In a serious future downturn without adequate member state fiscal stimulus, and with the BICC not a credible fiscal institution, Lagarde’s likely partner in creating the financial instruments the ECB can support would instead have to be the European Commission led by von der Leyen and Vestager, the likely vice president for economic affairs.

What tools are available to these leaders? One could be the revival, reform, and expansion of the European Financial Stabilization Mechanism (EFSM), which was employed in the European financial crisis. It could allow the Commission, guaranteed by the EU budget (i.e., member states), to borrow large sums in the current ultra-low interest rate environment,[2] issuing long-dated bonds eligible for ECB purchase.[3] The Commission could then use this money to cofinance public investments (deliberately broadly defined) in infrastructure, maintenance, education, or climate-related projects.

Depending on market conditions, such long maturity EU output stabilization and investment bonds (OSIBs) might be initially issued at negative interest rates. The debt could later be forgiven in return for member states implementing structural economic reforms to raise potential growth rates after the crisis, mimicking the intended function of the BICC.

Recalling the Greek program experiences and ongoing ECB support, EU OSIBs might also be rolled over in the future and maturities extended until such time in the (distant) future when the additional member state GDP generated by the timely countercyclical fiscal stimulus had generated enough extra tax revenues for member states to repay the Commission the value of the bond principal and retire the bond.

In extreme circumstances, OSIBs owned by the ECB could also be turned into new zero-coupon bonds with a perpetual maturity ensuring that no interest would have to be paid (or with negative rates received) and no principal ever repaid.[4]

Ultimately, the EU and euro area in particular may have to invent an EU Treaty–compatible version of Japan’s economic policies (Abenomics) to escape deflationary stagnation in its next downturn. Abenomics relies on the three “arrows” of closely coordinated monetary easing, fiscal stimulus, and structural reforms. The new leadership team offers hope that it will be up to this challenge.


1. I am indebted to my colleague Jeromin Zettelmeyer for raising this point.

2. Currently the EU’s yield curve is negative to a 5-year maturity, but in a new downturn it is certain that negative EU borrowing rates would extend considerably farther out into the future.

3. As part of the existing public sector purchase program (PSPP), the ECB already owns about €230 billion of securities from supranational issuers, so this would not be a material change in ECB practices.

4. This would obviously de facto erase the need to ever repay the OSIB and would also prevent the ECB from ever reselling it to a private investor, as a zero-coupon perpetual-maturity OSIB would have no value and no private investor would therefore buy it. This would again prevent the ECB from ever withdrawing the monetary stimulus provided when it bought the OSIB in the market and hence reduce its future capacity to fight inflation, a feature that might ironically be appealing to a central bank currently struggling to reach its inflation target.