Abstract

We review the recent literature on macroeconomic stabilization policy, with a particular focus on two major challenges that are particular to the post-crisis landscape. These are, first, how to provide meaningful economic stimulus when the zero lower bound on nominal interest rates is binding. Second, how to design a stabilization policy for the Eurozone that will remedy the large macroeconomic imbalances among member states.

Introduction

European policy-makers are currently facing formidable policy challenges. First, while many other economic regions in the world have shown tangible signs of economic recovery already in 2014, the Eurozone as a whole slipped into a downturn with high unemployment and current and expected inflation falling well below the 2 per cent target. Monetary policy will be constrained by the zero lower bound for the foreseeable future, giving the European Central Bank (ECB) little alternative to engaging in policy experimentation such as quantitative easing. Second, the progress towards the correction of internal imbalances has been very slow, with the questionable exception of the reversal of previous current account deficits, essentially driven by large and costly recessions in the high debt countries. Reform efforts have been frustrated by low economic activity and financial fragility, forcing governments in need of change to implement costly initiatives with scarce tax and financial resources. The inward-looking precautionary approach to fiscal policy adopted by surplus countries has ensured that the overall fiscal stance of the currency area is contractionary, at an inappropriately tight level for the Eurozone as a whole. Third, the Eurozone as an incomplete monetary union needs to ensure its sustainability via institutional development that requires strong political cohesion. Lack of sufficient institutional development has undermined timely and intense policy responses to the crisis, and created mistrust and conflict over viable solutions, as policy-makers are having to design stabilization mechanisms, at the same time as reaching agreement on the fundamental contracts and mutual insurance rules governing banking union, monetary backstops for public debt, and the credibility of the no-bailout principle. The process of overcoming the insufficient institutional development during a severe crisis has exacerbated policy credibility problems at country and union-wide level, and arguably created room for destabilizing speculative behaviour.