What the EU has learned from overcoming the financial crisis and COVID-19

The last twelve years have been deeply transformative for the European Commission and for the EU. The global financial crisis which started right at the beginning of my tenure as Director General – and whose ripple effects continued to be felt up until the end of my mandate – was a particularly testing episode for the EU. Even more testing has been the impact of the pandemic crisis that erupted in March 2020. The Commission has itself been an actor of change and, during all these years, I witnessed and participated in a deep transformation of its role and its contribution to European integration and global governance.

In a new book, I retrace my personal intellectual journey over the past twelve years. Many of the papers in the book were written together with Commission colleagues, but also with fellow economists at the IMF and the OECD. Most of them were published here on Vox.

In this column, I focus on some general principles that could guide the EU’s economic policymaking in the aftermath of the dual crisis that has plagued the European economy during the past twelve years.

The need to respond to two unprecedented crises in rapid succession tested the European Commission’s resolve and imagination to the limit. The challenges related to managing the pandemic crisis when the scars of the Great Recession were still healing and “building back better” put the bar of policy and institutional ambition even higher.

Based on my personal involvement in crisis management and response, I would draw six key lessons in approaching EU policymaking in the years to come:

1. Avoid ‘inverted pyramids’. Often, there is a disproportionate focus in EU policy surveillance on matters that are objectively less important. Although not always fair, a criticism has often been levied in the past at the EU for getting bogged down in the ‘decimals’. Policy surveillance should be recast to address what the EU Treaty dubs ‘gross errors’. The internalisation of spillovers (not only economic, but institutional and political) should be the guiding principle. Crucially, the implementation of Recovery and Resolution Plans (RRPs) will provide the opportunity to emphasise ‘gross advantages’ as well.

2. Do not fall victim to the ‘partial equilibrium’ syndrome. The financial crisis demonstrated that tensions in one corner of the euro area could have powerful consequences elsewhere and, under certain circumstances, become systemic. The stronger toolbox put in place during the financial crisis will help on that front, but it is unlikely to be sufficient. As the response to the Covid-19 crisis has shown, taking into account interdependences between countries (in the application of fiscal and macroeconomic surveillance) and between policies (notably fiscal and monetary policies), will be important to capture the euro area ‘general equilibrium’ dynamic.

3. Fight against ‘complete contracts’. During the financial crisis, the lack of trust amongst member states and between the latter and European institutions created suspicion in some countries about the use of any discretion in the implementation of the fiscal rules. This led to the attempt to codify all possible states of the world in complex algorithms so as to avoid discretionary decisions as much as possible. The over-engineering of the Stability and Growth Pact (SGP) is the quintessential example of this dérive. However, as economic analysis and experience show, complete contracts do not exist. Moreover, the increasingly sophisticated algorithms, often based on unobservable variables, add to complexity which itself undermines the effectiveness and transparency of surveillance. If the rules of macroeconomic and fiscal surveillance are to be simplified, member states have to accept that the Commission applies them using the appropriate degree of economic judgement.

4. Remember that going from A to B is not a straight line in Europe. The different sensitivities and complex political realities in the EU mean that proposals must usually appeal to different audiences and be accepted by countries with different social and political preferences. Therefore, achieving a consensus is often cumbersome and requires complex negotiations and ‘lateral progress’. Actually, aiming at drawing a straight line between A and B may be detrimental to the eventual success of the initiative. For instance, the call to boost public investment resonates better in certain countries if it is presented as demand policy, and in others if emphasis is put on its supply-side effects. Another example is the work on a safe euro area asset: emphasising its role in market deepening and strengthening the international role of the euro gives it a better chance to succeed than casting it as part of fiscal union.

5. Red lines are there to be crossed. As part of discussion in the Council or in the various Committees and fora of the EU, national authorities often arrive, as is natural, with a number of red lines dictated by domestic political considerations. Most of these red lines become less compelling if the common interest is brought into the picture and the time horizon over which certain policies or reforms are assessed is lengthened. An essential role for the Commission is to provide the intellectual arguments to help identify the lines that need to be crossed and hence help lower the ‘discount rate’ of national policymakers. The Commission did so in its proposals to tackle the economic fallout of the pandemic.

6. Do not become a ‘Japanese holdout’. The example of soldiers such as Teruo Nakamura – a private in the Imperial Japanese Army who was posted on his own on an isolated island and surrendered only in 1974, almost 30 years after the end of WWII – should inspire a lesson. Policy projects or approaches can at times be pursued long after their political relevance has passed or their economic rationale has proven obsolete. In that respect, “the difficulty is not so much to develop new ideas as to escape old ones”, as John Maynard Keynes famously remarked. Avoiding such a trap is particularly crucial today that the traditional economic paradigm is severely questioned.

Shaping tomorrow’s European economy is tantamount to building back better after the pandemic. It will require courageous political decisions. Within the EU, only the European Commission and its economists have the analytical capacity, the institutional competence, and the esprit de finesse to accomplish such a task.