This paper builds a model-based dynamic monetary and fiscal conditions index (DMFCI) and uses it to examine the evolution of the joint stance of monetary and fiscal policies in the euro area (EA) and in its three largest member countries over the period 2007-2018. The index is based on the relative impacts of monetary and fiscal policy on demand using actual and simulated data from rich estimated models featuring also financial intermediaries and long-term government debt. The analysis highlights a short-lived fiscal expansion in the aftermath of the Global Financial Crisis, followed by a quick tightening, with monetary policy left to be the “only game in town” after 2013. Individual countries’ DMFCIs show that national policy stances did not always mirror the evolution of the aggregate stance at the EA level, due to heterogeneity in the fiscal stance.

Achieving a balanced monetary-fiscal policy mix in the euro area is crucial to ensure that monetary policy is able to fulfil its primary price stability objective. This paper outlines, from an economic and legal perspective, the interaction between monetary and fiscal policy in light of the current monetary and fiscal stance and, in particular, the "quasi-fiscal" effects of some unconventional monetary policy measures. Since sustainable public finances are a prerequisite for a price-stability-oriented single monetary policy, the paper also analyses the EU economic governance review proposals. This document was provided by the Economic Governance and EMU Scrutiny Unit at the request of the Committee on Economic and Monetary Affairs (ECON) ahead of the Monetary Dialogue with the ECB President on 25 September 2023.

The euro area continues to perform well, owing to its sustained employment creation, rising disposable income, buoyant internal demand, and low inflation. Executive Directors agreed that favorable external developments and sound macroeconomic fundamentals had produced robust area-wide growth. They cautioned that high oil prices and a weak euro might undermine prevailing wage moderation and set in motion domestic inflation pressures. They emphasized the need to tighten monetary and fiscal policies, and accelerate structural reforms to sustain economic growth.

Recently, monetary authorities have increasingly focused on implementing policies to ensure price stability and strengthen central bank independence. Simultaneously, in the fiscal area, market development has allowed public debt managers to focus more on cost minimization. This “divorce” of monetary and debt management functions in no way lessens the need for effective coordination of monetary and fiscal policy if overall economic performance is to be optimized and maintained in the long term. This paper analyzes these issues based on a review of the relevant literature and of country experiences from an institutional and operational perspective.

In its current approach to achieve an appropriate euro area fiscal stance, the EU Commission asks countries with fiscal space to provide extra stimulus in order to compensate for countries that are constrained by debt sustainability considerations. However, the aggregate fiscal stance is not a particularly useful concept since it abstracts from too much relevant information at the country level. In particular, excessive stimulus in one country is likely to generate welfare losses there, since this may compromise fiscal sustainability and/or cause its economy to overheat. Additional spending in one country can help other countries only if (1) there are significant trade spillovers and (2) monetary policy does not respond to the increase in economic activity. Even then, the composition of national fiscal policies may be inappropriate, since additional spending may be called for in countries where it is not needed. To overcome these problems would entail moving towards a fiscal union (e.g. by implementing a cyclical risk-sharing mechanism), which can potentially loosen fiscal restrictions, but introduces risks of moral hazard and persistent one-sided transfers.

Reducing unemployment, strengthening the euro area's growth prospects and ensuring the future resilience of the European economy require better tailored fiscal tools at euro area level. Today, the limits of the EU's fiscal framework mean that the euro area has had to rely excessively on the monetary policy of the European Central Bank (ECB) to ensure macroeconomic stability. As these monetary policy tools are increasingly stretched, calls for a more balanced policy mix that includes more supportive fiscal policies have been voiced by the EU - including by Commission President Jean-Claude Juncker in his 2016 State of the Union 'Letter of Intent' and by ECB President Mario Draghi - as well as by a very broad set of stakeholders, from international organisations to academics. Against this backdrop, the Commission presented on 16 November a Communication 'Towards a Positive Fiscal Stance for the Euro Area', confirming its intention to promote a more supportive fiscal policy in the euro area. Given the challenges that lie ahead and the current economic juncture, there is a strong case for increasing public investments in areas that increase the resilience of the European economy. In short, there is both a need and a unique window of opportunity for the EU to take action on the fiscal front at this precise point in time. This increased fiscal responsibility must be implemented in combination with supportive structural reforms and investments, making sure the elements of the 'virtuous triangle' are mutually reinforcing.