European economic governance

17 November 2021 Blog

I believe that the objective of economic policy is to grow our stocks of economic capital in a sustainable wayAs our economies continue to recover from the COVID-19 shock, policymakers can turn some of their focus from the crisis response measures we have seen enacted to more medium and longer term questions of whether our economic frameworks are fit for purpose.

Taking a longer term view on economic policy is crucial. As I've said previously, successful economies need time to develop human and social capital, time to grow and nurture their natural capital, and time to build the financial and physical capital that is foundational to improving living standards.

All of these capitals represent our economic capital as, when combined, the stocks of natural, human, social and financial/physical capital generate flows of tangible and intangible outcomes and ultimately the conditions that individuals, communities and countries live in. I believe that the objective of economic policy is to grow our stocks of economic capital in a sustainable way.

And taking a longer term view is necessary if you are going to tackle issues such as climate change, or ageing populations in many countries around the world.

The importance of the European macroeconomic framework for Ireland

For Ireland, our macroeconomic framework has to be considered in the wider context of the European framework in which it is embedded. Sharing a common currency through our membership of the euro area is the obvious manifestation of this.

In fact we share an institutional architecture to manage the deep integration between our economies in the European Union (EU) and euro area (including the European Central Bank (ECB), European Commission, European Parliament and European Council) while we also share sets of rules which govern how we work, some of them in regulations and others in the Treaty on the Functioning of the European Union, such as the ECB's monetary policy role and the Stability and Growth Pact (SGP).

Last month, the European Commission relaunched its review of EU economic governance, and in particular the effectiveness of the SGP. The main aim of the SGP is to ensure that EU Member States pursue sound fiscal policies and maintain sound public finances. Sound public finances (and, by definition, sustainable debt) are prerequisites for good policymaking. Only with these can economic policy turn to the task of growing the stocks of economic capital in a sustainable way for the long-term.

This matters in particular for countries in a currency area (like the euro area) who have less scope to use monetary policy to counteract shocks that may only affect their own economies, or common shocks that are experienced more intensely in some Member States than others. Fiscal policy is an essential tool for policymakers to respond to such shocks (as we saw with the response to the pandemic). Macroprudential policies are also useful to mitigate country-specific risks.

For Ireland – a small open economy in a monetary union – this is all the more important, as building resilience through prudent fiscal policy in good times creates the necessary capacity to respond to shocks that affect our economy.

More broadly, given the tight integration between economies in the euro area, all 19 Member States who use the euro have a responsibility to pursue prudent policies as problems have the potential to spark a crisis which could spill over and threaten the integrity of the currency union.

A number of shortcomings have been identified with the SGP in its current form. For example, fiscal policies in Member States have tended to be pro-cyclical, meaning governments have not been as prudent as they could be in good times to build the necessary resilience to downturns. Moreover, the rules have become overly complex over time and have not supported longer-term investment as much as they need to. The time feels right for a discussion on how to tackle these issues.

So, for Ireland and other EU Member States, the SGP is a hugely important element of the framework for economic policymaking. However, while we must always work to ensure that the public finances are in a sustainable position, we should also be looking at our existing measures of debt sustainability against the long-term investment needed for our economies, for example the investment required to manage the transition to net zero emissions by 2050. The SGP will be an important factor for these decisions in the coming years.

The importance of the European macroeconomic framework for central banks

Now some of you may be wondering why the Governor of the Central Bank of Ireland – who has no responsibility for fiscal policy – is so interested in the SGP. Part of the answer is that providing economic advice is in the Central Bank’s ‘job description’.  But another part is that fiscal policy matters to the effectiveness of monetary policy.

I’ve previously discussed research from the Central Bank on the interactions between monetary and fiscal policy and these interactions were also considered in the recent ECB strategy review. So how do the policies interact? Well for a simple example, as government debt levels increase, questions surrounding fiscal sustainability inevitably arise. However, debt becomes more affordable as monetary policy eases and debt servicing costs fall.

While the policies do interact, it is important to note that the euro area’s institutional structure was designed to ensure central bank independence. We at the ECB set policy to fulfil our (price stability) mandate and control inflation without government interference. History has shown that an independent central bank setting monetary policy is more likely to be successful at maintaining price stability than governments who have to manage the slings and arrows of an electoral cycle. However, the last decade has shown the need for fiscal policy to play a greater role in the euro area than envisaged originally (around 30 years ago). Inflation has been too low in the euro area for a number of reasons and the ECB has reduced interest rates in response, as well as put in place less conventional policies such as asset purchases. In such circumstances, when monetary policy has reached its limits (the “effective lower bound”), fiscal policy becomes more important and more powerful and can help to boost economic growth, which in turn helps inflation to return to the central bank’s aim.

So, there are a number of reasons for central bankers in the euro area to take an interest in the debate around EU economic governance and SGP reform. I am particularly interested in how to encourage counter-cyclical fiscal policies to build resilience, as well as whether debt that has grown as a result of unique circumstances (such as the effects of the pandemic) should also be treated in a special way.

Another important issue is the need for a central fiscal capacity for members of the euro area. From a macroeconomic perspective, such a capacity could help to manage economic shocks to euro area members and also encourage investment for common endeavours. A recent example of this in action was the introduction of the Next Generation EU (NGEU) fund to counteract the shock of COVID-19 and make European economies and societies more sustainable, resilient and better prepared for the challenges and opportunities of the green and digital transitions. While it is too early to say whether the NGEU will be a success, even its announcement last year helped to provide reassurance and showed a path to a sustainable recovery with targeted investment that promotes the European priorities of becoming a modern, resource-efficient economy that is fit for the digital age.

However, the NGEU is a crisis-response measure and while it may prove to be a successful example of a central fiscal capacity in action, political will and agreement would of course be necessary for any move towards something more permanent.

Overall, I believe any potential reforms of the SGP need to find the correct balance to ensure sound public finances while allowing fiscal policy to play its part in achieving better economic outcomes.


The debate on the EU’s economic governance is ongoing and a number of questions are up for discussion including how to simplify the framework, how to ensure long-term sustainability while allowing for short-term stabilisation and how to take into account the changes to our economies from the pandemic. The answers to these questions – among others – matter to the evolution of the euro area’s macroeconomic framework and, ultimately, the wellbeing of all of us in Ireland and in the EU.

Gabriel Makhlouf

Read more:

A Letter to Students of Economics – 2021