Advanced economies may need to rely more heavily on fiscal spending if they want to avoid the fate of Japan with low inflation and alternative monetary instruments, according to new research from the European Central Bank.
Persistently low inflation threatens to become a “self-fulfilling prophecy” if businesses and households stop believing in rising prices and central banks fail to address pessimism, according to a study published Thursday. The Bank of Japan has been trying to heat the economy for 25 years.
But “policy makers are not reduced to inaction,” the study concluded. “When monetary policy is out of place to cut interest rates, a decisive countercyclical fiscal policy saves the economy from an equilibrium of low inflation.”
The survey could serve as an argument for officials wanting to dismantle EU rules, which would have led to years of unfair austerity and low economic growth.
Public spending played an important role in stabilizing the economy during the pandemic. Governments lifted rules designed to keep public finances under control and agreed to a combined €800 billion (US955 billion) in debt to fund the recovery.
But now the debate begins whether it is necessary to return to the old structure once the crisis is over.
Italian Prime Minister Mario Draghi, who served as ECB president until 2019, insisted on Wednesday that spending rules should be changed. This stance puts him on a collision course with favorite Armin Laschett, who will replace Angela Merkel as Chancellor of Germany.
Lachette said last week that sustainability policies should be reinstated after the pandemic’s impact on the global economy is over.
Although inflation this year is well above central banks’ targets in Europe and the United States as economies recover from the effects of the coronavirus, monetary officials say the rise in prices will be temporary.
The ECB has predicted that inflation will fall again next year and remain below the target of just 2%, despite negative interest rates and extensive bond-buying programs that have been in place for years.
ECB researchers recognize that a coordinated fiscal policy is difficult to follow in the eurozone, where public spending is managed by national governments and due to the fact that some countries are already highly indebted.
But the study has a suggestion: in the eurozone economy the ECB has long said a tool is needed.
“Another reason for building central financial capacity in Europe could be self-fulfillment of the low-inflation trap,” he said.
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