Pierre Nouailhetas-Baneth King’s College London European
The COVID-19 pandemic has heightened fear amongst economists and politicians that after prolonged struggles with a stubbornly low inflation rate, matters could worsen due to rising deflationary pressure. Amidst the restrictions taken by European governments to slow the spread of this coronavirus, economic activity has slowed dramatically - Businesses have been forced to close and people forced to stay indoors, putting European economies at a virtual standstill. Oil prices have dipped due to excess stock created by a price war and a general lack of demand, creating even greater short-term deflationary pressure. As can be expected, inflation in the Eurozone fell from 1.2% to 0.7% throughout the month of March - the lowest since October 2019.
Inflation is a regular source of focus for the European Central Bank. While historically, governments have gone to extreme lengths to avoid inflation from climbing too quickly because it lowers the real value of monetary assets, the EU’s issue is actually that the rate is too low. Since vowing to do ‘whatever it takes’ to save the Euro in 2012, the ECB has implemented quantitative easing measures and spent over €3 trillion purchasing government securities, but continues to undershoot its inflation target. The Eurozone seems to be facing a similar problem to that of Japan: a decreasing birth rate across the continent complemented by stagnant wages and low energy prices has rendered many QE procedures ineffective. COVID-19, along with the necessary restrictions which have been emplaced to fight it, has threatened to grind an already slowing European economy to a halt.
European governments have been quick to respond, however, passing staggeringly large stimulus packages in an attempt to maintain moderate levels of economic activity. Germany, France and Spain’s packages alone total almost €1.5 trillion. The European Central Bank has also further loosened its restrictions on quantitative easing and passed an additional €750 billion emergency program aimed at buying government bonds. This opens up a margin for states to continue generating incomes for businesses and corporations hit hardest by COVID-19. This unprecedented monetary stimulus has led some to argue that inflation is more probable in the short-term than deflation; However, the global economy has never experienced such a prolonged spell of inactivity and uncertainty, indicating that deflation - at least in the short-term - is the most likely.
Furthermore, the supply shocks caused by COVID-19 could be accompanied by an even greater decrease in demand. Money that would have been spent on flights or hotels is now likely to be saved due to a current lack of substitutes. The trillions of Euros poured into the central bank’s quantitative easing measures in the last 8 years have yielded few encouraging results, and the virus will only serve to create greater deflationary pressure. It seems increasingly evident that the ECB has lost its ability to control the inflation rate, and in this time of urgency, perhaps states and banks should focus solely on supporting their own economies, and let the inflation rate self-adjust.
The COVID-19 pandemic presents the opportunity for a renewed, sustained focus on fiscal policy. European governments have already passed unparalleled stimulus packages, but more action will be required to survive the economic aftermath of this coronavirus outbreak. Europe holds the highest Value-Added Tax rates in the world due to EU law which requires a VAT of at least 15% — accordingly, the 5 countries with the highest VAT are all EU members. Once the threat of the virus itself is contained and businesses are allowed to reopen, a targeted cut in VAT for the most heavily impacted businesses may very well be more effective in promoting consumer expenditure and slowing the impacts of this global recession than quantitative easing. When considering a cut in VAT, governments should prioritize smaller companies with less liquidity as well as businesses, such as restaurants or theaters, that were forced to shut-down completely. Finally, VAT is a strongly regressive tax, so a cut would directly benefit lower-income households who are most affected by COVID-19.
While this cut would reduce the EU’s income and liquidity, this measure only needs to hold long enough to outlast the immediate economic impacts of COVID-19. The ECB could target its remaining reserves towards buying securities from the most indebted economies, while more stable European states such as Germany and the Netherlands allow their debt to grow — a necessary sacrifice. The combination of vast injections to maintain incomes followed by considerable tax cuts to incentivize expenditure could be sufficient in preserving, if not boosting, economic activity. Such a sizeable fiscal stimulus is also likely to drive inflation upwards in the medium-term, once somewhat normal economic activity resumes. If this approach is effective, European governments could develop a more sustainable strategy that stresses a greater balance between monetary and fiscal policy. Economists have been asking whether a new plan of action is necessary, and COVID-19 has exacerbated the need for the EU to take decisive action.