Public Spending Offers Way Out of Low Inflation, ECB Study Shows

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Advanced economies may need to rely more on fiscal spending if they want to avoid Japan’s fate of being trapped with low inflation and an empty monetary toolkit, according to new research from the European Central Bank.

Persistently low price growth threatens to become a “self-fulfilling prophecy” if companies and households stop believing in rising prices and central banks are unable to counteract the pessimism, a paper published on Thursday said. The Bank of Japan has been trying to reflate the nation’s economy for 25 years.

But “policy makers are not reduced to inaction,” the paper concluded. “When monetary policy has run out of room for interest-rate cuts, decisive counter-cyclical fiscal policy protects the economy from the low-inflation equilibrium.”

Public Spending Offers Way Out of Low Inflation, ECB Study Shows

The research could be fodder for policy makers who want to jettison European Union rules that they say have led to unwarranted austerity and low economic growth for years.

Public spending has played a major role in stabilizing the economy during the pandemic. Governments suspended rules that are meant to keep public finances in check, and agreed on 800 billion euros ($955 billion) in joint borrowing for a recovery fund.

But now a debate is starting on whether to return to the old framework once the crisis is over.

Italy’s Prime Minister Mario Draghi, who was the ECB’s president until 2019, insisted on Wednesday that the spending rules must be changed. That’s putting him on a collision course with Armin Laschet, the front-runner to succeed Angela Merkel as German chancellor, who said last week that stability policies should be reinstated when the effects of the pandemic on the global economy are over.

While inflation this year is spiking above central-bank goals in Europe and the U.S. as economies emerge from coronavirus lockdowns, monetary officials have insisted that the price growth will prove temporary.

The ECB predicts inflation will fall again next year and continue to miss its target of just below 2% -- despite negative interest rates and massive bond-buying programs that have been in place for years.

The ECB researchers acknowledged that a coordinated fiscal policy is difficult to pursue in the euro area, where public spending is a matter for national governments, and when some of them are already highly indebted.

But they have a suggestion -- a tool that the ECB has long said the euro-area economy needs.

“Preventing self-fulfilling low-inflation traps could be another reason to create a central fiscal capacity in Europe,” they said

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