Leonardo Badea (BNR): The policy mix in response to current economic challenges

Globally, we are gradually evolving in the direction of living with this virus that has led to important changes in our existence. A significant impact of the pandemic was felt in the quality of people’s lives, but the sector where the most intense pressure was registered was the health system. Therefore, looking back, the actions of the authorities can be considered as channeled in two main directions: on the one hand to counteract the occurrence of infections and limit the spread of the virus, and on the other hand to improve the negative economic effects on people and companies. Unfortunately, the first category of measures has led to global supply shocks, especially in production, and blockages and other containment measures have caused widespread disruption to business. The pandemic has led to an economic and financial crisis that is likely to have long-term structural repercussions and has exposed the fragility of global society.

By Leonardo Badea, Deputy Governor of the National Bank of Romania

Statistically, the world economy has recovered strongly in early 2021 from the low levels caused by the evolution of the first waves of the pandemic, but towards the end of the period it slowed down due to new variants and new outbreaks, blockages in the supply chain, the shortage of labour, and the leaps and bounds of the vaccination process. It is natural that when there is a threat to personal health and safety, such as the COVID 19 pandemic, there is a reaction from society, because people adapt their habits and behavior and redefine their lifestyle. Some notions and values widely embraced in the past have undergone changes in times of crisis. This leads to deep debates and concerns within society about the way forward and the values to be respected. In such situations, the crystallization of new approaches and usages is not an easy and linear process but is marked by intense searches, syncopes, false tracks, stage failures, but the safety and health of others must be placed at the forefront.

The combined impact of the pandemic and the measures taken to control its development, as well as to limit the negative effects on the population and the economy, has led to changes in both the demand and the supply of goods and services. Moreover, these effects have been different over time. Thus, during the period of mobility restrictions, demand was lower, and people who were able to maintain their income (also as a result of government support measures) saved more. Later on, during the easing periods of last year’s restrictions, the additional savings previously generated fuelled a significant increase in demand. At the same time, however, the same restrictions have led to significant delays and malfunctions in the distribution chains as well as to lower capacity operation of the production facilities. The production costs of many goods and services have also increased due to the additional costs that manufacturers and providers have incurred in connection with social distance and health prevention measures. Subsequently, costs were significantly amplified by the shock of fuel and energy prices. As in the case of demand, the effects on the supply side have evolved differently over time and have had a low degree of predictability.

The elements outlined above now lead to a harmful combination for the economy and the society that we have not been seriously confronted with since the 1970s: risks of slowing the economic growth (especially due to alternating pandemic waves, high unpredictability, and depletion of additional demand, caused by increased savings during severe mobility restrictions) combined with a high level of inflation (largely generated by factors outside the influence of monetary policy).

Because we are in a situation where both demand and supply are affected, the way out of the complex crisis we are going through requires the coordination of all public policies. As we know, monetary policy acts on short-term demand and does not influence supply. Fiscal policy affects aggregate demand through changes in government spending and taxation. These factors influence employment and household income, which in turn affect consumer spending and investment. At the same time, the level of taxation can influence the desire to work, and government spending on health, education, and training could boost long-term labor productivity, thus having an impact on the supply side as well. However, the most relevant for stimulating supply are the much-talked-about structural reforms, which in turn are confined to the mix of economic policies.

Taken separately, neither monetary easing nor fiscal support would have been enough to cushion the shock when the COVID-19 crisis hit, and the very rapid unfolding of events made it impossible to use structural policies at the microeconomic level. Thus, the monetary and fiscal authorities had to join forces to provide the necessary macroeconomic support, blurring the traditional boundaries between monetary and fiscal interventions. The macro-prudential policy has also played an important role. Now that the economic challenges have changed, the policy mix is still extremely necessary and, in addition, must include the structural side in order to better offset the negative developments on the supply side.

When it comes to monetary policy, the context called for an immediate and decisive response to the outbreak of the pandemic crisis, and subsequently justified the continued adjustment of its conduct in a prudent manner. Monetary policy measures have been instrumental in easing the financial tensions caused by the pandemic shock and have allowed the money market and other segments of the financial market to function smoothly in order to finance the real economy and budget expenditures on good terms.

Looking ahead, monetary policy will continue to pursue medium-term price stability in line with the stationary inflation target, in a way that supports the recovery of the economy in the context of the fiscal consolidation process and in a way that protects financial stability.

The implications of the dosage of measures are significant for the success of coordinated monetary and fiscal policy action, in the sense of maintaining macro-financial stability (implicitly of prices and inflation control) without significantly affecting the visibly declining economic growth. And from this perspective, decision-makers are obliged to a very delicate “balancing act”. Let us remember that no more than a year ago there were still many opinions of well-known economists who said that the state should take advantage of the low level of interest rates at that time, which was then expected to maintain this level for a considerable amount of time, to borrow and use resources to stimulate growth. Public debt has risen sharply around the world since then, and rising inflation is putting upward pressure on interest rates and exacerbating the burden of public debt, limiting fiscal policy space and risking indirectly discouraging economic growth. In such a context, the broader the monetary policy acts to combat inflation, the more convincing the fiscal consolidation needs to be for investors, so as to offer them the prospect of an increasingly costly public debt curving and the maintenance of a sustainable level as a share of GDP. This would, in fact, make both policies act on a large scale to discourage demand, jeopardizing the much-needed growth in the equation of economic recovery, improving macroeconomic balances and structural problems, and so on.

From the point of view of fiscal policy, until the outbreak of the pandemic crisis, the issues that were debated were mainly pro-cyclical measures, the increase of the current account deficit, and the evolution of the external debt. Subsequently, the emphasis was on the need to implement economic recovery measures, simultaneously with those of fiscal consolidation.

As it is known, fiscal consolidation is a very important component for ensuring the sustainability of public finances and, implicitly, macroeconomic stability, but also one of the major challenges in the current context, marked by the need to identify a balance between the real and pressing need for fiscal adjustment and the imperative to continue to support economic recovery.

Very important from this perspective is the continuation of the path of gradual adjustment of the budget deficit towards the target set by European regulations, which is very difficult to achieve, namely reaching a level below the 3% of GDP limit by the end of 2024, which will allow recovering from the excessive deficit procedure, without prejudice to the prospects for economic recovery in the current pandemic context.

Gaining significant room for maneuver in fiscal policy by reducing the budget deficit from this year onwards appears to be a natural choice, even as the implementation of the general derogation clause in the Stability and Growth Pact continues in 2022, and is expected to be disabled from 2023.

While supporting the economy and the health care system continues to be a priority in the current specific circumstances, the paradigm of fiscal policy needs to be reconsidered as the impact of the pandemic diminishes, in the sense of reorienting it from urgent and exceptional measures to address the challenges posed by the health crisis towards structural reforms oriented objectives, which would contribute to the transformation of the Romanian economy into a resilient and robust economy, favorable to inclusion.

European funds are sources of financing that relieve the national budget, so the absorption of European funds is a basic element for ensuring fiscal and budgetary sustainability, for the development of the Romanian economy and society. As I have said before, European funds should be directed primarily at investments that promote economic development, such as those that support digitization or the green transition, structural reforms, including in public finance, to make spending more efficient and improve public resources management.

Fiscal consolidation and budgetary sustainability efforts to ensure sound public finances must also be supported by other fiscal-budgetary and economic reforms aimed at ensuring Romania’s real convergence with developed economies in the European Union, especially in areas such as tax administration, governance of state-owned companies, the public pensions system or the salary system of state-employed staff.

Fiscal consolidation requires fine-tuning of all categories of budget revenues and expenditures, but it is essentially the result of efforts to significantly reduce the dynamics of spending in relation to revenue growth. Among other things, pragmatism and objectivity are needed from the construction stage of the budget and its subsequent corrections, so that the assumptions regarding the evolution of the economy and the capacity of the authorizing officers to use the allocated funds are as realistic as possible.

We will probably have a real economic growth of at least 3-4 percent this year, which offers favorable conditions for fiscal consolidation because it lays the ground for increasing revenues even in the absence of tax increases if we take into account issues such as: reducing tax evasion, increasing the tax base, improving tax compliance and improving the efficiency of revenue collection in the state budget.

In such a perspective of economic growth, consolidation does not necessarily mean a reduction in public spending, as its qualitative efficiency can be considered, a context in which room for maneuver could be identified even for a reasonable and justified increase in spending, provided that their dynamics are considerably lower than those related to revenues, and the emphasis is on amplifying the multiplication factor in the economy.

A number of directions for further fiscal consolidation, contributing to the recovery and development of the economy on a sustainable basis, could include:

increase the collection of tax revenues, by: reducing tax evasion; digitization of business processes and provision of quality electronic services, in order to improve fiscal compliance and increase the efficiency of collection; reduction of administrative burdens and simplification of tax obligations; improved efficiency in tax collection and reducing the fiscal gap;
streamlining and making public spending more transparent, by: eliminating budget waste; allocation of resources according to result indicators; reorientation of public investment expenditures by moving from investments financed from national sources to investments financed by European funds; strengthening the corporate governance of state-owned companies; resource orientation towards investments in infrastructure, agriculture, rural development, energy system, advanced technology, green and digital transition;
improving the predictability of fiscal policies, an important objective for supporting the business environment in the very difficult economic context, both internally and externally.

Also in terms of fiscal policy, from the perspective of government debt, after in the period 2020-2021 its share in GDP increased considerably amid the adverse effects associated with the health crisis, reaching values close to 50% (increasing by more than 10 percentage points compared with the period 2016-2019), in order to maintain this indicator at a sustainable level, it is necessary to attenuate its dynamics, by improving the tools of public debt management, but also to ensure that the additional debt must correspond to structural changes in the economy, in order to allow in the future the payment of debts without sacrifices for the next generations.

In the context of those mentioned, along with the fiscal consolidation, structural reforms are particularly important from the perspective of the conduct and implementation of monetary policy. The level of absorption of European funds allocated to Romania is also essential, given that a coherent mix of macroeconomic policies that increase the growth potential of the economy and strengthen resilience to adverse developments is essential for the continued recovery of the economy on a sustainable basis.

As health risks are reduced, economic policy measures should move from an emergency regime to targets aimed at a sustainable and inclusive recovery.

Prioritization of European funding must be channeled towards investments that stimulate economic growth, especially those that support the green and digital transition, structural fiscal-budgetary reforms, including the quality of public finance resources management and the efficiency and transparency of public spending. In order to ensure sustainable economic development, the structure of budgetary expenditure, in particular public investment, needs to be optimized by making a gradual transition from investments financed from national sources to investments financed by European funds.

For example, the amount related to the implementation of the Recovery and Resilience Plan is 29.18 billion Eur, consisting of non-reimbursable financial support amounting to approx. 14.24 billion Eur and loans worth approx. 14.94 billion Eur. The pre-financing part represents the equivalent of 13% of the total amount allocated to Romania, respectively approx. 3.79 billion Eur, amounting to 1.85 billion Eur related to the part of grants and 1.94 billion Eur, related to the part of loans. The sectors that will benefit from the most important financial support through the Recovery and Resilience Plan are transports (7.62 billion Eur), education (3.60 billion Eur), the private sector, research, development, and innovation (2.55 billion Eur), and health (2.45 billion Eur).

The investments and reforms contained in the Recovery and Resilience Plan support the green and digital transition, contribute to the effective solution of the challenges identified in the European Semester and strengthen the growth potential, job creation, and the economic and social resilience of Romania. At the same time, the plan addresses a significant part of the older structural challenges that remained unresolved, as identified in the specific relevant recommendations addressed to Romania by the Council in 2019 and 2020.

To facilitate the green transition, the Recovery and Resilience Plan allocates 57% of the total measures to support environmental objectives (for example, for the modernization of the railway system 3.9 billion Eur, for urban mobility 1.8 billion Eur, for green energy production 0.85 billion Eur, for energy efficiency of buildings 2.7 billion Eur, for environmental and biodiversity protection 1.1 billion Eur). In order to ensure the digital transition, the Recovery and Resilience Plan allocates 21% of the total to measures to support this process, such as the digitization of public administration (1.5 billion Eur), the health system (0.47 billion Eur), and the education system (0.88 billion Eur).

These objectives are supported by policies at European level, including in the short term. Thus, one of the three major directions of the French Presidency of the Council of the European Union is a new European model of growth – in the economic and social field, the steps related to this direction taking into account mainly the objectives of climate change, digital transition and the stimulation of innovation, which are directly related to growth and the ability to create quality and better paid jobs.

Although the ideas presented above are not necessarily new, their implementation is not an easy path at all. In reality, this “balancing act” is a continuous process, which we have to go through step by step, always adjusting along the way because the level of unpredictability of economic developments remains high. Moreover, certain solutions in the area of fiscal policy and structural reforms require consistent and lasting political support in order to be implemented. In an article published in November last year, Claudio Borio (Bank for International Settlements) and his co-author argued that monetary and fiscal policies, as related state functions, face a double, long-term challenge. On the one hand, they need to regain room for maneuver in order to effectively fulfill their role of macro stabilization, and on the other hand, once these safety margins are restored, policies must remain firmly in a “corridor of stability”.

The balance of economic choice must be accompanied by the future consistency of public policies, without which today’s choice will not bear fruit tomorrow, as is desirable. An old Chinese proverb says that “coming events cast their shadows before” and perhaps that is why, looking to the future, it will be easier for us to make the decisions today.

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