The credibility of monetary policy and the fiscal response to the pandemic in the Eurozone

The novel nature of the economic and social crisis, due to the spread of COVID-19, requires new rules and a drastic change in the economic measures to be adopted. The pandemic has caused a spiral of supply-demand shocks that brings about several market failures that make necessary a public intervention to assure the return to health security in the first place and then to restore economic growth and reduce unemployment. Fiscal policy has to intervene both to cover health expenses and sustain families’ income and firms’ fixed costs, and to create the basis for a future recovery through investment. In order to guarantee the temporary stability of the resulting higher public debt, expansionary monetary policies have been implemented even in a non-conventional way. In the euro area, among other measures, a pandemic emergency purchase programme (PEPP) has been adopted, through which the European Central Bank (ECB) has been buying temporarily existing public debt on the secondary market. We ask whether the ECB should go even further monetising permanently on the primary markets the public debt of euro area countries or relieving a fraction of the debt that they are currently holding. An alternative possibility would be the issuance of perpetual bonds to be bought by the central bank. Needless to say, such measures are rather controversial, not only considering their political feasibility, but also for the feared effects on the central bank’s anti-inflationary credibility and on moral hazard. We argue that a sufficiently strong political will might help overcoming the objection regarding feasibility. Central bank’s anti-inflationary credibility may not necessarily be a concern: according to the credibility theory, in the case of unexpected shocks, no credibility can be gained by following policies that are not credible themselves. On the other hand, moral hazard cannot be an issue when a given measure is fully justified by the occurrence of extraordinary circumstances. Finally, we show that when the economy is hit by a stochastic shock, a moderate inflation might well be optimal, as it would allow a reduction of the unemployment rate, which is the second component in the government’s loss function.