Continued coordination of monetary and fiscal policies is essential for the European economy to recover from COVID-19

Total outstanding debt securities have increased by €1.35 trillion in the eurozone this year (as of end-Q3), equivalent to 17% of GDP, to combat COVID crisis. The vast majority of this increase has been general government debt, as European governments deployed a fiscal weaponry to keep human and workable capital afloat during lockdowns.

This increase in marketable debt is large and similar to that observed at the time of the global financial crisis, when it rose 24% of GDP in one year. But, unlike back then, it has not led to any significant change in yields and spreads of government bonds.

Why not? The difference this time is that the rise in debt securities has been accompanied by a similar and instantaneous increase in the European Central Bank's (ECB) balance sheet. This had increased by 14% of GDP this year (as of end-Q3). The amount of government debt securities not held by the ECB--i.e., the debt in "free float"--is still lower than in 2015.

This coordination of fiscal and monetary policies will continue to be essential to ensure the European economy recovers from the COVID-19 crisis. To make this happen, the EU budget rules have been suspended until the end of next year. They may be extended even longer. At its monetary policy council this Thursday, we expect the ECB will stretch duration of its extended support by six months at least, to end-2021.

A policy mistake at this delicate stage could trigger a market reaction and jeopardize financial stability, which is a prerequisite for the recovery. There are two possible sources of policy mistake: premature fiscal austerity or premature tightening of monetary policy. Premature fiscal austerity could occur, for example, if the EU asks the member states to reduce their debt-to-GDP ratios at a pace that jeopardizes the economic recovery. Premature tightening of monetary policy--a contraction of the central bank's balance sheet--could occur if we face a lasting inflationary shock. Both possibilities do not seem very likely in the current context, yet not totally impossible.