The coronavirus has exposed the European Union’s (EU’s) fault lines. For now, European Central Bank (ECB) bond purchases should hold things together. But ultimately, national governments will need to take some tough decisions to secure the EU’s future.
The EU’s internal inconsistencies are often masked when the economic and political backdrop is benign, only to be exposed again as the outlook darkens. The last major example of this was the sovereign-debt crisis almost a decade ago. Now, as we enter a new decade, the coronavirus (officially COVID19) has prompted another potential existential crisis.
Impressive Response Masks Fundamental Issues
The speed and magnitude of Europe’s COVID-19 response have been impressive. Outright fiscal stimulus has reached 3% of euro-area GDP (and rising), while an additional 16% of GDP has been pledged in the form of loan guarantees and tax deferrals. And these measures come on top of existing safety nets, or automatic stabilizers, which are extensive in most European countries—even before the crisis, Germany and Italy had schemes to subsidize the incomes of furloughed workers.
This support is being provided by national governments. But it is being underpinned at the collective level by a suspension of the euro area’s fiscal rules and by a €540 billion (4.5% of GDP) package of liquidity support. The latter includes a facility for governments to borrow up to 2% of their national output from the European Stability Mechanism (ESM) with very light conditionality (i.e., the money must be spent directly or indirectly on healthcare). And the ECB has underwritten all of this, promising to boost its asset purchases by at least €870 billion (7% of GDP) and, if necessary, to deploy these purchases more flexibly to support weaker euro-area sovereigns.
Despite these efforts, the COVID-19 outbreak has exposed deep flaws in the euro area’s political and institutional architecture. Politically, it has reminded us that European solidarity often runs only skin-deep. Institutionally, it has highlighted the absence of a centralized fiscal authority with revenue-raising powers that would allow it to address common shocks and the fact that individual euro-area countries don’t have lenders of last resort (despite the ECB’s valiant attempts to paper over these cracks).
In short, Europe’s monetary union is still missing vital elements of a political and/or fiscal union. This means the region will always suffer extreme stress when the global economy runs into difficulty and funding conditions start to deteriorate. And whatever the rights and wrongs of each country’s past behavior, that stress will always be felt disproportionately by debtor nations (where, of course, populist pressures are already rising).
Can the EU Sustain Positive Momentum?
Efforts to address these deficiencies and orchestrate a common response to COVID-19 have so far been disappointing. Last week, European leaders rubber-stamped the liquidity support measures already agreed on by finance ministers. They also agreed that a substantial recovery fund is urgently needed in order to rebuild national economies once the public-health crisis has passed. But there was no accord on the key question of how financial assistance would be provided—would it be in the form of loans (which would further encumber national balance sheets) or grants (which would not)? A decade on from the sovereign-debt crisis, the euro area remains deeply divided on this key issue.
Given the controversial nature of this debate, it is likely to take time for European leaders to agree on the modalities of a recovery fund. Whatever the outcome, though, it is highly unlikely that northern Europe’s creditor nations will agree to mutualize debt on the scale needed to refinance the postcrisis reconstruction of southern Europe. This doesn’t mean there won’t be some commonly financed assistance. Just that the bulk of the heavy lifting will remain with national governments—facilitated, of course, by ECB bond purchases.
Ultimately, there are limits on the extent to which the ECB can continue to step where governments fear to tread. But those limits are unlikely to be reached soon. And until they are, the ECB will continue to exert a powerful influence over the solvency of heavily indebted euro-area countries, like Italy.
Creditor and Debtor Governments Must Find Common Ground
Before the coronavirus outbreak, Italy had the second-highest government-debt ratio in Europe (135% of GDP) and extremely poor long-term growth prospects. With the economy set to contract by about 10% this year and the budget deficit likely to balloon higher, Italian government debt will probably rise to something like 160% of GDP. This would be higher than the Greek government’s debt in 2009. Not surprisingly, the Italian government is concerned that any attempt to fiscally reflate its economy next year would undermine its solvency even further (of course, Italy would already be insolvent were it not for support from the ECB).
Creditor nations are, of course, wary of any steps that might eventually lead to large-scale debt mutualization. But they’re not unsympathetic to the plight of countries like Italy. And they also realize that a lack of solidarity, particularly at a time when all euro-area countries face an unprecedented external shock, could be deeply damaging (perhaps fatal) to debtor nations’ perceptions of the EU.
The biggest casualty of the latest wrangle between debtor and creditor euro-area governments has been Italian bond yields, which have risen sharply in recent weeks. This has already led the Italian government to soften its opposition to ESM borrowing. Although the ESM is too small to be a game changer, it is symbolically important because it could (in theory at least) open the door for unconstrained bond purchases via the ECB’s open market transactions (OMT) program.
This emphasizes a key point. Unless or until Europe takes a decisive step towards fiscal union, the burden of holding the euro area together will continue to rest firmly on the shoulders of the ECB—which continues to stretch its mandate to absolute breaking point.
Just over a month ago, the ECB delivered its latest version of “whatever it takes”, promising to “explore all options and all contingencies to support the economy” and adding that it “will not tolerate any risks to the smooth transmission of its monetary policy in all jurisdictions of the euro area.” For the time being, this should be sufficient to keep a lid on Italian bond yields. But we doubt this is sustainable over the longer term. Ultimately, the decisions the ECB is pre-empting need to be taken by democratically elected governments.
Darren Williams is Director—Global Economic Research at AllianceBernstein.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.