The virus and the euro

The coronavirus pandemic is a lethal stress test for more than health services, ruthlessly exposing economic vulnerabilities as well. No surprise then that in Europe, now the epicentre of the global epidemic, the still fragile currency union at its core has been under renewed pressure. But is Europe ready to do “whatever it takes” again to ensure that the euro survives its latest ordeal?

A striking feature of the pandemic is that the two countries worst affected are currently Italy and Spain, which lead a grisly global league table for the death toll, exceeding even the number in China. The Johns Hopkins University coronavirus website showed today* 8,215 deaths in Italy and 4,858 in Spain, together making up just over half the total worldwide. That contrasted with 304 in Germany, the most populous country in Europe.

The health divide between southern and northern Europe now overlays the economic rift that opened up ten years ago in the euro crisis. The accompanying new economic shock is especially unbearable in Italy and Spain because they had such a tough time then (and before that in the financial crisis of 2008). Italy’s plight is acute because unlike Spain its subsequent recovery has been sluggish, leaving its economy in 2019 still 4 per cent smaller than in 2007. Spain’s GDP was 6.5 per cent up on its pre-crisis peak (in 2008), but that was still much less than Germany’s 14.5 per cent growth over the same period.

The new economic crisis unleashed by the pandemic has called into question again whether European leaders, led by Angela Merkel because of Germany’s economic and fiscal clout, went far enough in tackling the euro crisis. This was eventually resolved through three main reforms. First, the northern members reluctantly agreed to bail out four beleaguered economies in southern Europe (and Ireland as well) whose governments could no longer finance themselves in the markets. They formalised that support, which came with stern conditions for the borrowing countries to put their economic and fiscal houses in order, by setting up a permanent rescue fund, the European Stability Mechanism (ESM).

Second, in order to break the “doom loop” between rickety banks and shaky states in vulnerable economies, the eurozone embarked upon a banking union (still incomplete). The European Central Bank (ECB) was put in charge of supervising banks in the 19-strong euro area and new arrangements were set up to deal with failing banks that pose wider risks to financial stability.

Third, the ECB reinvented itself under the leadership of Mario Draghi, who took over the helm in November 2011. It was Draghi’s celebrated pledge in July 2012 to preserve the euro that ended the acute phase of the euro crisis. Draghi then got the ECB to adopt quantitative easing—creating money to buy bonds—a policy that had previously been regarded as beyond its remit. By the time he stepped down late last year, the ECB had purchased €2.6 trillion of assets since embarking on QE in 2015.

The reforms were far-reaching but they lacked one crucial element. There was no move to buttress the monetary union with a fiscal union. For Germany, that was a step too far. Merkel ruled out the mutualisation of debt across the members of the euro area through devices such as jointly issued “eurobonds,” which would in effect put German taxpayers on the line for debts incurred elsewhere.

Fiscal efforts were indeed necessary, argued the northern creditor countries. However, they should be undertaken at national level and the aim was to reduce deficits and debt. Germany showed it meant business as its budget balance moved into surplus. Having risen to a high of 82 per cent of GDP in 2010 after the financial crisis, German government debt last autumn was only just above the 60 per cent limit set in the 1992 Maastricht treaty which paved the way to monetary union.

Europe’s response to the coronavirus pandemic has followed this template. Once again the moving force at the eurozone level is the ECB, now headed by Christine Lagarde who replaced Draghi last November. After an initial misstep when she appeared earlier this month to call into question the central bank’s role in restraining the gap between bond yields in Italy and Germany (where they are lowest), the ECB has acted decisively with its “pandemic emergency purchase programme,” under which it will buy an additional €750bn of assets by the end of this year, taking its total purchases over the next nine months to just over €1 trillion.

By contrast, budgetary help has essentially been at national level, facilitated by a suspension of Europe’s fiscal rules. On Monday Germany announced a supplementary budget for this year in which it would borrow €156bn (4.5 per cent of GDP), together with massive support to prop up stricken businesses through guarantees. German politicians and officials say that the government can act now because it prioritised sound public finances after the crisis.

But is this enough? Since the coronavirus outbreak intensified, the Treasury and the Bank of England have been co-ordinating Britain’s fiscal and monetary response. Rishi Sunak’s budget on 11^th March with what turned out to be his first instalment of emergency help was preceded for example by an early-morning dose of monetary medicine. Just days before Mark Carney stepped down as governor, the Bank announced a half-point cut in interest rates together with measures to support bank lending. By contrast, the ECB lacks a similar fiscal counterpart to undertake a similar joined-up response.

That should change, argued nine eurozone leaders, including France’s Emmanuel Macron, Italy’s Giuseppe Conte and Spain’s Pedro Sánchez, on the eve of Thursday’s EU summit (held by teleconference). In a letter to Charles Michel, the President of the European Council, they said that the ECB’s measures should “be accompanied by equally bold decisions on fiscal policy.”

Specifically, they urged “a common debt instrument issued by a European institution to raise funds on the market on the same basis and to the benefits of all member states.” This suggestion for “coronabonds” was provocative because it is essentially a new version of the eurobonds that Merkel adamantly refused to contemplate during the crisis, a rejection that formed part of her election manifesto in 2013. The notion remains anathema in Berlin. In a recent interview with newspaper Handelsblatt, Economy Minister Peter Altmaier, a close ally of Merkel, was scathing about “supposedly new brilliant concepts” being presented which are “resuscitations of long discarded ideas.”

The attempt to push through coronabonds got nowhere at the summit. The trouble is that the proposal favoured by Merkel—a credit line from the ESM—is likewise anathema in southern Europe because of the fund’s association with harsh conditionality during the euro crisis. Whatever fudge finance ministers now suggest, it will be a far cry from the burden-sharing envisaged through coronabonds.

Even so, the pandemic will force a rethink of the eurozone’s ever more baroque fiscal rules. Even before the latest deluge of borrowing Italian debt was 137 per cent of GDP (its lowest in the two decades of monetary union was 104 per cent in 2007). A new set of simpler and more transparent rules is needed to take account of such realities as well as the new normal of very low interest rates.

* Accessed at 16.15 on 27th March