Editors' note: This column first appeared in the Vox eBook Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes, available to download here.
Faced with a huge increase in the number of COVID-19 cases, by now all EU governments have undertaken strategies of varying degrees to ‘flatten the curve’ – that is, to reduce the rate of growth of the pandemic in order to avoid a collapse of European healthcare systems. This strategy has an unfortunate economic consequence – what was already a sharp supply and demand shock is now a brutal, legally enforced, sudden stop to our highly interconnected economies.
Over the next few months, we face an unprecedented drop in the EU’s GDP. This one may dwarf the 2008 financial crisis.
Can we put the economy in the freezer without damaging it?
We cannot predict how long the virus will last, which sectors and supply chains it will disrupt, or by how much GDP will drop. The risk is that many loans will simply not be repaid, ever. Credit default swaps on European corporates (iTraxxIndex) reached prices on 12 March implying a 38% default probability (Ainger 2020).
At this point standard demand management is useless. Governments do not want to stimulate economic activity – they are doing all they can to stop it [with social distancing policies] ... Instead, economic policy must ensure that the economy survives a ‘freeze’ of 3 to 6 months.
As ECB President Christine Lagarde pointed out in her testimony that same day, this is a problem of state and fiscal capacity, not one of monetary policy. However, at this point standard demand management is useless. Governments do not want to stimulate economic activity —they are doing all they can to stop it (they are asking people to stay at home!). Instead, economic policy is needed to ensure that the economy survives a ‘freeze’ of (hopefully, no more than) three to six months.
For this to be possible, member states and EU institutions must insure all workers, families and SMEs against the bankruptcy risk this stoppage creates. Sadly, what is now on the table fails to accomplish this aim.
In this chapter, I propose a €500 billion package (the “bazooka” in German Minister of Finance Olaf Scholtz’s parlance) to fight the virus, stabilise the European economy, and protect its jobs while the economy is in the ‘freezer’. Then I discuss how to finance this package.
A €500 billion ‘bazooka’ to fight COVID-19, stabilise the economy, and save jobs
The package has three aims:
- First, help member states undertake the healthcare spending they need to defeat this pandemic.
- Second, provide a financial backstop to companies, particularly small and medium-sized enterprises.
- Third, support employment protection schemes throughout member states, so that a minimum of jobs are lost.
To finance the package, I conclude a straight Eurobond is probably not a realistic option, either legally or politically. I discuss three possible alternatives.
- First, the status quo, where member states finance the spending, as now, with the ECB ready to intervene as needed when and if the markets get riled up by the risk of financing the growing debt.
This ‘path of least resistance’ is actually quite risky as it may force the ECB to get too close to the limits of its mandate.
- Second – and the quickest legally and least politically costly – the sovereign bond-backed securities (SBBS) proposal, passed by the European Parliament in March 2019 and only lacking the Council approval, could be approved after very little work by the Council.1
It would allow member states to finance the ‘bazooka’ with less fear of destabilising the markets.
- Third, it could be financed through the ESM, which, to facilitate its usage, should step in using the emergency procedure.
A clear engagement by the European Stability Mechanism (ESM) will allow the ECB to play its role by activating its Outright Monetary Transactions (OMT) programme. I propose the creation of a specific instrument within the ESM, tailored to take into account the present situation – an instrument in which the (necessary) conditionality could be linked to investments in the key priority areas discussed in this piece.
The Commission’s response: Flexibility, not money
The measures announced by the European Commission this week tried to accomplish two objectives: to make full use of the flexibility in EU fiscal and state aid rules, and to mobilise the European budget. The Commission has decided that Europe will not stand in the way of EU member states’ responses, but it has not mobilised new resources to aid those responses.
To ensure that member states act boldly, the Commission has granted them greater freedom to stimulate their economies. First, by relaxing state aid rules if the aid is intended to compensate citizens or companies affected by the coronavirus. Second, by recalling the exceptions in the Stability and Growth Pact (SGP) that allow for increased flexibility in times of need. By broadly interpreting the provision for unusual events beyond government’s control and by triggering the escape clause, the Commission has paved the way for member states to use ample resources to tackle the crisis.
Target existing resources to the coronavirus response
The Commission announced it will mobilise the EU budget through the Coronavirus Response Investment Initiative. First, it has mobilised €1 billion in guarantees from the European Fund for Strategic Investments (EFSI), which would be leveraged by the European Investment Bank (EIB) to provide €8 billion in liquidity to the private sector. Second, the Initiative would mobilise €37 billion to support member states’ healthcare systems, SMEs and workers. Out of the €37 billion, €8 billion will consist of funds that were already allocated to countries to carry out projects but were yet to be completed (and spent). If fully used, these could be complemented by €29 billion in further structural funding (these including national co-financing).
The Commission’s proposal will not be nearly enough. Forgoing enforcement of our common fiscal and state aid rules is not a coordinated action at the EU level. It is just letting member states act as they see fit.
Alas, the Commission’s proposal will not be nearly enough. Forgoing enforcement of our common fiscal and state aid rules is not coordinated action at the EU level. It is just letting member states act as they see fit. As for the money, it will not suffice, and even then, the allocation of spending among member states will be that of structural funds. It will not be based on any factors related to the impact of COVID-19. The Commission’s most common phrase while answering questions during their presentation was: “if we had time, the tools would have looked very different”.
A European bazooka to protect jobs and wages
What Europe has put on the table will not be enough. Consider the “protective shield for employees and companies” that the German government proposed (Scholz and Altmaier 2020). It will bring massive tax cuts, the activation of Germany’s short-term employment protection programme (Kurzarbeit), and €550 billion in loans to the private sector. It is a “bazooka” for the German economy, as Finance Minister Olaf Scholz put it.
A plan with this level of ambition could not be undertaken by many other member states. With elevated debt levels and, in some cases, fast growth in contagion, some countries may fear that were they to propose a plan of this size, they might face funding difficulties in their sovereign debt markets. It is clear then, that a European approach is needed to avoid the financial fragmentation that could, as in 2011, put the survival of the euro and the EU at risk.
A plan with this level of ambition could not be undertaken by many other member states… a European approach is needed to avoid the financial fragmentation that could, as in 2011, put the survival of the Euro and the EU at risk.
A key argument against any common fiscal policy is the risk of moral hazard – a European budget, it is argued, rewards the imprudent. In the current context, however, this argument does not apply. Given the shock is exogenous, it is ludicrous to imagine countries did not act hoping for a collective action.
What would it entail for Europe to achieve its level of ambition? I believe that €500 billion distributed throughout the main priorities that the Commission has outlined:
- Help member states undertake the healthcare spending they need.
A 5% increase in EU-wide healthcare spending would cost around €50 billion. This would secure an EU-wide medical response in areas such as purchasing medical supplies, recruiting medical personnel, and retrofitting different venues to serve as temporary hospitals.
- A financial backstop for companies, particularly SMEs. Such a programme would bring guarantees, credit lines, and working capital loans to ensure SMEs remain liquid and can return back to normal when the economy is ‘unfrozen’.
This would mean a programme with the level of ambition of the German bazooka. Relative to GDP, the German level of ambition would entail a €2.2 trillion programme at the EU level. Assuming the level of leverage the EIB can achieve, this would require around €275 billion in guarantees.
- A European Kurzarbeit programme – a programme to support short-term employment protection facilities throughout member states.
The main objective of these facilities will be to ensure firms have liquidity without having to fire workers. Instead of letting them go, companies would be able to reduce the hours of their workers (by 100% if needed) under these schemes. The state would compensate workers for (a significant part of) the lost wages.
Even though the package would be financed with public funds, if the programme does not run for an extended period of time, it will end up saving money for the taxpayer, as it will maintain the link between workers and firms and avoid the risk of a deep recession.
Given that explicit Kurzarbeit programmes are already in place in 17 EU member states (European Commission 2020b), in the rest it would have to finance other similar employment support programmes. The general condition would be that the link between employee and the job is not cut, so that the contract remains in place.
Such a programme could also be a stepping-stone towards establishing the European Unemployment Reinsurance, once it is adopted. For this mutualised package, and assuming EU governments would fund half of the cost of an 8% reduction in working hours of EU workers for three months, we estimate that the cost of this leg would hover around €175 billion.
How to pay for the bazooka
The three-pronged package would constitute a genuine coordinated fiscal response at the EU level, but it is clear member states would have to raise substantial amounts of debt to finance it. With automatic stabilisers depleting national budgets and member states making use of the flexibility provided for in the SGP, concerns about the sustainability of sovereign debt loom large.
After the plunge in the stock markets this past week, a market reaction to increased stress on public finances is likely, so innovative European funding mechanisms are needed. At the same time, the difficulty is that, given the need for a prompt action, we cannot take the time to develop legislative proposals and ideas from scratch. We must work from what is already on the table. Against this backdrop, I see three ways forward:
- Have the ECB step in
- Create a European Safe Asset, or
- Integrate the ESM into the EU’s legal framework.
Expand the role of the ECB to step in
Some have argued that member states should borrow as much as they need and that, in the event of any market reaction, bold action from the ECB would calm the markets. For them, the ECB would expand its sovereign bond purchasing programme and target its purchases to those countries most affected by the coronavirus. However, it is no surprise that the recently announced purchases will be targeted to the corporate debt market. The ECB’s headroom for an expansion of sovereign bond purchases is unclear, and would face substantial legal and political challenges.
After the plunge in the stock markets this past week, a market reaction to increased stress on public finances is likely, so innovative European funding mechanisms are needed.
The ECB faces two self-imposed limits: its 33% position limit, whereby it cannot purchase more than a third of any given issuance; and its capital key guidance, whereby it must attempt to purchase sovereign bonds along the shares of its own capital contribution key. The position limit was raised from 25% during the last crisis, but further increases would present serious legal challenges. If the ECB held, for example, 40% of Italy’s debt and Italy were to default, the ECB would be placed in a position where it would have to vote in favour of or against the restructuring. This would expose the ECB to legal challenge, since the measure could be interpreted as being contrary to Article 123 TFEU and against its obligation of abstaining from monetary financing of member states. Some have pointed to potential legal loopholes around this (Canepa 2019), but the legal challenges would be unavoidable.
Alternatively, one could argue there is no need to increase the limit; the ECB today only holds about 22% of the total sovereign debt (Becker 2019), and it could simply reach the limit for all sovereigns. However, given that countries have widely differing debt-to-GDP ratios, reaching 33% on all sovereigns would entail a permanent deviation from the capital key —the ratio of sovereign purchases to capital contribution would be twice as high for Italy as that for Germany (Carrión Alvarez 2020). Given deviations from the capital have been a major point of contention for northern member states, the political challenges might be insurmountable.
Sovereign bond-backed securities
The establishment of sovereign bond-backed securities (SBBSs), a new category of bonds, would enable member states to increase their debt levels without causing market instability. SBBSs are a new kind of safe asset, issued by the private sector and backed by a diversified portfolio of euro area government debt. Because pooling and diversification are only done at the private-sector level, SBBSs bring no additional fiscal costs and don’t involve any kind of subsidies or mutualisation of risks. Crucially, due to the tranching involved in the issuance, SSBSs would be considered safe assets, and their prevalence in the market would bring the stability needed for additional public debt issuances to be feasible.
The establishment of sovereign bond-backed securities, a new category of bonds, would enable member states to increase their debt levels without causing market instability. SBBSs are new kind of safe asset, issued by the private sector and backed by a diversified portfolio of euro area government debt.
Initially proposed by a group of economists that I was a part of (Brunnermeier et al. 2011), it has been thoroughly studied and endorsed by the ECB and the European Systemic Risk Board (Cœuré 2016, ESRB 2018). Essentially, the regulation simply eliminates a few existing prudential obstacles that as of now prevent the market-led development of SBBS.
The key for our purposes is that today there is already a proposal on the table, approved by the European Parliament in 2019. It is just waiting in the Council’s drawers. SBBSs are a low-hanging fruit that could be implemented fast and effectively, and that would help calm market concerns immediately.
Creating a European Monetary Fund
The euro was built on two complementary but unequal pillars: a single monetary policy, conducted by the ECB; and decentralised fiscal policies, left in the hands of the member states (albeit constrained by common rules limiting their action). This asymmetric architecture had shortcomings, as proven by the sovereign debt crisis, contributing to building uncertainty about the permanence of the single currency and giving way to redenomination risk. To tackle this, a fiscal lender of last resort was put in place in 2012 – the European Stability Mechanism (ESM). Its purpose, as stated in Article 3 of its Treaty, is to “provide stability support (…) if indispensable to safeguard the financial stability of the euro area”.
Yet, with the coronavirus causing havoc, pressure could once again become unbearable for member states, leading the ESM to step in. By involving the ESM, member states would be granted access to €500 billion under the best possible financing conditions. This would be done in full compliance with the European Court of Justice’s case law as set in Pringle, as they would still be liable to repay the loans.2 A key drawback, however, is the lengthy approval process that ESM programmes need to undergo since they require the participation of national parliaments. Moreover, if COVID-19 causes more cases of quarantine/confinement for MPs, national parliaments may not be able to take decisions. To speed up the process, it would be desirable to trigger the emergency procedure already in place under the ESM Treaty, which allows for decisions to be taken by a qualified majority of 85% of the votes cast.
The ESM’s underlying logic derived from a context in which considerations regarding budgetary discipline and moral hazard were the norm (De Gregorio 2012). This, however, cannot be extrapolated to the present situation. That is why it is necessary to adapt its design and make it fit for purpose. The Commission’s 2017 proposal to integrate it into the EU legal order, by establishing a European Monetary Fund, could very well be the perfect occasion in which to make the necessary changes. Based on Article 352 TFEU and without requiring Treaty change, the creation of a European Monetary Fund should be swiftly approved in the European Parliament and Council.
This endeavour would allow for an ambitious European response. To do so, a new instrument, tailored to take into account the present situation, should be added to the ESM’s toolbox. Its required conditionality – legally essential to comply with the no-bailout clause in Article 125 TFEU (De Witte and Beukers 2013) – could be linked to investments in the key areas outlined above: healthcare systems, short-time employment schemes, and liquidity and other support for SMEs. Additionally, the ECB could also get involved through its announced but never implemented Outright Monetary Transactions (OMT) programme if the situation continued to deteriorate. The ESM programme would provide, following the Gauweiler ruling, the legal cover the ECB needs to be able to serve as its de facto backstop. By activating the OMT programme, the ECB would thus purchase unlimited amounts of member states’ government bonds, putting an end to the excessive risk premia asked in the markets and thus preserving “the singleness of monetary policy”.
To prevent the European economy from stalling, we must strive to preserve the links upon which it is based. The disruptive impact of the fight against COVID-19 on jobs, debts and loans, as well as on supply chains, puts at risk the entire economic fabric of European economies. If we do not act as the situation requires, we may find that when we want to go back to normal after the virus has passed, we will find it impossible to do so.
The situation is particularly risky for euro area countries, which could face renewed flight to safety and doubts about the sustainability of the commitment to the euro in the face of a massive growth in debt levels (redenomination risk). We must assuage market doubts about our determination to protect the euro and European economies. The funding plans proposed here are based on legislative proposals that already exist but have not yet been developed. It is now time to finish implementing them.
Ainger, J (2020), “Investors on War Footing for Europe Crisis After Crash”, BloombergQuint, 13 March.
Becker, S (2019), “European Central Bank: Updated Capital Key “Forces“ The ECB To Reduce Holdings Of Italian, Spanish And French Bonds”, Deutsche Bank Research, 3 April.
Brunnermeier, M K, L Garicano, P Lane, M Pagano, R Reis, T Santos, D Thesmar, S Van Nieuwerburgh, D Vayanos (2011), “European Safe Bonds (ESBies)”, The Euronomics Group.
Canepa, F (2019), “Loophole May Clear ECB’s Way To Buying More State Debt - Sources”, Reuters, 26 June.
Carrión Alvarez, M (2020), “The Limits Of QE II”, Funcas Europe.
Cœuré, B (2016), “Sovereign debt in the euro area: too safe or too risky?”, Keynote address.
De Gregorio, A (2012), “Legal developments in the economic and monetary union during the debt crisis: the mechanisms of financial assistance”, Common Law Review 49.
De Witte, B and T Beukers (2013), “The Court of Justice approves the creation of the European Stability Mechanism outside the EU legal order: Pringle”, Common Market Law Review 50.
ESRB – European Systemic Risk Board High-Level Task Force on Safe Assets (2018), “Sovereign Bond-Backed Securities: A Feasibility Study”, European Systemic Risk Board, January.
European Commission (2020a), “Report on the proposal for a regulation of the European Parliament and of the Council on sovereign bond-backed securities,“, COM(2018)0339 – C8‑0206/2018 – 2018/0171(COD).
European Commission (2020b), “Communication on the Coordinated economic response to the COVID-19 Outbreak”, COM(2020) 112, 13 March, p. 7.
Scholz, O and P Altmaier (2020), “A protective shield for employees and companies”, BMBF and BMWi joint paper, 13 March.
1 For details of the SBBS proposal, see European Commission (2020a).
2 See http://curia.europa.eu/juris/document/document.jsf?docid=130381&doclang=en