In response to the pandemic, several proposals have been advanced to mobilise large amounts at the European level, mostly to address the needs of periphery countries. The negotiations have proved extremely contentious and, with respect to the demands of periphery countries, the inevitable outcome will be general disappointment and recriminations.
In this column I will argue that this is the unavoidable result of the lack of realism of these proposals, which do not take into account the preoccupations of core countries. But first I advance a more realistic, if also more prosaic, proposal, based on the notion that periphery countries are much better equipped to make it on their own than is commonly perceived, with a little help from the ECB. I will take the case of Italy for illustrative purposes, starting with two premises:
- First, Europe would not stand in the way of a large increase in the budget deficit of Italy. The Stability and Growth Pact has been de facto suspended, and nobody in Europe has objected to the measures already taken, or about to be taken, by the Italian government amounting to around €70 billion (3.5% of GDP) in just two months, plus about €600 billion in guarantees. And more spending will come, without objections from Europe.
- Second, Italy is not constrained in its access to the market and its borrowing costs, while higher than in other European countries, are still manageable at all maturities.
Thus, the problem for Italy is not to save a few billions for a few years by borrowing through a supranational debt rather than on the market. Borrowing via Eurobonds or the ESM, regardless of how it would be treated by Eurostat (i.e. as official debt or not), is debt and will be treated as such by the market. Thus, Italy’s problem is whether, having borrowed a lot now, it might face a sovereign debt crisis down the road. If such a crisis occurs, it will be worse than in 2011-12 because the debt burden will be higher and the recession deeper.
The ECB's Pandemic Emergency Purchase Programme
Here is where the ECB comes in. The really distinctive feature of the new programme of asset purchases, the Pandemic Emergency Purchase Programme (PEPP), is that the ECB has publicly announced it is ready to exercise the outmost flexibility in the geographic distribution of its purchases; it is no longer bound by the principle of proportionality to the capital key of each country.
Of course, the ECB will not stand ready to buy any amount of Italian debt in case of an incipient sovereign debt crisis. The ECB is adamant in distinguishing between two cases: it will not do anything that smacks of ex-post monetary financing of reckless deficits; but it will do whatever it takes to prevent a crisis hitting a responsible government from threatening the integrity of the euro area.
The lines are unavoidably fuzzy: what constitutes ‘reckless’ behaviour and ‘responsible’ behaviour is largely subjective. Exactly because of this, the solution has to be pragmatic. In implementing its fiscal expansion, Italy must just be careful to proceed in broad agreement with its euro area partners and the Commission. In practice, all Italy has to do is behave as a ‘good citizen’, keep the lines of communications constantly open, and pursue a frank and straightforward interaction with its partners and the Commission in deciding its fiscal policy stance. The ECB will then be unlikely to refuse its bazooka in case of an incipient sovereign debt crisis.
Importantly, purchases of Italian debt under PEPP, like PSPP, end up on the balance sheet of the Bank of Italy (with the exception of 20% that are purchased directly by the ECB). Losses would be borne by the Bank of Italy (i.e. by the consolidated Italian public sector). This is a key difference with Eurobonds and the like, and it should attract less opposition from Germany and its allies. But even if it did, ECB decisions are taken by majority rule, and in the past even major decisions – including, it seems, PEPP – have been taken with the opposition of Germany. In contrast, a Eurobond without the participation of Germany is simply unthinkable. This solution is also different from the OMT programme, which requires participation in a contentious ESM programme and would most likely imply loss-sharing.1
One might think that this proposal is equivalent to surrendering some of Italy’s sovereignty – a disguised conditionality. Not really – just being a good citizen buys a lot of mileage. For instance, Italy would have to avoid a repeat of its behaviour in 2011, when the government agreed to (extremely limited) budget cuts with the ECB and then, immediately after securing the ECB’s intervention with the Security Market programme, reneged on its promises. Italy would also have to avoid isolated posturing such as that at the latest Eurogroup (“Eurobonds or nothing”), which appeared puzzling to all other participants. But all this is far from a surrender of sovereignty.
Still, this is not a fireproof solution. The PEPP is set to expire at the end of 2020; however, it is easy to envisage that it will be renewed, particularly if the need emerges. It might also be unwise to put too much pressure on the ECB as the saviour of last resort. The ECB is rightly proud of its image of independence and would do nothing that could jeopardise a reputation earned from 20 years of operations, all the more so if publicly put under pressure by politicians. But as long as the Italian government follows the pragmatic approach described above, deploying an Italy-specific bazooka in order to avoid a sovereign debt crisis and keeping its own reputation intact are not mutually incompatible goals for the ECB.
What about the alternatives?
In any case, the alternatives are worse, and insisting on them is counterproductive because it risks fracturing the euro area. Consider first Eurobonds in their various guises (see Bénassy-Quéré et al. 2020 for a recent, quantitatively limited version). A Eurobond is debt issued collectively by the euro area countries, who assume a joint and several liability. In case of default by a country of 10 euros, any one of the remaining euro area countries can be called to pay the entire amount of 10 euros; only afterwards can that country call on the other non-defaulting countries to pay their share of the 10 euros. It is obvious that this exposes the core countries to enormous potential risks.
Proponents of Eurobonds almost never address precisely how the proceeds would be divided. But since Eurobonds have been conceived as a way to help periphery countries, it is likely that in practice most proposals would call for a disproportionate distribution to periphery countries. This doubles the risk to core countries.
Finally, Eurobonds would do little to ease the strain on periphery countries. These are not currently constrained in their access to the market, so the only real advantage of Eurobonds to them (barring an unequal distribution of resources – see above) is to reduce their cost of borrowing. Suppose the latter fall by, say, 100 basis points at ten years: this is €1 billion on Eurobond borrowings of €100 billion. Spain, which already borrows at 100 basis points below Italy at ten years, would gain almost nothing.
The Recovery Fund is conceptually similar to Eurobonds, except that it would likely fund itself with debt issued under a several liability (in a several, or proportionate, liability, all non-defaulting countries would be responsible for paying a pre-specified proportion of the default). In this respect it would be only slightly less risky to core countries. In all other respects, it shares the same problems as Eurobonds.
Consider the most recent variant that is circulating in the press at the time of writing (20 April): a gigantic fund of up to €1.5 trillion, administered by the Commission, funded or guaranteed by the EU budget, and dispensing a mixture of loans and direct grants to periphery countries. To the extent that contributions to the EU budget are roughly proportional to GDP, this would transfer an enormous and disproportionate amount of resources to periphery countries with a proportionate liability of core countries.2
European Stability Mechanism intervention
In the European Stability Mechanism the liability of, say, Germany is capped to 27% (Germany’s capital key) of the €80 billion in paid-in capital plus the €620 billion in maximum extra callable capital. In addition, an ESM loan is subject to some conditionality, and in theory it is senior to all other debts except to the IMF. Hence an ESM loan is less risky to core countries than a Eurobond, but it is still risky.
And again like Eurobonds, ESM intervention would do little for Italy in practice. A typical ESM loan would be in the order of, say, €40 billion. The interest rate on this loan would probably be lower than that on a Eurobond (the ESM is protected by a large callable capital and is theoretically senior). So the savings for Italy would be, say, €500 million per year. However, for better or worse, the ESM is virulently opposed by three Italian parties, of which one is in the government coalition. Accepting an ESM loan would almost certainly bring down the government and strengthen the hand of the sovereignist opposition – a stiff price for a saving of €500 million. In addition, its seniority would make the domestic government debt more risky.
So these various proposals either have no chance of being implemented, or they are not very useful for periphery countries, or both. Perhaps even more importantly, they might conceivably increase the risk of disintegration of the euro area in the long run. In core countries, resentment towards Eurobonds or the €1.5 trillion European Commission fund, even among moderate voters, would explode at the first occasion. In periphery countries, resentment towards the conditionality of an ESM loan would weaken any government that signs it, and if a sovereignist coalition comes to power it would almost certainly demand a renegotiation or default on the loan. This would mark the end of any form of core solidarity with periphery countries for years to come, and quite possibly lead to ‘Italexit’.
Bénassy-Quéré, A, A Boot, A Fatás, M Fratzscher, C Fuest, F Giavazzi, R Marimon, P Martin, J Pisani-Ferry, L Reichlin, D Schoenmaker, P Teles and B Weder di Mauro (2020), “ A Proposal for a Covid Credit Line”, VoxEU.org, 21 March.
1 The ECB has never revealed how the OMT programme would be structured, but losses incurred in the Security Market programme were shared.
2 In addition, this would just kick the can down the alley because it would then open the question of how to finance the EU expenditures that are no longer covered by the contributions used to pay for the direct grants or for a possible default.