Europe’s Moment of Truth

By Ashoka Mody

Wednesday, April 29, 2020

On April 16, responding to the COVID-19 crisis, French president Emmanuel Macron said Europe had arrived at its “moment of truth.” Economics is a “moral science,” he insisted. The euro zone’s financially stronger nations, therefore, have an obligation to look after their weakest partners by establishing a fund that “could issue common debt backed by a common guarantee.” It was the expected high-minded call for a technocratic solution, and it dodged the fundamental underlying political question. In a euro zone still based on nation-states, the strong, broadly speaking, ‘northern’ members have always asked why they should aid their weaker southern counterparts. Today, leaders of those northern states are being called to help the southern members on a scale never before contemplated. Not surprisingly, when they all met in a videoconference on April 23, they ignored Macron.

Europe is indeed at a moment of truth, but European politicians have yet to grasp how bleak that truth really is. All economic forecasts today are too optimistic. Even the strongest European countries will have their hands full coping with domestic economic distress. In such conditions, everyone is on his own. Cooperation is hard enough within federal states, as recent tensions in Germany and even more so the U.S. demonstrate. Cooperation on the scale required within the euro zone, based as it is on the E.U.’s confederation of nation-states, would require a remarkable political revolution.

All economic forecasts are optimistic

Every country in the world is experiencing an economic slowdown. But the downturn will be particularly severe in Europe, because European nations entered the COVID-19 crisis in a near-recessionary condition. The virus has caused them severe economic damage, and their tightly interlocked economic relationships with one another and with China hold them hostage to the economic performances of their trading partners.

Any expectation of a swift, V-shaped recovery from this sharp economic decline is delusional. Although some countries and regions are beginning to experiment with lifting their economic lockdowns, the process will be slow and will deliver limited economic gains. President Donald Trump may want to speed up the reopening of the American economy, but a recent authoritative study of the 1918–1920 influenza pandemic in the United States warns that if non-pharmaceutical interventions don’t continue, more deaths and greater economic damage will result. Hence, as Donald McNeil writes in the New York Times, the opening-up period will be a “dance,” an extended back-and-forth. “Essential parts of the economy could reopen, including some schools and some factories with skeleton crews,” McNeil notes. But where the virus threatens again, authorities will need to pull back and wait before attempting to repeat the process.

Such a staggered and fitful reopening will bring with it a slow recovery. An economy is like a system of cogs and gears. Different parts of the economy reinforce demand for one another. If, for example, restaurants work at only 30 percent capacity because of lingering fears of infection and their customers’ shrunken ability to spend, many restaurant suppliers might not see value in incurring the costs of restarting their own operations. Such stoppages will filter down the supply chain, sending some producers into bankruptcy and causing long-term damage. The negative effects of a partial recovery will be magnified in a world of international supply chains. Even when a country’s businesses are ready to sell goods and services, its international buyers might still be in complete or partial lockdown.

Uncertainties — about the likely course of the disease and the timing and coordination of the economic resumption — will add to the depth and duration of the downturn that lies ahead. The uncertainties are reflected in historically high stock-market volatility, especially when measured by the number of days on which the market has gained or lost at least 2.5 percent of its value. Using this metric of volatility in their historical economic models, Stanford University economist Nick Bloom and his coauthors anticipate a slump that is larger and more prolonged than that predicted by virtually any other forecast.

Compounding these handicaps is the unprecedented amount of debt that households, companies, banks, and governments have racked up. According to the Washington-based Institute of International Finance, outstanding global debt doubled from $120 trillion in 2006 to $240 trillion in 2019, reaching 320 percent of world GDP. Far too many countries (and all sorts of borrowers within each country) took advantage of ultra-low interest rates to maintain (or even increase) high levels of indebtedness. Debt ratios rose especially for corporations and almost every government. Now, borrowers must repay those debts amid collapsing output.

European banks, especially in the southern euro zone, have particular vulnerability here because borrowers have yet to fully repay debt accumulated during the global financial crisis of 2007–2009 and the euro-zone crisis that followed. Making matters worse, in both the north and south of Europe, banks have chronically low profitability. European banks had been trading at market-to-book value ratios of well below one even before the coronavirus pandemic began; those ratios have now fallen farther. Financial markets are saying to banks, “Your assets are worth much less than you think they are,” and it’s not hard to see why. Many banks face the prospect of large losses — in some cases so large as to put their solvency in question, thus threatening a wider financial crisis. Foreseeing intensifying stresses, investors are already demanding higher interest rates for new lending to European banks.

While all European countries can anticipate a terrible economic year ahead, COVID-19 has landed hardest on the weakest of them: Italy. The Italian economy has not grown since the creation of the euro zone in January 1999, and it was in one of its near-perpetual recessions when the virus began raging through Lombardy and the Veneto, the country’s most productive regions. The cracking of the Italian fault line will send financial tremors throughout Europe and the world. Everyone who needed to know did know that Italy did not belong in the euro zone. Saddled with undisciplined politics, the Italian economy depended on the accommodating flexibility of the lira whenever it was in trouble. The fact that the ongoing crisis is so ferocious puts that historical error in even starker relief.

Europe’s problem: It is a confederation of states

The euro zone has to deal with this impending economic and financial crisis within the framework of a confederation of states similar to the one that governed the United States between 1776 and 1789. In those years, the states refused to share the burden of Revolutionary War debts and pension obligations to soldiers. New York state famously held on to tariff revenues collected on imports at its ports. In the same way, on matters that significantly impact national budgets, the E.U.’s member states have placed national interests ahead of the union’s broader objectives. The incentives to continue doing so are even higher, because the sums required to dig out of this crisis are so huge.

The U.S. is a useful benchmark. Despite the chaos and damage the federal government has caused in coordinating the containment of the virus and despite ideological disagreements in Congress, the U.S. economy will receive a fiscal stimulus of upward of 10 percent of GDP through successive messy initiatives.

In the euro zone, the northern countries have the money to revive their economies, if just barely. The southern countries do not. Germany, like the U.S., is very likely to end up running a fiscal deficit greater than 10 percent of its GDP as a result of measures to boost its domestic economy, and will probably need additional funds to prop up its banks. Italy and Spain, undergoing much larger economic shocks, have even greater fiscal-stimulus needs, but lack the money to finance them. The Italian and Spanish governments also need to worry about debt — over 20 percent of their GDP — due for repayment this year. Will investors lend them new money to roll it over?

Whichever way you look at the numbers, Italy needs at least €200 billion in stimulus money and possibly another €200 billion as a safeguard in case the markets do not step up to purchase the portion of its government debt maturing this year. Spain will need more than half those sums. The exact amounts are fuzzy, and a moving target, but they are large and neither Italy nor Spain can rustle them up without outside help. The European response to this predicament is to lend to Italy and Spain through official funding sources. But such a strategy would ensure that these two beleaguered countries will emerge from the crisis with truly gigantic debt burdens. Instead, common sense suggests that, between them, Italy and Spain should receive grants of perhaps €100–150 billion to tide them over the coming months.

In the U.S., the stimulus funds dispensed under the CARES Act include grants of about $150 billion to the states and eligible local governments. It is important to note that in the United States, sizeable fiscal transfers occur automatically. The worse hit the state is, the less it pays by way of federal income taxes and the more it receives in benefits. But even so, the states need more to cover their steep revenue shortfalls, and they are lobbying the federal government hard to get it. Matters in the euro zone are way more serious. Because the euro zone does not have a central budget, member states do not receive the automatic support through reduced taxes and higher spending that U.S. states do. Hence, the Italian and Spanish needs for large fiscal grants are urgent, but it’s hard to imagine that a confederation of states would find the necessary political consensus to provide them.

Europe’s involutionary overdrive

Unable to act on the scale required, European leaders have settled for pretending to act. Plans and ideas have generated great excitement only to fade and give way to newer plans and newer ideas destined to meet the same fate. On April 9, European Union finance ministers ended one of their marathon negotiations with illusory promises of new money. Under one initiative, member states would pledge €25 billion of guarantees, which the European Commission would use to borrow €100 billion. The Commission would lend that €100 billion to governments to share the costs of keeping workers on payrolls. How and when such an idea might become operational remain unknown, as do who, in particular, will dole out the funds, and what political legitimacy they will have to decide who gets funding priority. (While those questions are being pondered, the Finnish government is already backing away from its commitment to this plan, and other member states may well soon follow suit.)

Another idea is that the European Investment Bank (EIB) would offer €25 billion of guarantees to private lenders. The hope is that lenders would be willing to lend up to €200 billion to European borrowers. This plan — a rewarmed version of similar past plans — would merely reshuffle and relabel some of EIB’s lending, with negligible impact on growth and employment.

Finally, there is the possibility of Governments’ borrowing from the European Stability Mechanism (ESM), the euro zone’s bailout fund. This money was always available. The amount lent would be for virus-related expenditures only, and would be capped at 2 percent of a country’s GDP, but would come with fewer strings attached than in the past. The amounts are too small to help significantly but would ladle on more undesirable debt.

With regard to the big prize, Macron’s Eurobonds, or “corona bonds” plan as some call it, the madness continues. In dry legalistic terms, this plan would allow governments to borrow jointly. In practical terms, it would put Germany on the hook if the Italians did not repay their debts. It is no surprise then that the Germans have steadfastly said “Nein.” Germany’s refusal is fortunate for Macron, who made yet another headline-grabbing gesture without the money to back it up. If they borrowed jointly, the euro zone’s member-states would need to repay the corona bonds jointly, and France is already struggling to pay its own bills. Besides which, the question of who will decide who gets to spend the funds from a corona bond remains unanswered.

People look to Germany as the billpayer of last resort. But Germany has its own long-term problems. Its gasoline–based car industry is facing obsolescence. China, the most rapidly growing market for German exporters in the last two decades, was slowing down even before the coronavirus struck. And German universities are ill-prepared for ongoing technological changes. Germany is still Europe’s most powerful country, but it is a diminished giant.

Prodded to act in the “European cause,” German chancellor Angela Merkel reacted angrily. “You can’t accuse everybody else of being less European than you are every time you don’t get what you want,” she told her fellow leaders. She then used a bureaucratic trick that served her well in 2017–2018, when Macron was pushing hard for a single euro-zone budget: She pointed instead to the E.U.’s budget as the ultimate source of funds. That strategy, she knows, is the best way to kill any new funding plan. The E.U. has a total spending authority of about a trillion euros over seven years, and the next budget cycle is caught in a cruel vise. Claimants on the E.U.’s budget have grown while the departure of the United Kingdom, a significant net contributor, has left a hole that no one is willing to fill.

All hopes now are focused on the prospect that member states will pledge even more money by way of guarantees that will allow the European Commission to borrow from financial markets. If this plan does not fizzle like the corona-bonds plan, it will come too late, well after the crisis has taken a savage economic toll. If the buzz from European leaders is correct, the Commission would eventually use its borrowed funds not only to lend more money to member states, but also to make outright grants. If so, will richer member states agree to a scheme that would, logically, almost certainly end up leaving them out of pocket?

In uncharted waters

While this impasse continues, all eyes are on the European Central Bank (ECB). The ECB can, in principle, print money to postpone the day of reckoning. But the ECB is the central bank of a confederation of states. In the United States, the United Kingdom, or Japan, the central bank buys the government’s bonds knowing that if it incurs losses, the government will raise taxes on its own citizens to make whole the central bank’s capital. Indeed, that understanding underpins the current support operation in which the Fed is expected to buy more U.S. treasuries than the net new borrowing by the government. The Federal Reserve System is also providing credit lines to support municipal bonds, with the important provision that the federal government will share any losses incurred.

The ECB has given itself the authority to buy bonds of up to about €1 trillion. That sum seems large by euro-zone standards, but is trivial compared to the range and size of the Fed’s coronavirus-related measures. The basic difference is that the ECB has no fiscal counterpart. The ECB already owns 23 percent of Italian government bonds. If it were to cover Italy’s financing needs this year, it would end up owning over 40 percent of Italian government debt. If the Italian government then failed to service the debt held by the ECB, German and other taxpayers would — without their consent — need to replenish the ECB’s capital and effectively foot the bill for Italy.

By not dealing with the mess now, the euro-zone will find itself dealing with an even larger mess later. The ECB cannot solve the euro zone’s fundamental flaw. It is a central bank without a fiscal union — a confederation of states that may have reached the limits of confederation acceptable to the voters of many of its member states.

When I concluded the hardcover edition of my book EuroTragedy two years ago, I offered a final prediction: “A new crisis—and there always will be a new crisis—will test the euro zone severely, especially if, as is likely, Italy is the epicenter of the crisis. Political divisions will deepen as financial tensions unfold, and the crisis could tear through the euro zone’s financial safety nets.” That moment may now have arrived.

The extraordinarily severe COVID-19 crisis is set to confront European leaders with a choice they have so far ducked. Will they move the euro zone (or even the broader E.U.) toward a genuine federation, which subordinates national parliaments to a European parliament with unquestionable democratic authority? Will they instead wait for a miraculous economic recovery? If they wait, Italy’s (and Spain’s) debts — and financial-market pressures — will mount, forcing a decision between dramatic, politically concerted support or a retreat from postwar integration.

It is into these uncharted waters that Europe has now embarked.