The Corona Test For The Euro Zone

COVID-19 will test the new financial architecture of the euro zone. Since the euro crisis, new instruments have been developed, such as the European Stability Mechanism (ESM) and the ECB’s Outright Monetary Transactions (OMT). OMT being the bazooka the ECB created, but never needed to use, after Mario Draghi in 2012 pledged to do “Whatever it takes to save the euro”. The question now is whether policymakers are willing to use them.

Last week, as we came to realise the unprecedented economic impacts of COVID-19 we saw also how leading thinkers quickly made proposals for dealing with these impacts. In this blog we discuss some of those ideas — including those co-authored by SFL-members.

SFL-chair Arnoud Boot (Amsterdam University) is co-author of a proposal of the Sustainable Architecture for Finance in Europe (SAFE-institute at the Goethe University in Frankfurt) and Dirk Schoenmaker (Erasmus University Rotterdam) cooperated on a proposal with the Brussels think tank Centre for Economic Policy Review (CEPR). We compare their proposals with those of Bruegel (Brussels), the Hertie School Jacques Delors Centre (Berlin) and a proposal of the German economists Schularick (Macrofinance Lab Bonn) and Steffen (Frankfurt School of Finance).  

All the papers warn of the severity of the current crisis, drawing comparisons to the Lehman- and eurocrisis. Whereas then the financial sector was the source of the instability, now it is a virus epidemic. The problems in the real economy may very well turn into a financial crisis of a similar scale: “The virus epidemic carries the risk of a financial pandemic” (SAFE)

In order to prevent this happening, all argue for various forms of direct stimulus: “a quick and targeted provision of liquid funds to those firms that face a break in production and/or their supply chain, and also to those that have suffered a large decline in demand” (SAFE). This could be done through schemes such as the German Kurzarbeit or company loans by commercial banks backed by governments, the European Investment Bank (EIB) or the European Bank for Reconstruction and Development (EBRD). Bruegel also advocates “the provision of monthly lump-sum transfers to the self-employed that are immediately vulnerable to a collapse in demand.”

All argue that the scale of this support effort will be very large. CEPR estimates the “direct cost of discretionary measures (emergency health-and-lockdown measures plus economic relief)” to be “of the order of magnitude of one to one-and-a-half percent of annual GDP”. Bruegel puts that number at 2.5% of GDP.

CEPR stresses that we face “not just a liquidity problem but also a solvency problem.” Particularly in the services sector income will be lost — even if the lock down is lifted relatively quickly. Restaurant and theatre visits will mostly be cancelled, not postponed. And the lock down may last longer than initially estimated. Hencelosses need to be taken: “These solvency problems cannot be addressed by monetary policy and even less by micro and macroprudential policies. Fiscal intervention will be key.” (CEPR).

In the current ‘lock down’ phase of the crisis, with the supply side inherently limited, demand stimulation is less important. It may however be needed when things get back to normal. In the following ‘recovery’ phase CEPR proposes demand stimulation: “a sharp rebound is likely but it may be muted by lost confidence and revenues. It will call for significant fiscal demand support to help avoid an anemic recovery. (..) The most appropriate vehicle is likely to be direct transfers to households.”

All authors stress the need for coordination at the European level for all of these measures. The Hertie paper points out that “the cost of the measures is very likely to be significantly smaller than the losses incurred in a deeper crisis that would permanently wipe out production capacity and human capital” and that “in Europe’s integrated economies, measures will spill over between member states. Therefore, governments should have a keen interest in ensuring that their neighbors and trading partners also deliver a forceful response to avoid a deeper recession.”

Bruegel notes that the EU’s fiscal rules do not constrain a targeted fiscal response: “Firstly, any one-off budgetary spending incurred in relation to the response to the outbreak is excluded from the computation of the structural balance. Secondly, the current fiscal framework already provides adequate margins of flexibility to cater for “unusual events outside the control of government”. This is, however, provided that “the temporary deviation does not endanger fiscal sustainability in the medium-term”.

This condition may prove hard for some euro member states. If not recognized by the policymakers themselves, the market will do so — leading to rising yields. CEPR: “like after the Global financial crisis, the hard constraint may not be the Stability Growth Pact (SGP) but rather the ability of national governments to borrow several additional percentage points of GDP.”

The German and Dutch governments have ample fiscal room, with the latter boasting it can spend 80-90 billion euro before the 60% debt limit of the SGP is reached. Italy, however, would actually need to pay off over 1300 billion euro of its debt to achieve that level. These discrepancies are widely acknowledged and different solutions are proposed that build on solidarity between EU-member states.

SAFE explicitly mentions Italy: “If sovereign debt levels are as high as in Italy, for example, the extra funding capacity of the state is quite limited, as the debt terms of the sovereign will spiral downwards as well. When push comes to shove, the doom loop between the escalation of bank default risk and sovereign default risk, the source of the 2011 euro crisis, returns ominously.” Hertie points to the same danger, not only for individual countries, but for the euro itself: “Especially for large member states, it might be too late to save them once they do lose market access. This would result in the unraveling of the euro zone with devastating economic consequences.” “A sudden rise in interest rates in some member states, which would in turn make their debts unsustainable” is according to CEPR not a theoretical threat “given that some governments are already on the razor blade.”

SAFE refers also to the chances of bank runs in the weaker euro member states: “Absent a credible European deposit insurance, there may be doubt about the resilience of a national, largely pay-as-you-go backed deposit insurance system, particularly in smaller and weaker countries. Depositors may join the flight to quality, asking for redemption – and a bank run may get under way.”

For that reason all argue in favor of EU- or euro-level financing, sharing the burden between the stronger and weaker member states. Bruegel argues that “The EU could provide insurance to countries or regions most affected through its budget. The EU Treaty contains a solidarity clause that invites the EU and its members to act jointly in a spirit of solidarity (..). On this basis, the EU could provide financial aid to countries or regions most affected by the COVID-19 outbreak”. To this end “the bond purchase programmes of the ECB and other European central banks should be increased. Increasing sovereign bond purchases would help support distressed sovereign bond markets”.

CEPR proposes “A European catastrophe relief plan aiming at supporting the combined efforts of the member states in combating the pandemics (..) This is clearly an exogenous shock with very large spillovers across the member states, justifying a co-financing of containment measures and related losses. (..) This would require finding the means to release tens of billions of euros from EU resources, despite existing limitations to the use of the EU budget.” CEPR argues furthermore that in the case of rising interest rates for some euro member states “there would be no other solution than an ESM financial assistance programme or, rather, the activation of the ECB’s Outright Market Transactions scheme (OMTs). The fiscal adjustment programme would need to be postponed to the post-crisis period”.

Hertie too argues that policymakers should be ready “to use all available ESM instruments to ensure the necessary market access.” “Should member states lose market access (..) they should get full access to the ESM without losing any of their sovereignty in this crisis and hence should not face any conditionality. Specifically, member states could point to the precautionary credit lines available under the ESM treaty. The biggest advantage we have compared to the great financial crisis is that today we have the instruments in place to guarantee market access. But their effectiveness depends on the political will to actually use them in times of need. (..) The ECB needs to complement this statement by governments with a clear commitment to use all its available instruments, including Outright Monetary Transactions (OMT). (..) The backstop for the Single Resolution Fund should be put in place immediately to assure markets that there are sufficient funds available to tackle a systemic banking crisis.”

In addition Hertie calls for “a scheme based on Art. 122 of the Treaty. It would extend interest-free loans to national social security schemes” as well as EIB support guarantees “by national promotional banks for private sector loans to businesses under strain from the virus. If the EIB needs more capital, member states should provide it jointly”

Schularick and Steffen specifically discuss the dangers for the banking sector. They conclude that “a recapitalization of the banking sector of the euro zone might be inevitable.” In this “we need to avoid repeating past mistakes. Liquidity guarantees of undercapitalized banks from governments are counterproductive and might even sow the seeds for future crises.” They argue in favor of an approach as in the US in 2008 of proactive recapitalization of banks. Here too, however, not all member states could do this alone: “As recapitalization is limited by a country’s fiscal capacity, this has to be an effort at the euro zone level with European resources. This also helps avoiding another doom loop. The doom loop between weak sovereigns and weak banks was probably the single most important factor why Europe was less successful than the U.S. in fighting the 2008 crisis.”

Schularick and Steffen also look to the ESM for a solution: “The European Stability Mechanism (ESM) should be the main vehicle that spans the protective shield for all euro zone banks. The ESM has an unused tool to directly recapitalize banks. However, the total amount available for this instrument is limited to €60 billion (compared to assets of euro zone banks of €25 trillion and tier-1 capital of about €1 trillion). This tool is too small”. They “propose tripling the ESM money currently available to at least 200 billion euros. This corresponds to about 20% of the tangible equity and about 50% of the current market capitalization of euro zone banks and thus could absorb substantial losses. (..) Importantly, these funds should be the first line of defense and not only be used after national resources are exhausted.”

All proposals agree that a common European approach is needed, and warn that not all member states will be able to pay for this themselves. In different ways the ESM is seen as a necessary tool, backed up by the ECB if needed, through buying bonds of specific countries in its OMT-program. It is clear that policy makers, both monetary and fiscal, do not have such a common approach. Whereas the ECB has announced its willingness to provide ample liquidity, its President has raised doubts about the willingness of the ECB to help specific countries, such as Italy.

The euro group has stressed the need for a common approach. Up to now this consists mainly of the sum of national instruments, supplemented by money that the European Commission found in the current EU-budget. But most importantly, there is no signal yet that the ESM instruments will be used if one or more member states lose market access and can no longer fund fiscal deficits.

The Financial Times reports that within the Eurogroup some feared that introducing the ESM now might actually spark a panic. However, given the rising bond yields of Italy — but also of Spain and Portugal — voicing a greater willingness to use the ESM — and thus paving the way for OMT by the ECB — may actually be just what is needed to restore confidence and effectively fight the current health, economic and financial crisis. It may be what is needed for the euro zone to pass the Corona test.