Strategies for the euro

Pumping still more liquidity into Europe’s pandemic-frozen economy hardly addresses underlying problems. But how EU leaders go about financing the massive new outlays is a tricky question – and the most likely borrowing scheme will have long-term consequences.

The ECB headquarters skyscraper seen from behind Frankfurt’s Iron Bridge
Frankfurt am Main, March 10, 2020: The European Central Bank (the building in the background) has registered the first COVID-19 casualties among its staff. The institution also faces formidable policy challenges as a result of the pandemic. © dpa

In a nutshell

  • European policymakers agree that a massive liquidity injection is the right response
  • It remains unclear who will foot the bill
  • Borrowers will most likely be member states with the ECB acting as the ultimate guarantor

This report is part of a GIS series on the consequences of the COVID-19 coronavirus crisis. It looks beyond the short-term impact of the pandemic, instead examining the strategic geopolitical and economic effects that will inevitably be felt further in the future.

The economic crisis triggered by the coronavirus has exposed the inner fragility of the eurozone’s architecture and could lead to its collapse. 

As weeks go by, it is apparent that policy options for Brussels and Frankfurt are limited and the challenge is not just a matter of financial engineering. To summarize, all euro-country leaders believe that a major injection of liquidity to sustain aggregate demand is the only suitable response to the crisis. It makes political sense. Acknowledging the obvious – that the problem originates from a dramatic drop in production and thus is a supply problem – would necessitate policy responses that the public cannot be expected to like. 

Debtors-creditors game

Policymakers also agree that public debt is the technical device through which liquidity is created and injected into the economy. The mechanics are simple. Debtors issue bonds. Creditors/buyers purchase those bonds with euros, which are then transferred to national governments. Finally, the latter spend those euros as they deem appropriate. Not surprisingly, however, opinions diverge when it comes to identifying debtors and creditors in this scheme. Put bluntly, who will pay the bill?

Puppet masters found a shrewd way to downsize the role of the ECB and its president took the bait.

Different proposals are on the table. If one sets aside technical intricacies, the ideas are rather simple. Some suggest that each government take care of its problems and issue public debt accordingly. This would be “business as usual” and was perhaps the initial EU approach. In this light, one may consider the clumsy remarks delivered by European Central Bank (ECB) President Christine Lagarde on March 12 as an attempt to sound out how European public opinion and national governments would react to such a straightforward solution. 

The ultimate guarantor

The reaction was forcefully adverse and Ms. Lagarde was left holding the baby. She was quick to backtrack, but lost prestige and has been de facto sidelined. One may venture to say that puppet masters found a shrewd way to downsize the role of the ECB and that its president took the bait. 

Others would put forward a financing scheme in which each government would issue its own treasury bills and, therefore, be responsible for servicing them. However, the EU or the ECB would furnish support by standing as the ultimate guarantor. This strategy would raise two delicate questions. 

First, since the EU would pay for its members’ possibly irresponsible financial behavior, Brussels would need to be able to monitor and steer fiscal policy in the countries that took on debt under EU guarantees. The requirement appears necessary, given that everybody seems intent on forgetting – perhaps too hastily – the fiscal constraints defined by the Maastricht Treaty. The second problem is that, should a government fail to service its public debt, it is not clear which resources the EU could use to step in. 

According to a third possibility, Brussels, or an agency controlled by Brussels, would issue Eurobonds of some sort to obtain cash, which would then be lent to national governments. In this case, of course, the ultimate debtors are member states, but two problems remain. What would happen if national authorities default, or ask for some kind of debt restructuring? 

In addition, how would those funds be distributed among the many EU countries eager to borrow? 

The Union’s value

The debate on what to do and how to do it started in early March 2020. It is not settled yet. On the one hand, the EU’s deliberation procedures are not designed for quick decision making. On the other – perhaps more importantly – in its almost 30 years of existence, the EU has failed to clarify the border between national and European solidarity. In particular, the ambiguities surrounding the role of the euro and the ECB have not been sorted out. They add to the current state of confusion. 

EU leaders are unlikely to sit down now to better define the notion of a united Europe. Yet the pressure of the looming catastrophe could help them focus. Policymakers across the continent need to assess how much they value the Union and the common currency as they are today, and decide how much they are willing to pay to continue having them.

Making sure that the EU does not sink is the main concern for Brussels.

In other words, the good news is that the virus is replacing the stale more-Europe and harmonized-Europe rhetoric with more specific issues of debt financing and collective liabilities. The way Brussels (and Frankfurt?) will finance the next round of public spending is going to profoundly affect how the Union functions in the next few years.

In this context, leaders’ priorities and beliefs play a crucial role. By defining pressure groups and their interaction, they shape future outcomes. One presumes that making sure that the EU does not sink is the main concern for the Brussels authorities. Free trade within the Union, redistribution among the member countries (35 percent of the EU budget), subsidies to producers (50 percent of the budget) and pervasive regulation across a large number of industries are all at stake.

No euro, no EU

Although hardly anybody questions the size and composition of the expenditure budget, the EU authorities and apparatus know that if a member country drops the euro, it will also leave the Union. Therefore, to save the European project, one must keep the euro. It follows that if one wants to save the currency, one must increase the cost of its collapse, both for business and for the man in the street. To this end, Brussels could decide to jump at the opportunity offered by the present crisis and flood investors with long-term euro-denominated assets of all sorts, backed by the beneficiaries (governments), or by an ECB commitment to monetize the debt if necessary. 

Given the present situation, the latter solution seems more likely to win political approval. 

Long-term manipulation of interest rates brings dangerous side effects.

Other solutions amount to merely kicking the can down the road and risking popular rage. Consider a situation in which each government is required to return the money it borrowed from Brussels. In large member countries like France, Italy and Spain, the debt-to-GDP ratio is currently about 99 percent, 135 percent and 96 percent, respectively. If one assumes a 6 percent drop in GDP and an increase in public debt equal to 12 percent of GDP (as a consequence of COVID-19), these debt-to-GDP ratios will rise to some 118 percent, 156 percent and 115 percent. 

Such debts could be sustainable only if the ECB committed to keeping interest rates close to zero for decades. This, however, would make little sense. The past years have shown that long-term manipulation of interest rates brings dangerous side effects and encourages all governments to run ever-larger budget deficits. Eventually, these countries could decide to leave the eurozone either way.

The winning strategy

Shared responsibility is also unlikely to work. Creating a system in which EU member B foots the bill if member A is unable to service its debt is a recipe for disaster. On the one hand, it would encourage generalized profligacy. On the other, it would spawn permanent distrust and tensions within the Union. 

To sum up, if one abstains from questioning the wisdom of reacting to the coronavirus crisis by issuing vast amounts of public debt, the best strategy for preserving the euro and avoiding further, very long-term distortion of the interest rates boils down to two actions. 

The first is flooding the market with euro-denominated assets so that the public has a vested interest in protecting the common currency and avoiding forced conversion of their bonds into national currencies at discretionary, fire-sale exchange rates. 

The second is forcing the ECB to accept the possibility of monetizing the debt by acting as the ultimate guarantor of reimbursement. Will this happen? Probably, albeit in an opaque manner, to save face. 

Some might not like this scenario, but the alternative is likely worse. An open-ended commitment to keeping interest rates at zero and bailing out profligate governments would be, in fact, the perfect time bomb.

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