The pandemic and its economic shockwaves are fundamentally re-ordering world affairs. Look no further than Europe.
Recent announcements by European policy makers have integrationists in ‘federal fever’. It is easy to see why. But rather than referring to recent events as a ‘Hamilton moment’, reminiscent of US history, it is more appropriate to look at European history and consider that policy makers have ‘crossed the Rubicon’, with all that may imply.
For many years, the economist community has solemnly warned that European Monetary Union remains unfinished business. There is no need to repeat the criticisms at length, including the lack of a fiscal union, the inability of the EU budget to act as a counter-cyclical mechanism, or dangerous links between sovereign debt and bank balance sheets. The ECB has held the situation together since the 2012 crisis, albeit under threat from the recent decision of the German constitutional court.
The pandemic has forced a material change. Interestingly, the catalyst is not another European financial crisis. Spreads between Italian and German bond yields had not widened to alarming levels, nor is the Euro under pressure in global foreign exchange markets.
To be sure, other areas of concern are in plain sight. A growing Euro-sceptic tone, especially in Italy, threatens to be amplified by the worst economic crisis since the 1930s. The ECB expects to see Eurozone GDP fall by about 8.7% this year, with only a modest recovery anticipated in 2021 and 2022. Accordingly, it expects inflation will remain well-below target until at least 2023. Independent forecasts are less optimistic.
Never let a crisis go to waste must be a motto written on the walls of Brussels. Indeed, the EU is responding to the joint pandemic and economic crises by taking unprecedented actions, potentially with far-reaching implications.
First, the agreement between Merkel and Macron for a stimulus package worth 5-6% of GDP to support weaker European countries is cleverly designed. Classic objections to previous schemes have been worked around: grants rather than loans, borrowing in the private markets but issuing in the name of the EU rather than via national budgets, temporary in name to get around the opposition from fiscally cautious nations, yet a series of tranches to build over time.
Secondly, Berlin—usually the paragon of fiscal rectitude—has outlined a €130bn stimulus package, representing almost 4% of German GDP, to support consumer spending and business investment. Following major fiscal easing in March, Germany’s insistence on ‘austerity’ has ended.
Thirdly, while the ECB’s announcement to raise QE ceilings is not novel it is large. The commitment to swell the balance sheet by €1.3 trillion equates to roughly 10% of Eurozone GDP. In a world already awash with liquidity, the favourable response of the Euro, large-cap European equities and peripheral bond spreads to the ECB’s announcement was quite understandable. To be sure, even as markets rejoice, others fret. Will this balance sheet expansion be put to good use, or is the central bank on a slippery slope?
Moreover, even if the demand stimulus works it must be matched by supply side initiatives. Criticisms are already coming forward that Europe is only taking steps to support today’s jobs and zombie companies, rather than to address much needed-structural reform, flagging potential growth or secular challenges. Italy’s central bank governor has warned that Rome cannot accept grants from the rest of Europe without undertaking a serious overhaul of the economy. Some argue that Germany’s stimulus package will result in the biggest re-engineering of its economy in the post-war era, yielding a behemoth of state capitalism as seen in France or even China.
Other doubts are surfacing. The ECB is rapidly following the Bank of Japan down the path of financial repression. On some estimates it will buy enough government debt this year and next to cover fully the Eurozone governments’ anticipated deficits. Will it be able, one day, to reverse its actions without producing a sharp rise in borrowing costs?
Indeed, the real long-term risk is that monetary policy papers-over structural fault lines that politicians are unwilling or unable to address. Europe’s demographic burden, historically weak productivity growth, fragile banking sector, the threat to exporters from Chinese competition, and export dependence when a multilateral trading system is disintegrating in the face of nationalism, are all challenges that easy money cannot address.
These challenges are not exclusive to Europe. The outcome of this global pandemic remains uncertain. It is wise to act pre-emptively when downside perils dominate. But the risk is that such policy makes it all too easy to muddle through. Major economies, Europe in particular, are becoming ‘Japanified’, characterized by sluggish growth and low productivity, unable to adapt because of their massive debt burdens, yet able to resist market pressures due to the resolve of the central bank and a sustainable balance of payments position. It is a recipe for avoiding crisis, but also one that breeds fodder for populism as solutions that could offer a more promising future are postponed.
The Macron-Merkel package, which offers a European—indeed federal—fiscal response to the current crisis is indeed a ‘crossing-the-Rubicon’ moment. But stepping over a threshold is risky unless it is accompanied by a well-thought-out plan to address not just the immediacy of a crisis, but also the path to a better and more sustainable future.
It is worth recalling the aftermath of Julius Caesar’s irrevocable decision to cross the river Rubicon in 49 B.C. He became de facto ruler of Rome and was dead five years later.
Be careful what you wish for.
