European Pandemic Recovery: An Opportunity to Reboot

Forum DOI: 10.1007/s10272-020-0903-3 Agnès Bénassy-Quéré and Beatrice Weder di Mauro* European Pandemic Recovery: An Opportunity to Reboot After a period of hesitation, national governments in Europe have reacted forcefully to the pandemic through various strategies combining social distancing, testing, quarantining and lockdowns. Although doing nothing was not an option and would itself have disrupted economic activity, several weeks of strict lockdown have triggered an economic crisis of at least twice the size of that of 2009. Furthermore, the recovery is likely to be slow due to depressed consumption and investment, and it will require fast reallocations in both the labour market and the capital market. and government deficits in the order of 10% of GDP or more. To restate the obvious, during a pandemic, coordination is key as the virus disregards national borders and is powerful enough to disrupt cross-border supply chains. However, even under such obvious circumstances, European coordination has proved as painful as ever. Accordingly, pre-COVID-19 weaknesses in the governance of the euro area have quickly come back to the forefront. Europe’s failure to manage a bold, common response would further increase divergence, strengthen anti-European forces and fuel populism. The debate about the financing of the euro safety net (e.g. coronabonds versus the European Monetary Mechanism, ESM) has already been very bruising and has created the impression of disregarding European solidarity. The German Constitutional Court ruling on the ECB’s past policy may also contribute to further polarisation. This is not the time to play with matches. The fault lines of the Maastricht architecture are now widely recognised (e.g. Bénassy-Quéré and Giavazzi, 2017). During and after the sovereign debt crises of the 2010s, several major reforms were carried out: introduction of an emergency assistance scheme (ESM), extension of the ECB’s toolkit with Outright Monetary Transactions (OMTs), negative interest rates and quantitative easing, reinforcement of fiscal and macroeconomic surveillance and a banking union. The shock being both exogenous and dramatic, one could have expected European politicians to temporarily set their disagreements aside. Before the crisis, they were discussing whether the next Multiannual Financial Framework (MFF – the seven-year budget of the European Union) would be set at 1.02%, 1.07% or 1.11% of gross national income. Just a few months later, we are talking about thousands of lives, millions of unemployed, © The Author(s) 2020. Open Access: This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (https://creativecommons.org/licenses/by/4.0/). Open Access funding provided by ZBW – Leibniz Information Centre for Economics. * This article is based on Bénassy-Quéré and Weder di Mauro (2020). Agnès Bénassy-Quéré, Université Paris 1 Panthéon-Sorbonne, France. Beatrice Weder di Mauro, Johannes Gutenberg University of Mainz, Germany. ZBW – Leibniz Information Centre for Economics Fundamental fl aws of the euro area architecture Although these reforms were far-reaching, they were still unfinished. As argued notably by the “7+7 report” (Bénassy-Quéré et al., 2018), financial markets were still fragmented within the euro area, the ‘doom loop’ (close relationship between banking risk and sovereign risk) was alive and well, macroeconomic convergence was a work in progress, inflation was too low despite the fact that monetary policy had not yet been normalised, fiscal policy had little room for manoeuver in various countries and was inexistent at the federal level. In brief, despite its stronger banking system, the euro area was not ready for the next crisis. Even more worrisome, the fundamental flaw of the euro area architecture was not addressed before the COVID-19 crisis. Given that both monetary financing of government deficits and fiscal bailouts are prohibited by the treaty, a country with plunging nominal GDP and skyrocketing government debt will likely need some form of debt relief. But debt restructuring is extremely difficult given the concentration of government debt in the balance sheets of the resident banks. Some banks may see their capital wiped out. They may also fall short of liquidity since government bonds are routinely used to get liquidity on the repo market and from the central bank. 205 Forum Figure 1 Phases of the coronavirus crisis Time Phase I Phase II Phase III Full lockdown Gradual opening Open (with some restrictions) Instruments Maintain liquidity Cash, debt and guarantees Liquidity to solvency: equity or equity-like Mixture of debt and grants: funding of public and private investment Principles “Do everything you can” to prevent mass insolvencies Repair: design smart equitable burden sharing 1. 2. 3. Allocate based on the severity of the economic and social impact Promote investment in future technologies and sectors, support reallocation out of sectors with longterm damage Relevel the playing field, revitalise the internal market, protect the Schengen area Source: Authors’ elaboration based on Anderson, J., S. Tagliapietra and G. Wolff (2020), Rebooting Europe: a framework for post-Covid-19 economic recovery, Bruegel Policy Brief, 2020/1. Before the COVID-19 crisis, the euro area debate was evolving along three main lines: • How to stabilise the financial sector through a smooth transition towards more diversified balance sheets, together with the introduction of deposit reinsurance as a ‘safe asset’ (Schnabel and Véron, 2018); • How to restore the fire power of macroeconomic policies, notably through a reshuffling of fiscal rules and the introduction of a European ‘fiscal capacity’ (7+7 report, 2018; European Fiscal Board, 2018, 2019); • How to avoid a deflationary bias related to the asymmetric adjustment burden between surplus and deficit countries (Bénassy-Quéré, 2017). As the crisis unfolds, the consequences of this unfinished work will progressively appear. Repair, reboot, recover Figure 1 illustrates the progression of the crisis over three phases. The first was the acute phase of the medical emergency with the economy in lockdown. In this phase, the first priority of government was to avoid unnecessary suffering, closure of firms and loss of jobs. Governments’ and central banks’ actions were all about providing enough liquidity to households, firms and banks, and the guiding principle was “act fast and do whatever it takes” (see Baldwin and Weder di Mauro, 206 2020). In the acute emergency, governments have provided cash, loans and guarantees to compensate as much as possible the losses incurred because of the lockdown. Considerations about firms’ future repayment ability (due to possible long-term changes in demand patterns or because they may already have been unviable before this crisis) had to take a back seat. Similarly, questions about the long-run debt sustainability of (...truncated)