After new ECB program and fiscal loosening, the EU needs joint action vs. pandemic

European Central Bank President Christine Lagarde announcing the bank’s emergency program last Wednesday.
Wednesday, March 25, 2020

In late July 2012, several months after the European Union, with the International Monetary Fund, concluded a second bailout for Greece and only a few days after the EU agreed to provide up to €100 billion to assist the Spanish government in recapitalizing the country’s banks, Mario Draghi, the president of the European Central Bank, famously told investors in London the ECB would do everything in its mandate to keep the eurozone intact – “whatever it takes. And believe me, it will work.” And in the months and years that followed, it did indeed do whatever it took; it created an Outright Monetary Transactions program (OMT) to purchase short-term government bonds, a Targeted Longer-Term Refinancing Operation (TLTRO), a program to buy Asset-Backed Securities (ABS), and a program of Quantitative Easing (QE) under which the ABS program was expanded to include bonds issued by eurozone governments. As a result, Italy, with more than €2 trillion of public debt and a debt/GDP ratio of 127 percent the next looming target for the markets after Greece and Spain, never needed a bailout.

As the coronavirus pandemic swept through Italy, Spain, France, Germany and other member states of the EU last week, bringing with it dramatically-increasing rates of infection and death, strains on hospitals and health systems never previously seen in peacetime, the closure of innumerable businesses in the wake of country-wide lockdowns, and the prospect, in the near future, of widespread business failures, dramatic increases in unemployment, and a recession the severity of which can only be guessed at this point, Europe had what may in time come to be regarded as another “Draghi moment” when Christine Lagarde, his successor, announced, after a late-night emergency meeting by phone of the ECB’s Governing Council last Wednesday, creation of a Pandemic Emergency Purchase Programme (PEPP) under which the ECB will purchase up to €750 billion of private and public sector securities. Sounding much more like Draghi than she had the previous Thursday in announcing a package of monetary policy measures, Lagarde tweeted, “Extraordinary times require extraordinary action. There are no limits to our commitment to the euro. We are determined to use the full potential of our tools, within our mandate.”

The ECB’s creation of PEPP followed less than a week after its March 12 announcement of a comprehensive package of monetary policy measures that included additional longer-term refinancing operations (LTROs) to provide liquidity support to the euro area financial system until its third series of targeted longer-term refinancing operations (TLTRO III) is extended in June for another year, as well as commitment of an additional €120 billion in net asset purchases through the end of the year to its current monthly €20 billion in Quantitative Easing. Unfortunately, in announcing the March 12 program, Lagarde made comments that suggested not that the ECB would, as Draghi had pledged, do “whatever it takes” but, rather, that it wasn’t particularly concerned about the market for government bonds. It wasn’t the job of the ECB, she said, to respond to the bond market: “We are not here to close spreads; this is not the function or the mission of the ECB.” Instead, she said the response to the crisis must be “fiscal first and foremost” and called on the EU governments to pursue “an ambitious and collective fiscal response.” She was of course right. But the markets were looking for another “Draghi moment,” not comments suggesting the ECB isn’t concerned about the bond market and thinks it’s up to the national governments to respond to the crisis with their fiscal policies, and her comments prompted a large selloff of government bonds.

On March 13, the day after Lagarde’s faux pas, if it can be called that, European Commission President Ursula von der Leyen, perhaps prompted in part by Lagarde’s emphasis on the need for the governments to use fiscal policy to counteract the effects of the crisis, stated the crisis would “very likely” cause a recession this year and warned the member states they would need to act boldly in order for the economy to recover next year. Instead of the previously-predicted growth of 1.4 percent in the EU GDP this year, she announced the Commission now expects a one percent drop in GDP. Taking a cue from Draghi, she said the Commission, for its part, would “do whatever is necessary to support the Europeans and the European economy.” Toward that end, she announced two proposed regulations for consideration by the Council and Parliament. One would create a Coronavirus Response Investment Initiative designed to promote up to €37 billion in investment in member state health care systems and for working capital for small and medium enterprises and labor market support. The other would increase the funds available to member states and accession countries for disaster relief through the EU’s Solidarity Fund. More importantly, prompted by the European Council’s call after in its Mar. 10 video conference for the flexible application of the EU’s fiscal rules, von der Leyen said the Commission would adopt a position of “maximum flexibility” in regard to the application of the EU’s rules pertaining to state aid and to the application of the Stability and Growth Pact, implying that the heretofore sacred 3 percent of GDP limit on budget deficits would be loosened for the members of the eurozone.

On the same day, Olaf Scholz, the German finance minister, announced the government would provide unlimited liquidity assistance to businesses by increasing their access to loans from the state-owned KfW development bank and increased its lending capacity by about €100 billion, while at the same time the Bundestag acted to expand the country’s short-time work (Kurzarbeit) scheme that assists companies in paying workers put on reduced work time. Meanwhile, following a speech the night before in which French President Emmanuel Macron announced the government would take “exceptional measures” to assist businesses and would “bear the financial burden of the people who have to stay home,” Bruno Le Maire, the finance minister, announced the government was prepared to spend “tens of billions of euros” in an emergency package that would enable businesses to keep paying their employees and banks to keep lending to businesses. “We will,” he said, “do everything necessary and more.”

Last Monday, following up on the previous week’s European Council videoconference, the Eurogroup, which consists of the finance ministers of the EU member states that are in the euro area, agreed that an “immediate, ambitious and coordinated policy response is needed” and therefore put together “a first set of national and European measures while setting a framework for further actions to response to developments and support an economic recovery.” It reported that it had decided, thus far, on fiscal measures equivalent to about one percent of GDP to support the economy in addition to automatic stabilizers and had committed to provide liquidity facilities of at least 10 percent of GDP consisting of public guarantee schemes and deferred tax payments. It agreed that all of the governments would allow automatic stabilizers to function fully, regardless of their budgetary impact, and would implement all necessary measures to ensure that the economic consequences of the pandemic are tackled. It agreed that, to the extent required, the governments would implement temporary measures such as immediate fiscal spending aimed at containing and treating the disease, liquidity support for firms facing severe disruption and liquidity shortages, and support for affected workers. In addition, it said it would make full use of the flexibility that exists in the Stability and Growth Pact, meaning that automatic revenue shortfalls and expenditure increases resulting from the economic downtown wouldn’t affect compliance with the Pact and all temporary fiscal measures taken in response to the crisis would be excluded when assessing compliance with the EU’s fiscal rules and requirements. And it welcomed the Commission’s readiness to activate a general escape clause that would allow further discretionary spending and welcomed as well its guidance on the scope for supporting firms that is available within state aid rules under the current circumstances. In concluding, the ministers said, in the spirit of Mario Draghi eight years ago, “We will take whatever further coordinated and decisive policy action is necessary, including fiscal measures, to support growth and employment.”

Last Tuesday, in another videoconference, the European Council endorsed the Eurogroup’s statement and invited it to “continuously and closely monitor economic and financial developments and to adopt without delay a coordinated policy response to the rapidly evolving situation.” It expressed its support for the various initiatives taken by the Commission, including the adaptation of the state aid rules and the use of the flexibility provided for in the Stability and Growth Pact, and its recourse to the EU budget. And, echoing Draghi, it said, “The Union and its Member States will do whatever it takes to address the current challenges, to restore confidence and to support a rapid recovery, for the sake of our citizens.”

Last Wednesday evening, after its emergency telephone meeting, the Governing Council of the ECB announced creation of the new €750 billion Pandemic Emergency Purchase Programme (PEPP), a temporary asset purchase program that will purchase both private and public sector securities until the end of this year. In addition, the ECB will expand the range of eligible assets under its Corporate Sector Purchase Programme (CSPP) to include non-financial commercial paper, thereby making all commercial paper of sufficient credit quality eligible for purchase under the CSPP. And it will expand the scope of its Additional Credit Claims program (ACC) to include claims related to the financing of the corporate sector. In concluding, the Governing Council said it is “committed to playing its role in supporting all citizens of the euro area through this extremely challenging time. To that end, the ECB will ensure that all sectors of the economy can benefit from supportive financing conditions that enable them to absorb the shock.” Echoing Draghi as the European Council had the previous day, it said it “will do everything necessary within its mandate. The Governing Council is fully prepared to increase the size of its asset purchase programmes and adjust their composition, by as much as necessary and for as long as needed. It will explore all options and all contingencies to support the economy through this shock.”

The ECB’s PEPP is obviously very important. But an asset purchase program, however large it may be, will not, by itself, enable the member states to deal with the economic consequences of the pandemic. For that, as the European Council and Eurogroup recognized, a substantial fiscal expansion is also required. Following the Eurogroup and European Council announcements, several of the member states announced significant increases in spending and/or decreases in taxes. In France, Le Maire, the finance minister, announced a €45 billion package that includes €32 billion for deferral of corporate tax and social security charges and €9 billion for payments to workers temporarily unemployed. In addition, the government will guarantee €300 billion of bank loans to businesses to ensure that they remain in business. In Spain, Prime Minister Pedro Sánchez announced a commitment of €100 billion in loan guarantees for businesses, especially small and medium enterprises, as well as a moratorium on mortgage and utility payments for those who lose their jobs and income. The government will also provide support for a short-work scheme similar to Germany’s that will allow employers to suspend rather than lay off workers while the latter continue to be paid and receive benefits. And in Italy, the government announced it will provide an additional €25 billion in spending that includes support for the hard-pressed health system, payments to the self-employed, payments to companies that are paying laid-off workers or paying workers who would otherwise be laid off, and cash payments for families with children and those who are still working.

Those efforts are important and will no doubt be helpful in dealing with the economic consequences of the pandemic. But only one state – Germany – appears to have fully grasped the full potential impact on the economy. Operating on an assumption that GDP this year will drop by 5 percent, on Monday Olaf Scholz, the finance minister, presented, and the German cabinet approved, a package worth up to €750 billion. If approved by the Bundestag, Germany will spend an additional €123 billion this year as part of a €156 billion supplementary budget that also foresees a reduction of €33 billion in tax revenues. As a result, the government will have to borrow an additional €156 billion this year, which will require authorization to suspend the constitutional “debt brake” which limits borrowing to 0.35 percent of GDP. The extra budget includes, among other things, a €50 billion program to aid small businesses and the self-employed who are threatened with bankruptcy and €10 billion to enable more companies to apply for aid under the short-term work program. In addition to the supplemental spending, the government will create a €500 billion bailout fund, the Economy Stabilization Fund (WSF), that will have up to €100 billion for the recapitalization of companies and up to €400 billion for loan guarantees of corporate debt at risk of default. It will also provide €100 billion to the KfW, the state’s development bank, for liquidity assistance for troubled companies. The government will have to borrow €200 billion to cover the recapitalization program and the assistance for the KfW, which means that, in order to fund both the supplemental budget and the bailout fund, the government will have to borrow a total of €356 billion, which is equivalent to roughly 10 percent of the German GDP. For a country with a deep collective aversion to budget deficits and public debt, the scale of the program will no doubt prompt heated debate. But the debt hawks who think the program is extravagant and unnecessary may someday be glad the government put it together and approved it.

For the EU, however, the fact that Germany has the financial resources and leverage to implement the package it approved Monday raises the question of what, if anything, should be done to shield the other member states, especially those which have been especially hard-hit by the coronavirus and don’t enjoy Germany’s financial resources and leverage, from the potential economic consequences of the pandemic. (According to the Johns Hopkins Coronavirus global tracking system, as of early today Germany has had 32,952 cases and 171 deaths while Italy has had 69,176 cases and 6,820 deaths, Spain 42,058 cases and 2991 deaths, and France 22,304 cases and 1,100 deaths.)

It’s clear that for Italy, Spain and France, saddled as they are with higher levels of public debt, relative to GDP, and lacking the financial leverage in the markets that Germany enjoys, something more is needed beyond PEPP plus fiscal self-reliance. Specifically, there is a need for an EU-wide fiscal response – something that is, of course, currently impossible given the fact that the entire EU budget represents only one percent of the EU’s aggregate GDP. Last Friday, Italian Prime Minister Giuseppe Conte called on the EU to use the “full firepower” of its European Stability Mechanism, which has €500 billion available to support euro area member states needing a bailout. And on Monday, Spanish Prime Minister Pedro Sánchez called on the Eurogroup to come up with a “big Marshall plan – a big public investment plan” for the EU.

Last night the Eurogroup held a two-hour meeting by telephone to consider the question and perhaps come up with a proposal to the European Council in time for the latter’s video conference tomorrow. Among the options discussed were amending the ESM to enable it to provide the states that have been most hard-hit by the coronavirus with credit lines or liquidity facilities or, alternatively, creating a new EU debt instrument and issuing bonds backed by the collective resources of the 27 member states. The ministers were unable to agree on a joint statement but there was, according to Mário Centeno, the Eurogroup president, “broad support” for some type of “pandemic crisis support safeguard” in the ESM.

Whatever the option, one thing is clear: The time for the EU to act is now.


David R. Cameron is a professor of political science and the director of the European Union Studies Program.