Not Another Eurozone Crisis
(Massimo Paolone/LaPresse via AP)
Not Another Eurozone Crisis
(Massimo Paolone/LaPresse via AP)

This piece is reprinted with permission from Geopolitical Futures.

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It didn’t take long for the pandemic-induced economic downturn in Europe to uncover the skeletons of the previous decade’s eurozone crisis. The Dutch finance minister suggested that Brussels investigate why southern states had less fiscal capacity than the north to respond to the crisis. Berlin reflexively said “nein” to jointly issued debt. A key word in an interview with the European Commission president, who is German, was supposedly mistranslated in a way that suggested an offhand dismissal of the south’s proposed solution. Italian leaders reacted angrily, but the most heated reply came from Portugal’s prime minister, who labeled the Dutch finance minister’s remarks “repugnant.” It was like a replay of 2012, only faster.

Wounds on both sides of the rough divide between north and south have yet to heal, and on the surface it seems the sequel will surpass the original crisis. The economic collapse itself, unprecedented in nature, is expected to be worse. Brexit and the emergence of euroskeptic political parties after more than a decade of European crises have intensified the debate. The battle lines are more clearly drawn, with the southern states this time united and fiercely opposed to austerity, which is thought to have made their recoveries harder and ultimately to have been counterproductive to the European experiment. The days of France and Germany moving in lockstep on the eurozone appear to be over, with French President Emmanuel Macron serving as a leader of the southern bloc – even if in practice he is still functioning as a mediator.

But this isn’t yet a second crisis of the euro – the European Central Bank has seen to that. For now, it’s just a nasty political dispute that looks like a crisis. Still, sooner or later – probably sooner – the eurozone states will have to deal with structural contradictions at the heart of the union, and it can’t be taken for granted that public fury at the bloc’s failures can be boxed up forever.

Backdoor Solidarity

The first sign of trouble came at the end of February, when peripheral eurozone bond yields started creeping up. It briefly became an emergency when, on March 12, European Central Bank President Christine Lagarde raised doubts about her commitment to, as her predecessor famously said in 2012, do “whatever it takes” to save the euro. Over the next six days, Italian, Spanish, Portuguese and Greek bond yields surged. They came nowhere near the levels seen during the eurozone crisis, but they were enough to summon memories of the darkest days of that crisis.

Just before midnight on March 18, the ECB announced a 750 billion-euro ($813 billion) Pandemic Emergency Purchase Program, raising to some 1.1 trillion euros the total amount of assets due to be purchased by the bank for the rest of the year. More important, the ECB ignored its self-imposed limitations by saying the emergency program would not be bound by rules dictating the quantity of a state’s debt that the bank can buy. It also said rules that determine what share of each country’s debt it must buy (to keep the ECB from disproportionately funding one state’s borrowing) will be interpreted flexibly, meaning, for instance, that purchases of Italian bonds can be frontloaded. These constraints had been in place to satisfy hawkish central bank chiefs and leaders in the north, and indeed, the Dutch and German central bank chiefs reportedly protested but were overruled by Lagarde.

The ECB announcement had two important consequences. First, it worked: Bond yields fell close to pre-crisis levels. Second, because it worked, it absolved European capitals of the need to show solidarity, at least for now.

Whistling Past the Graveyard

With the luxury of time, leaders have pitched their own preferences for remaking the eurozone. The northerners suggested that the 410 billion-euro European Stability Mechanism bailout fund could extend credit lines to member states in need. Tapping the ESM would make a state eligible for the ECB’s Outright Monetary Transactions program, which entails unlimited bond purchases. Critics pointed out that, in light of PEPP, a promise of unlimited bond-buying was redundant. With that program due to expire at the end of 2020, however, this may not be the case by next year.

The bigger problem is political. The ESM was designed to help specific states in need, not to fix a generalized shock, so it is pathologically conditional. This makes the ESM toxic in Italy, where it is synonymous with austerity and sovereignty sacrificed to cold northerners. (In an amusing twist, Italian Prime Minister Giuseppe Conte initially supported the ESM plan, apparently underestimating the level of contempt it engenders in Italy.) With the euro-critical League currently sitting as Italy’s most popular political party by a wide margin, Rome’s tenuous ruling coalition has limited political space to maneuver. Germany has signaled that it would be willing to apply only the faintest hint of conditionality to ESM credit lines – just enough to ensure that funds are spent on coronavirus-related expenses – but the Netherlands and Austria have been less flexible. Their hard-line stance is first and foremost about domestic politics – the Dutch ruling coalition is itself fragile – but it’s no coincidence that the ESM approach could force Italy and other recipients in the south to undergo structural reforms that the north has long demanded. (The debate in the north is still shaped by moral hazard concerns, even though Italy has run larger primary surpluses on average than either Germany or the Netherlands since 2008.)

The south’s counteroffer came on March 25, when nine eurozone states including France, Italy and Spain presented their own plan for a “common debt instrument”colloquially known as a coronabond. According to the proposal, coronabonds should be of “sufficient size and long maturity to be fully efficient and avoid roll-over risks.” Proponents argue that the coronavirus crisis is a symmetric shock, and thus that there is no moral hazard, and that coronabonds would by definition be an extraordinary one-off measure.

The north, however, smells a trap. It worries that an acceptance of debt mutualization now – even if only for debts incurred responding to the pandemic, not preexisting debts – would normalize debt mutualization as a policy tool for future crises. More fundamentally, there’s the political problem of convincing national parliaments in the north to agree to coronabonds. German Chancellor Angela Merkel in particular has dismissed the idea on the basis that eurobonds by any name would never pass the Bundestag.

The result is a bitter stalemate. On Wednesday, France tried to bridge the divide with a proposal to create a temporary rescue fund controlled by the European Commission. (In essence, coronabonds by a different name.) Germany came back with light-conditionality ESM loans, an expansion of the European Investment Bank’s firepower to fund the recovery and an EU-wide unemployment fund of up to 100 billion euros. And the Netherlands proposed a modest grant of up to 20 billion euros, with the only conditions being that the money be spent on health care systems or the labor market. None of these proposals will be accepted as-is, but they will be discussed by eurozone finance ministers on April 7.

Approaching the Rubicon

In the meantime, there’s a political crisis brewing, with Rome at its center. Italy was already one of the most euroskeptic member states before Brussels and the other capitals botched their initial handling of the pandemic. While Italy, whose outbreak started before the rest of Europe’s, was asking for help, its neighbors were putting up border checks and placing restrictions on exports of personal protective equipment. Brussels, with no authority in public health matters, could only move around relatively meager funds to help Italy, propose joint procurement of equipment and try to put national leaders in the same room. After a few days, the European Commission had browbeaten Germany into dropping its intra-EU export restrictions and proposed a strategic reserve of medical supplies. German hospitals took in dozens of Italian coronavirus patients. French officials were angrily demanding recognition that, together with the Germans, they had donated more masks to Italy than had China, whose assistance came earlier and with vastly more fanfare. (Enthusiasm in Italy for China’s aid has not been much dented by revelations that some of Beijing’s supposed donations turned out to be purchases and that tests and equipment were apparently of low quality.)

But the damage to Europe’s image was done. In a March 25 survey by Termometro Politico, 42 percent of Italians said Europe had hindered the country’s response and that this was a reason to leave the bloc. A Monitor Italia poll on March 12-13 found that 67 percent of Italians considered EU membership a disadvantage, a jump of 20 percentage points compared to November 2018. Luigi Di Maio, Italy’s foreign minister and former leader of the euroskeptic Five Star Movement, has been a cheerleader of Chinese assistance, drawing an implicit contrast to Europe. Matteo Salvini, the leader of the opposition League and an on-again-off-again proponent of leaving the euro, tweeted that Italy should defeat the virus and then reconsider its EU membership. In this environment, Italy’s demand for “solidarity” – which for Rome means coronabonds – takes on greater significance.

This battle will likely drag out for months – thanks in part to the ECB’s intervention. By soothing sovereign bond markets, the central bank bought European leaders time to debate, but, ironically, it also removed the sense of urgency. In fact, it’s possible that – in an almost implausible scenario involving a rapid economic recovery – no further massive European response will be necessary at all. But every eurozone state’s finances will be in worse shape after the pandemic is over, and each state’s tolerance for more debt is different. Goldman Sachs forecasts that Italy’s debt-to-GDP will climb above 160 percent this year, from about 135 percent today. With numbers like that, there’s only so much can-kicking Europe can do before it runs out of road. Italy and others will likely continue to need help refinancing their extra debt burdens from fighting COVID-19.

To date, when it comes to sharing the economic costs of the pandemic, Europe’s elected leaders have chosen to show solidarity in secret, via the actions of unelected officials at the ECB. But as the crisis draws to a close, pressure from Amsterdam and Frankfurt to wind down the ECB’s extraordinary measures will grow – particularly given fears that post-crisis demand could outstrip supply and lead to inflation, a bugbear in German folklore. Calls from Berlin to rein in public spending – EU caps on deficits have been lifted to address the coronavirus crisis – will also return as loud as ever. At that point, what is mostly a low-stakes, if animated, political dispute will turn back into a full-blown eurozone crisis, and decisions about the future of Europe will need to be made.