As the peak of the crisis passes in Europe, with infection rates slowing and pressure on health systems easing, countries have begun to focus on the recovery. Euro area GDP contracted by 3.8% in 2020 Q1, with France, Spain, and Italy all contracting by more than 5%. And, that is just the start — economic activity probably troughed in April, with the second quarter’s GDP print likely to reveal an unprecedented fall in output. As a result, national governments have announced large-scale spending to support their economies, assisted by the ECB’s easing of monetary conditions. The European Commission has now joined the cavalry.
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Following on from the historic Franco-German debt mutualisation proposal, Commission President Ursula von der Leyen announced plans for a €750bn recovery fund, involving €500bn worth of grants and €250bn worth of loans, with money allocated to the economies that have been worst hit by COVID-19 crisis. While the specifics are yet to be finalised (and are likely to be watered down to please more frugal members), the political capital generated by a deal could be immense. Having lost its second-largest economy as a member state six months ago, the EU will be keen to prove its worth during times of crisis, especially in countries such as Italy. As seen in the chart below, the market-implied probability of sovereign default for both Italy and Greece has risen significantly since the end of 2019, both now sit above 10%.
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Fathom has long argued that the lack of fiscal transfers makes the euro area an imperfect monetary union, but that a permanent mechanism for debt mutualisation would be a game changer. Politicians are keen to stress that this is a one-off resulting from the unique circumstances that they are facing. However, as we saw with QE in the last crisis, policies designed to be temporary can be hard to dispose of. The proposed sum is small compared to overall EU GDP. But if this is just the beginning of a much larger EU debt-issuance programme, it could spur pro-growth government spending in sluggish economies, bringing euro area inflation closer to 2%, helping an ECB that is desperately out of ammo.
The ECB is one of few central banks to have held interest rates despite its economy being hit badly by the virus, as it was already at the effective lower bound. Furthermore, it is worth remembering that the coronavirus crisis is not a closed case. Should a second wave of lockdowns be required, the ECB will have little choice but to expand a purchase programme that is already vast, or take interest rates further into negative territory, which until now they have seemed reluctant to do.
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