How Can We Avoid a Euro Crisis?

by Daniel Fernández Kranz, Associate Professor of Economics and Chair of the Department of Economics at IE Business School. LinkedIn

by Fernando Fernández, Professor of Economics at IE Business School.

Europe faces an unprecedented crisis whose length and consequences are as yet unknown. Its response will be remembered and will influence the feelings of its citizens, a growing number of whom are starting to distrust the European project.

Besides the two crises on everyone’s mind—the health crisis and the economic crisis—there is also a third one that will largely define the future consequences of our current moment: a potential debt crisis. To prevent this outcome, Europe must mutualize the costs of the imminent economic crisis. If Europe allows its member states to go into debt individually to finance their stabilization programs, its own survival as a monetary union would be called into question. And yet, the massive purchase of government bonds announced by the European Central Bank (ECB) entails precisely that: more national debt, which sooner or later will burden the states issuing it.

On March 23, the International Monetary Fund issued a report warning that the intensity and cost of this crisis could be similar to that of 2008. During the last crisis, Spain’s national debt rose from 35% of GDP to its current level of 100%, while Italy’s rose from 95% to 140%. It was possible to do this without incurring unsustainable increases in debt servicing costs thanks to the ECB’s bond-buying program—the same one now poised to be implemented again. Can Spain, Italy, and other countries withstand the future burden of another colossal debt increase?

Two ways out

There are two main ways to prevent individual states from emerging from this crisis further indebted: “coronabonds” and helicopter money. Both would involve distributing—that is, mutualizing—the cost of the current economic emergency among all member states by creating a real European payer of last resort.

Coronabonds are European bonds that would be paid for and financed by the entire union. Although they would involve taking on more debt, this debt would be backed by the union as a whole. Helicopter money would be printed by the ECB and delivered to governments, companies, and citizens. It would not have to be repaid, but it would come at a cost: it would permanently devalue the currency in which the money was issued. To the extent that the currency—the euro—belongs to all of us, we would all shoulder the burden.

Europe could choose either of these options, given that the third and most direct option—an anticrisis budgetary facility financed by issuing extraordinary eurobonds—is not on the table. We fear, however, that the authorities will not choose any of these options, resorting instead to more politically cautious—but less effective—solutions such as the current plan for the ECB to buy government bonds or for loans to be provided through the European Stability Mechanism (ESM).

Both plans would increase the member states’ national debt, limiting their future options with regard to budgetary policy, unless the ECB is willing to forgive that debt, assume the loss as its own, monetize it, or use the ESM to finance bailout programs—those dirty words—by issuing European bonds. Both cases would amount to a deferred mutualization of the sovereign debt issued by the members states as a consequence of the coronavirus.

A silent threat

The first warning came in October 2018, when Italy’s coalition government presented a budget for the following year with a significantly larger public deficit than what had been agreed with Brussels. The market interest rate on ten-year Italian bonds rose to 3.7%, an impossible cost for a country with accumulated debt totaling 140% of its GDP. The Italian government soon amended its budget proposal.

The second warning came just a few days ago, after the government announced a nationwide lockdown. Italy’s risk premium doubled in just six days, from 1.20% to 2.40%. On March 18, the ECB was forced to respond: “Extraordinary times require extraordinary action.” Later that afternoon, the ECB announced a €750 billion emergency plan. Italy’s risk premium stabilized—for the time being.

A brave, united Europe

Italy’s experience shows us that countries with excessive debt levels can permanently lose the trust of the markets, leaving them with little room to maneuver on economic policy, which in turn jeopardizes their chances of recovery and makes them highly vulnerable to external shocks. As it stands, the plan announced by the ECB still translates into more national debt and could therefore aggravate the problem in the future.

Europe must act bravely and with a united front. Investors who have always been suspicious of the euro’s sustainability are wondering, “If not now, when?” The intensity with which this sudden exogenous crisis affects each country will depend on chance and the particular social and human structure of the population. But it has nothing to do with earlier economic management.

No country deserves to suffer this crisis. The fear that coronabonds or helicopter money will generate a problem of incentives or a moral hazard is completely unfounded in the current extraordinary context. The good news is that, unlike the financial crisis of 2008, this crisis did not originate in malfunctioning economies or markets. Therefore, once the health emergency ends, a quick recovery might just be possible.

For this to happen, however, the right recipes must be applied. Europe, the monetary union, faces a Hamiltonian moment: if it fails to mutualize its debt, many countries will wonder what it is for. No responsible government would refrain from doing everything it could to save its productive structure.