NN IP: Eurozone fault lines are back in the spotlight

April 17, 2020

Willem Verhagen, Senior Economist Multi-Asset at NN Investment Partners (NN IP), writes in a recent article: 

The corona crisis puts the spotlight squarely on the fault lines in the institutional design underpinning the European monetary union. The central issue is how to minimise the potential for destabilising capital flows within the region. The core countries argue that every country should insure itself against this risk. The periphery, however, is light-years from this point, and the corona crisis will only push them further away.

The Eurozone needs a public-sector mechanism that will recycle fund flows from current account surplus countries to deficit countries in times when the private sector refuses to do so. The European Stability Mechanism and to an even greater degree the European Central Bank’s balance sheet have performed this function for the past 10 years. In dealing with the corona shock, EMU leaders are once again relying on the ECB. This may not be enough in the long run.

Destabilising capital flows are the real problem

Destabilising internal flows is not an issue in a solid nation-state like the US. The reason is the high level of real economic and financial integration among the individual states. Moreover, the federal government acts as an automatic stabilizer that transfers funds from states with an external surplus to deficit states whenever private-sector financing dries up in a panic.

The Eurozone could stabilize itself by improving the internal markets and by moving towards full banking and capital markets union, but this process is likely to take decades. In the meantime, the need for a public-sector recycling mechanism will be stronger than in the US.

Fortunately, the region has had a kind of minimal degree of public-sector recycling since 2012 in the form of the liquidity hospital, the ESM, which provides loans against strict conditionality. Still, the bulk of recycling is done “by stealth” via the ECB balance sheet. The drawback of the latter route is that it has no democratic legitimacy and shields politicians from having to take tough decisions to implement a lasting solution to this problem.  

Self-insurance is not likely to work

The preferred solution of some core-country politicians is to have all countries engage in a form of self-insurance by pursuing a “twin surplus” strategy. The central idea is that all countries should pursue a large current account surplus, meaning no country would be dependent on net capital inflows. This would also allow each country to build up a war chest of net foreign assets to draw on in a downturn. A second objective of this strategy is to create fiscal surpluses and push the sovereign debt ratio to a level low enough to keep default risk negligible in the eyes of investors.

There are a number of problems with this strategy. First of all, self-insurance is usually less efficient than pooling risks. This is why insurance companies exist. Secondly, in a relatively closed economy like the Eurozone, it is impossible for all countries to run large current account surpluses. If one country saves, another country must borrow. Even if this were possible, it would imply an EMU-wide current account surplus too large to be absorbed by the rest of the world, which is already awash with savings.

The twin-surplus strategy is thus clearly deflationary, a characteristic that is only reinforced by the fiscal rules. These rules put all the entire burden of adjustment on the deficit countries and provide no mechanism for the surplus countries to keep overall EMU demand at a robust level. Finally, self-insurance offers no guarantee that sovereign risk premiums will not fall victim to self-fulfilling dynamics that amplify rather than attenuate risks of the kind seen in 2011-2012 in peripheral space. Such dynamics can be short-circuited only if the ECB acts as an unconditional lender of last resort to sovereigns.

Dealing with the corona crisis

The corona crisis is a large common shock which could substantially increase intra-EMU divergence due to the different starting positions in growth levels and sovereign debt ratios. Full mutualisation of the fiscal costs of the crisis would merely preserve these starting positions. Legacy debt issues would remain the responsibility of the individual countries. Amplification of these starting positions could bring the region to the brink of collapse. In theory, the ECB balance sheet can prevent this, but in practice the ECB will probably not be able to use this unlimited firing power. If it takes very large amounts of peripheral debt onto its balance sheet, it may be accused of monetary financing. In the much longer run, when the time to tighten policy comes, the ECB could be faced with a trade-off between price stability and sovereign debt sustainability.

European finance ministers reached a compromise last week on this thorny issue, one that kicks the can down the road and leaves the crucial details vague. It consists of four elements. First, all countries are granted an ESM credit line of 2% of GDP, where the only conditionality is that the funds be used for healthcare-related purposes. The second element involves guarantees from the European Investment Bank, which can in turn be used to guarantee EUR 200 billion in loans to small and medium-sized businesses, on top of the national schemes totalling EUR 2 trillion.

The third and vaguest element is a EUR 100 billion (0.6% of GDP) program to finance national unemployment schemes. Under this program, the Eurogroup will start working on a recovery fund that may use “innovative financing”, which could in theory be the start of a region-wide public investment program funded by common issuance, but whether that happens in practice remains to be seen.

The measures announced so far will not even come close to covering the likely increases in sovereign debt ratios of 20 to 40 percentage points due to the corona shock. The bulk of the costs of fighting the virus will end up on national sovereign balance sheets, and divergence in sovereign solvency across the region will increase further. The ECB balance sheet can compensate in the short term, as its emergency purchase program is unlimited and the limits have been suspended, but in the long term, a real solution must be found. If not, the peripheral countries could be condemned to eternal stagnation and unbearably high funding costs.”