Europe's response to the economic impact of Covid-19

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“Europe will be forged in crises, and will be the sum of the solutions adopted for those crises” - Jean Monnet

Progress in the construction of Europe has always been made as a result of crises. At first, when faced with a threat affecting all or a considerable number of member states, governments usually respond by seeking solutions at the national level and tend to break ranks with European unity.

This type of strategy has, however, rarely been successful and when it becomes obvious that a problem exceeds the scope of the nation states, a “European solution” is finally implemented. This is how the EU has been built, amongst crises, improvisation and all-night meetings where agreements are reached without the signatories being fully aware of the consequences.

Progress in the construction of Europe has always been made as a result of crises

But this is the only way: the only thing that is pooled is the ability to take decisions when one’s own impotence becomes evident. So far, this has worked well and today’s Europe, despite its imperfections, is far better than any other alternative based on conflict rather than cooperation.

European history is full of examples of crises that ended up bolstering the Union. The coronavirus crisis will be no exception. 

Despite attempts by certain nations to isolate themselves from others to prevent contagion and its economic fallout, the evidence undeniably shows that this virus knows no borders, that patterns are being repeated and that the only difference is the moment when the epidemic becomes massive in each country.

Hence, the only effective response is a coordinated response by the Union, a response that will have to be improvised as time goes by and the crisis evolves but which will create a series of entities and coordination methods that will forever remain in the legacy of European institutions.

Against this backdrop, this policy insight aims to try to answer three questions.

1. The first is: what will the economic consequences of the epidemic be? We know that they will be deep but we do not know how deep. We still have insufficient reliable data to be able to quantify its scope. But qualitatively, we intuitively know that it will make the economy and employment plummet to unprecedented levels. Nor do we know how long it will last. We know it will be temporary – all epidemics and all crises finally come to an end – but it is still too early to know exactly how long this crisis will last. We can only examine reasonable scenarios.
2. The second question I think should be considered is: What incentives for co-operation exist in the European Union? When faced with the option of individual or coordinated action, why is it better to coordinate with other European states? What are the pros and cons? As we will see, in the end, the result will be a mixture of national and European measures but the European component is essential in order to minimise the impact of the epidemic.

Finally, we must consider what economic policy the Union should implement in order to mitigate the impact of Covid-19. The mechanisms are few in number but many are extremely powerful and, in any case, crucial for the continent as a whole.

The magnitude of the crisis is a great opportunity to make citizens believe in the European project once again

The challenge is enormous. The magnitude of the crisis is a great opportunity to make citizens believe in the European project once again and eliminate the nationalist tendencies that have been advancing across the continent. Once again, if the EU rises to the circumstances, the European project will make progress until the next crisis.
 

Calculating the impact of this crisis is no easy matter because these are uncharted waters. Previous epidemics such as SARS in 2002-2003 affected a far smaller geographic area and period of time and cannot, therefore, be used as a measuring rod for the current crisis.

The shocks that will hit the economies…

The economies will be affected by five negative shocks as a result of the spread of the virus.

1. A supply shock, caused by the disruption of production chains of semi-finished products made in China and other Asian countries. This shock causes disruptions and delays to production and would have happened even if the virus had not spread beyond Asia.
2. A second supply shock caused by the measures taken by governments to restrict the free movement of people and the shutdown of businesses in order to contain the spread of the virus. This shock has the greatest impact because it affects, on the one hand, all the sectors obliged to close, i.e. the retail sector, haulage, the entire hotel and catering industry, etc. It also affects the economy as a whole because these restrictions limit people’s access to their workplace and oblige them to improvise new ways of working.
3. A demand shock due to the drop in consumption and investment caused by the considerable increase in uncertainty and the decline in the income of companies and consumers.
4. A second demand shock due to external causes caused by the decline in the income of countries on the receiving end of exports and also the restrictions on the movement of persons from third countries.
5. A tight squeeze on liquidity for consumers and companies. As their income falls, their solvency and therefore their access to borrowing will also decline.

The only positive impact is the change in the price of oil which has fallen as a result of this crisis from US$60 per barrel at the end of February to around US$30 at present.

China, the future imperfect of other economies

Being the country where the epidemic originated, China is obviously one step ahead in everything, from the evolution of the contagion to the economic impact of the epidemic, about which some data already exist.

In the first two months of the year, China’s industrial production fell by 13.5% compared to the same period in 2019. This is the first drop in the industrial production of this Asian country since 1990 when the period of opening up began. In the months prior to the epidemic, industrial production in China was growing at a rate of some 6%-7%.

By industry, the manufacturing exporters hit hardest have been automotive (-32%), transport equipment (-28%), textile (-27%), metal (-27%), electrical machinery (-25%) and non-metallic machinery (-21%).

Retail sales have suffered similar declines. In the first two months of the year they fell 20.5% compared to the same period in the previous year, when a growth rate of around 8% was recorded until December. A particularly sharp drop has been recorded in consumer durables: cars (-37%), furniture (-33%), appliances (-30%), jewellery (-41%) and footwear and clothes (-31%).

What do we know about the other economies?

As regards the economies outside China, no data are yet available to determine the consequences of the spread of the virus. The magnitude of the declines will, however, undoubtedly also be considerable.

There are not even any data available from February and March for South Korea and Italy: the first two developed economies to be affected by the spread of the epidemic. Nor have there been any updates to the forecasts made by international economic bodies that might enable the impact of current events to be evaluated.

Recovery could be faster once the health crisis ends if appropriate economic policies are implemented

It does, however, seem likely that the contraction will be even bigger than the great recession of 2008-2009. Nevertheless, unlike what happened back then, recovery could be faster once the health crisis ends if appropriate economic policies are implemented.

The OECD’s interim forecasts published on 3 March, anticipate a slow-down in China’s growth this year, staying below 5%, and a drop in the growth of global GNP from 2.9% to 2.4%. This report has obviously been superseded by subsequent events.

On 13 March, the European Commission published a report evaluating the possible impact on the EU economy as a whole, including worst-case scenarios, depending on the evolution of the pandemic. In comparison with the growth forecast of 1.4% of GDP for the EU-27 that the Commission made in January, they now forecast a drop in GDP of at least 1.1% as a result of the epidemic, with a substantial, albeit incomplete, recovery in 2021.

The European Commission forecasts a drop in GDP of at least 1.1% as a result of the epidemic

The Commission believes that, of these 2.5 percentage points, most of the decline in the growth rate of the European economy is due to the supply shocks and the liquidity squeeze, and that a considerable part of this drop in activity can be reversed by economic policy.

In the Eurozone, we have only just begun to receive opinion indicators but they are stark. The composite PMI index fell to 31.4 down from 51.5 in February. This is the lowest figure since records began in 1998 and is the largest ever decrease in a single month. As was to be expected, the service sector was hit harder than manufacturing. The impact on consumer confidence was similar: it fell 5 points in March, a bigger drop in a single month than even in 2007-2008.

The first data for Spain, which do not yet reflect the full impact of the state of alarm, indicate a reduction of 75% in passenger transport, 60% in retail business and 70% in car sales. In addition, the considerable weight of the service sector (and specifically tourism) in the Spanish economy, plus the considerable number of SMEs, make Spain more vulnerable to shocks of this type.

The first data, therefore, leave no doubt about the profound impact that the epidemic is having. The shock will be greater than the one experienced during the Great Recession, although it is expected to be shorter.

It is different too, having been caused by factors outside the economic system, rather than by macroeconomic imbalances that needed to be remedied. It is, therefore, reasonable to expect a speedy recovery when the emergency is over, but this will depend on how long it lasts and the economic policy implemented in response.

We know that we face a shock of historic magnitude that will overwhelm the capacity of even the largest nation states. But we also know that it will not affect all countries equally. The economic structure of member states is not homogeneous, therefore the impact of the shocks described above will also vary.

We know that we face a shock of historic magnitude that will overwhelm the capacity of even the largest nation states

Thus, economies that rely heavily on industry, such as Germany, will be affected to a greater extent by the disruption of value chains, but they may be able to make up for some of the lost production in future months.

Economies that rely heavily on tourism (France, Spain, Italy…), however, will be hit very hard by restrictions on the movement of people and will not be able to make up subsequently for the dinners not served and hotel rooms not rented out. Liquidity squeezes, on the other hand, will have a greater impact on countries with a more atomised production structure and higher borrowing in the private sector.

But, in addition, the initial fiscal situation of each of the economies in Europe is quite different. Some countries have considerable room for fiscal manoeuvre which can be used now, whereas others have significant structural deficits and their wriggle room is now very limited. Thus, Germany, Austria, the Netherlands, Denmark and Sweden, for example, have a structural fiscal surplus, whilst Belgium, Spain, France, Italy and Romania have structural deficits above 2%. 

The same can be said of the debt-to-GDP ratio. The peripheral countries have high levels of public debt, near or above 100% of GDP, while the Nordic and German countries have much smaller, more sustainable amounts of debt.

Normally speaking, it may be expected that countries like Spain – which relies heavily on tourism, has an economy based more on SMEs and has little fiscal wriggle room – will have a harder time than more industrial countries such as Germany with larger companies and room to increase spending in the public budget. What incentive is there then for a country like Germany to cooperate with countries like Spain and implement coordinated economic policies in response?

The answer is that after the lessons learned during the Great Recession, another crisis with an asymmetric impact on the Eurozone could prove fatal for its monetary union and the European Union. And the costs of a non-Europe are intolerable for all member states. Let’s see why.

The 2008-2012 crisis stretched the monetary union to breaking point. The reason was that its impact was very different on the original core countries (Germany, Austria, the Netherlands, Luxembourg...) and the peripheral countries (Spain, Italy, Greece, Ireland and partly France). 

The creation of the euro meant the disappearance, in a very short time, of the risk premiums of the peripheral countries. This facilitated their access to credit to an extent never seen before, and cheap borrowing led to an overheating of the economy, an increase in the value of assets, a loss of competitiveness and external indebtedness in the following years. None of this was sufficiently offset by fiscal policy or by structural reforms.

The costs of a non-Europe are intolerable for all member states

The central countries that constituted the original core area, on the other hand, remained more stable because the cost of their borrowing did not fall much, although they did benefit from the "artificial" growth of the peripheral economy.

When the bubble burst, external finance was needed in order to redress the imbalances of the periphery and this caused unprecedented political tensions within the European Union. But faced with the prospect of the EU breaking up, the ECB decided to do everything within its power to keep the eurozone together, and the Eurogroup decided to help, albeit with certain conditions, the peripheral countries that had problems.

Everyone’s calculation was correct. If the euro broke up, the single market would follow. The periphery would suffer a deep recession followed by a devaluation whose effects would last for decades.

But the centre would not do much better. The value of their currencies would fall and they would lose many of their main export markets. The European Union is so closely integrated that the main export markets of all EU countries include their partners in the monetary union.

The bankruptcy of any state jeopardises the stability of the financial system of the other EU countries

In addition, the companies in the EU mainly make their direct investments in other European countries, and all the banks in Europe are creditors of states, companies and families who are also from other states. This means that the bankruptcy of any state jeopardises the stability of the financial system of the other EU countries.

The single market and the monetary union have been so successful that they cannot be separated without destroying the economies that are separated. The European economies are like Siamese twins: if they are separated to save one, both might die.

If it was necessary to cooperate then to keep the monetary union intact, a similar argument can be applied to the coronavirus shock. It is true that some states deserve to be reprimanded for not doing their fiscal adjustment homework properly, which is why they now have less wriggle room.

If any component in the monetary union fails, they all fail

But it is equally true that if any component in the monetary union fails, they all fail. A eurozone still recovering from the previous crisis cannot afford any more doubts about its viability: the price would be too high for everyone.

What economic policy should Europe respond with? In the short term, the aim of the economic policy must be to minimise the impact of the epidemic on the European economy. The most likely scenario, according to the working hypothesis, is that the main impact will last a few months.

But during this period, a very high percentage of activity will be totally paralysed as a result of the measures taken by governments to slow down the epidemic.

This paralysis will necessarily destroy part of the productive fabric

The longer these measures last, the greater the drop in the incomes of workers who lose their jobs, the greater the numbers of jobs destroyed permanently and the greater the number of companies that close down completely. In other words, this paralysis will necessarily destroy part of the productive fabric and if it lasts a long time, the ensuing destruction will increase exponentially.

However, recovery will be faster if the paralysis is shorter. Ideally, when restrictions are lifted, demand will returns to its pre-epidemic level. It may even be higher for a while because confinement will cause a pent-up demand, particularly for durable consumer goods, that could be recovered later. Restaurant meals that are not served are lost forever, but fridges not sold now could be sold in a few months.

Recovery will be faster if the paralysis is shorter

But for this to happen, it is important for savings not to soar as a precautionary measure – but this might happen if unemployment remains high due to many workers no longer having companies to return to because they have closed down during the lockdown.

This is why the measures taken by all countries are aimed at keeping the business world alive, particularly SMEs, by injecting cash into the economy, making working conditions as flexible as possible to maintain as many jobs as possible, avoiding the definitive termination of employment contracts and maintaining income.

In addition, a fiscal stimulus is also needed, when the contagion prevention measures are lifted, to ensure the speedy recovery of demand and employment.

But national measures are not enough. The magnitude of the crisis is so great that joint action by the EU is needed. Non-coordinated actions could jeopardise the Union. This is why the European institutions must not only help make national policies a success, they also have their own mission of safeguarding the Union.

The magnitude of the crisis is so great that joint action by the EU is needed

And yet, the different EU bodies were slow to react at first: this often happens during crises. But as the consequences of the epidemic have spread and the extent of the impact has become known, this has gradually changed.

Monetary policy: the European Central Bank

The ECB is the only agent in the realm of economic policy with sufficient power at the European level. This power will be necessary in a scenario like the current crisis for two reasons.

• Firstly, because member states will have to issue large amounts of public debt to cover the deferrals of tax payments being used to inject cash into European companies, and SMEs in particular, and to finance the public deficits arising from the automatic stabilizers and discretionary income support measures.
• On the other hand, the asymmetric impact of the shock and the different fiscal approaches of the member states will inevitably end with the market tending to differentiate between securities and an upsurge in tensions on the bond market, equal to or greater than those seen during the Great Recession.

The ECB is the only agent in the realm of economic policy with sufficient power at the European level

At the beginning of the crisis, the ECB adopted a half-hearted stance. Declarations by ECB president Lagarde to the effect that it was not the ECB’s mission to reduce risk premiums and avoid the fragmentation of the Eurozone unleashed a veritable storm in bond markets. Despite the subsequent rectification, fragmentation had already begun and risk premiums soared.

The ECB initially put very few monetary measures on the table, just an extension of long-term loans to banks and an additional €120,000 million. Basically, the ECB’s message was, unlike that of the Federal Reserve and the Bank of England, that this was a problem that governments should solve by means of fiscal policies and supply policies, and that it was not a matter for monetary policy.

However, in view of the deteriorating situation and the incipient fragmentation of the public debt markets, on March 18, the ECB decided to launch a new programme to buy a considerable amount of securities: €750,000 million. An appropriate programme in terms of volume and flexibility, both geographic and as regards the types of securities that can be purchased.

This measure immediately took the pressure off risk premiums, being a sign that the ECB would once again do whatever was necessary to safeguard the monetary union. To understand the scale of this programme, it must be said that the ECB balance sheet at the end of 2019 was €4.67 trillion, of which €2.85 trillion were purchases by the ECB of debt issued by Eurozone residents which, prior to the Great Recession, accounted for just 0.15 trillion.

In addition to these amounts, the ECB has announced potential purchases of an additional 0.75 trillion, i.e. an increase in the purchase of securities equal to one third of all purchases in recent years.

Fiscal policy: the Eurogroup, fiscal regulations

The ECB cannot, however, do all the work. With the Governing Council already pushing its statutes to the limit, decisive action is required regarding fiscal policy together with monetary policy.

There are three matters on the table:

1. The first is about how countries can be allowed to make the expenditure needed during this crisis without disrupting the necessary unity of the fiscal rules in a monetary union.
2. The second concerns how this expenditure should be funded: whether it should be dealt with by each member state individually, or whether the debt issuance should be backed by the Eurozone as a whole.
3. And the third, whether the Union should coordinate a joint fiscal stimulus.

The first of these three matters has already been settled by the Eurogroup on 16 March. The second has yet to be decided. And the third has yet to be considered.

In the announcement made on Monday, 16 March, the Eurogroup acknowledged that the impact of the crisis on the budget would be considerable and it would, therefore, use all the flexibility permitted by the Stability and Growth Pact to adapt fiscal regulations to the circumstances. 

In this respect, automatic stabilisers (higher unemployment expenditure and lower tax revenues due to the decline in activity) would be allowed to come into full play and the extraordinary fiscal expenses caused by the epidemic would not be taken into account when verifying compliance with the tax regulations stemming from the Stability Pact. It was also agreed that the European Commission could use the Stability Pact escape clause, which, in essence, allows the application of fiscal rules to be suspended in extraordinary circumstances.

The Eurogroup statement was disappointing because it did not propose any significant European initiative

The statement was, however, disappointing because it did not propose any significant European initiative. It did not address the coordination of fiscal stimulus at the Union level to help activity recover when the emergency is over, and neither did it consider the possibility of the Union backing the necessary debt issuances that national support packages will require.

During their last meeting on 24 March, the Eurogroup discussed different ways of providing support for member states via the European Stability Mechanism (ESM). From the outset, due to opposition from Germany and the Netherlands, the possibility of issuing debt backed by the Eurozone as a whole in order to finance part of the fiscal effort to be made by all member states was ruled out. In other words, the issuance of eurobonds, coronabonds or any other form of pooled public debt was left off the table.

As their president pointed out, as a result of that meeting it was agreed to mobilise up to €500,000 million via a fund based on the ESM’s current capacity to grant precautionary lines. He did not offer any further details, but it does not seem to be a horizontal financing mechanism, but rather an instrument that member states would have to request and which would be granted in exchange for conditionality with a greater or lesser degree of laxity.

In view of the magnitude of the crisis, its origin and its impact on all member states, now is the time to sow the seed of a European treasury

This approach, if confirmed, would not eliminate the problem of the stigma of this type of instrument and, therefore, it would not be a crisis prevention mechanism but rather a financing mechanism for when a member state is in trouble. This proposal, yet to be approved by the European Council, is far removed from Europe’s need to create truly effective instruments in response to shocks with asymmetric impacts. In view of the magnitude of the crisis, its origin and its impact on all member states, now is the time to sow the seed of a European treasury.

Other policies: European Commission and EIB

Other European entities that have taken action are the European Commission and the European Investment Bank (EIB).

From a budget viewpoint, the European Commission has very little wriggle room. The Union budget is just 1% of EU GDP, and most of it is spent on agriculture and regional policy. This is why the financial contribution has been limited to €37,000 million for the Investment Initiative in Response to Coronavirus (for health, SMEs and the job market), with an additional 28,000 million, for this purpose, from regional funds.

Furthermore, member states may use any unspent residual balances of structural funds to co-finance this initiative instead of having to return them to the Commission.

The EIB will earmark €25,000 million for loans to SMEs and will mobilise €40,000 million of resources. These amounts, as we can see, are significant but insufficient, and reveal the Union’s lack of financial clout.

The EIB will earmark €25,000 million for loans to SMEs and will mobilise €40,000 million of resources

The Commission’s most important task is its basic role, i.e. ensuring that the single market remains fully operational. Its rupture is inevitable because the virus containment measures restrict the free movement of people, goods and services. 

But the Commission has already warned that it must be done in a coordinated, temporary manner with the least possible impact. Hence, on 16 March, the European Commission issued border control guidelines to be implemented by member states in order to safeguard the health of citizens and the availability of essential goods and services, with particular emphasis on maintaining the free movement of goods, preventing unnecessary interruptions to production chains and enabling the transport sector to keep going as much as possible.

The Commission has also pledged to allow greater flexibility as regards the rules of state aid for the sectors hit hardest by the epidemic in order to enable subsidies for paying wages and working capital.

But once again, the effectiveness of this measure depends, ultimately, on the financial capacity of each member state. To be precise, subsidies of up to €800,000 per company may be granted; loans backed by states may be given; loans with subsidised interest rates may be given; and greater flexibility in export credit insurance will be allowed.

The Commission has pledged to allow greater flexibility as regards the rules of state aid for the sectors hit hardest by the epidemic

The Commission has also earmarked €47.5 million for medical research from its Horizon 2020 emergency funds for 17 research projects to combat coronavirus: treatment, vaccines, limiting infections, etc. A similar amount is expected to be raised from the private sector.

Other institutions have also acted within their sphere of competence. The European Banking Authority, for example, decided that the competent authorities in each member state should make maximum use of the flexibility of current regulations to support the financial sector. Along the same lines, the ECB’s supervisory authority granted temporary capital and operating margins to banks in the Eurozone.
 

This crisis must serve to establish permanent institutions and policies to avoid having to improvise solutions, which always take time and are hard to implement, in any similar situation in the future.

• As mentioned earlier, we must not waste this opportunity to create a European finance mechanism to help offset asymmetric shocks. Coronavirus affects everyone, but in different ways, and same will apply to crises in the future.
• The fiscal flexibility that the Eurogroup has shown when dealing with this crisis must also be applied to a coordinated effort to create a fiscal stimulus to ensure a speedy recovery when restrictions are lifted.
• We must design an exit strategy. When the epidemic subsides and we gradually return to normal, member states will be left with a significant outlay and a level of borrowing for which current Stability Pact regulations have no answer. We must adapt these regulations to ensure that deficit adjustment and debt reduction are feasible and do not strangle an incipient recovery unnecessarily. This is the smartest way to win the support of citizens for the necessary regulations of fiscal stability.
• The Multiannual Financial Framework discussions taking place at the moment must contemplate the possibility of increasing the maximum European budget in order to develop common policies to deal with this type of emergency.