The significant impacts an EU recovery fund would have

Once taboo, debt mutualisation has come to the fore of European politics courtesy of the COVID-19 pandemic


The announcement dropped like a bomb in European capitals, most of which were still under strict lockdowns. In a joint press conference, German Chancellor Angela Merkel and French President Emmanuel Macron proposed an EU recovery fund that would offer €500bn ($569.2bn) in grants as an economic lifeline to pandemic-stricken members of the union. Authorities on recent EU history hailed this as a Hamiltonian moment, a reference to Alexander Hamilton, the visionary who spearheaded the federalisation of states’ debt in the US.


The proposal stopped short of mentioning eurobonds, a financial instrument collectively guaranteed by EU member states that has become a bone of contention in the bloc’s response to the novel coronavirus. And yet, it was instantly recognised as a bold step towards bringing the union closer to what was hitherto unthinkable: joint debt issuance, a typical feature of fiscal unions. Wolfango Piccoli, co-president of political risk advisory at Teneo, a US management consulting firm, told World Finance: “The French-German [proposal] broke two fundamental taboos: it opened the possibility for European governments to engage for the first time in massive joint borrowing, and sanctioned significant fiscal transfers between its member states.”


Beware the frugal four
Just 10 days after Macron and Merkel let the cat out of the bag, the European Commission announced its own plan. It was even more generous, offering an extra €250bn ($284.5bn) in loans on top of the €500bn grants proposed in the French-German plan. The funds will be raised via EU-issued bonds and financed through a series of new taxes and levies. These include staples of the EU repertoire, such as taxes on large corporations and tech powerhouses, as well as measures reflecting Brussels’ Green Deal, including taxes on carbon and plastic. The €750bn ($853.6bn) recovery fund, aptly called Next Generation EU, incorporates the essence of the French-German proposal and also adds ideas from countries that are less enthusiastic about shared debt. Michael Hüther, a German economist and director of the German Economic Institute, told World Finance: “The commission’s proposal clearly bears the signature of the German and French Governments, as it includes a high level of transfer. The question is, however, whether this high level is necessary to help the affected states in the current situation.”

The timing and innovative set-up of the EU recovery fund has boosted the hopes of Europhiles that something bigger is in the works

The proposal comes with various conditions that make it less ambitious than what its main beneficiaries were hoping for – grants will not be used to finance existing debt, for example. Its timing and innovative set-up, however, has boosted the hopes of Europhiles that something bigger is in the works. Bonds will be issued in the name of the EU, while the commission will oversee fund allocation. For over-indebted countries with volatile sovereign credit ratings, this will be a boon, as the bonds will have the coveted AAA rating that puts them into the ‘safe asset’ category. But Hüther believes the impact on the EU’s coffers remains a concern: “The repayments will place a heavy burden on the EU budget for many years, from 2028 onwards. EU taxes proposed by the commission to finance the fund are unlikely to find a majority among member states.”

The commission needs to convince all member states that its plan is the best way to move forward. Persuading Austria, Denmark, the Netherlands and Sweden – a bloc that has been named ‘the frugal four’ for its aversion to shared debt – will take a lot of effort and possibly some concessions. A few days before the commission announced its proposal, the frugal four presented a different recovery policy, offering loans rather than grants and emphasising the temporary character of any intervention. However, the commission’s plan is expected to get the green light in one form or another, given that it bears the stamp of the Franco-German engine that traditionally spearheads reform in the EU. Piccoli said: “The negotiation will be a tough one, but given that Germany is the biggest contributor, it will go a long way to convince some of the reluctant countries.”


EU turn
France has always been a champion of debt mutualisation, driven by its precarious economic position – the country’s public debt is approaching the 100 percent debt-to-GDP threshold (see Fig 1). Macron is also a staunch Europhile with bold ideas for the future of the bloc. Until recently, though, Germany was the unofficial leader of the frugal group: several economists, including former Greek finance minister Yanis Varoufakis, floated the idea of issuing eurobonds during the sovereign debt crisis, only for it to be rejected by the German Government. This is why Merkel’s sudden embrace of the idea has come as a surprise.


Some point to fierce pressure from Ursula von der Leyen, who was the longest-serving member of Merkel’s cabinet before becoming president of the European Commission, as a possible explanation. The fact Germany will take over the European Council presidency in July and lead negotiations on the EU’s 2021-27 budget might also have played a role. Others point to more pragmatic reasons, such as concerns over Italy’s soaring debt, which currently sits above €2.4trn ($2.73trn), several times more than that of Greece. Adding further debt to tackle the consequences of the lockdown would make Italy’s recovery more difficult.

Some cracks in the opposition to eurobonds emerged in March, when a group of influential German economists published an article via several European media outlets, calling for the issuance of €1trn ($1.14trn) in crisis bonds. Hüther, who was among the authors, told World Finance: “The union is sending a strong signal of European solidarity in a situation where the cost of borrowing at the European level is very low.” The German public had started to warm to the idea at the peak of the COVID-19 pandemic, with the local press stressing the importance of European solidarity during a global healthcare crisis.

Some fear that the wounds to European solidarity will take a long time to heal

As Jonathan Hackenbroich, a policy fellow for economic statecraft at the Berlin branch of the European Council on Foreign Relations, explained to World Finance: “The German economy is dependent on exports [see Fig 2] and a liberal trade order. With that being more difficult internationally, the government knows that a strong EU market becomes more important, and Germany can’t just focus on exports to third countries.” He added that developments on the other side of the Atlantic might have influenced the German Government’s decision: “Germans and [other] Europeans can’t make their own economic decisions in some instances anymore because of US economic nationalism. The dollar, which Europeans used to view almost as a public good, is getting weaponised. That’s partly why the German Government recognises how important it is to have a strong European market.”



Merkel’s political calculations may have played a role, too. The German chancellor is expected to step down next year, giving her leeway to make difficult decisions without taking the political cost into account. Hackenbroich believes the successful management of the healthcare crisis in Germany has led to a renaissance of ‘Merkelism’: “The reason why [Merkel] can dare to make concessions is that she is highly popular. Her party is leading the polls by a wide margin because she [has] handled the crisis really well so far. German people are happy that their leader is Merkel and not someone like [UK Prime Minister] Boris Johnson or [Brazilian President Jair] Bolsonaro.”



Pulled in different directions
The ambitious French-German proposal couldn’t have come at a more crucial time for European unity, which is being challenged by two parallel crises: the pandemic, and the heated debate over how to respond to the economic tsunami caused by strict lockdowns. Old grievances, thought to be dormant since the worst days of the Greek debt crisis, have come back to the fore. The push for debt mutualisation was led by Spain and Italy – the two countries that took the biggest hit during the early stages of the pandemic – and has been backed by Portugal, France, Ireland and Greece.

Joint debt issuance may be seen as a pattern to be followed in the future, but it is a prospect that will likely be met with fierce resistance

Frugal member states from the North were having none of it, though, as they were wary of moral hazards that could delay reforms in Southern Europe. In a Eurogroup meeting via videoconference in late March, the Dutch finance minister Wopke Hoekstra sparked uproar when he demanded that Brussels investigate why some countries were not prepared for a financial crisis just a few years after the previous one. Not one for mincing his words, Hoekstra categorically rejected eurobonds as an irrelevance. To southern ears, this was nothing more than hubris while the virus claimed the lives of thousands of people daily. Dropping all pretence of diplomatic courtesy, the Portuguese Prime Minister António Costa dismissed Hoekstra’s remarks as “senseless” and reminiscent of the eurozone’s recent woes: “No one has any more time to hear Dutch finance ministers as we heard in 2008, 2009, 2010 and so forth.”

Costa’s remarks reflect the deep frustration that can be found in Southern Europe over what was deemed to be unwarranted virtue signalling from the frugal North during an unprecedented healthcare crisis. Member states’ political leanings also contributed to the acrimony, with the left-wing governments in Portugal, Spain and Italy protesting that a decade of austerity had left them with little leeway to support their economies while generous bailout packages were needed for companies and employees. Passions ran high, with Italian politicians going as far as accusing the Netherlands of being a tax haven.

One of the lasting impacts of the COVID-19 pandemic may be the transfer of more power to Brussels

The tension exposed the new internal dynamics within the EU. The UK’s departure has created a gap in the balance of power between France, which usually sides with southern members, and Germany, previously the leader of the frugal North. Onno de Beaufort Wijnholds, a Dutch economist who previously served as executive director of the IMF, has suggested that Germany may have welcomed the eagerness of the Netherlands to take up the mantle of fiscal probity: “It may well be that Germany prodded its neighbour to lead the opposition, thus having the initial Italian wrath directed at the Netherlands. The Netherlands – like Germany and some other northerners, but this time [in a] more outspoken [manner] – does not wish to participate in a transfer union without some conditionality. Without it, we might see Italy becoming a ‘super Greece’.”

Some fear that the wounds to European solidarity will take a long time to heal, with Euroscepticism rising in Spain and Italy, which have hitherto been deemed as bastions of the EU. In the eyes of Lorenzo Codogno, former chief economist at the Treasury Department of the Italian Ministry of Economy and Finance, the euro has become an anathema for many Italians. As he explained to World Finance: “The root of the problem is that Italy is the only country in the eurozone that still has real GDP per capita slightly below the level [it had] when the single currency was launched in 1999. It is not the euro’s fault, but it is too easy to make a connection between the two phenomena.”



En garde, Madame Lagarde
Italian sentiment towards the EU was further bruised in March, when European Central Bank (ECB) President Christine Lagarde remarked that “the ECB is not here to close spreads”, referring to differences in eurozone members’ borrowing costs. The timing couldn’t have been more unfortunate, as Italy was facing the peak of the COVID-19 pandemic. The country’s bond yields were already reaching levels reminiscent of the sovereign debt crisis and Lagarde’s comment sent them even higher. Many compared her insouciance with the conduct of her predecessor, Mario Draghi, who, at the peak of the Greek crisis, said the ECB would do “whatever it takes to preserve the euro” – a statement that boosted market confidence in the eurozone.
Piet Haines Christiansen, Chief Strategist (ECB and Fixed Income) at Danske Bank, told World Finance: “[Lagarde] got off [to] a rough start with that comment. In retrospect, it was right, but it is not something that markets wanted to hear.”

Christiansen went on to argue that the ECB seems to have adopted an approach close to the ‘Greenspan put’ principle that reigned supreme in the 1990s, ensuring that spreads stay under control without actively intervening to close them.

The furore over Lagarde’s comment cast the ECB into the centre of the debate over the future direction of the eurozone. Since the sovereign debt crisis, the bank has been propping up the continent’s financial system through quantitative easing and bond-buying programmes, vastly expanding its balance sheet.

The same approach was followed in March when the bank launched a new €750bn ($853.6bn) pandemic emergency purchase programme (PEPP) that aimed to support pandemic-hit countries and companies, while its public sector purchase programme (PSPP) kept serving as a backstop for sovereign debt. A key goal for the bank is to prevent a ‘doom loop’ of rising sovereign credit risk that drags down banks in the weakest members of the eurozone. Christiansen said: “The ECB can continue the PSPP and PEPP programmes for as long as it takes. We should never underestimate what they can do. They set the rules of the game.”

Even before the pandemic, critics were pointing to the limits of this approach. Many economists have warned that monetary stimulus has artificially inflated asset prices and hit savers through negative interest rates while supporting indebted southern member states. Others have stressed the need for fiscal stimulus driven by governments. This now seems inevitable: as the EU builds up its defences through the commission’s recovery plan, the ECB is expected to take a less active role. Hackenbroich said: “Merkel has been clear that governments should shoulder some of the burden of the ECB. There will be more of a balance, but the ECB will remain key to eurozone policies.”


The first step
Time is pressing for speedy solutions as the economic consequences of the pandemic become clearer (see Fig 3). The ECB has warned that the eurozone’s economy will shrink by eight to 12 percent in 2020. Merkel, meanwhile, has said consultations with national parliaments and the European Parliament should be concluded in the autumn. Some expect that a typical ‘Eurofudge’ deal will be made at the last minute. Wijnholds told World Finance: “A compromise will most probably be reached, leaving both parties somewhat unhappy with a result that they can sell to their home base.”



Merkel and Macron have recognised that their plan was a temporary response to the pandemic, with more robust action needed in the future. Joint debt issuance may be seen as a pattern to be followed in the future, but it is a prospect that will likely be met with fierce resistance. Hüther said: “The proposals should not lead to structural changes in the EU financial architecture or repeated borrowing at the European level. The fund entails the risk, however, that in future crises the commission will very quickly press for further EU borrowing.”

The COVID-19 pandemic has reasserted the importance of the nation-state. Borders were re-established between Germany and France, even if temporarily. One of the lasting impacts of the pandemic, however, may be the transfer of more power to Brussels.

The fact that Germany insisted on tying recovery policies with the bloc’s long-term objectives, such as the EU’s Green Deal and digital transformation, points to a deeper commitment to the European project. Some see an idiosyncratic fiscal union rising from the embers of post-pandemic Europe, with the next step being a common budget for the eurozone – a pet project of the French president. As Hackenbroich explained, Europhiles may only have to play the waiting game: “[A] fiscal union is too far-fetched yet, although [the French-German proposal] is a step towards it. More taboos will have to be broken for that.”