Christine Lagarde warned European leaders last week that the COVID-19 epidemic risked pushing the economy into a new 2008-style crisis. So far, the response from politicians to the president of the European Central Bank has been late and insufficient.
The elements for a comprehensive response are clear: Governments should unleash a large-scale fiscal stimulus, while the ECB launches a credible and sizeable bond-buying program to ensure there is no adverse market reaction. The euro zone may eventually get there, but it is taking far too long in the process.
The Eurogroup of finance ministers held a six-hour long video conference call on Monday, which produced an extensive list of pledges. There are some positives: Finance ministers are in favor of stretching the euro region’s fiscal rules to deal with the emergency. They also support the ECB’s actions to ensure that there is no fragmentation in the euro area’s financial markets. This means they understand what a successful crisis response will look like.
The big problem, however, is that the strength of their intervention is for now woefully inadequate. The Eurogroup says eurozone governments will give additional liquidity to companies worth around 10 percent of total gross domestic product. This follows Germany’s announcement that it will unleash a big “bazooka” worth 550 billion euros ($605 billion) from Kfw, its state-owned lender, to companies. So long as the economic crisis is temporary, providing liquidity is certainly the best tool of defense. It will assuage the risk that viable companies go bust just because of the epidemic.
However, there is also a need for sizeable fiscal transfers to support the healthcare system and combat an unprecedented fall in foreign and domestic demand. Italy has put together a fiscal boost worth 25 billion euros, including 600 euros for every self-employed person for the month of March. The total size of these commitments across the euro region is worth just one percent of the area’s gross domestic product. This may be sufficient to deal with a mild recession, but it pales in comparison with the size of the shock facing the global economy.
As the epidemic continues to spread, more governments will have to take unprecedented containment measures such as those in Italy, France and Spain. These lockdowns will have an enormous cost, which will force finance ministers to open their purse even more. The Eurogroup should have made it much clearer in its statement on Monday that the fiscal response will inevitably be larger. But there is little doubt that we are about to see much higher fiscal deficits in the euro area -- and rightly so.
Some governments -- such as Germany -- have room to increase spending and cut tax receipts without fearing for their own debt sustainability. Others -- such as Italy, Spain and perhaps France -- do not share this luxury. The yield on Italy’s 10-year debt is now 2.38 percent, up from 0.9 percent just two weeks ago. These levels are still manageable, but there is a risk they could get out of control.
The euro zone’s preferred instrument for dealing with the risk that the financial markets could turn against one country is a structural adjustment program. This includes loans from the European Stability Mechanism -- the euro zone’s rescue fund -- and the ECB’s “Outright Monetary Transactions” program. This ensures that the ECB buys unlimited quantities of a country’s short-term bonds. In return, the recipient country must sign up to a list of measures, such as structural reforms.
This approach would make sense if the economic and financial shock of the novel coronavirus were hitting just one country. Instead, it is spreading quickly across the currency area. The ESM only holds 500 billion euros in lending capacity -- and it has already committed 90 billion euros. Moreover, the COVID-19 shock is self-evidently exogenous: It would be absurd -- and politically inept -- to demand structural reforms in exchange for help during a pandemic.
The solution must be in a credible and forceful bond-buying program from the ECB. This would convince the financial markets that there are no risks in holding Italy’s or Spain’s government bonds. In fact, the more credible the ECB’s pledges, the lesser the need to buy bonds. Reassured investors will do the buying for the central bank.
Unfortunately, the ECB has failed so far to provide that calming presence. Last week, it promised a 120 billion euros additional bond-buying program, but initially said this would be skewed in favor of corporates. Lagarde made a terrible communication blunder when she said that the ECB’s role is not to close spreads. This has raised long-lasting questions over the credibility of the central bank’s role.
Luckily, the ECB president and several governing council members have walked back the mistake. They should now go a step further: They should scrap their self-imposed limits on what bonds they can buy, and make it clear they are ready to expand the size of their scheme to combat any risks to the stability of the euro. Meanwhile, they should step up their purchases of the sovereign bonds of weaker states, as they appear to be doing.
The long-lasting solution to the COVID-19 epidemic will only come from scientists, but policy makers must do their part to mitigate the shock. This requires an unprecedented level of coordination between the monetary and the fiscal authorities. The euro zone must act quicker and more forcefully than it has done so far.
Ferdinando Giugliano writes columns on European economics for Bloomberg Opinion. -- Ed.