‘The EU recovery fund is too little, too late’

Ashoka Mody on the vast economic crisis facing the EU.

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The EU is facing the largest economic crisis in its history. As the Covid crisis first began to ravage Italy, the EU struggled to offer a unified, coherent response. Earlier this month, Angela Merkel and Emmanuel Macron launched a joint proposal for a €500 billion recovery fund. European Commission president Ursula von der Leyen has turned that into a €750 billion fund, financed by joint EU borrowing, which has been widely lauded as a historic step for EU integration. But also in the past few months, the German courts have caused a lot of trouble for the European Central Bank, questioning the legality of its quantitative-easing programme, which could also have major implications for the EU’s ability to steer Europe’s recovery. Ashoka Mody teaches economics at Princeton and is author of EuroTragedy. spiked caught up with him to find out more about the crisis.

spiked: How bad is the current economic crisis in the European Union and the Eurozone?

Ashoka Mody: We know, for example, that in the first half of 2020 the Italian economy will contract by about 15 per cent. That is pretty much data, not just a guess. The big question is going to be how much more it will deteriorate in the rest of the year. As a benchmark, I would say that the United States, despite all the fumbling it has done in its management of the health crisis, is probably going to see less of an economic contraction than any of the European countries.

The European countries have a set of additional problems. One is that they trade a lot more than America does. What we are seeing right now is that this crisis has affected pretty much every country around the world. When trading partners do not function at a normal operating capacity, they import less from each other, which weighs down each other’s exports.

Another issue for European countries is that Europe comes into this crisis with a larger debt burden. In Germany, the government itself does not have a large debt burden, but companies do. For the rest of Europe, even the government debt burdens are extraordinarily high. Household debt levels are also high.

The third problem for Europe is that European banks are much more fragile. These three factors are relevant, both in terms of thinking about how deep the crisis will be and thinking about what the recovery will look like.

Altogether, my view is that Europe is worse off than the United States, and within Europe, Italy and probably Spain are worse off than the others. What I am also noticing is that France is doing rather poorly. The major countries in the south of Europe are going to face an economic shock that is both deep and potentially long lasting.

spiked: What does the economic shock in Italy mean for other European countries?

Mody: It depends a great deal on what the policy response is going to be. Again, this is seen as a moment of hope, because the somewhat frightening judgment of the German court on the limits of the European Central Bank (ECB)’s operations has been dismissed by most commentators as not having any teeth. And there is a proposal for the European Commission to borrow and give grants.

My concern is twofold on that front. Number one: starting with the plan for grants, Italy and Spain are wounded now, and this is like promising a bandage to someone which will arrive in six months’ time. The wound has to be treated now otherwise the bleeding will cause a lot of distress, both humanitarian and economic.

Italy in particular is in a weak situation because it comes into this crisis as a country that has not grown for 20 years. The idea that it might get some grant money in six months’ time is no consolation, because Italy probably needs something like 10 to 15 per cent of GDP stimulus now. The US is going to do a fiscal stimulus in that range. It has a much stronger economy, and a lesser impact from Covid. If the US needs that level of stimulus, then Italy certainly needs a stimulus of that order of magnitude. Therefore, in preventing contagion in Europe, the bottom line is going to be how active the ECB will be.

spiked: You say the German court’s ECB judgment has no teeth, but a lot of people are concerned that German courts have hobbled the ability of the ECB to act, in ruling past quantitative easing illegal. But you don’t think that judgment is cause for concern?

Mody: No, just to be completely clear, I was only reporting what others have so far responded. Many commentators, particularly those who style themselves as pro-Europeans, have been too quick to dismiss the German court’s decision, for two reasons.

Firstly, they have ridiculed its economic analysis, which I think is somewhat misplaced. In the end, the court is asking one basic question, which is that if the Eurozone has to have a unified monetary policy, how far can it go to supporting the monetary and fiscal interests of one individual member country? In other words, monetary policy for the Eurozone is one matter, and monetary policy for Italy or for Spain is another matter. This central question translated into operational terms is what share of Italian bonds can the European Central Bank buy before it becomes legally and politically unacceptable?

Before we went into this crisis, the ECB, through its prior quantitative easing purchases, already owned about 23 per cent of Italian sovereign debt. Now, we can expect that through the course of this crisis, over the next six to nine months, if the ECB is going to have a material impact on sustaining Italy, it will need to buy another 20 per cent of Italian debt. This means it is entirely possible that by the end of the year, the ECB will hold something in the range of 40 to 45 per cent of Italian debt. At that point, the ECB effectively owns Italy.

Remember, the ECB is not a normal central bank – it is not a central bank for a nation state. The ECB is the central bank of a confederation of states. As a consequence, the Italians will owe money indirectly to the Germans. Any time a foreigner like you or me sells an Italian bond, takes the money out of Italy, and puts it into a German bank, that money effectively becomes owed to the Germans, through the ECB.

The Germans keep a very watchful eye on those numbers because they know that if at any point the Italians are near to defaulting on the debt, either the ECB itself will need to somehow repay that debt on behalf of Italy, or the Italians will have to default. If you combine a scenario in which the Italian GDP remains 15 to 20 per cent below its level at the start of the year, its debt burden increases, its revenues decrease sharply, and the ECB now holds a lot of that debt, there will come a certain point at which the Italians will have to repay that debt, either to private investors or to the ECB.

And the political question that will then arise – and this is what the German court is essentially asking – what will happen to the claims of other member states? That is an unanswered question. For that reason, dismissing the German court is way too premature, because, either as a legal question or as a political question, it is very likely to reappear before the year is out.

spiked: Do you think the EU is in some way trying to downplay or deny the political faultlines here?

Mody: Yes. I always come back to this one anchor: the EU is a confederation of states. In a confederation of states, each nation will act in its self-interest. Solidarity and European sovereignty and political camaraderie are all lovely phrases, but they do not have any operational content.

I find that a number of my pro-European friends are now pointing the finger at the Dutch and others who are protesting against this bond initiative Merkel and Macron have announced. They are describing them as miserly and stingy. This sort of name-calling is unbecoming, but it is also completely besides the point, because the notion of what constitutes solidarity has to be embedded in a social contract, and there is no social contract. In fact, the social contract is the opposite.

For that reason I remain very pessimistic, even though, today, there is a great deal of optimism about this latest fund initiative. Not only do we now know for certain that it will come too late, but even when it does come it is not clear whether it will have any meaningful quantitative impact.

There are several problems that are already written into even the Merkel-Macron agreement, such as who will receive the money and who will repay the bond. We know, as we discussed, that France will receive money, so the question then becomes: who will not receive money? If there are so many claimants on the money, will Italy and Spain get the large sums that they need? And the biggest question is, who will repay the money?

This is where the French angle becomes particularly important, because if the French say that they want to be net recipients, then all we are left with is the Germans, the Dutch and the Austrians, and maybe the Danes and the Swedes, to pay for France, Italy and Spain. People are very excited about this initiative but I do not think anyone has done those sums. These are all very large countries whose needs are huge.

There are two key terms in the European terminology – net contributor and net recipient – and the question is going to be: if this bond does materialise, who is going to be net contributor who is going to be net recipient? That is going to be a very contentious debate in the months to come, which is why I have very little hope for this bond initiative. This is why the ECB becomes the only game in town, and hence, the German court’s judgment and the break it applies on the ECB, either directly or indirectly, becomes crucial to the evolution of the crisis in Europe.

spiked: We have seen a lot of nations, even within the European Union, act unilaterally to try to save their economies. For example, the trillion-Euro package that Germany has created for itself, which is well outside the usual rules of the European Union. Are countries other than Germany naturally hobbled in their ability to deal with this crisis by virtue of being in a monetary union?

Mody: Not simply by virtue of being in a monetary union, because I think even the Europeans at this moment understand that trying to apply their fiscal rules now would be so egregious that everyone would disregard them.

That said, what is more significant is whether countries other than Germany can do the kind of fiscal stimulus that Germany is able to do. It becomes very important also in the discussion of the European bond that even Germany is currently stretched by the stimulus policy it is enacting.

Germany also has to worry about the fact that it is a diminished giant. Its car industry was already beginning to feel considerable stress, and this crisis has given it a further knock. Germans are not prepared for the technological revolution going on around the world. They have fallen behind not only America, but also East Asia. The Germans have to worry about themselves – both in relation to the crisis and in relation to the fact that they have been, in a longer-term sense, beginning to acquire some of the characteristics of a declining nation.

The other countries all come into this crisis with very high debt-to-GDP ratios. The Italians already had debt worth 135 per cent of GDP. The French and Spaniards had debt worth 100 per cent of GDP. We know that their ability to inject a stimulus of 10-15 per cent on their own is very much more limited than it is for the Germans – unless they get huge support from the ECB which, directly or indirectly, finances that stimulus.

We do not know if or when the point might come when markets look at a large fiscal stimulus in France and feel they do not want to finance it. Maybe that day will never come, maybe markets will give the French authorities some room for manoeuvre, and let them run up a large debt level. I do not know the answer to that. But I suspect that France, Spain and Italy will, at some point in the coming months, face a moment when markets begin to baulk. That is what creates the problem.

The main problem is that we have one monetary union with one monetary policy, but countries going in very different directions. In the United States, the states and the federal government have been at odds. Despite that, there have been significant fiscal transfers to states already, and I expect that those transfers will increase. In the European Union and especially in the Eurozone, those fiscal transfers do not exist, which is why this artificial construct of the bond is being created to somehow simulate those fiscal transfers. But I would be stunned if those numbers are in any way meaningful in the end. And in any case, they will come too late for this crisis.

spiked: It is obviously incredibly important to stabilise the economies with fiscal and monetary stimulus in the short term. But is there a longer-term danger that quantitative easing gets out of control, if it is no longer corresponding to real economic activity?

Mody: That is a very good question, but a very difficult debate. Not just in Europe but in Japan and the United States, central banks have gone out on a limb, and they have expanded their balance sheets hugely. The question is about how they are going to deal with those balance sheets in the long run, and whether they will ever pull them back. Those are very big questions, to which I do not know the answers.

But I will say that one long-term feature, which is relevant, particularly in the European context, is that starting some time in 2008, we began to see a divergence between Germany, France and Italy. Germany was doing relatively well, France doing modestly and Italy doing poorly. Covid has made that divergence much greater, and that will now persist for a number of years. In this crisis, the nation states have diverged even more than they had in the previous crisis, and the political tensions, anxieties and divides will correspondingly increase.

In a more medium-term, structural sense, I think we are in for a lot of anxiety over the future of Europe. These small initiatives like the European bond are going to get lost in that bigger picture – if they ever materialise. I think that, as a consequence, the future of Europe is a cause for great concern, because as the economic divergence inevitably increases, the political divisions will also increase.

There was no need for the Eurozone – it was a completely mindless idea. But once in place, it has these inevitable dynamics. In terms of solutions, I always have to come back to a primary question: can you have a monetary union for a confederation of states? The Europeans like to dismiss that fundamental problem. They claim to be a multi-level state and in so doing they try to obfuscate that basic question of who the ultimate political authority is, of who is accountable to the European people. They have never tried to answer that fundamental question, and they are finding it hard to answer even today, and so continue to bypass it.

Unless Europeans realise the time has come to take a serious look at an entity that has not just the look and the feel but the real characteristics of the United States of Europe, these problems are going to continue. I know this sounds a bridge too far at a moment like this when the immediate problems are already so acute, but my historical view is that unless that basic question is addressed, the technocratic fixes will never be sufficient.

Ashoka Mody was talking to Fraser Myers.

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