Europe displays rare unity over relief fund

Putnam Fixed Income Team, 06/30/20


  • Europe is making strides as Germany drops its resistance to fiscal burden sharing.
  • A proposed €750 billion recovery plan will be a powerful tool for managing the region’s economy.
  • Some countries, including France and Germany, are showing a few early signs of recovery.

Italy and Spain are leading calls among the countries most affected by the coronavirus pandemic for more help from the European Union (EU). They argue it is time to revisit a eurozone-wide fiscal mechanism with joint borrowing. Amid signs of rising hostility in Italy against the EU, German Chancellor Angela Merkel and French President Emmanuel Macron — in what some have claimed is a breakthrough — proposed establishing a €500 billion recovery fund. This initiative would involve the issuance of common debt and is no doubt a significant change for the region.

Germany is relaxing its fiscal hold

The proposed fund would be funded by the EU budget. The European Commission will borrow these funds and then disburse them via the European budget. The relief fund would create a new liability for Germany, which it had previously resisted. Germany has decided the threat to the cohesion of the eurozone is large enough that it has to move decisively. Therefore, this is a step forward. Still, it remains unclear how large a move this is and how closely it will come to be the kind of common fiscal policy mechanism that analysts have long claimed is essential.

Germany has decided the threat to the cohesion of the eurozone is large enough that it has to move decisively.

First, this is technically only a proposal from Germany and France. The European Commission, the bloc’s executive branch, plans to add an additional €250 billion in loans aimed at lifting the region from its economic slump. The remaining members of the “frugal five,” now the “frugal four” (Netherlands, Austria, Finland, and Sweden) are unhappy and are preparing a counterproposal. However, France and Germany are the most important countries in the EU, and they usually get their way. Still, nothing will be concrete until it has been approved by all EU countries at a meeting expected in July. The details of the mix of loans and grants, and how much money each country will receive, will have to be agreed.

The experience with the EU is that these things don’t get resolved quickly. This is because it involves the EU budget, where discussions were already proving extremely difficult. Part of the reason is because of Britain’s withdrawal from the EU and the consequent loss of its budget contributions. Therefore, it will take a while to nail down all the details of the recovery plan. As always with these things, the details matter.

Opening the door for more stimulus

Secondly, the size of the new fund, once it is agreed, matters. Italy’s main problem is its size, debt load, and long history of extremely slow growth. Even generous terms on new EU funding won’t help Italy unless the amount of easy money is large. In addition, it is not clear that northern Europe’s taxpayers are prepared to support Italy on the scale that would make a real difference to the country’s debt dynamics.

It is important, however, to note that a door, previously closed, has now been opened.

It is important, however, to note that a door, previously closed, has now been opened. In the EU, once a principle has been conceded, it never returns. So, this mechanism — even though it has been designed with this particular problem in mind — is a powerful new tool for managing the region’s economy. The new initiative and the European Central Bank’s (ECB) generous quantitative easing program shifts the risk profile of the euroland periphery countries.

The key risk remains Italian politics. If the current government falls, and Matteo Salvini’s League party comes to power, it is possible Italy would begin to flout the eurozone’s fiscal rules and dare the ECB to stop buying Italian bonds. At some point in the future, persistent slow growth could force even a moderate Italian government into this position. But the likelihood of this happening in the near term has fallen substantially because of Germany’s concession on debt being financed through the EU budget.

Some green shoots

Cyclically, the eurozone looks to be in a decent place. There are some clear signs of recovery in many countries. Germany has just agreed to a decent fiscal package to help the economy recover. There are also some encouraging signs in Italy and France. Spain, however, is lagging quite badly. Although no one is out of the woods yet, recoveries are slowly underway.

The ECB is also doing its bit to help, with an expansion of its QE program and confirmation that the program will continue at least until June 2021. In early June, the central bank said it will increase its Pandemic Emergency Purchase Program by €600 billion. That comes on top of €750 billion of government bond purchases announced in March. These steps are more aggressive than expected, and while they are not game changers, they are helpful.

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