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The stabilisation of the euro area through monetary policy and financial assistance is not sustainable

Point of View, 28.05.2020 Research Areas

The pandemic crisis opens a window of opportunity to initiate structural changes in euro area countries, says Paweł Tokarski. Monetary policy and financial assistance alone are not enough.

The current public health crisis has become a major challenge for European economies. It particularly affects countries in the southern part of the euro area, as they are still suffering from the effects of the euro crisis. In the absence of a convincing fiscal policy response from the European Union (EU) or the euro area, the European Central Bank (ECB) has once again stepped in to stabilise the common currency. An intervention by the ECB costs little politically: It does not require a decision by the heads of state and government, nor does it require the approval of the parliaments of the Member States. Without the rapid intervention of the ECB in this very volatile crisis, the single currency would most likely already have been seriously threatened.

Even in the euro crisis, the ECB’s expansive monetary policy had supported the affected economies. In the face of low interest rates, governments saved hundreds of billions of euros for debt servicing at the time. However, the ECB’s stabilisation policy had various undesirable side effects. Low interest rates hurt savers and inflated the real estate bubble. The purchase of Member States’ debt securities also led to the increased involvement of the ECB in their economic and fiscal policies. Pressure from the central bank on the Irish government in 2010 to bail out distressed banks with taxpayers’ money is evidence of this. Another example is the secret letters sent by the central bank to the Italian and Spanish governments in August 2011, giving them an ultimatum to initiate reforms. The recent large-scale purchases of government bonds in response to the pandemic could – if the ECB continues its policy in this way for a longer period of time – once again make the ECB a hostage of the economic policies of the affected countries.

Legally questionable commitment of the ECB

It is also problematic that such a massive engagement by the ECB goes beyond its designed role and raises legal questions, as shown by the recent ruling of the German Federal Constitutional Court (BVerfG). The central bank’s main weapon is its potential ability to intervene indefinitely in the financial markets, including the purchase of government bonds. However, the BVerfG has formulated conditions for the purchase of assets, including an upper limit per issuer and a time limit for these transactions. With these limitations, the Eurosystem’s ability to effectively stabilise public debt over the course of several years is brought into question.

The euro area countries should use the time given to them through the ECB intervention to reduce their dependence on the ECB’s monetary policy. First and foremost, they must address their structural problems.

However, the measures adopted so far to combat the consequences of the pandemic have primarily been limited to financial support. For example, the EU has approved various aid instruments for the countries affected by the pandemic totalling up to €540 billion, including the instrument for short-time working (SURE). The Commission’s new draft for the EU’s multiannual financial framework will also take greater account of the costs of the pandemic crisis, including a new huge €750 billion recovery instrument, higher than the one proposed jointly by France and Germany. The financial solidarity expressed here is important, but money alone is not enough to alleviate the structural problems in southern European countries. Even before the euro crisis, the economic models of many of these countries were unsustainable in the long term due to insufficient competitiveness, excessive debt, and unfavourable demographic changes. The current crisis provides an opportunity to reflect on how economic models can be reoriented, for example towards digitalisation, environmental sustainability, investment in human capital, and a reduction in bureaucracy for businesses.

Stabilisation of Italy essential for the single currency

Although these issues affect, to varying degrees, each euro area Member State, including France and Germany, the main challenge to euro area stability is the development of the EU-19’s third largest economy, Italy. The impact of the pandemic has further worsened the economic situation of the country, and ambitious responses are now needed at the EU and euro area levels. In addition to the generous provision of concrete grants – not loans – it is a matter of skilfully engaging in dialogue on the necessary structural reforms and exerting political pressure from various sides: from the European Commission and the Eurogroup, but also from Berlin and Paris. A new EU strategy for Europe’s economic recovery and development until 2030, which could be adopted at the end of the German EU Council Presidency, would make sense here. It would make it possible to move away from the short-term focus on the immediate consequences of a pandemic. The decisive factor for its success, however, would be the willingness of the political class in Rome to take responsibility for serious reforms.

The pandemic could be a defining moment for the euro area. If this economic crisis – the most severe in decades – can be used as an opportunity for structural change that will reduce the level of mistrust between northern and southern Europe, the next logical step is the permanent joint issuance of bonds to stabilise the enormous increase in debt after the crisis. If the euro area fails on the reform path today, we will wake up tomorrow with more debt and face the same problems as before – but with less time and fewer instruments to deal with them.

This text was also published on fairobserver.com.