How to finance the recovery from the corona crisis

While the coronavirus crisis is still looming, European governments are having discussions on how to deal with its massive economic consequences. TheIMF published a study which shows how “the Great lockdown” will cause a 3% fall in global GDP. By comparison, in the 2008 financial crisis global GDP fell by 0.1%. The European Union will be the most affected area with a loss of 7.5% of GDP for the Euro area.

Millions ofjobs have already been lost and the unemployment rate is expected to rise dramatically. In such a situation state economic intervention of unprecedented volume is fundamental. Right now there is a discussion on how to help European states with one of two options: the Emergency Stability Mechanism (ESM) or shared debt called Eurobonds. One block was headed by Italy and Spain, who needed funds to guarantee the payment of wages during the lockdown, and a larger amount to be used as a stimulus in the next few months to kickstart the recovery. On the other side of the issue, there are the Netherlands, Finland and Germany, countries which despite having been hit by the crisis seem still to think about these instruments in a pre-crisis old fashion. The other European countries seem to be somehow in the middle, mainly in favour of the economic stimulus but also worried not to contradict Germany too much. In the past weeks we reached a point in which the Portuguese prime minister Costa defined the position of the Dutch finance minister Hoekstra as‘repugnant’. A possible mediation seems to be that of theRecovery Fund, but its characteristics remain unclear and no concrete action has been taken. But what are these instruments? In this article, we will explain the mechanism behind the creation of debt in Europe, and why Eurobonds are a necessity even for those who are currently opposing them.

How do countries typically raise money?

Generally a country funds itself using taxation, when a country wants to invest in itself, and its current level of taxation is not enough, it can borrow money to raise funds. In general, the government does this through the means of the treasury, an institution which issues "debt certificates" on behalf of the government, called bonds. The treasury borrows money from private institutions, and these certificates are effectively I.O.U. documents with an expiry date and a promised yearly interest rate called coupon. The higher the demand for bonds in the market the lower the interest rates fixed at issuance on the debt. These documents are targeted for financial institutions, like banks, which then resell them to the public.

A concrete example can help to understand this mechanism. Let's imagine that a friend asks you for a loan to start a pizza place. First he asks you for the money to buy a pizza oven, just enough to start a home delivery business. You're happy to lend him the money, however, since the success of the business is uncertain, you charge him an interest rate on the load as compensation for the risk taken. The delivery company is a success, so your friend decides to expand. Once your friend repays his debt, he asks you for more money to set up a restaurant where he can serve clients. If he keeps asking for more money to make more investments you might still be inclined to lend, but you will starting asking for a higher interest rate if you believe that the investments are becoming riskier.

What's the role of the European Central Bank (ECB) in all of this? By buying and selling bonds on the market the central bank influences the demand for bonds, and therefore its interest rates at issuance, as well as the quantity of money in circulation. Thus it has the ability to stabilise prices and control inflation through printing or collecting money, which is the ECB's main tole. But this then poses a question - can a central bank buy bonds directly from a national treasury at issuance to finance directly a national budget? In an ordinary situation, the central bank shouldn't buy bonds directly from the treasury, however, whenever it owns bonds it is effectively lending to the treasury. One day the treasury should repay the debt but in the meantime the central bank is actually lending to the government.

To understand why a central bank should not buy bonds directly let’s go back to the example of the Pizza place. What if your friend wants to make more investments in the business and keeps asking for more money. But at the same time he hasn't earned enough to repay your debt so - instead - he borrows money from others to do so. Everything looks a lot riskier. You might still lend him money at a higher interest rate or, in the worst case, you will not lend him money at all unless you are sure that the other person from which he sources the money is a good guarantor. In the end, you find out that he receives the money from an unknown wealthy benefactor. This seems like a great idea until you start wondering where the wealthy benefactors money comes from and if its not fake. Then you might start reconsidering your investment. These are the same questions that investors in bonds ask before loaning to a country when the budget keeps increasing year on year and is financed not by taxation but by the printed money of the central bank. In addition, more printed money would also mean higher inflation.

Does this mean that the central bank should never do this? Not necessarily. If a country is in a deep recession, timely intervention from the central bank could be crucial. However, it should not be done continuously otherwise the other investors would again start demanding higher interest rates. On the other hand in an unparalleled recession like the one we live today, increases in public debt are inevitable and the intervention of the central bank is essential. What's the key for not having higher interest rates? The credibility of a country to be able to repay its debt through actual future growth.

The issue with the EU monetary union is that it has a central bank but it lacks a central budget and a central treasury. Bonds are currently individually issued by the local treasuries of each EU country. There's no coordination in the formation of the budget and each country issues bonds in different ways, and at different interest rates. This also creates competition on the bond markets between EU countries. At last, given its mandate, the ECB is compelled to buy bonds to, and only to, control for inflation and bond price stability (this means to stop the bond prices going down too fast and their interest rate rising).

What are Eurobonds?

Imagine instead that your friend gathers a group of friends and collectively they request a loan from you, where they share the risk. Each one has its own history of failures and successes. As long as some of them have been successful in the past and have other sources of income, you would perceive lending them the money as a less risky investment, then loaning only to your friend, and you would be happy with a lower interest rate. This is the core principle of Eurobonds.

The dynamic would be the same with a European budget shared across countries which have different growth rates and income from taxation. Then the portion of the budget related to each country could be refinanced at lower rates for struggling economies than if done individually. This is because they would all be perceived as liable for the debt and also to step in to cover it in case one of default. This is the idea behind Eurobonds and the creation of a European Treasury which would issue bonds on behalf of the aggregated European countries. An essential tool to source money in extreme economic conditions such as those we are experiencing right now.

ESM and PEPP

Are there currently other existing credit risk-sharing programs across the EU? The first defined as such was theEuropean Stability Mechanism (ESM), approved in 2011 during the Greek crisis. Its main purpose is to provide support to countries in financial difficulty. The ESM does so through many channels, buying out their bonds, providing loans to the governments or financing its banking system. The ESM sources money partially issuing its own bonds on the market and partially from its capital.Individual EU countries, partitioned like shareholders of a company, are the contributors to its initial capital and vote on the possibility to increase its capital pool.

The difference between this and a risk-sharing mechanism like Eurobonds is that each country is only liable up to their contribution to the capital and this is tiny if compared to the entire EU budget. If for example a country or banking system is not able to repay its loan, then the ESM would only be able to repay bond-holders up to the total capital contribution of each country. In this way, the countries are only partially liable and only partially share the risk for the ESM default. Moreover, if in an extreme example, Italy would ask for a loan from the ESM and default, not only the country would not be able to repay the loan, it would also not be able to contribute to its share of the ESM budget. Therefore there is the risk that the bondholders will not be repaid.

To reassure the ESM bond investors on the risk in ESM loans, the commission has conditioned the loans to a memorandum to which countries in difficulties have to commit. However, since the ESM is used only in critical circumstances,this is irrelevant, and its real credibility to repay the money borrowed depends only on the commitment of its guarantors and on the amount of money that has been already given out on loans.

In conclusion, the ESM is not a money printing institution like the ECB. The extent of its support is limited and depends on the EU countries which are reluctant to support the project. Moreover,it’s potential lending firepower is up to USD 550 billion. This could have been enough to bail out a moderate economy like 2011 Greece, with a GDP of roughly USD 290bn, but is nowhere near to be helpful to support a larger economy like Italy, which has a GDP of more than 2 trillion USD. As a consequence, the ESM is of very little use in periods of crisis and even less useful in the case of a group of countries defaulting partly or fully.

Now, on the 9th of April the Eurogroup proposed to use the ESM to finance part of the investments that the EU countries will have to face during the COVID crisis. It has been said that the conditionalities will be ultimately waived. However we don’t know how these investments will be directly funded. This approach dictates two problems. First, differently from a collective debt initiative, if countries will access these funds on a request base, even without conditionality, by doing so they will implicitly admit to be in difficulties. This could create a stigma in the market on their bonds,with consequences potentially worse than the fragile status quo. This could discourage further the use of the ESM. Secondly,the fund seems targeted only at investments related to healthcare. This excludes all the other investments to corporates and small/medium enterprises necessary to create the right stimulus in a depressed economy.

The other instrument on the table is the new Pandemic Emergency Purchase Programme (PEPP) announced by the ECB on the 18th of March 2020. This consists of a large scale asset purchasing program of up to €750bn, of both private and public bonds across the entire EU such as banks, corporates and governments debts. This is an extension of the alreadyexisting ECB monthly Asset Purchasing Program (APP) started during the 2011 crisis. The APP was consolidated in 2014 to support the price stabilization effort of the ECB. Since 2014 it has purchased a total of Eur 2,600 bln worth of bonds.

However, the main issue with this financing approach, besides not being enough, is that it doesn't target directly the public. Rather it targets governments and banks, hoping that this will result in public investments and cheaper bank loans to the public: what the ECB calls“transmission mechanism”. In reality, this money does not finance directly governments budgets, while in periods of crisis banks are also reluctant to issue loans to costumers who are already in financial difficulty, especially at low interest. For this reasoneconomists advocate “helicopter money”: the governmental institution including the ECB should channel their finances directly to the public.

Eurobonds and financing the recovery

Eurobonds are thus the only instrument which would allow to stimulate the economy by injecting money in the market . Thanks to Eurobonds people who cannot work could receive concrete and immediate help. Differently from other instruments, Eurobonds would share the risk for such an investment between all European countries. Consequently, the risk would be minimal, and at a lower cost. As such Eurobonds are indispensable to all the countries in order to deal with the present crisis.

Even if we hypothetically imagine that countries like Germany and the Netherlands could afford to deal with the crisis without Eurobonds, a Spanish or Italian crisis would affect the other countries. A European systemic crisis is on the table. First of all, European economies are so connected that there cannot be a crisis in Spain without the Netherlands suffering from it. Secondly, the German economy is hugely based on exports, andmore than 50% of German exports are to other countries in the EU. In the case of the Netherlands this percentage is even bigger, at 77% of its total exports are to within the EU. As a consequence, if one or more European countries suffer from the crisis, this will inevitably affect the other economies.

Finally, this conception of different nations with different debts is very old and does not describe the current European situation. The number of European citizens working all across Europe, as well as the interconnections between countries economies and corporations, show a much more complex reality. Germany cannot be a model economy because not all European countries can base their economies on export. In order to work, the European Union needs a wide internal consumer market, which is the main destination for many German products, as well as products of the other European countries. Especially now, when world trade is at stake because of the virus, stimulating the European common market is particularly important. No economy in the EU is big enough to survive this crisis, but Europe as an aggregate is one of the largest economies in the world.In conclusion, Europe is at a turning point. There is no more space for hesitation and half measures. A coordinated European plan of massive investment is needed.Eurobonds are a necessity and the best instrument to deal with the current crisis. More generally, they are instruments which can help to fix the imbalances between the European economies. They are not a concession made from certain countries to others. Nor their creation has to be discussed in terms of solidarity. Rather they are an essential tool towards a stronger, more equal and integrated European economy.