Amid the devastating human and economic toll caused by the Covid-19 pandemic, for the first time in history, EU nations agreed to a sizeable fund – to be financed by jointly guaranteed borrowing – to finance expenditures throughout the bloc. The plan, which is yet to be ratified, was received positively in many different corners. But will the pandemic recovery fund be able to support Europe’s recovery and reduce social inequalities? Will it be a major step towards federalist integration?
Before addressing these questions, let me take a step back to highlight some fundamental tensions within the EU, the differentiated impact of the pandemic on European nations and the various initiatives aimed at fostering solidarity within the EU.
Social inequalities in the EU
Most EU countries have generous welfare systems, income inequalities within EU countries are much lower than in the US and most developing countries, and poverty, as measured by the World Bank, is very low. Yet for those Europeans who live in poor conditions, face job insecurity, suffer from unmet medical needs or feel lack of opportunity, it is little solace that the situation is worse elsewhere in the world.
A particular worry is countries falling behind economically and socially. Italy, for example, had the same level of per capita income as Germany in the early 1990s (measured at purchasing power parity, which adjusts incomes for price level differentials). Now Italy is 25% lower. When adjusting for inflation, all main segments of Italian society suffered from income declines from the mid-2000s to the mid-2010s, with low earners suffering more than high earners. The youth unemployment rate is around a third, and the share of early school leavers is 14%, the fifth worst value in the EU. It is not surprising that Italian voters expressed their dissatisfaction by voting for populist and more politically extreme parties in recent elections.
But there are success stories too. Ireland was well below the EU average in the early 1990s and is now the second-richest country in the bloc, after Luxembourg, in terms of per capita income. Central European nations that joined the EU in 2004–2013 have shown impressive convergence in the past 25 years.
Still, anti-EU sentiment has been on the rise both in Italy and in many central European countries for some time, as reflected by the election of governments that have clashed with
EU institutions. Disagreement on immigration policies is a common theme, topped by fiscal woes in Italy and rule of law concerns in some central European countries. Certain foreign policy issues, in particular the attitude towards Russia, are another sticking point.
The views on the desirable course of action over these subjects differ so much across member states that it is almost impossible to find a common solution. Existing rule of law procedures will not lead to anything, given that allies will veto one another’s punishment. Thus, in a number of important areas that are at the heart of fundamental EU values, EU cooperation mechanisms hardly work. This does not preclude successful cooperation in other areas, yet the mistrust resulting from fundamental disagreements makes it harder to find common ground.
The differentiated pandemic hit
Naturally, the severity of lockdown measures, as well as the importance of tourism (a sector particularly badly hit by lockdowns) to a country’s economy correlate with economic distress. But there are two additional important factors.
The first is the ability of national fiscal policy to contain the economic fallout from the pandemic. Thanks to the suspension of European fiscal rules in March and the relaxation of European state aid rules in the same month, EU member states were able to provide fiscal stimulus packages. But such ability differs: calculations by Bruegel show that countries with weaker public finances, such as Italy and Spain, provided significantly fewer immediate fiscal support measures than countries with healthier fiscal accounts, such as Germany and Denmark.
The second factor is the quality of governance, as revealed by the econometric estimates of André Sapir, using World Bank governance indicators. He conjectures that the governance indicator could reflect the quality of behaviour of both private and public economic agents, and thus countries with weaker indicator scores might have suffered from weaker responses, amplifying the adverse economic effects.
Beyond country differences, different socio-economic groups were also hit to varying degrees. IMF research finds that epidemics raise income inequality, reduce the share of incomes going to the poorer segments of society and lower the employment-to-population ratio for those with basic education but not for those with advanced degrees. The authors warn that Covid-19 could raise inequality too, and recent data suggests that this is the case. From the last quarter of 2019 to the second quarter of 2020, the number of jobs occupied by low-educated workers (lower secondary and below) declined by 7% in the EU, while jobs for tertiary-educated workers expanded by 3%. Elementary occupations saw a 10% drop, the number of service and sales workers fell by 8%, and plant and machine operators and assemblers declined by 5%. In contrast, professionals gained 4%.
The ability to work remotely online greatly influences labour market outcomes, as research by the US Bureau of Labor Statistics shows. About 70% of those who completed university studies are able to work from home, compared with about 15% who have not completed secondary school. As regards occupations, two-thirds of professionals and 85% of
management can work from home, in contrast to close to zero for workers in transportation, installation, construction and agriculture.
Thus, better-educated and higher-income earners have a much greater ability to telework and are much less prone to job losses than lower-educated and poorer colleagues. Consequently, the Covid-19 pandemic has further increased social disparities between the poor and the rich even in Europe, where governments put in place massive employment protection programmes. The different fiscal capacity of member states, as well as differences in their quality of governance, raises further questions about EU-wide solidarity.
Initial pandemic solidarity measures
The EU’s ability to offer solidarity is constrained by its institutional set-up. Ultimately, what it can provide depends on member states’ will. The EU, as a legal entity, does not have any tax-raising ability, and any EU financial resources have to be approved unanimously by the 27 member states.
Still, the European Commission quickly recognised the severity of Covid-19 and played important supporting and coordinating roles starting in February, in areas such as public health, travel, transportation, vaccine research and digital solutions. While the Commission does not have any new financial resources, it proposed a number of changes to the existing EU budget, such as to mobilise all unused funds, allow reallocations between and within programmes, simplify access criteria, provide liquidity by delaying the repayment of unspent pre-financing and abolish national co-financing of EU cohesion spending. In addition, the suspension of fiscal rules and relaxation of state aid rules were crucial in allowing EU governments to introduce fiscal packages aimed at containing the public health, social and economic fallout from the coronavirus.
Arguably, while these measures were helpful, the first big splash came from the European Central Bank (ECB), albeit as a damage limitation attempt after its President, Christine Lagarde, pushed Italian and other euro-periphery yields to the sky on 12 March by saying “we are not here to close spreads”, referring to the differences in borrowing costs of euro area governments. Over the following days, an intense communication effort tried to calm the situation, but ultimately the 18 March announcement of the €750bn Pandemic Emergency Purchase Programme (which in June was expanded to €1,350bn) brought calamity to euro area government bond markets. The ECB also relaxed bank capital rules, offered credit to banks with a subsidy, and accepted a broader range of assets and less creditworthy assets as collateral from banks. These measures contributed to financial stability in the euro area and beyond and lowered government bond yields, which helped member states to implement their fiscal stimulus measures. Thus, similar to the 2012 euro crisis, the ECB took decisive measures relatively early on, underlying its central role in European crisis management.
The March–April gatherings of European finance ministers led to feeble results, despite their praising their own actions as comprehensive. Three concrete common financial instruments were decided. One was the ministers’ endorsement of the Commission’s proposal for a new employment-support facility called SURE (the temporary Support to mitigate Unemployment Risks in an Emergency), which offers cheap loans to member states
up to €100bn. So far, 18 countries, including some EU-sceptic countries like Hungary and Poland, have applied for €90bn of loans in total, suggesting that this instrument is broadly appreciated. The second instrument is a €240bn pandemic credit line from the European Stability Mechanism (ESM), the eurozone’s rescue fund, to cover pandemic-related healthcare costs. No country has applied for it in the past half year, and my bet is there will be no application for it in the future either. This is because the ESM is a rescue fund and a loan from it could signal that the requesting country has weak public finances. The third financial instrument is a €200bn extra liquidity boost to the European Investment Bank’s capacity to support hard-hit small and medium-sized enterprises in the EU. While useful, this instrument is not a game changer.
Justifying an EU-wide recovery fund
An oft-repeated phrase is that a monetary union is not sustainable without a fiscal union. In my view, this claim is too simplistic. Let’s consider the justification for financial solidarity in the current pandemic.
Clearly, countries with low public debt, such as Germany and the Netherlands, do not need any fiscal support from a centralised fiscal capacity. France, the second-largest country in the EU, has a considerably higher level of public debt than Germany, yet France does not need any fiscal help from its neighbours. Central European euro members, such as Slovakia and the three Baltic countries, have healthy public finances and good growth prospects, so these countries could also easily weather a fiscal storm. The very reason a eurozone-wide, or an EU-wide, fiscal support is needed is that some countries in southern Europe, most notably Italy, Spain, Greece and Portugal, have high public debt and low fiscal space to support their own economies. The growth outlook of these countries is not so bright either. Their unemployment rates were well above the EU average even before the pandemic, their social disparities are wider than elsewhere in Europe, and their government effectiveness and corruption control are weaker.
These countries will struggle under the financial burden resulting from the pandemic-related economic collapse. If left alone, their economies would become further depressed, for a longer period, escalating already widespread social inequalities. The popularity of anti-EU political parties could strengthen, further hindering the smooth functioning of the EU.
Several EU members faced fiscal tensions after the 2008 global financial crisis and subsequent euro crisis, which primarily resulted from unsustainable fiscal, credit and external debt positions. That time, eight EU countries received financial assistance loans with strict conditionality. The Greek programme was particularly problematic, as it was based on overly optimistic assumptions, required very large fiscal consolidation at a time of drastic economic contraction, and the detailed conditionality was intrusive. In most countries obtaining financial assistance, GDP and employment fell more than planned, while poverty increased. These experiences made EU financial assistance unpopular.
The Covid-19 public health crisis and consequent economic collapse is a completely different situation. The pandemic is an extraordinary external shock causing human suffering in a way unseen since the Second World War. Article 3 of the Treaty on European
Union includes the objective of promoting economic, social and territorial cohesion and solidarity between member states. When, if not now, should this prevail?
It is also in the self-interest of countries with healthier fundamentals to offer help. The serious economic and social decline of southern European member states will also adversely affect northern members. The risk of a massive sovereign debt crisis, as well as a eurozone breakup, would increase, with dire consequences throughout the EU.
I am sure Angela Merkel and Emmanuel Macron recognised these risks and their responsibility to act when on 18 May they called for a recovery fund which would redistribute €500bn among member states to help “the most affected sectors and regions”, financed by borrowing on markets on behalf of the EU. This was an unprecedented proposal in the EU’s history. Within a week, a counter-proposal came from the so-called ‘frugal four’ countries: Austria, Denmark, the Netherlands and Sweden. They essentially called for a substantial reshuffle of current EU spending, which includes even more money than the proposed recovery fund. They also called for a temporary recovery fund that only provides loans and avoids any mutualisation of debt. The Franco-German proposal and the frugal counter-proposal highlight the starkly opposing views on European solidarity among member states.
On 27 May, the European Commission quickly followed up with a comprehensive proposal, including a recovery fund named Next Generation EU (NGEU), involving €500bn expenditures and €250bn loans. Subsequent negotiations lowered the expenditure component to €390bn and increased the loan component to €360bn, and this was approved by the European Council on 21 July. The EU will borrow to finance the expenditures and the loans, with all member states guaranteeing this borrowing.
NGEU has had positive effects already, by boosting confidence and sentiment around the actions the EU is prepared to take to protect its populace. The borrowing costs of Italy and Spain have fallen, and a recent EU bond issuance was oversubscribed 13 times. The risk of a euro area breakup has receded. However, a number of questions loom over the process.
First, is NGEU big enough? No. Italy would be likely to obtain about 5% of its annual GDP (distributed over six years), while Spain would get about 7%. These are large amounts and can make a difference, but in themselves these sums will not materially change the public debt profile of these countries. To reduce the debt burden, policies fostering growth are needed.
Second, will NGEU reduce social disparities within the EU? Yes and no. Yes, because it will likely narrow economic divergence between countries. But it is hard to see how NGEU spending, which should focus on green transition and digitalisation, will address longstanding social disparities within countries, which were further exacerbated by the pandemic.
Third, will NGEU bonds contribute to capital market developments? Yes. The EU is set to become the greatest supranational bond issuer. EU bonds could become a reference asset for financial markets, which would be a benefit on its own. For this reason, but also because repayment of EU debt would necessitate national taxpayer money, members might decide to roll over maturing EU debt, like national governments roll over their maturing debt.
Finally, will NGEU plant the seeds of deeper EU fiscal integration? Unlikely. The debate leading to the adoption of the package revealed deep-rooted disagreements. Ultimately, all 27 member states agreed to the package. But the frugal four agreed only because of the extraordinary human and economic toll, and they obtained larger EU budget rebates as well as some control mechanisms. One such mechanism is a ‘red card’ procedure, whereby any country could raise concerns about NGEU spending in any other country. The other is a yet-to-be-agreed rule of law procedure, which could lead to suspension of EU funds in case of rule of law deficiencies. While such control mechanisms can be helpful in ensuring better spending of EU money, they also have the potential to generate endless disputes between member states, undermining possible new EU-wide instruments.
At the time of writing, Hungary and Poland had put a veto on the EU budget deal, including the recovery fund, because of their disagreement with the rule of law procedure. We do not know if there will be a compromise, or if both sides will remain firm. The latter option would lead to a deep political crisis, unless voters in Hungary and Poland decide on new governments with a more cooperative attitude. Unanimity requirements do not make the prospect of reforming EU decision-making bright. In a deepening political crisis, the recovery fund could be set up as an intergovernmental agreement between the willing 25 member states.
Nevertheless, let me close with an optimistic observation. The various instruments proposed by the Franco-German duo, the European Commission and the ECB demonstrate that, when the EU faces an extraordinary shock, member states are able to put aside their day-to-day disputes and find common solutions fostering solidarity. There is hope for common solutions when the next crisis comes – at least for the coalition of the willing.
This article first appeared in the RSA Journal
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