Blog

by Dimitri Zabelin, Data Policy Analyst at World Economic Forum

Looking Back & Going Forward: The Future of the Eurozone After COVID-19

As of this moment, Europe has over 181 million confirmed cases of the COVID-19 virus, and over 3.91 million deaths. Amid the coronavirus-induced panic-selloff in global equities in March 2020, regional benchmarks like the DAX lost over half a decades-worth of gains in a month. Markit PMI for the same month printed record-breaking low figures that made the 2008 financial meltdown look like minor deviations in economic activity. The immense magnitude of both those events, and how Europe is still recovering from it today – financially, economically and politically – underscores the destabilising nature of the virus. For the Eurozone and its members, it is acting as the ultimate test of Europe’s resolve of unity. The fundamental question is: will the friction lead to fracture or fraternity?

Sanctuary & Sin: Rushing Peace

To better understand Europe’s current predicament, it is crucial to identify Europe’s key structural problems and what catalysts widened these regional, multidimensional fissures. One dates to the creation of the Eurozone itself. Haunted by the pain of two world wars, European officials sought to find a way to end intra-regional conflict. Through a series of treaties that wove Europe closer together, the result was a union and the creation of the European Single Market, underpinned by the so-called Four Freedoms: the free movement of goods, capital, services, and persons.

In this regard, the European Union and the Eurozone can arguably be seen as a project that used economic means to achieve a political end: peace. Europe was eager to repair its political wounds and create regulatory parameters – like the Growth and Stability Pact – to facilitate the Eurozone as a currency union to function optimally. However, these rushed measures, put ahead of other considerations, were the proverbial original sin.

A major critique of the Eurozone is the lack of key institutions that could have been used to counter the regional asymmetries that exist today. These include provisions to account for severe divergences in interest rates among Eurozone members, policies to address asymmetric recoveries from shocks, and for export/import balances that would ordinarily be rectified with a flexible exchange rate. One policy that continues to be debated is the issuance of so-called Eurobonds that are backed not by individual countries but by a collection of them.

However, one of the conditions of forming a currency union means a single monetary policy for all its constituents. But as Nobel Prize-winning economist Robert Mundell notes in his assessment of the Eurozone, the nature and identity of each European member is “too diverse to easily share a common currency”. These include cultural and demographic factors that become pronounced during times of crises. Competing priorities from countries within the continent meant different policies were needed to address unique situations in each Eurozone state. However, the relatively rigid nature of the Eurozone prevented such accommodations, consequently creating the tinderbox of resentment that would later burn when other crises hit.

The (Debt) Prisoner

Following the famous crash of the collateralized debt obligation (CDO) market in 2008, the contagion spread to Europe. Portugal, Spain, Italy, Cyprus and most-famously, Greece were hit hardest. They all subsequently suffered severe debt crises as fears of insolvency began to spread. The perception that these countries would not be able to pay off their debt caused borrowing costs for their sovereign-issued bonds to surge. Between July 2011 and March 2012, Greek 10-year bond yields spiked almost 200 percent from approximately 14.5% to over 41.4%. The country then descended into economic and financial despair.

To avoid defaulting on their debt, the Greek government accepted loans that were attached with austerity conditions. These provisions laid the foundation for what would later become a “mobilization of resentment” among a disgruntled populace. Protests and riots ensued, ultimately culminating in what would become a small-scale humanitarian crisis. Being part of that currency zone meant Greece lacked independence in monetary policy, and regulatory constraints prevented the government from using bold fiscal measures. The crisis exposed the institutional rigidity placed on Eurozone member states, and the divergence in preferred policy prescriptions between Germany, the IMF and ECB versus Greece amplified regional tensions.

The Gunslinger: Italian Fiscal Exceptionalism

The divide would again resurface in 2018 with the Italian general election.  5-Star Movement (M5S) leader Luigi di Maio and Lega Nord party leader Matteo Salvini both became Deputy Prime Ministers with Guiseppe Conte as the Prime Minister.

The day of the election, the Euro plunged against the US Dollar and Swiss Franc while the spread between Italian and German debt yields significantly widened. The volatility in financial markets resulted in investors demanding a higher premium for holding Italian sovereign debt that they saw as comparatively riskier with the new coalition. Much like Greece, Italy also lacked the ability to use monetary and fiscal tools to reinvigorate economic activity, and this is where the political fallout of the debt crisis would make its reprise: the perception that Greece lacked autonomy over its economic trajectory fueled Eurosceptic narratives that Brussels is a sovereignty-violating technocratic leviathan.

As a way to revive economic growth, Salvini and di Maio put forward a proposal to expand the country’s budget deficit far beyond the recommended limits set forth by the European Commission. This is because Italy’s debt-to-GDP ratio stands at over 130%, and fiscal regulations constrict the ability of a country to run a bigger deficit once the country’s debt threshold exceeds 60%. This framework was put in place to avoid a country incurring so much debt that its ability to service these obligations becomes a point of doubt, consequently precipitating a sovereign debt crisis – like Greece.

Italy’s fiscal exceptionalism was a dangerous game to play for two key reasons. First, an imposition of the Excessive Deficit Procedure (EDP), would reinforce the narrative that Italy lacks sovereignty and that an outside force is dictating Italian affairs unfairly. As a result, this would likely only fuel the Eurosceptic flame that continues to burn intra-regional cohesion. The second was that if Brussels capitulated and was allowed to incur excessive debt, it could destabilise the entire Eurozone if investors started to believe that Italy – the third largest Eurozone economy – would become insolvent.

Ultimately, a resolution was reached whereby they agreed upon a middle ground for debt and the country avoided the EDP. Having said that, this underlying narrative of country vs supranational organisation and the perceived lack of autonomy would rear its ugly head again in a much more dire context.

The Reckoning: COVID-19

The shock of COVID-19 sent the Euro tumbling against the US Dollar and Swiss Franc along with domestic equity markets. Spreads on credit default swaps for sub-investment grade bonds surged along with sovereign bond yields for structurally distressed Eurozone states. To preserve financial stability, the European Central Bank (ECB) implemented a ‘non-standard monetary policy measure…to counter the serious risks’ known as the Pandemic Emergency Purchase Programme (PEPP).

Echoing Mario Draghi’s famous “whatever it takes” moment during the peak of the Eurozone debt crisis, ECB President Christine Lagarde said in response to the PEPP program: “There are no limits to our commitment to the euro”. This unwavering devotion to the Eurozone strengthened the Euro by virtue of the resilience it signaled. Along with many other policymakers, Ms. Lagarde emphasized the need for a coordinated fiscal strategy to ensure economic activity is not only preserved but revitalised.

Without getting into too much detail – more of which can be found in a timeline of articles I authored in the summer of 2020 – the internal rift between North and South stalled negotiations of a 750 billion Euro aid package. The biggest point of contention was over the loan-to-grant ratio of the rescue fund as well as the degree of oversight that would be tied to the distribution of it. Mediterranean states expressed trepidation in accepting loans that were stipulated to be monitored from outside their borders.

After much deliberation, the 27 member states and European Commission (EC) agreed to a 750bn Euro aid package. EC President, Ursula Von Der Leyen, announced on May 28 2021 that they are ready to “go to the markets to raise money”. This solidarity offered another lesson to Euro traders after the Eurozone debt crisis: don’t bet against European unity, not yet anyway.

Redemption? The Future of the Euro & Eurozone

Eurozone states should remember that unity as a moral and financial value pays short, medium and long-term dividends. It is the basis for cooperation that gives investors a sense of stability – and quells fears of insolvency – and European constituents a reinforcement of a regional identity. The latter is the basis for multinational coordination, with the alternative being every man for himself.

The pandemic amplified Europe’s structural problems by placing greater pressure to resolve them at a time when global geopolitics were generally quite belligerent. COVID-19 has and will continue to test the bloc’s resolve; but it may ultimately give way to an economic rebirth of Europe that had been held back by inward-thinking nationalism and elements of an out-of-touch bureaucracy. In the end, Europe’s friction did not lead to fracture but to a greater sense of fraternity; though internal fissures and wounds from the past remain. For the next crisis – and there will be another – European officials will need to remember to embed multi-lateral unity at the center of their policy prescriptions. This is the way to elevate Eurozone stability and the welfare of its constituents.