Covid-19 shakedown : the European way out


As Covid-19 is a crisis of an unprecedented kind, it has called for its set of unprecedented economical measures designed for an optimal recovery. This articles explores the monetary and budgetary options at hand.


When walking down the streets of most EU countries in July, one would never think a global pandemic has occurred, confining hundreds of millions of Europeans for a couple of months, if it were not for the face masks and the hydroalcoholic gel dispensers at the shops entries. Yet, like all others, the European economy has been badly hurt for the past few months because of the global lockdown implemented to prevent the spread of Covid-19. The back-to-normal status will not make up for the loss of three months of economic production. Even though some sectors and branches were able to put in place telework, a large share of the economic output was cut short. On June 10th, the OECD predicted that the initial direct hit of this “Great Confinement” – as baptised by the IMF – would go from -23% to -31% for the G7 countries, namely -29% for Germany and -26% for France.

OECD previsions are grim. Depending on the occurrence of a second wave or not, the Euro area’s GDP is forecasted to go down by between -9% and -11% in the most recent outlook. Whatever the scenario, we will need at least two years to be back to the 2019 level in terms of production. This will, by then, be 6 to 10 points of index lower than the 2022 previsions made in late 2019 (i.e. no coronavirus) [see graph]. Worldwide, the recession is predicted to hit -4.9%. Only the super-dynamic emerging powers will be able to stay in the green (1% for China compared to 6.2% last year). In the eurozone, unemployment should go up by 40%, from 6.6% to 9.2%. Spain could see its unemployment rate go from 13% today up to 20% in late 2021.

Several economic mechanisms have been set in motion during the crisis. At first, there was a massive negative demand shock initiated by the lockdowns, restraining consumers’ purchases of various non-necessary goods and services. The firms reacted by lowering their production to fit the demand and find a new equilibrium. The decrease in production implied the decrease in labour demand and hence increased unemployment as seen above. However, unemployed people saw their purchasing power decrease just the same. The economy went back through a demand crisis where demand decreased and production had to adjust. In these conditions, the economy cannot restart and is bound to depression. As the prices go down (deflation), even the richest do not find it economically optimal to buy today (t = p), as in the future the prices will be even lower (t+1 = p*0.9  for a 10% deflation), fuelling the never-ending mechanism. This was theorised as the “deflationary spiral” [read more about it here]. Fortunately, major economists have found – theoretical – ways to get out of such a trap. For Keynesians, the public powers should invest in purchasing power, in such a manner as creating a positive demand shock which will require the production to follow in the inverse loop. For neoclassicals, it should directly invest in production to boost GDP growth at the root. Now, the measures taken in the Euro Zone are a bit of a mix.

Schematically, economics theorises two main levers of action to regulate growth: monetary policy and fiscal/budgetary policies. Monetary policies deal with banks and the cost of money through guiding interest rates while fiscal policies deal with taxes and subventions for citizens and firms. In the European Union, they are controlled by two different, independent institutions. Indeed, the monetary policy is led by the European Central Bank (ECB), which is independent from the executive powers in order to guarantee fair levels of inflation at all times (2%), when the budget is controlled by the European Commission and the European Council.

First, the objective of the ECB is to foster purchasing power and consumption, as they have decreased and will continue to do with the crisis. In an interview for a group of economic magazines, Christine Lagarde, head of the ECB declared that Price stability is at the heart of our mandate, with inflation of below, but close to, 2%”. How to avoid deflation, when more people are unemployed, and firms are in difficulty to sell their products? The ECB has launched a Pandemic Emergency Purchasing Plan (PEPP) that is quite similar to the Quantitative Easing (QE) used during the 2008 crisis. During the time of the coronavirus crisis, the ECB will buy public and private debt bonds for at least €750 billion. “We have been very clear, and we continue to be very clear – we will not hesitate to adjust the size, duration and composition of the PEPP to the extent necessary.”, says Christine Lagarde. By doing so, the ECB avoids confidence issues and will lower the rates at which States and private actors will be able to borrow (safer bonds, like the one guaranteed by the ECB, generate lower interest rates because of the lower risk taken by the investor), hence increasing their purchasing power and their room for manoeuvre while reducing their debt in the long run. If the ECB is not opting for  “conventional” monetary policies (lowering guiding interest rates), it is simply because the rates are already at their lowest levels and they cannot switch to negative. Since March 2016, refinancing rates for private banks have been of 0%.

Besides these monetary levers employed by the independent, federal Central Bank, States too have a role to play to exit the crisis smoothly. In this matter, the EU is introducing a brand-new way to function, following the idea of a common debt – coronabonds, initially expressed by E. Macron and A. Merkel on May, 18th – throughout the Union. Before the crisis, the EU’s shared budget was of €1 trillion on 2021-2027. According to Ursula von den Leyen, President of the European Commission, the EU would borrow an extra €750 billion to add to the budget in the context of Covid-19. Among those, €250 billion would be lent to EU Member-States at preferential rates according to the damages of the crisis (91 billion to Italy, 63 for Spain). The other €500 billion would take the form of subventions (81 billion to Italy, 77 to Spain, 39 to France, 29 to Germany). This money is hereby being gathered to avoid EU countries drowning in debts, as well as to provide for the many extra expenses generated by the lockdown and the public care to ill citizens. For instance, such money will be useful to cover the costs of partial unemployment. During the lockdown, about 40 million citizens earned 60% to 70% of their wages when not working. This enabled firms not to have to fire their workers, hereby ending precious contracts. It may also be used to pay extra wages promised by several Head of States to health workers, or to other professionals  who were “indispensable” during the peak of the pandemic.

It is still unclear how these two levers – monetary and budgetary – will be used by EU countries and whether they will be fully efficient. Still, they should help at least to hinder the consumption-level drop and amortise the depression shock. It is certain, however, that such a centralised European debt should push towards more federalism within the EU, as Member-States will be more bonded and interdependent than ever after this symmetric shock.

As The Quarterly publishes this article, the Member-States just came to an historical agreement, pushed by French President Emmanuel Macron, of a common debt of €750 billions to get out of the crisis. The magazine will analyse it and interpret it for its readers within the upcoming weeks.

Article by Léandre Ostier. Illustration by Jimena Madrigal.

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