New Challenges for the Eurozone Governance: Joint Solutions for Common Threats? 3030623718, 9783030623715

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José Caetano Isabel Vieira António Caleiro   Editors

New Challenges for the Eurozone Governance Joint Solutions for Common Threats?

New Challenges for the Eurozone Governance

José Caetano · Isabel Vieira · António Caleiro Editors

New Challenges for the Eurozone Governance Joint Solutions for Common Threats?

Editors José Caetano University of Évora Évora, Portugal

Isabel Vieira University of Évora Évora, Portugal

António Caleiro University of Évora Évora, Portugal

ISBN 978-3-030-62371-5 ISBN 978-3-030-62372-2 (eBook) https://doi.org/10.1007/978-3-030-62372-2 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Foreword

The leading thread of this book is quite topical. It investigates to what extent the ongoing crisis is a revealer of the euro area design shortcomings, asking at the same time whether the crisis can become a catalyst for well-known needed reforms. The crisis basically exposed two of those flaws: the vulnerability of weaker countries’ national debt markets to pure liquidity squeezes and redenomination risk and the inadequacy of the fiscal policy framework. The Stability and Growth Pact (SGP) had to be suspended as fiscal policy was at the centre of the response to the crisis. In fact, direct transfers of income to households were an essential policy component as well as subsidies, capital injections, loans, and guarantees to maintain firms afloat to survive lockdowns and demand collapse in several sectors. In an unprecedented decision, the EU countries approved a e750 bn Recovery Plan, that inaugurated a European-level fiscal stabilisation effort that has been interpreted as the beginning of fiscal union. Some even hailed it as a sort of European Hamiltonian moment. Despite being a gamechanger, there is some exaggeration in that assessment. There is no creation of a permanent Stabilisation Fund and no mutualisation of debt. Contrary to a complete Eurobond, which has “joint and several” liability, the issuance of bonds by the EU Commission does not make member States liable for more than the part of the debt proportional to their GDP and population. Nevertheless, common issuance by the Commission on that scale is unprecedented and represents a welcomed addition to European safe assets with top ratings. Three other elements of the package are equally without parallel: it is a truly European-level fiscal stimulus; it is mostly distributed as budget transfers and not loans; and is distributed according to needs and not on a proportional basis. This last point can be illustrated by recalling that of the total e390 bn grants, Germany was proportionally entitled to 96 bn but gets only 27 bn or 0.7% of its 2019 GDP. In contrast, Greece receives 11% and Portugal 6.7% of their respective GDPs. This indisputable act of European solidarity has an overall meaning that transcends any details. First, it is proof that in situations of stress, the EU does not abandon its members to fend for themselves and takes collective responsibility. This assurance made European assets gain market value and the euro to appreciate. Second, the decision is a clear reflection of the growing awareness of the new geopolitical situation that is squeezing Europe in the great power game that is substituting a waning v

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multilateralism. All European countries, including the bigger ones, need more than ever the protection of a cohesive European power. The fact that the euro is the crucial cement of this community of interests makes it more unbreakable. The big question now is to assess whether the unprecedented decision of the e750 bn Recovery Plan is the harbinger of other reforms, heading for a higher degree of fiscal union or whether the political capital spent to achieve that decision implies a greater difficulty to muster the political will to go further. As it is usual in EU history, the pressure of events will dictate the outcome. Two significant pressures for change are clearly emerging as a consequence of the crisis: first, the necessity to revise the Stability Pact and second, the need to complete the Banking Union and review adjacent regulations, as the stressful situation of the banks will deteriorate next year. In a still remote worst-case scenario, it may become necessary to tweak the BRRD and allow public support to troubled banks overwhelmed by high NPL losses and low profitability. Regarding fiscal policy, deficits and the deep recession imply increases of more than 20 p.p. in debt to GDP ratio in many countries. The slow recovery that will follow is not compatible with an aggressive fiscal consolidation in the near future. A double deep recession, like the one in 2012–2013 must be avoided. The Stability Pact will have to be revised, and the EU Commission already announced that internal preparatory work has started. Active fiscal policy will be indispensable for years to come in advanced economies beset by secular stagnation and the insufficiencies of monetary policy.1 The majority of views about the SGP reform seem to point to the adoption of an expenditure growth rule. This change would eliminate any reference to cyclically adjusted deficits that were an attempt to make the initial Pact less procyclical. Despite an intelligent expenditure rule being able to be less procyclical than the existent SGP, two points of caution are warranted. First, the anti-cyclical element of an expenditure rule can be overturned if it aims at a low debt-to-GDP ratio in a short period of time. Considering the unavoidable higher debt legacy of the corona crisis, it is imperative to avoid any strict formula for the convergence to the Treaty target. Second, an expenditure rule has difficulty in dealing with severe unexpected recessions and should, therefore, be complemented by a permanent European Stabilisation Fund based on unemployment thresholds. Desirable but apparently less pressing reforms will take more time, like the creation of a sizable permanent market for a European safe asset, indispensable for a true capital markets union, and the internationalisation of the euro.2 Meanwhile, monetary policy framework is being revised, hopefully, to become more flexible and symmetric, suitable for the implicit and independent cooperation with fiscal policy in situations like the current one. 1 Constâncio, V. (2020) “The Return of Fiscal Policy and the Euro Area Fiscal Rule” in Comparative Economic Studies 62, 358–372. 2 Constâncio, V. (2019) “European Financial Architecture and The European Safe Asset” in the book from the European University Institute, Florence, European Financial Infrastructure in the Face of New Challenges pp. 11–22, https://fbf.eui.eu/ebook-download-european-financial-infrastru cture-in-the-face-of-new-challenges/.

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The present deep recession has so far wiped out 15 years of Euro Area growth and more than 20 of some peripheral countries. The recovery will be sluggish and will leave behind many socio-economic scars. Other difficult decisions and reforms may become necessary. The present book offers a thought-provoking map to explore possible policies for that challenging future. Lisbon, Portugal

Vítor Constâncio

Vítor Constâncio was Vice-President of the European Central Bank from June 2010–2018. At the central bank of Portugal, he was Director of the Economics Department, Deputy Governor, and from 2000 to 2010 was Governor of the Banco de Portugal. He was Finance Minister in 1977– 1978. At the Lisbon School of Economics and Management (ISEG), University of Lisbon, he was coordinator of the Master’s degree on Monetary Policy from 1989 to 2010. He is now President of the School Board at ISEG, and Professor at the Master’s Degree in Banking and Financial Regulation at the University of Navarra, Madrid.

Introduction

The idea to publish this book was sparked in March 2020 by the unexpected and abrupt widening in some Eurozone sovereign bond spreads against Germany. Such episode reopened painful memories of events leading to the 2011 sovereign debt crisis, when the fears of financial market agents challenged the Economic and Monetary Union’s (EMU) integrity and survival. The traumatic recollection of such period exposed the fact that, in spite of the improvements achieved in the meantime, previous flaws in the Eurozone architecture had yet to be mended. The behaviour of bond spreads in March, and the complexity of the interactions that underlie it, renewed the interest of reflecting on possible effects of the COVID-19 pandemic triggered economic, social and, eventually, financial crises on the Eurozone as a whole and, particularly, on its governance. The previous debate over the causes and implications of the sovereign debt crisis was crucial for the process of monetary integration in the European Union (EU). In fact, events relevant within the Eurozone often end out indelibly affecting the entirety of the Union. It was thus not surprising that, faced with the evident governance flaws and with the uncoordinated political responses to the crisis, European leaders attempted to find solutions. It was nevertheless obvious that, despite such efforts, as soon as the most impressive impact of the crisis dissipated, the major previously detected structural problems remained unresolved. And when the current crisis emerged, EMU was still facing its most relevant challenge of becoming more resilient, effective and fair. Amongst its main unattained objectives, we count the failure to complete the banking and capital markets unions, expected to reinforce risk-sharing between banks and governments and to improve the allocation of financial resources; the lack of effective articulation of national fiscal policies and of a central budgetary capacity, capable of exercising stabilization in the Eurozone; and the lack of structural reforms to anchor a more balanced EMU in what concerns creation and distribution of wealth. Furthermore, legal obstacles to the monetization by the European Central Bank (ECB) of Member States’ public debts, rooted on the questionable no bailout clause imbedded in the European Union Treaty, and the recurring doubts concerning the justification for public debt acquisition by the ECB, remain hovering as veiled threats. To attest it, the German Constitutional Court recently argued that previous ECB ix

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actions violated the principle of proportionality. It is a fact that massive purchases of sovereign debt have generated significant side effects by bringing interest rates close to zero. Such effects have far exceeded the statutory objective of keeping inflation under control and have put the ECB under a pressure that may endanger its future course of action. Also the divisive issue of debt mutualisation, at the heart of political debate during the previous crisis (following the high debt costs imposed by financial markets on some EMU countries, which endangered the sustainability of their public debts) did not vanish but lost momentum in political agendas. There were interesting nonexplored proposals, limiting the degree of individual and collective responsibility, and eventually providing support for the emergence of safe assets, capable of providing stability and liquidity to the European Public Debt market and preventing banks’ exposure to their sovereigns. But progress in exploring such possibilities was incipient and when Italy, Spain and Portugal’s debt spreads significantly widened in March, in part following Christine Lagarde’s reckless statement that it was not the ECB’s responsibility to reduce public debt spreads in EMU, panic returned to financial markets and fears of reliving the past re-emerged in full force. In such context, and given that the current crisis is intrinsically quite distinct from the previous one, we anticipate that there are reasons to expect that present events will play a crucial role in the enhancement of the Eurozone’s sustainability. First, the current economic shock is exogenous and was not provoked by the behaviour of any government or private sector agent. Second, this is a common shock with distinct impact across EU countries. Third, the economic crisis facing the EU comprises a complex mix of supply and demand shocks. On the supply side, the restrictive measures adopted to operationalize social distance and to contain the spreading of the virus have drastically reduced production. Restrictions on human mobility and work activities have led to an unprecedented drop in aggregate demand. Such contraction justifies the anticipation that eventual inflation peaks prompted by supply restrictions will not materialise, unlike the more serious threat of a probable deflationary trend that is already emerging. Initially, discussions over the best response to the COVID-19 crisis revived preexisting fracture lines dividing countries and taboo issues, but they also reflected a consensus concerning the urgency of addressing the serious economic and social problems that had emerged. In a second moment, when the crisis showed impressive signs of severity and contagion over various countries, progress was made and a European level reaction was designed. Its most relevant features are the adoption by the ECB of expansionary monetary policy measures, the European Commission’s actions to support Member States domestic policies, the relaxation of the rules of the common competition policy on state aid, and the activation of the safeguard clause that suspends the application of the Stability and Growth Pact. However, it was the political agreement reached in mid-May 2020 by Angela Merkel and Emmanuel Macron that marked the third phase of the EU’s response. This agreement unblocked the stalemates of previous European Council summits and allowed the planning of structural courses of action. It also leads to the creation of a e500 billion donations-based recovery fund to support countries in their combat to

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the pandemic crisis and leveraged the Commission’s end of May proposal of a strategy to solve current problems and to prepare the future for the next generation, which together with the new proposal for a Multiannual Financial Framework for 2021– 2027, amounted to around e1.8 billion. These are relevant and innovative solutions, involving amounts of money never previously matched by any EU programme. It was this proposal, adjusted after intense and dramatic negotiations, that was approved by the European Council in July 2020, and which includes the Next Generation EU instrument, to support the crisis most affected countries with a e750 billion fund, financed by new EU debt. According to the Council’s resolutions, e672.5 billion will constitute the Recovery and Resilience Fund, comprising grants and loans. The remaining funds will be allocated as flexible subsidies to respond to the crisis and to support transition to a greener economy. To some, these decisions reflect a slow and uncoordinated response to the crisis, with the added disadvantage of having been achieved through discussions that deepened divergences between EU members. To others, amongst which we count ourselves, the outcome of discussions was a ground-breaking, though incomplete, plan and a renewed opportunity to address relevant gaps still pervasive in the architecture of EMU. This agreement concerning the recovery plan and its budget are unprecedented in the EU, and it is almost impossible to identify a comparable example involving sovereign states elsewhere. It therefore has an enormous political reach, resulting in greater flexibility and capacity for the EU fiscal policy and opening new perspectives for monetary integration. The agreement breaks taboos and overcomes red lines that have divided countries. For instance, the assumption of debts at the European level and the allowance of funds based on needs, are some of the aspects that have long been undermining discussions about the functions of the Community Budget and the mutualisation of debt. A first relevant innovation is the financing of the Recovery Fund by EU’s direct issuance of debt, making it one of the largest issuers of mutualized sovereign debt in the world and creating a European asset of very low risk that will compete in a market hitherto dominated by the USA. This solution has the potential to overcome previous legitimacy problems. The crisis-specific solidarity mechanism is based on grants to be allocated to specific ends, but lacks intrusive and stringent conditionality. Furthermore, the ubiquitous rhetorical question of moral risk that the mutualisation of debt often invokes no longer applies. Given that countries are not expected to intentionally incur in situations that allow access to financial funds, such risk no longer exists. A second novelty of this settlement follows from the first, described above, since the plan implies a superior fiscal capacity by the EU, an aspect that some European politicians have always tried to avoid. In fact, to guarantee the necessary financial resources, a higher volume of tax revenues will be needed, and so the sacred limits of the common budget of around 1% of GDP are largely exceeded. It remains to be seen whether the agreed measures are temporary or permanent. In order to guarantee reimbursement, the EU should introduce new taxes that guarantee its own revenue in addition to tariffs and the share of national VAT receipts. There is some consensus concerning the opinion that the new taxes should be directed to areas that cross

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national borders, such as, for example, carbon emissions or financial and digital transactions. This is a matter on which European institutions will have to decide soon. The third originality of the Recovery Plan is the permission given to the European Commission to borrow in financial markets and, also, the logic and terms for the repayment of loans by individual Member States (which may be extended until 2058). This goes beyond the financing of EU budget exclusively through own resources and state contributions. In view of the current low interest rates paid by the most solid sovereign debtors, this leverage will allow EU to access (almost) unlimited funding, at a low cost and with long repayment schedules. While being relevant to unblock issues that have so far prevented the adoption of joint solutions for avoiding and resolving crises in the Eurozone, the agreed decisions apply without distinction to all EU Member States. Such measures were not designed to address specific EMU challenges, resulting from the fact that EMU has a common central bank but not an equivalent fiscal authority. The Eurozone thus faces a crucial asymmetry which, in the face of specific shocks, considerably limits its action, especially, as is currently the case, when the margin for manoeuvre of monetary policy with practically zero interest rates is very low. A common fiscal instrument would reduce exposure to sovereign risk when issuing debt and would also allow a more adequate use of fiscal policy in response to adverse shocks. Ideally, such reaction would be provided by means of a stabilization fund capable of issuing low-risk debt. But this would also require a degree of risk-sharing that most Member States are not yet ready to accept and it is understandable that, without the backing of political union, such mechanism lacks in legitimacy. However, EU’s reaction to the pandemic already exhibits signs of some risk-sharing and of some flexibility, evident for instance in the credit lines provided by the European Stability Mechanism for health care and by the European Commission to mitigate unemployment risks. A monetary union needs a mechanism to limit externalities, operating in the presence of both deficits and surpluses. The response to crises requires coordinated fiscal policies of an anti-cyclical nature and a central fiscal capacity is an essential way of ensuring that they are provided. Such mechanism should not prevent heavily indebted countries from recurring to expansionary fiscal strategies to stimulate domestic demand in case of need, and this would only work if countries are prevented from accumulating unsustainable levels of debts when times are normal. EMU thus needs effective rules to limit moral hazard that are so far lacking. Naturally, there are structural aspects, related to the persistence in the Eurozone of distortions in relative prices of goods and services, which will remain unresolved. Fixing them would require real devaluations to reduce differences in competitiveness levels or permanent transfers between members that European leaders openly repudiate. A new governance structure in the Eurozone must recognise the need for a common fiscal capacity and for an effective and complete banking union, with the means to prevent and manage crises. Both are well beyond the recent decisions of the European Council, for to make them possible and to allow the rules that would ensure their feasibility and functionality, EMU would require new institutions and

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a higher level of political integration. The proposals approved so far reflect the will of the Member States, of which the new German position on monetary integration emerges as determinant. But they also reflect the joint efforts of academics that have for so long reflected on, and searched solutions for, EMU’s underlying problems so that it may overcome its growing challenges and enhance the odds of its survival. All those reflecting on EMU’s troubles have eloquently pointed out the need to change the current model of the Eurozone governance and of doing so quickly. The pandemic crisis has re-ignited a long-lasting debate, providing new momentum for the (re)start of crucial discussions that may lead to the revision of EU Treaties. The purpose of this book is to contribute to such profound and enlightening debate, by integrating the views of more than 30 economists and political scientists, who have agreed to assess current and future Eurozone threats and challenges from multidimensional perspectives. The result is a large variety of insights and reflections that provide answers to the book’s title question “New Challenges for the Eurozone Governance: Joint Solutions for Common Threats?”. The problems addressed by the authors are not easily classifiable into distinct categories. Most chapters overlap different subjects and provide more than one avenue for possible progress in what concerns the future of the Eurozone governance. For this reason, the book does not separate the authors’ contributions into different formal parts, but presents them sequentially, opening with more wide-ranging or structural analyses, subsequently offering assessments of the monetary, fiscal, social and institutional dimensions, and closing with an overarching assessment of the impact of major crises upon theoretical macroeconomic frameworks and its implications for the future of the Eurozone. The first three chapters focus on how the COVID-19 pandemic has provided the opportunity to implement much-needed institutional changes in the Eurozone. Boitani & Tamborini, focus on how reform has been thwarted by the so-called NorthSouth divide, despite the current consensual view of its urgency. Heine & Herr point out examples of specific measures aimed at enhancing monetary and economic integration. Travelling back to the Great Depression of the 1930s, the authors illustrate possible consequences of economic policy errors in the Eurozone’s reaction to the current crisis. A governance paradigm shift towards a more comprehensive and integrated approach is defended by Mendonça & Vale to both provide a better response to the pandemic and to enhance the international role of the EU. Monetary topics are the object of the next three chapters. Braun-Munzinger, Carmassi, Kastelein, Lambert & Pires point out how the incomplete banking union has already facilitated the first responses to the COVID-19 crisis and explain how its completion will benefit the European integration project as a whole. Considering monetary stability as a guiding principle, Castañeda sets up a rule-based monetary strategy for the ECB in the current low inflation and near-zero interest rates environment. Caetano, Ferreira & Dionísio focus on the role of Eurobonds and on how they may be instrumental for a new Economic and Monetary Union governance model based on the principle of subsidiarity and putting aside concerns over moral hazard and the intrusive and stringent conditionality.

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The chapters by Cruz, Rangel & Parejo, and by Katsikas address fiscal stabilisation and fiscal governance. The former discuss the utility of implementing automatic fiscal stabilisation capable of not only solving macroeconomic and social problems, but also of eliminating moral issues and the discretionary image of public spending. The later, analyses EMU’s current design of fiscal governance, the short-term changes implemented to address the most pressing current fiscal requirements, and its limited and uncertain long-term impact. The next set of chapters concentrates on labour markets and on social dimension linked to the EMU. Silva & Duarte estimate a dynamic stochastic general equilibrium model to assess macroeconomic consequences of a (COVID-19 prompted) labour supply shock. Their simulations indicate that even a shock that solely affects one of the two considered regions pushes both areas into stagflation, stressing the need for policy coordination in countries sharing a common currency. Jurado & Pérez-Mayo show how, after serious economic crises, social inequalities are exacerbated and propose policies that allow a timely reaction to the asymmetric after-effects of the current crisis on Eurozone households. Relatedly, and given the expected loss of jobs provoked by the pandemic, Andor revisits the main characteristics of the European Commission’s instrument SURE, designed to provide temporary support to mitigate unemployment risks in an emergency. The empirical assessment developed by Liotti & D’Isanto leads the authors to defend that the impact of the pandemic crisis on unemployment should be counteracted, not by means of labour market deregulation, but with measures designed to support demand. Building on past experience of how attempts to resolve economic crises have negatively impacted human rights and social cohesion, Neves discusses Eurozone governance reforms required to adequately answer current challenges without disregarding implications for citizens’ confidence in EU institutions and for the growing influence of anti-EU political parties. The political nature of European integration developments underlies the chapters by Leitão, and by Vila Maior & Camisão. Leitão addresses the political essence substantiating the legitimacy assumed by the representatives of the so-called frugal and Southern countries that have adopted opposed positions in what regards reactions to the COVID-19 crisis. Vila Maior & Camisão analyse the differences in the institutional response to the current crisis, discuss the institutional rebalancing of the EU and assess impacts for the sustainability of the European integration project. The final chapter, by Hierro, Atienza-Montero, Domínguez-Torres & Garzón, shows how major economic crises shape macroeconomic theoretical development. The authors defend that past and current crises have exposed the inadequacy of the theoretical framework rooting EMU’s institutional design and thus that adequate policy reactions to the distinct challenges have so far required the disregard of established rules based on out-of-date economic orthodoxies.

Contents

The Future of the Eurozone: A Reflection Paper on the North/South Divide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Andrea Boitani and Roberto Tamborini

1

European Monetary Union and the COVID-19 Crisis: A Tightrope Act with the Risk of Falling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Michael Heine and Hansjörg Herr

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Europe at the Crossroads of the COVID-19 Crisis: Integrated Macroeconomic Policy Solutions for an Asymmetric Area . . . . . . . . . . . . . António Mendonça and Sofia Vale

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From Deadlocks to Breakthroughs: How We Can Complete the Banking Union and Why It Matters to All of Us . . . . . . . . . . . . . . . . . . Karen Braun-Munzinger, Jacopo Carmassi, Wieger Kastelein, Claudia Lambert, and Fatima Pires A Rule-Based Monetary Strategy for the European Central Bank: A Call for Monetary Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Juan E. Castañeda

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Searching for a New Balance for the Eurozone Governance in the Aftermath of the Coronavirus Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 José Caetano, Paulo Ferreira, and Andreia Dionísio Surfing the Epidemic at the Zero Lower Bound: A Eurozone Fiscal Era? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Esteban Cruz-Hidalgo, José Francisco Rangel-Preciado, and Francisco Manuel Parejo-Moruno Reforming Under Pressure: The Evolution of Eurozone’s Fiscal Governance During a Decade of Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 Dimitris Katsikas

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Essential and Non-essential Goods: A Dynamic Stochastic General Equilibrium Modeling of the Infectious Disease Coronavirus (COVID-19) Outbreak . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 Nuno Baetas da Silva and António Portugal Duarte Social Challenges for the Eurozone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 Antonio Jurado and Jesús Pérez-Mayo Protecting Jobs and Incomes in Europe: Towards an EU Capacity for Employment Stabilisation in the Pandemic Period . . . . . . . . . . . . . . . . . 207 László Andor Changes in Labour Market Institutions and Unemployment in European Countries: An Empirical Analysis on the Shortand Long-Run Effects of Flexibility Measures . . . . . . . . . . . . . . . . . . . . . . . . 227 Giorgio Liotti and Federica D’Isanto Austerity, Human Rights Erosion and Political Radicalization: Implications for Eurozone Governance Reform . . . . . . . . . . . . . . . . . . . . . . . 247 Miguel Santos Neves The Politics of Covid-19: The Discourse on the Nature of the Economic Crisis and the Legitimization of EU’s Response . . . . . . . 267 António Leitão Institutional Rebalancing in the Wake of the Covid-19 Pandemic . . . . . . . 285 Paulo Vila Maior and Isabel Camisão The Post-pandemic Euro: Macroeconomic Lessons Learned from Crises and Economic Orthodoxies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 Luis A. Hierro, Pedro Atienza-Montero, Helena Domínguez-Torres, and Antonio J. Garzón

Editors and Contributors

About the Editors José Caetano holds a Ph.D. in Economics from the University of Évora. He is an Associate Professor of Economics at the same university, the Director of the Master Programme in International Relations and European Studies, and a researcher at CEFAGE. His research interests are international economics and European integration, on which he published several articles in international journals and books. In 2018, he coedited the book “Challenges and Opportunities for Eurozone Governance”. Isabel Vieira holds a Ph.D. in Economics from Loughborough University. She is a Professor at the University of Évora and a Researcher at CEFAGE. Her areas of interest are economic integration and education policies, on which she has published book chapters and articles in international peer-reviewed journals. António Caleiro has been an Assistant Professor at the University of Évora since May 2001, after obtaining a Ph.D. in Economics from the European University Institute (Florence, Italy). His research and teaching activities plainly reveal his multidisciplinary skills, which a simple query to his curriculum would have made clear.

Contributors László Andor Hertie School of Governance, Berlin, Germany; Department of Economic Policy, Corvinus University, Budapest, Hungary Pedro Atienza-Montero Department of Economics and Economic History, University of Seville, Seville, Spain

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Editors and Contributors

Andrea Boitani Department of Economics and Management, University of Trento, Trento, Italy Karen Braun-Munzinger European Central Bank, Frankfurt, Germany José Caetano CEFAGE, IIFA, Universidade de Évora, Évora, Portugal Isabel Camisão Faculdade de Letras da Universidade de Coimbra and CICP, Research Center in Political Science, Coimbra, Portugal Jacopo Carmassi European Central Bank, Frankfurt, Germany Juan E. Castañeda Institute of International Monetary Research, University of Buckingham, Buckingham, UK Esteban Cruz-Hidalgo University of Extremadura, Badajoz, Spain Federica D’Isanto Department of Political Sciences, University of Naples Federico II, Naples, Italy Nuno Baetas da Silva Faculty of Economics, CeBER—Center for Business and Economic Research, University of Coimbra, Coimbra, Portugal Andreia Dionísio CEFAGE, IIFA, Universidade de Évora, Évora, Portugal Helena Domínguez-Torres Department of Economics and Economic History, University of Seville, Seville, Spain Paulo Ferreira VALORIZA—Research Center for Endogenous Valorization, Instituto Politécnico de Portalegre, Portalegre, Portugal

Resource

Antonio J. Garzón Department of Economics and Economic History, University of Seville, Seville, Spain Michael Heine HTW University of Applied Sciences, Berlin, Germany Hansjörg Herr Berlin School of Economics and Law, Berlin, Germany Luis A. Hierro Department of Economics and Economic History, University of Seville, Seville, Spain Antonio Jurado Departamento de Economía, Universidad de Extremadura, Cáceres, Spain Wieger Kastelein European Central Bank, Frankfurt, Germany Dimitris Katsikas Department of Political Science and Public Administration, National and Kapodistrian University of Athens, Athens, Greece Claudia Lambert European Central Bank, Frankfurt, Germany António Leitão International Politics and Conflict Resolution, Centre for Social Studies, Faculty of Economics, University of Coimbra, Coimbra, Portugal

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Giorgio Liotti Department of Political Sciences, University of Naples Federico II, Naples, Italy António Mendonça ISEG—Lisbon School of Economics and Management, University of Lisboa, Lisbon, Portugal Miguel Santos Neves Autonoma University Lisbon, Lisbon, Portugal Francisco Manuel Parejo-Moruno University of Extremadura, Badajoz, Spain Jesús Pérez-Mayo Departamento de Economía, Universidad de Extremadura, Badajoz, Spain Fatima Pires European Central Bank, Frankfurt, Germany António Portugal Duarte Faculty of Economics, CeBER—Center for Business and Economic Research, University of Coimbra, Coimbra, Portugal José Francisco Rangel-Preciado University of Extremadura, Badajoz, Spain Roberto Tamborini Department of Economics and Management, University of Trento, Trento, Italy Sofia Vale Department of Economics, ISCTE—IUL, Lisbon, Portugal Paulo Vila Maior Universidade Fernando Pessoa e CEPESE, Universidade do Porto, Porto, Portugal

The Future of the Eurozone: A Reflection Paper on the North/South Divide Andrea Boitani and Roberto Tamborini

Abstract There is now a wide agreement that reforms of the architecture of the Eurozone (EZ) are needed, reforms aimed at fostering further integration of economic policy and governance. Behind the plea for “more Europe”, divergences loom large across member states. The cleavage is normally represented in geographic mode, the Northern EZ countries (NEZ) on one side, the Southern EZ countries (SEZ) on the other. It is quite clear that divergences have more to do with economy and polity than with geography. Suspicion runs high and mutual trust runs low between SEZ and NEZ. In these circumstances, it is extremely difficult to reform the EZ, while the conditions are set for populist, sovereigntist, anti-European movements to thrive. However the COVID pandemic may turn out to be a catalyst of reforms. We first attempt at understanding the legacy of the EZ crisis of the 2010s and its mismanagement by appealing to the present “consensus view”. This effort will help the reader focusing on why NEZ and SEZ disagree and to find out whether and how they can agree. Second, we try to build on this common narrative in order to identify the possible consensus changes in the EZ rules and institutions. Keywords Eurozone institutions and governance · North-South divide · Eurozone reform proposals

1 Introduction The Eurozone (EZ) has been pounded by two worldwide storms of abnormal magnitude in a decade: the 2008–2009 Great Recession and the 2020 COVID-19 pandemic. While in its infancy age 1999–2007, the economic performance of the European This chapter draws on a report of the authors prepared for the Friederich Ebert Stiftung Italia, Rome-Berlin http://library.fes.de/pdf-files/bueros/rom/16042.pdf. A. Boitani (B) · R. Tamborini Department of Economics and Management, University of Trento, Trento, Italy e-mail: [email protected] R. Tamborini e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_1

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single currency area was close to that of the other European-Union countries or other comparable areas like the United States, after the 2008–2009 shock the EZ displayed poorer economic performances. Indeed, there was a “Europeanisation” of the crisis, with the double-dip recession of 2012, the public sector involvement in the bank crises leading to the sovereign debt turmoil between 2010 and 2012, growing socio-political tensions across member countries, lack of clarity and determination at the level of supranational governance institutions. The foundations of the EZ have seriously been shaken by the first stress test of its (short) history. In 2014, Charles Wyplosz published a paper that expressed the growing discontent for the way in which the EZ was managing the crisis, with the harsh title: “The Eurozone Crisis: A Near-Perfect Case of Mismanagement”. “The Eurozone crisis occurred – he wrote - because the institutional setup was imperfect” (p. 12). The idea of the institutional roots of the EZ crisis, and hence the need for extensive reforms, has gained momentum both at the academic level (e.g. Baldwin and Giavazzi 2015, 2016; Delatte et al. 2017; Franco-German economists group 2018) and at the level of top institutions.1 The kernel of the various reform proposals is the need for further steps in institutional integration at the supranational level epitomised by the completion of the Monetary Union with a Banking Union, a Fiscal Union, and a Political Union. The EZ, and EU at large, were caught unprepared by the disaster of the COVID-19 pandemic. More because the EU and the EZ have never developed sufficient common tools to cope with systemic crises than because the pandemic was unexpected. With the benefit of hindsight, the crisis of the 2010s has largely remained a missed opportunity (e.g. Franco-German economists group 2019). The Banking Union is on a slow-motion track with two partial achievements: the single supervision on major banks, and the single resolution mechanism for bank crises. Negotiations are instead at a stalemate on a third key element, the common deposit insurance. The Fiscal Union, i.e. resources, authorities and rules for a common fiscal policy in the EZ, is a political enigma. The general feeling is that “something has to be done”, yet little is actually done. The absence of a common fiscal policy has hampered a strong and prompt collective reaction to the COVID-19 crisis. The Political Union remains the ideal end, but it is nowhere near reaching the stage of a political agenda. In this paper, we investigate the reasons that thwart progress on the way of the completion of the Monetary Union. Certainly, there is no lack of proposals of the highest scholarly and technical quality able to balance different and conflicting aims and means. The ultimate problem is clearly one of different views of what the Monetary Union should be, rooted in national interests, attitudes of public opinion, and hence political will. Divergences have certainly yawned as a consequence of the mismanagement, and missed opportunities, of the last decade’s crisis. A widely used reading grid of the divergences is of a geographical nature: the North EZ countries 1 As testified by the so-called Five Presidents Report (Juncker et al. 2015), and the subsequent docu-

ments of the European Commission (2016b, 2017a, b). The Mission Letter to the Commissionerdesignate for the Economy by the new President of the European Commission U. von der Leyen collects some of the previous proposals. Relevant speeches of the former President of the European Central Bank should also be mentioned (e.g. Draghi 2014a, b, 2015).

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(NEZ) on the one side, and the South EZ countries (SEZ) on the other.2 We abide with this practice, though the classification of countries is not so clear-cut as it may appear. The North-South divide is rooted in, and breeds, mistrust. This is, in our view, the deep disease that cripples EZ reforms and may pave the way to its eventual collapse. Indeed, there are reasons for reciprocal mistrust that should be taken seriously on both sides. Taking the view from the South, we seek to find a common ground description of the present shortcomings and needs of the EZ and, based on this, to reach a reasonable agreement between NEZ and SEZ on a minimal set of reforms aimed at safeguarding and strengthening the common house. To begin with, limited, or biased, reciprocal knowledge is one of the seeds of mistrust. Hence we try to offer a better characterisation of the two camps, also warning that the consequences of the COVID-19 shock are going to change the boundaries of the earlier geopolitical map. Second, we attempt to outline a narrative of the crisis and of its mismanagement by appealing to a “consensus view” that progressively emerged mainly around “mainstream” economic principles, which, admittedly, are not those referred to by “hardliners” in the NEZ or in the SEZ. This effort will help the reader to focus on why there are disagreements about the present state and the future of the Eurozone and to find out whether an agreement can be reached. Finally, we aim at grafting on this common narrative the possible consensus changes in the EZ rules and institutions. Will the pandemic be a catalyst of goodwill or mistrust? To overcome mistrust, a common step towards sovereignty sharing is necessary. That is to say new rules and new cooperative policies should be envisaged and entrusted, not to newly created technocratic entities or to a purely intergovernmental arena, but to genuinely supranational institutions while national responsibilities should be strengthened. Reforming the EZ is not going to be easy. As in any “high politics” operation, a unique combination of vision, determination and brinkmanship is needed. Business as usual would stand just as a new ascenseur pour l’échafaud of the EZ and the whole of Europe.

2 About North and South It is glaringly obvious that the North-South divide of the EZ has to do with economic and political cleavages more than with geography. The South of France has a lower latitude than the North of Italy and the North of Spain. Slovenia has more or less the same latitude of Northern Italy, but it is closer to Austria under many respects. A broad-brush characterisation of the typical NEZ country, vis-à-vis the typical SEZ country, is higher per capita income and growth capacity, stronger fiscal discipline (smaller and less frequent fiscal deficits, lower public debt), greater competitiveness (export-driven economy, and large trade surpluses). These differences are reflected in the attitude towards the EZ institutional and governance issues, which 2 Another

popular classification system is the “Core” versus “Periphery” one (e.g. Campos and Macchiarelli 2016). By and large Core is synonymous with North and Periphery with South.

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is conditioned by the performance and interests of the home economy. Hence, the typical NEZ country feels more comfortable within the existing EZ setup, with a consequent conservative attitude, whereas on the SEZ front the attitude is more critical and favourable towards change. A commonly shared view locates Austria, Estonia, Finland, Germany, Latvia, Lithuania, Luxembourg, the Netherlands, Slovakia, and Slovenia in the NEZ, whereas Cyprus, Greece, Italy, Malta, Portugal and Spain are located in the SEZ. Belgium, France and Ireland are of more uncertain classification. They share some strengths with the NEZ but also some weaknesses with the SEZ. Moreover, during the crisis of the 2010s, and more clearly in response to the COVID-19 shock, the governments of these countries took a position more supportive of the views of the SEZ than of the NEZ. As with all aggregations across complex phenomena, the risk of void stereotypes is high. The self-imposed attribute of “frugality” by the NEZ, and other North non– EZ countries (as opposed to SEZ profligacy) may be questioned on the ground of facts. For instance, most of the NEZ display per capita public expenditure and tax revenues far higher than the SEZ countries’ average. Moreover some of the “frugal” (the Netherlands, Sweden, Denmark) carry a heavy burden of private debts as a share of GDP (ranging from 250% to 300%), a much heavier burden than in some SEZ countries. Neither NEZ nor SEZ are fully homogenous areas. For a large part the NEZ consists of “small countries” economically orbiting Germany. Economic integration with Germany is both a strength and weakness of these countries as they remain highly dependent on the German business cycle and world trade trends as well as on the health of the German banking system. Apart from size and other aspects of economic development (gaps in per capita income are large), a major difference across the NEZ is that the small countries are not affected by regional dualism, unlike Germany (East-West).3 Regional dualism, as we shall see below, is a critical factor, more important than usually believed, which the largest NEZ country shares instead with other large EZ members like Italy, Spain, France and Belgium. In the SEZ political and cultural diversity are everywhere apparent. Structural economic features also vary widely. Italy is the second manufacturing and exporting country in Europe. Its current account balance has been positive most of the time. Northern Italian regions are closer to Southern Germany than to other SEZ countries as regards per capita GDP, productivity and industrial specialisation. The value-chain integration between some of the North-Italian and South–German manufacturing firms should also be stressed. On the other hand, more than other SEZ countries, Italy has long been affected (especially in the 1980s and in the early 2000s) by the soft budget constraint syndrome and is now overburdened by a high-debt legacy. Yet after Greece and Italy, the third country in this league is Belgium, one of the NEZ (intermittently).4

3 The

post-2008 increase in standard of living disparities across German regions is documented in Fink et al. (2019). 4 As for Italy, the two German-speaking economists Heimberger and Krowall (2020) dispel some fake stereotypes widespread in the NEZ.

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Even more importantly, structural features and actual performances of countries change over time, and hence their attitudes towards the EZ, particularly after major events. The four geo-economic panels of Fig. 1 highlight this point by means of the four broad-brush performance indicators of the EZ countries (variable composition) mentioned above: growth rate of per capita income, net exports as per cent of GDP, the public deficit/GDP ratio and the public debt/GDP ratio. Indeed, the North-South categories have come into use, and bear some relation with data, as a consequence of the polarisation of countries during the post-crisis decade 2009–2019. Beforehand, the geo-economic maps were more mixed. Germany was underperforming while some Southern countries (Spain, Portugal, Cyprus, even Greece) displayed some “Northern” characteristics (in terms of growth, trade and public finances) which were later overturned in the post-crisis years, when a country like Ireland was also associated with the infamous GIPSI group (to be identified with the SEZ). As indicated above, other countries, such as France, Belgium, or for some aspects Italy, seem to dwell in a mixed territory sharing some characteristics of both sides at different times. We have also included in the four panels of Fig. 1 available early evidence of the effects of the COVID-19 shock. It has been observed that this is a symmetric shock with asymmetric consequences. Indeed, averaging the 2020–2021 forecasts of GDP growth and of public finances provided by the 2020 Spring release of the European Commission, an even more clear-cut polarisation seems to emerge along an ideal line running from the Atlantic to Piraeus, that is a North-East versus South-West cleavage (a new Curtain?), which threatens to be the hallmark of the post-COVID19 new decade. Germany seems to always be the centre of gravity, being able to tilt the scales either way. In conclusion, it may be argued that notwithstanding all the previous caveats, the North-South characterisation does capture a persistent divergence across the EU, both at the structural level and at the level of political attitudes towards the Monetary Union. In the following discussion, we shall mostly concentrate on the latter.

3 The European Crisis of the 2010s: A Tale of Sins and Expiation? Behind the general plea for “more Europe”, divergences along the North-South cleavage loom large. While there is broad agreement regarding the list of the ingredients of the crisis (see e.g. the “consensus view” gathered by Baldwin and Giavazzi 2015, 2016), the prevailing narrative in the NEZ downplays the dimension of institutional mismanagement of the crisis to emphasise the responsibilities of single countries (notably the SEZ ones; see e.g. Sinn 2014), whereas the opposite view of the causal ranking is dominant in the SEZ countries.5 5 To

be honest, they are not only dominant in the SEZ countries. Wyplosz (2014), Wren Lewis (2015) and De Grauwe (2013) are examples of a group of international scholars who lay the stress on institutional failures and responsibilities of dominant (NEZ) countries therein.

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Panel A. Growth rate of per capita income (year averages)

1999-08. EZ year average 3.6%

2009-19. EZ year average 1.8%

> EZ ave.

< EZ ave.

2020-21. EZ year average 0.3%

EZ ave.

< EZ ave.

2020-21. EZ year average 4.7%

surplus

< EZ ave.

< EZ ave., 3%>

2020-21. EZ year average 6%

> 3%

Fig. 1 Geo-economic maps of the Euro Zone. Source Eurostat, AMECO Database, June 2020

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Panel D. Public debt as percent of GDP (year averages)

1999-08. EZ year average 68.7% 2009-19. EZ year average 89.7% 2020-21. EZ year average 100.7%

< 60%



> 100%

Fig. 1 (continued)

Our take on the consensus view is that the crisis originated in the US and spread across the world, but that there was indeed a dramatic “Europeanisation” of the crisis—mainly through private financial channels—which was exacerbated and prolonged by the interaction among flaws inherent in the EZ governance and structural factors in the SEZ as well as in the NEZ countries. These factors specific to different countries were also the cause of their different responses in the course of the crisis, but shifting the blame on the SEZ as scapegoats is misleading and feeds demagogic propaganda on both sides of the Union. The typical NEZ narrative of the crisis points to two specific weaknesses (“sins”) of the SEZ that may explain their bad response to the crisis: notably fiscal profligacy (excess public deficits and debts) and loss of competitiveness (large and persistent current account deficits) (e.g. Sinn 2014). If not the primary cause of an asymmetric (self-inflicted) shock of the SEZ, these factors have been pointed out as major determinants of the weaker resilience of these countries in the post-shock years as well as a threat to the stability of the EZ. This view quickly took hold within EU institutions, paving the way to the Macroeconomic Imbalances Procedure included in the “Six Pack” adopted in 2011 (European Commission 2010, 2016a). These macroeconomic imbalances, of which the SEZ themselves were deemed responsible, are also indicated as the causes that made “austerity” inevitable. Such imbalances are present in the general scenario of the crisis, but they should not be overemphasised or taken out of context.

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3.1 Public or Private Profligacy? As to public profligacy, it is hard to point to it as a general cause of the crisis. Panels C and D of Fig. 1 show a general “discipline effect” on public deficits and debts from 1999 to 2008, with perhaps deviations in the post-2009–2011 recession. The large majority of countries remained, over time, below or not far from the thresholds established by the Stability and Growth Pact. Only in the case of Greece do we have a blatant case of government profligacy (and disguised public accounts). More specifically, the average debt/GDP ratio of the SEZ fell from 61.8% in 1999 to 59.6% in 2007, with Cyprus (51.5%) and Spain (35.5%) at the lowest end of the ranking of public debtors. As for the budget deficit, with the 2009 exception, Italy has been running a primary surplus for more than 20 years, although it was very small in the 2001–2005 period. Spain had a primary surplus above 2% of GDP between 1999 and 2007. The true stability threats were nested, largely unnoticed, in private debt/credit relationships across the EZ, the channel through which the financial turmoil migrated from the US to Europe (e.g. Lane 2013; Baldwin and Giavazzi 2015). Extensive empirical research has detected factors that are unrelated to the so-called fundamental valuation of sovereign debts (e.g. Caceres et al. 2010; Favero and Missale 2011; De Grauwe and Ji 2012, 2013). Particular attention has been devoted to clear symptoms of self -fulfilling speculative attacks, that is contagious beliefs about insolvency of a sovereign that become true as they trigger fire-sales of its debt, and an “euro dummy” effect, that is an extra-premium charged by investors, with respect to non-euro standalone countries with similar debts, due to the lack of a lender of last resort in the EZ. The immediate impact of the 2012 ECB’s “whatever it takes” on interest rate spreads showed quite clearly that these factors, together with redenomination risk (i.e. the risk that one or more countries exit the euro) were major drivers of the crisis.

3.2 Current Account Imbalances: Whose Sin? Shifting the focus from public to private finance implies a parallel shift from internal to external imbalances (Lane 2013; Gros 2013; Mazzocchi and Tamborini 2019). The large current-account deficits of almost all the EZ countries vis-à-vis the German surplus that opened up between 2004 and 2012 play a central role in the crisis narrative. The culprit is seen in the growing divergences in competitiveness of deficit countries. The most common indicator is the real exchange rate, measured as the ratio of the unit labour costs between one country and another (or an aggregate of trading partners). Indeed, setting the average real exchange rate of deficit and surplus countries equal to 100 in 1999, the former peaked at 117 in 2012 vis-à-vis the latter plunging to 98. All of the SEZ were at the time deficit countries, so that current-account imbalances appeared as another cleavage between the NEZ and the SEZ.

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Competitiveness—though a notion that can hardly be applied to a whole country (Krugman 1996)—is a critical factor for growth, and the NEZ crisis narrative contains elements of truth. Yet criticisms have been raised, and alternative views have been put forward, on three main issues that ought to be taken into account: (1) the relevance of current account imbalances in a monetary union, (2) their causes and connection with the crisis, and (3) their policy implications (see Mazzocchi and Tamborini 2019, for an extended coverage). Looking first at long-standing federative countries, the question naturally arises why internal current-account imbalances are so important in the EZ whereas nobody cares elsewhere (who has ever heard about current-account imbalances of Florida or Brandenburg?). The point (O’Rurke and Taylor 2013) is that intra-EZ imbalances are not comparable with intra-US (or East-West Germany) imbalances because the EZ is not a federal state with a central government and a fully-integrated capital market. On the other hand, intra-EZ imbalances are not comparable with those that may occur among independent monetary sovereigns either, for the basic reason that the latter should be ready to cover payment imbalances with foreign currencies, whereas the EZ countries share the same currency (Pisani-Ferry and Merler 2012; Collignon 2014). Second, most of the time open economies, or regions within the same national boundaries, follow different growth paths, with different rates of growth of prices, wages, population, capital, employment. These differences quite naturally lead to large trade and capital flows. A classic argument in favour of free mobility of persons, goods, and capitals is precisely that it enables open economies to take different economic trajectories while having access to wider pools of resources (Blanchard and Giavazzi 2002). Third, a fundamental macroeconomic law states that a net exporter of goods and services also registers excess national saving (private + public) above national (private + public) investment and will also be a net exporter of capitals. This is an entrenched pattern of the NEZ countries, especially Germany, where the excess of national savings over investment has escalated from 6.8% of GDP in 2005 to 10% in 2018. Hence credit-debt positions growing large are the necessary flip side of the coin in the competitiveness race. Different economic trajectories and the ensuing transfers of resources may embed long-term troubles as to their sustainability (Acocella 2016). Yet identifying pathological imbalances is a difficult task, and for some scholars a narrow notion of price-cost competitiveness is misleading (Wyplosz 2013, 2014). Indeed, the problem with the real exchange rate is that it does not identify for what reason misalignments arise. Esposito and Messori (2016) show that while nominal wage growth and inflation were broadly aligned across countries, surplus countries enjoyed faster productivity gains that lowered their relative unit labour costs. In the surplus countries, wages were not keeping pace with productivity gains, that is real wage depreciation was under way. Is this kind of competitiveness policy sustainable in a monetary union? Is there a sense in which underpaying workers below their productivity should be a model—or a necessity—for the EZ as a whole?

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3.3 Inevitable Expiations or Crisis Mismanagement? Fiscal consolidation, also known as “austerity”, and rebalancing of current accounts were the two hallmarks of the EZ crisis policy. This choice loaded a heavy asymmetric burden onto the shoulders of the countries with both fiscal and external imbalances— mostly the SEZ and Ireland. Those, however, were the days of confidence in neutral or expansionary fiscal consolidations (Buti and Carnot 2013). As is well known, a heated debate, that we cannot go into here, arose among scholars, politicians, and public opinion. If in 2013 the German Minister of Finances W. Schäuble declared that “Nobody in Europe sees a contradiction between austerity and growth. We have a growth-friendly process of consolidation” (The Wall Street Journal, April 11), as of today the “consensus view” is much less optimistic. The change of judgement was marked by the famous mea culpa of the IMF about the large and persistent forecasting mistakes of the effects of austerity on growth (Blanchard and Leigh 2013). There is now agreement that austerity was applied too early, too widely and in an uncoordinated manner, with two perverse consequences. (1) the country-by-country approach (induced by the regulatory framework) contributed to the serious underestimation of the negative impact of consolidation plans activated in a large number of countries at the same time ignoring their reciprocal “spillover effects” (in’t Veld 2013). (2) austerity turned out to be self-defeating for the purpose of fiscal consolidation; while it harnessed fiscal deficits quickly, the debt/GDP ratio grew more in those countries where stronger consolidation policies were enforced.6 This triggered self-fulfilling speculative attacks. On the other hand, as was deemed necessary by Daniel Gros (2013), the domestic contraction and nominal deflation induced by austerity was, in Keynesian fashion, the main driver of external rebalancing (see Esposito and Messori 2016; Mazzocchi and Tamborini 2019, and Fig. 27 ). Whatever the effect of austerity on growth has been vis-à-vis other concomitant factors (see Fragetta and Tamborini 2019), the crisis policy choices have left deep and lasting scars on the EZ economies and societies. Were the EZ policy choices inevitable? As a matter of fact, the EZ institutions embraced the NEZ point of view, focused on fiscal indiscipline and loss of competitiveness of the SEZ. In the previous section, we have shown that such a point of view was rather narrow and skewed. It failed to understand the financial origins of the crisis, its diffusion and contagion dynamics, the private-public “doom loop”, the transmission channels to the real economy, up to an overall systemic crisis. The frantic creation of new instruments and regulations—“Two Pack”, “Six Pack”, “Fiscal Compact”, etc.—was not aimed at fixing the emergent flaws in the design of 6 In

fact, the negative impulse to GDP growth may make the debt/GDP ratio rise instead of falling (Nuti 2013; Tamborini 2013; Boitani and Perdichizzi 2019; Boitani et al. 2020). 7 The total current account imbalance of the deficit countries as a whole peaked at 6% of their aggregate GDP in 2008. It was completely reabsorbed by 2012, and since then has been in positive territory reaching 2% of GDP in 2017. At the same time, the average nominal GDP of the then deficit countries was 48% of that of the surplus countries, reached 55% in the run-up of current-account imbalances, and eventually fell back to 45% in 2017.

% CA(DEF)/GDP(DEF)

The Future of the Eurozone: A Reflection Paper …

3 2 1 0 -1 -2 -3 -4 -5 -6 -7

11

2017

2000

0.45

0.50

0.55

0.60

GDP(DEF) /GDP(SUR) Fig. 2 The adjustment path of the current account of the deficit countries and their nominal GDP relative to surplus countries, 2000–2017. Deficit (surplus) countries are those with negative (positive) current account between 2000 and 2008. Source Mazzocchi and Tamborini (2019)

the system but at giving more prominence and strictness to its entrenched conceptions. The change of the disastrous course of the crisis arrived only when, in the Summer of 2012, the ECB took control of the sovereign debt crisis (Wyplosz 2014).

4 What Is the Nature of the Eurozone? Despite the growing consensus on the inadequacy of EZ institutions and policies, so far little progress has been made in particular as far as reforming the apparatus of fiscal governance of the EZ which is on the frontline of the political divide (see, e.g., Delatte et al. 2017; and Asatryan et al. 2018, for an overview of the issues) is concerned. The state of play as of 2019 can be epitomised in two alternative reform models: the Maastricht 2.0 model, and the Confederal model. The Maastricht 2.0 model, more akin to the view of most NEZ governments, rests on the judgement that it was not compliance with, but violation of, the Maastricht principles and rules (with the benign neglect of a “politicised” Commission) that generated the crisis, whereas these rules remain a fundamental pillar of a sound EZ. Consequently, when the followers of this view talk about “more Europe” they mean further devolution of sovereignty towards supranational agencies essentially “technocratic” in nature (e.g. the European Fiscal Board and national fiscal boards) with a clear mandate and power to enforce the rules vis-à-vis democratically elected governments. Different strands of critical thinking on the EZ architecture, as well as the governments of the largest SEZ countries converge on the Confederal model, with France as possible mediator (as can be understood from Macron’s famous Sorbonne speech in November 2017, and the joint Meseberg declaration with Chancellor Angela Merkel

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in June 2018). In this view, the crisis has brought to the forefront two most compelling problems: (1) no one is in charge for the EZ as a whole at the supranational level with the exception, by statute, of the ECB; (2) the governance mechanisms in place have proved unable to coordinate national policies, and provide proper macroeconomic stabilisation. The confederal inspiration should be understood in a broad sense, meaning that the aim is the creation of larger pools of common resources, extension of risk-sharing tools, and in parallel the development of bits of genuine supranational government (not just governance) with clear institutional legitimacy with respect to both the EU order and the national constitutional orders. One may wonder what the nature of the Monetary Union is. With the Single Market in an institutional vacuum, we have created a “competition union”, i.e. an arena where countries are called to participate in a competition in which there are losers and winners of trade and GDP shares. The idea is that the losers will learn from the winners so that all will be winners (unlikely). Of course, the winners may be happy with this “hunger game” (Storm and Naastepad 2015), and the losers come to understand why they lose and how to improve. Yet the “competition union” requires (and to some extent creates) losers who absorb the excess capacity of the winners; hence losers (net importers) are not the doom of the winners (net exporters) but are necessary for their success. When talking about the costs and benefits of the monetary union, serious and responsible opinion makers in the winner countries ought to explain that having losers tied up in a common currency is a key factor of their success (the alternative would be a systematic appreciation of the exchange rate swallowing the competitive advantage, as it happened in the 1970s and 1980s). A “competition union” is bound to end up in “a zero sum game”. If net importers struggle (or are forced) to become net exporters themselves, the outlet markets shrink for all. The winners take home the largest share of a shrinking pie. There is only one escape route from the zero-sum game: that all countries become net exporters visà-vis the rest of the world. This is actually what has been going on after the crisis therapy (only France now has a foreign deficit), as clearly shown by Fig. 3. Does this mean that the “competition union” is eventually a success, albeit at some cost for the laggards? Not so much. The implication is that the EZ as a whole is running production capacity in large excess of domestic demand, as indicated by the declining overall growth performance of the EZ in Panel A of Fig. 1 vis-à-vis its growing export capacity in Panel B. The data also show that extra-EZ trade has substituted, not integrated, intra-EZ trade. In 2000, intra-EU exports amounted to 2.2 times extra-EU ones, in 2017 1.4 times. That is to say, we have created a single market of about 400 million people and then we have our industries depending on the ups and downs of demand and political benevolence abroad. The export-led growth model long pursued by Germany is appropriate to small open economies and to emerging economies (or countries in the aftermath of a devastating war). However this may become unsustainable for large developed economies, already commanding a disproportionate share of world trade. They become subject to the risks of sudden stops to their exports because of trade barriers set up by other countries. This argument also makes the objective of transforming the EZ, not to say the EU, into an export-led economic area highly questionable. The above-mentioned

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13 SPA

500

POR

400

NET

300

LUX

200

ITA

100

IRE GRE

00

GER

-100

FRA FIN

-300

BEL

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

-200

AUS EZ12

Fig. 3 Current accounts of the early 12 EZ countries 2000–2017 (Billions of euros). Source Elaborations on Eurostat, AMECO database

risks would be magnified by triggering the trade war reactions on the part of the rest of the world even more easily than in the case of a single (albeit large) export-led country such as Germany.

5 NEZ and SEZ Policy and Ideology Cleavages The political lines of defence against undesirable changes in the EZ governance are often buttressed by deployment of economic principles on both sides of the front. Here we wish to discuss briefly, and non-technically, three keystones in the NEZ positioning: rules against discretion, moral hazard and risk reduction versus risk sharing. “Discretion” is the necessary evil, as it were, of incomplete contracts, and the true task of high-rank charts is how to discipline, not suppress, discretion. This is generally accomplished under two dimensions. First, define who is constitutionally allowed to exert discretionary decision-making—in liberal democracies these are elected representatives. Second, strike a balance between tying the hands of the decision-maker (minimise the abuse of authority) and its scope of effective discretion in the face of unforeseen contingencies (remembering that the electors do expect the elected to exert their powers in such contingencies). As pointed out by Mario Draghi (2019) pure rule-based policymaking has proved to be unfit for the EZ. Rules are static, i.e. they “cannot be updated quickly when unforeseen circumstances arise, while institutions can be dynamic and employ flexibility in their approach” when economic conditions abruptly change. Rules lose credibility if applied with discretion and/or with some sort of opaque “flexibility”. “This is why there are always tensions when it comes to economic policies that

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follow the rules-based approach”. The alternative is an institution-based approach, that is institutions invested with a mandate and defined powers, that can be subjected to democratic control. Another effect of mistrust is the threat of “moral hazard”, which is ubiquitous in NEZ rebuttals of reform proposals involving some degree of mutual insurance. This argument is also the main firewall against the creation of a common budget. In simple words, the NEZ reject mechanisms that may impair the pressure on weaker (SEZ) members to reform themselves and behave properly, and hence lead to permanent transfers to SEZ. Important as it may be for an accurate design, moral hazard seems overstretched to cover political fears. Discussing the subtleties of moral hazard is beyond the limits of these notes, but a couple of general considerations are in order. Were moral hazard the tombstone of insurance schemes, insurance companies would not have survived. Theory and practice of control of moral hazard have made enormous progress in parallel with risk management techniques. For instance, the argument that shock absorbers (e.g. unemployment benefits) may conceal permanent transfers presumes the inability to distinguish between a shock and a permanent state. True, this is a difficult distinction to make, yet this has not prevented the adoption of the Fiscal Compact which is based on that distinction. The proposals of shock absorbers elaborated by top scholars include devices that minimise moral hazard (see Sect. 6 below) On the other hand, the fact that moral hazard has two sides is almost ignored. Besides the most feared incentive to buy insurance and take on too much risk for all, there is the failure to buy insurance as a consequence of underrating of risk (“it cannot happen to me”). In the former case, there is over-insurance, in the latter under-insurance. Both are collective failures that impose welfare losses on each and all members. A related example is the NEZ two-stage strategy of risk-reduction prior to risksharing, that has set the Banking Union on a slow-motion track. Though seemingly reasonable, the two-stage strategy hinges on uncertain foundations. According to the classic theory of risk, the distinction between risk reduction and risk sharing is superfluous: risk sharing is the means by which risk is reduced. With the twostage strategy, there would be a higher probability of a new financial crisis while the redenomination risk, far from decreasing, would skyrocket once again as happened in 2011–2012 before the ECB announced it would do whatever it takes to save the euro. Here, as in other fields, there seems to be an obdurate resistance to recognising the systemic effects of seemingly efficient (or convenient) policies taken in isolation. As stressed by the Franco-German economists’ document (2018) and by the former president of the ECB, Mario Draghi, “the dichotomy between risk-reduction and risk-sharing that characterises the debate today is, in many ways, artificial. With the right policy framework, these two goals are mutually reinforcing. Public risksharing through backstops helps reduce risks across the system by containing market panics when a crisis hits. And a strong resolution framework ensures that, when bank failures do happen, very little public risk-sharing is actually needed as the costs are fully borne by the private sector” (Draghi 2018).

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6 Reforms on Which NEZ and SEZ Might Agree At the outbreak of the COVID-19 pandemic in February 2020, the two main supranational policymakers, the newly elected Commission and the newly chaired ECB, reacted swiftly with a clear determination not to repeat the mistakes made ten years earlier. The Commission gathered an emergency package of e540 billion ready for worst-hit member countries—with most of the funds coming from the European Stability Mechanism and the European Investment Bank, i.e. from outside the EU budget. For the EZ, the Commission also announced the suspension of the deficit limits of the SGP, and the ECB the extension of its purchases programmes of assets and public bonds. However, the EZ was caught in the political stalemate between the two governance models discussed above. At the first post-COVID European Council in March, the leading NEZ governments remained faithful to their view that each country should do their home-works using their own fiscal means and resisted any enlargement of the EU fiscal space, and the issuance of common debt. They were prepared to pass nothing more than the Commission’s and ECB’s emergency plans. An alternative front, formed by SEZ governments flanked by others, such as those of France, Belgium, and Ireland, called for the opposite approach, i.e. the creation of a common pool of resources levered with common debt—the so-called European Recovery Fund (ERF). A major political turn, however, occurred when Germany joined France in a common proposal which was based on the ERF model. The Commission’s proposal, named “Next Generation EU” (NGEU) is in fact an elaboration on the ERF model on a scale of e750 billion (e500 billion grants and e250 billion long-term loans), to be collected also by issuing ad hoc bonds and grafted onto the EU 2021–2027 budget. Upon rebalancing grants (e390 billion) and loans e360 billion), and introducing a role for the Council in the supervision on their use, NGEU was passed by the Council on July 20th after four days of harsh negotiations. This brief recollection of recent events is preparatory to addressing the question of whether or not the COVID-19 pandemic will be the catalyst of the long-awaited reforms of the EZ governance. The active support to the NGEU approval by the German government may prove to be a true “game changer”. On the other hand, the Commission has swiftly made it clear that NGEU will only be temporary, i.e. restricted to dealing with the aftermath of the COVID pandemic, and that the suspension of the Stability and Growth Pact is only temporary. Yet it is also apparent that the Commission is now in search of some union-wide tax revenue in order to serve interest and principal payments as the EU will have its own debt (some 6% of EU GDP). Anyway, NGEU is not conceived as a permanent counter-cyclical budgetary instrument such as the one we recommend in what follows, nor can it resolve other deficiencies in the EZ capacity of macroeconomic governance. In order to achieve a “complete” Monetary Union, the EZ fiscal capacity must be built together with some other institutional and policy reforms. National fiscal rules and common stabilisation policies can no longer remain detached. Although a “great reform” is not to be adopted at once, the overall perspective and each step should be made clear in advance. Good news is that

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one of the main EZ institutions, the European Fiscal Board (2019), has recently taken the lead in this line of reform providing a balanced framework for further discussion. Moreover, some similar indications can also be found in the Mission Letter to the Commissioner-designate for Economy by the President of the European Commission. The new fiscal regulation system does not necessitate a major overhaul of Treaties. It should confirm the commitment of member countries to sound public finances. It should be made clear that reforms of the rules are not intended as an easy way to dispense with responsibility in debt reduction on the part of high debt countries. Debt reduction must take place where and when necessary. In particular, member countries should abide with the principle that national governments are free to broaden or restrict the welfare state provisions in their own countries, in the fulfilment of the government budget constraint, i.e. by guaranteeing that fiscal revenues are tuned to match public spending, at least in a reasonable time span. No new structural current expenditure should be permanently debt financed. This principle has been overlooked at times or permanently in some SEZ countries (Italy and Greece are the leading examples).

6.1 A Common Fiscal Capacity The first pillar of EZ reforms is to build up a common fiscal capacity of the EZ (not necessarily of the EU) with three much wanted ends: (1) to improve both economic and financial stabilisation in each member and the entire EZ; (2) to allow for a strategy of parallel sharing and reduction of risks (see Sect. 5); (3) to downsize the dimension of national competences and budgets, thus easing their control and compliance with the rules. A decade after the outbreak of the financial crisis there is not much dispute about this. The debate is on the details, which of course matter the most. First of all, the size of this common fiscal capacity. If it is to be lower that 1–2% of EZ GDP it will be far short its stabilisation target. Second, a (small) fiscal capacity which is not aimed at economic stabilisation would miss its most relevant goal. Such a common fiscal capacity should start with a European (or EZ) unemployment insurance scheme funded by each and every member state as a share of its GDP, along the lines discussed in detail by Beblavý and Lenaerts (2017) and Dullien et al. (2017), and politically supported by the German Finance Minister Olaf Scholz. With such a scheme only cyclical changes in unemployment (beyond a given threshold) would be financed by the EZ or EU fund. Once again, experimenting with the EU-wide SURE mechanism introduced in order to face the post-pandemic upsurge in unemployment will help. Another prominent component of the EZ budget that should be addressed is public investments. The NGEU plan can offer the right approach to both the funding and the spending side. The programme should also be designed in such a way as to prevent national bureaucracies and national rules from hindering or delaying the implementation of the Recovery Plans. Once again some transfer of sovereignty to a supranational institution should be envisaged.

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The final key is backstops against systemic financial crises. Paradoxically, this is the area—the so-called Banking Union—where the reform process first started during the crisis, but political negotiations then put it on a slow track. Paralysing controversies concern the “details” of the two main institutions on which general agreement exists in principle: a common deposit insurance, and a “European Monetary Fund”. This is the field where mistrust matters the most, and challenges political will and leadership.

6.2 A New Set of Fiscal Rules Reforming the fiscal rules should reconcile long-run sustainability of public debt with stronger stabilisation tools and policies, and the accumulation of public capital. Therefore, debt reduction plans must be credible, as to timing and intensity. This means that governments should take consistent actions, and that these actions should be politically viable and economically sound (blood and tears plans are likely to be punished by investors, as happened in 2011–2013; see Sect. 4). In the spirit of controlled and disciplined discretionality recalled above, the debt target may remain the 60% of GDP—though “the norm is, indeed, to a large extent arbitrary”—but “the adjustment of public debt could be made country specific, either by changing the reference values of the Treaty protocol, or by differentiating the speed of adjustment towards the current debt reference value” (EFB 2019, p. 88). In consideration of the contingent economic conditions of the country, debt reduction should not require fiscal consolidation in recessions when it may lead to lower GDP and higher unemployment. Alternatively, a country consistently engaged in debt reduction should be supported by effective common stabilisation tools if hit by an adverse shock. A shift of focus from year-by-year deficits to medium-long term sustainability of debt, while taking into account the cyclical position of the economy, has already taken place with the Fiscal Compact, alas increasing, instead of reducing, the complexity and opacity of the previous apparatus of rules and of their implementation. The procedure is still pro-cyclical due to the fact that the crucial variable used to correct nominal budgets in order to calculate structural ones (the output gap) is itself nonobservable and its estimates are frequently revised. Such estimates in turn depend on another unobservable variable, i.e. potential output, whose estimate appears to be strongly path-dependent. This hardly supports compliance with the rules. The quest for more simplicity, transparency, and efficacy of the rules is now widely shared (Franco-German economists group 2018, 2019; Darvas et al. 2018; Tooze 2019). The kernel of the EFB proposal is the introduction of a single indicator of fiscal performance: a ceiling on the growth rate of net primary expenditures over three years, such that public debt reduction is allowed. This indicator satisfies simplicity, observability, and room for fiscal stabilisation when needed. The time also seems ripe for the so-called Golden Rule on public fixed net investment expenditure (Truger 2016; EFB 2019). Such a rule should also be included so as to relax the expenditure ceiling, in order to protect net public capital growth,

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which has often been the scapegoat of fiscal consolidation and the perfect example of the joint negative effects of pro-cyclical and growth-defeating policies.

6.3 A Fiscal Stance of the Eurozone The third pillar of fiscal reform is coordination of national fiscal policies and a common fiscal stance vis-à-vis monetary policy. Saying that this would jeopardise the holy independence of the Central Bank is philistine. Especially when it is the Central Bank itself—in line with the “new conventional wisdom”—that demands more active and coordinated fiscal policies in order to overcome the limits of monetary policy in the face of today’s challenges (ECB 2019). The definition of a fiscal stance of the EZ and of individual member countries should be at the heart of such a fiscal policy coordination (Bénassy-Quéré 2016; Boone and Buti 2019), in order to make the EZ fiscal framework more symmetrical. Political control over cooperative policies should be retained and exerted by (representatives of) national governments. The creation of a “European Ministry of Economy and Finance” seems therefore a perspective consistent with the reform proposals examined so far (European Commission 2017c). A lot of stumbling blocks stand in the way. The two front matters are how this new body is appointed and with what mandate and powers (see Asatryan et al. 2018, for an overview). Anyway, this innovation requires a clear commitment by all parties to creating genuine supranational policy-making institutions with transparent democratic legitimacy (i.e. members backed by national political mandate), general rules as guidelines, and a controlled and disciplined scope for discretion. Better rules and policies are not enough. “Fixing the euro needs to go beyond economics” (Delatte 2018). New common institutions are necessary. Key to overcoming the mistrust that permeates the reform process of the EZ is finding the right institutional model within which the reformed EZ should be framed (Delatte 2018; Andreozzi and Tamborini 2019). This, in our view, should consist of a supranational upgrade towards sovereignty sharing. That is neither further sovereignty devolution to technical entities which are supposed to mechanically enforce rules nor extensions of the disorderly intergovernmental approach that took the hold after the financial and economic crisis (Bastasin 2015; Fabbrini 2015).

7 Conclusion “Is the fulfilment of these ideas a visionary hope?” Keynes asked himself in the final chapter of his General Theory. He didn’t attempt an answer. However, he reckoned “people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out”. We believe people in the EZ are precisely in

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the same position: ready to receive reform proposals and even eager to try them out. Governments of NEZ and SEZ countries should now deliver. It is natural to wonder how is it that so far none of the many proposals for EZ reform on the table has received political support. The answer is simple. There is general dissatisfaction with the status quo, but diagnoses and cures and national interests differ at the political level, hence so do reform agendas. Therefore, Europe in the near future will be the field not only of the battle between pro-Europe and anti-Europe forces, but at the same time also of the confrontation between different views of the future of Europe. This confrontation will be more polite, but no less hard and probably more fundamental. If anything because a bad reform or no reform will also, sooner rather than later, pave the way to the final victory of the mounting anti-Europe forces. Genuine reformers will need the credible determination to present all other players with a clear-cut alternative: either a serious reform is begun here and now, with all the necessary ingredients—some which the South dislikes and some which the North dislikes—or everyone will have to take their own share of responsibility for saying “No” to a genuine and sustainable European Economic and Monetary Union.

References Acocella N (2016) Signalling imbalances in the EMU, in B. Dallago, G. Guri, J. McGowan (eds.) A Global Perspective on the European Economic Crisis, London: Routledge, Ch. 2, pp. 48–67. Andreozzi L, Tamborini R (2019) Models of supranational policymaking and the reform of the Euro Zone. Journal of Policy Modelling, 2019(41): 819–844. Asatryan Z, Debrun X, Havlik A, Heinemann F, Kocher M, Tamborini R (2018) Which Role for a European Minister of Economy and Finance in a European Fiscal Union? EconPol Policy Report, No. 6. Baldwin R, Giavazzi F (eds.) (2015) The Eurozone Crisis. A Consensus View of the Causes and a Few Possible Solutions, London, CEPR Press. Baldwin R, Giavazzi F (eds.) (2016) How to fix Europe’s Monetary Union: Views of Leading Economists, London, CEPR Press. Bastasin C (2015) Saving Europe: Anatomy of a Dream, Washington, Brookings Institution Press. Beblavý M, Lenaerts K (2017) Feasibility and added value of a European unemployment benefits scheme. CEPS, Brussels. Bénassy-Quéré A (2016) Euro-Area fiscal stance: From theory to practical implementation. CESifo Working Paper Series No. 6040, Munich. Blanchard OJ, Giavazzi F (2002) Current account deficits in the Euro Area: The end of the FeldsteinHorioka puzzle? Brookings Papers on Economic Activity No. 2. Blanchard OJ, Leigh D (2013) Growth forecast errors and fiscal multipliers. American Economic Review, Papers and Proceedings (103): 117–120. Boitani A, Perdichizzi S (2019) Public expenditure multipliers in recessions. Evidence from the Eurozone. EABCN Conference, Bank of Spain, Madrid. Boitani A, Perdichizzi S, Punzo C (2020) Nonlinearities and expenditure multipliers in the Eurozone. DEF Working Papers No. 89, Università Cattolica, Milano. Boone L, Buti M (2019), Right here, right now: The quest for a more balanced policy mix. Vox-EU, October 18. Buti M, Carnot N (2013) The debate on fiscal policy in Europe: Beyond the austerity myth. ECFIN Economic Brief No. 20.

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Caceres C, Guzzo V, Segoviano M (2010) Sovereign spreads: Global risk aversion, contagion or fundamentals? IMF Working Paper, n. 120. Campos N, Macchiarelli C (2016) Core and periphery in the European Monetary Union; Bayoumi and Eichengreen 25 years later, Economics Letters (147): 127–130. Collignon S (2014) Taking European integration seriously: competitiveness, imbalances and economic stability in the Euro Area, in Collignon S, Esposito P (eds.), Competitiveness in the European Economy, New York, Routledge. Darvas Z, Martin P, Ragot X (2018) European fiscal rules require a major overhaul. Bruegel, Policy Contribution No. 18. Delatte A (2018) Fixing the euro needs to go beyond economics. Vox-EU, 23 October. Delatte A, Fuest C, Gros D, Heinemann F, Kocher M, Tamborini R (2017) The Future of Eurozone Fiscal Governance, EconPol Policy Report No. 1. De Grauwe P (2013) Design failures in the Eurozone. Can they be fixed?, European Commission, Fellowship Initiative “The Future of the euro”, European Economy, Economic Papers No. 491. De Grauwe P, and Ji Y (2012) Mispricing of sovereign risk and macroeconomic stability in the Eurozone. Journal of Common Market Studies (50): 866–880. De Grauwe P, Ji Y (2013) Self-fulfilling crises in the Eurozone. An empirical test. Journal of International Money and Finance (34): 15–36. Draghi M (2014a) Unemployment in the Euro Area. Speech at the Annual Central Bank Symposium in Jackson Hole, August 22, www.ecb.org. Draghi M (2014b) Stability and prosperity in Monetary Union. Speech at the University of Helsinki, November 27, www.ecb.org. Draghi M (2015) President’s introductory remarks at the regular ECON hearing, Brussels, September 23. Draghi M (2018) Risk-reducing and risk-sharing in our Monetary Union. European University Institute, Florence, May 11. Draghi M (2019) Sovereignty in a globalised world. Università degli Studi di Bologna, February 22. Dullien S, Fernández J, et al. (2017) Fit for purpose: a German-Spanish proposal for a robust European Unemployment Insurance Scheme. Friedrich Ebert Stiftung. ECB (2019) 20 years of European Economic and Monetary Union, Frankfurt-am-Main, ECB. Esposito P, Messori M (2016) Improved structural competitiveness or deep recession. Luiss-Sep, Working Paper No. 3. European Commission (2010) Surveillance of intra-Euro-Area competitiveness and imbalances. European Economy No. 1. European Commission (2016a) The macroeconomic imbalance procedure. European Economy, Institutional Paper No. 39. European Commission (2016b), White Paper on the Future of Europe, Brussels, March. European Commission (2017a), Reflection Paper on the Deepening of The Economic and Monetary Union, Brussels, May. European Commission (2017b) Roadmap for Deepening the Economic and Monetary Union, Brussels. European Commission (2017c) A European Minister of Economy and Finance. Communication, Brussels 6.12.2017, COM (2017) 823 final. European Fiscal Board (2019) Assessment of EU fiscal rules, August, https://ec.europa.eu/info/pub lications/assessment-eu-fiscal-rules-focus-six-and-two-pack-legislation_en. Fabbrini S (2015) Which European Union? Europe After the Euro Crisis, Cambridge, Cambridge University Press. Favero CA, Missale A (2011) Sovereign spreads in the Euro Area: Which prospects for a eurobond? CEPR Discussion Paper Series No. 8637. Fink P, Hennicke M, Tiemann H (2019) Unequal Germany. Friedrich Ebert Stiftung. Fragetta M, Tamborini R (2019) It’s not austerity. Or is it? Assessing the effect of austerity on growth in the European Union, 2010–15. International Review of Economics and Finance (62): 196–212.

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Franco-German economists group (2018) Reconciling risk sharing with market discipline: A constructive approach to Euro Area reform, CEPR Policy Insight No. 91. Franco-German economists group (2019) Euro Area architecture: What reforms are still needed, and why. Vox-EU, May 2. Gros D (2013) Foreign debt versus domestic debt in the Euro Area, Oxford Review of Economic Policy (29): 502–517. Heimberger P, Krowall N (2020) Seven surprising facts about the Italian economy. Social Europe, June 25. in’t Veld J (2013) Fiscal consolidations and spillovers in the Euro Area periphery and core. European Economy, Economic Papers No. 1506. Juncker JC et al. (2015) Completing Europe’s Economic and Monetary Union, Brussels, European Commission. Krugman PR, (1996) Pop Internationalism, Cambridge MA, The MIT Press. Lane PR (2013) Capital flows in the Euro Area. CEPR Discussion Paper No. 9493. Mazzocchi R, Tamborini R (2019) Current account imbalances and the Euro Area. Alternative views. EconPol Working Paper No. 27, Nuti DM (2013) Perverse fiscal consolidation. Conference on Economic and Political Crises in Europe and the United States, Trento, Italy, November 7–9. O’ Rourke HK, Taylor AM (2013) Cross of Euros. Journal of Economic Perspectives (27): 167–192. Pisani-Ferry J, Merler S (2012) Sudden stops in the Euro area. Bruegel Policy Contribution, n. 6. Sinn HW (2014) The Euro Trap. Oxford, Oxford University Press. Storm S, Naastepad CWM (2015) Europe’s hunger games: Income distribution, cost competitiveness and crisis. Cambridge Journal of Economics (39): 959–986. Tamborini R (2013) The new fiscal rules for the EZ. Threats from heterogeneity and interdependence. The European Journal of Comparative Economics (10): 315–336. Tooze A (2019) Output gap nonsense. Social Europe Journal, April, 30. Truger A (2016) The Golden Rule of public investment – A necessary and sufficient reform of the EU fiscal framework?. IMK, Hans-Böckler-Stiftung, WP No. 168. Wren Lewis S (2015) Who is responsible for the Eurozone crisis? The simple answer: Germany. The Independent, December 13. Wyplosz C (2013) Europe’s quest for fiscal discipline. European Economy, Economic Papers No. 498. Wyplosz C (2014) The Eurozone crisis: A near-perfect case of mismanagement. Journal of Applied Economics (33): 2–13.

Andrea Boitani is a Professor of Economics, Department of Economics and Finance, Catholic University of Milan. M.Phil. in Economics, University of Cambridge (UK), 1982. Member of the editorial board of several Economics and Law scientific journals. Has been Advisor to the Italian Treasury (1993–2003) and several times to the Secretary for Transport between 1995 and 2018. Seats in the Board of Directors of Atlantia s.p.a. Main research fields: Macroeconomic theories and policies, Money and Banking, Transport policy and regulation. Has published 12 books and over 60 national and international articles in refereed journals and contributions to collective books. Roberto Tamborini is a Professor of Economics, Department of Economic and Management, University of Trento. M.Phil. in Economics, University of Cambridge (UK), 1984; Ph.D. in Economics at the European University Institute, Florence, 1991. Fellow of the School of European Political Economy, Free University ‘Guido Carli’, Rome. Member of the Board of Experts of the Monetary Dialogues of the European Parliament. Main research fields are Macroeconomic theories and policies, Monetary and financial economics, European economic policy. Scientific activity—has produced about 90 national and international publications of monographs, contributions to collective books, articles in refereed journals.

European Monetary Union and the COVID-19 Crisis: A Tightrope Act with the Risk of Falling Michael Heine and Hansjörg Herr

Abstract The COVID-19 crisis has the potential to lead to long-term stagnation in the European Monetary Union (EMU). Especially the following challenges can be identified: a lack of labour market institutions can lead to nominal wage cuts and deflation; the lack of a strong fiscal centre can lead to an insufficient long-term stimulation after the COVID-19 recession; high levels of debt and non-performing loans can hamper growth; the insufficient real convergence can add to political destabilization. The Great Depression in the 1930s and the long-term stagnation in Japan after the asset market bubble in the 1980s support these arguments. The European Central bank, as the only powerful supranational institution, follows overall a good policy but one that is not sufficient to stabilize a monetary union. A more comprehensive integration of the EMU is needed to prevent the danger of its breakdown. Keywords COVID-19 · EMU · Great Depression · European integration

1 Introduction In 2020, the COVID-19 crisis led to a severe economic crisis, the extent of which cannot yet be predicted. Market forces alone cannot be expected to overcome the crisis in an economically and socially acceptable way. As the Great Depression in the early 1930s shows, economic policy mistakes can have devastating economic, social and political consequences. In the European Monetary Union (EMU), the situation is characterized by a double problem. First, a longer-term strategy for economic recovery is needed. Second, the EMU is still a fragile project. The EMU was created in 1999 without sufficient steps having been made towards integration. The neoliberal dream of shifting economic policy competences to a supranational level in order to put a stop to democratic and national claims and create a rule of experts and technocrats M. Heine HTW University of Applied Sciences, Berlin, Germany H. Herr (B) Berlin School of Economics and Law, Berlin, Germany e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_2

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(Slobodian 2018) has proven to be a crisis-prone, unstable project. The EMU is extremely ill-prepared for overcoming a serious crisis. The following section outlines the development of the EMU and identifies its weaknesses. The third section uses the example of the Great Depression and the continuing stagnation in Japan to show which economic policy mistakes can lead to bad and even catastrophic developments. The fourth section draws conclusions.

2 Developments in the Euro Area Before the COVID-19 Crisis The creation of the EMU failed to establish politically and economically adequate institutions that are necessary for a stable monetary union. In the following, various central weaknesses of the euro area will be described (for details of the various policy areas and for sources, see Heine and Herr 2021).

2.1 Insufficient Real Economic Convergence and Inequality Real GDP growth in the EMU was higher before the Great Recession than after—in the years from 1999 to 2007 it averaged 2.3% and from 2010 to 2019 it was just under 1.4% (OECD 2020). The second recession in 2011 and 2012 contributed to this development. Germany, Portugal and Italy had relatively low growth rates before the Great Recession, the other EMU countries performed relatively well. Thereafter, Germany performed comparatively well, while Greece fell into a deep crisis. In Italy, economic development virtually stagnated. Portugal and Spain were able to increase their growth only after a long crisis. France occupied a middle position (Fig. 1). In 2019 even before the COVID-19 crisis, there were signs of an economic slowdown. After the Great Recession, the EMU was not in a position to eliminate mass unemployment. The EMU unemployment rate at the end of 2019 was 7.6%; in Greece 17.3%, Spain 14.1%, Italy 10.0% and France 8.5%. Germany managed to reduce it to 3.7% (OECD 2020). Table 1 shows the ratio of per capita income in some EMU Member States compared to the EMU average in 2000 and 2019. Among the large countries, Germany is clearly the winner, while Italy is the loser. France developed unsatisfactorily, although it is still above the average. Spain, Portugal and Greece show no convergence. If we look at the 11 founding countries of the EMU plus Greece, which joined in 2001, we see that with the start of monetary union, the real income convergence of these countries came to a standstill and differences even increased after

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Fig. 1 Real GDP in selected EMU countries, 1999–2020, Index 1999 = 100 Source OECD (2020), Real GDP forecast (indicator), OECD “double-hit, scenario”, https://doi.org/10.1787/1f84150b-en (accessed on 1 July 2020) Table 1 Relation of GDP per capita to average GDP per capita in the EMU and Gini coefficient Country

GDP per capita to Gini coefficient disposable income EMU averagea (years in brackets)

Gini coefficient market income (years in brackets)

2000

2019

2017 if not otherwise shown

2017 if not otherwise shown

Austria

120

122

30.2 (1997)

29.7

48.5

Belgium

113

115

26.8 (1997)

27.4

48.5

France

109

106

32.3 (1994)

31.6

51.9

Germany

109

115

28.3 (1998)

31.9 (2016)

50.0

Greece

66

58

37.0 (1995)

34.4

52.8

Ireland

126

193

35.6 (1996)

32.8 (2016)

53.5

Italy

104

86

35.2 (1995)

35.9

51.6

Netherlands

132

134

28.1 (1999)

28.5

44.5 (2016)

Portugal

61

59

38.7 (2003)

33.8

51.7

Spain

81

80

36.7 (1995)

34.7

50.7

40.7 (1997)

41.4 (2016)

50.5

USA a 19

–

–

EMU countries in 2015. Source GDP per capita and market Gini coefficient Eurostat (2020); Gini coefficient disposable income World Bank (2020)

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the Great Recession (Cabrillac 2019).1 It follows “that the adoption of a common currency may have instead been a factor of divergence and, in particular, a source of a growing gap between a ‘virtuous core’ and a ‘sinful periphery’” (Estrada et al. 2013: 601). Only the Eastern European EMU countries have caught up significantly. A longer-term view since the end of the 1990s does not show a clear increase in the Gini coefficient for disposable income in the EMU (Table 1). For example, the Gini coefficient increased during the existence of the EMU in Germany, Finland and Italy, but decreased in France and Spain. In the USA, on the other hand, this coefficient has risen from an already extremely high level of 40.7 to 41.4 in 2016. In 1979, it was still 34.6, i.e. at the level of many European countries (World Bank 2020). Regarding the Gini coefficient for market income, the following observation emerges: “Interestingly, the market income Gini has been larger in Europe than in the US since the early 1990s. However … in Europe, the tax and welfare systems have been tweaked in effective ways, increasing their redistribution capacity over time … and achieving an increasing gap with market income Gini” (Bubbico and Freytag 2018: 4). However, the Gini coefficient masks the fact that a “precariat” has developed in many European countries. According to studies by Eurostat (2019), 21.7% of the population in the EU were exposed to the risk of poverty and social exclusion in 2018.2 Before the COVID-19 crisis, about one-eighth of the workforce in Germany lived in persistently precarious conditions (Stuth et al. 2018). There are three potentially explosive developments in the EMU. First, divergences between the core countries of the EMU were already increasing before the COVID19 crisis. Second, the Gini coefficient for market income in the EMU also rose to a very high level. There is a danger that in a crisis, redistribution mechanisms will be radically reduced and inequality will jump to levels similar to those in the US. Third, the high percentage of the population in situations of relative poverty and exclusion threatens social and political coherence within countries and the EMU as a whole.

2.2 Danger of Deflation As is well known, the European Central Bank (ECB) has an inflation target of close to, but below 2%. From 1999 until the Great Recession in 2007, this was almost achieved with an average inflation rate of 2.1%. Between 2010 and 2019, the average inflation rate was only 1.3%. Especially in times of crisis, the EMU is threatened to slide into deflationary waters. In 2009, the inflation rate was 0.3%, in 2014 only 0.4% and in the two following years 0.2% (Fig. 2). In 2019, when growth was still comparatively good, the inflation rate in the EMU was 1.2%; in Greece 0.25%, in Italy 0.61%, in 1 The development of GDP in Ireland is strongly linked to the location of European headquarters of

multinational companies, which are primarily settling in Ireland for tax reasons (cf. Joebges 2017). Luxembourg is also a tax haven. 2 This group covers persons with an equivalised disposable income below 60% of the national median of equivalised disposable income and persons with material deprivation.

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Fig. 2 Inflation rate in selected EMU countries, 1999–2020. Source OECD (2020), Inflation forecast (indicator). https://doi.org/10.1787/598f4aa4-en (accessed on 1 July 2020)

Spain 0.7% and in France 1.11%. With the outbreak of the COVID-19 crisis, the EMU 2020 is on the brink of deflation. The development of the price level is largely determined by costs, especially wage cost, i.e. the ratio of nominal wages to productivity (Keynes 1930). If nominal wages increase by 3.5% and productivity by 1.5%, unit labour costs increase by 2%. Now, there are a number of other factors that influence costs—the exchange rate, taxes, changes in commodity prices, etc. Devaluations in particular can lead to devaluationinflation spirals. Changes in functional income distribution can also influence price levels, but these take more time. More important are imbalances between supply and demand on goods markets. A demand overhang leads to rising prices when it meets fully utilized capacities. Declining demand leads to reduced production, but also to falling prices, for example when companies with financial problems lower their prices to increase individual sales. Despite these various factors that influence the price level, Fig. 3 shows a close relationship between the developments of unit labour costs and the inflation rate in the EMU. For the two business cycles of the existence of EMU, 2001–2008 and 2009–2019, annual average values also make this clear. Changes of unit labour costs are thus without doubt in the EMU the anchor for price level development (cf. Herr 2009). Functional wage increases in a currency union should correspond to the mediumterm productivity development of the respective member state plus the target inflation

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Fig. 3 Unit-labour costs and price level in the EMU 1999–2019 (percentage change). Source OECD (2020), Unit labour costs (indicator). https://doi.org/10.1787/37d9d925-en (accessed on 1 July 2020); OECD (2020), Inflation (CPI) (indicator). https://doi.org/10.1787/eee82e6e-en (accessed on 1 July 2020)

rate. Then the target inflation rate would be reached in the medium term and the price competitiveness of the regions of a currency union would remain unchanged. In the EMU, France corresponded roughly to this norm (Fig. 4). In Greece, but also in Spain or Portugal, increases were clearly too high. Germany radically improved its price competitiveness until the Great Recession as unit labour costs stagnated. After 2009, there were decreases in unit labour costs in Greece, Portugal and Spain and very low increases in Italy. In Germany, they rose more strongly, but without fully compensating for the long period of stagnation before that. These developments reflect that there is no wage coordination whatsoever in the EMU. There are no central EMU collective bargaining parties and thus no EMUwide wage negotiations. And there are no minimum wages agreed upon at EMU level that can provide an orientation for wage developments. Even in countries with weak trade unions, such as the US, there are some coordination mechanisms, for example, a national minimum wage, central wage negotiations in some industries, a signal function of wage development in the public sector, or discussions about wage development in national media. None of these exist in the EMU. This shows a dangerous underregulation. The Macroeconomic Dialogue of Social Partners, which was established in 2009 and where representatives of the ECB, the European Commission (ECo), the European Council and top European representatives of the social partners meet

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Fig. 4 Nominal unit labour costs in selected EMU countries, 1999–2019, 1999 = 100. OECD (2020), Unit labour costs (indicator). https://doi.org/10.1787/37d9d925-en (accessed on 1 July 2020)

twice a year, is a forum for informal exchange of information and cannot currently coordinate wage developments (Koll and Watt 2017).

2.3 The ECB Keeps the Monetary Union Together The formation of EMU meant a radical reduction in interest rates for most member states (Fig. 5). Long-term interest rates already adjusted during the preparatory phase of the EMU and were then almost identical until 2009. Low interest rates were a gift for most countries. Before the EMU, Germany had one of the lowest real interest rates in Europe for decades due to its comparatively low inflation rate and the constant upward pressure on the D-Mark. There is a second effect. Since the ECB sets a uniform refinancing interest rate for all countries, this means high real interest rates for countries with comparatively low price level increases, as for example Germany. Against the background of low real interest rates, easy access to credit and lax financial market regulations, all Southern European EMU countries experienced a real estate bubble and in some cases a consumer-driven boom similar to that in the USA. This constellation led to relatively high growth in Spain and Greece, but also in France (Fig. 1). In Germany, by contrast, growth was subdued as demand for capital and consumer goods remained low. There was also no real estate boom. Instead, Germany built up very high current account surpluses during this phase, which were reflected in high deficits in other EMU countries (cf. Hein and Detzer 2015).

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Fig. 5 Long-term interest rates (10-year government bonds) in the EMU 1995–2019. Source OECD (2020), Long-term interest rates (indicator). https://doi.org/10.1787/662d712c-en (accessed on 1 July 2020)

Interest rates on government bonds moved radically apart in the EMU from 2010 onwards. In this phase, the financial markets began to doubt whether Greece and other countries would be able to service their government debt (see below). This was because a no-bail-out clause applied in the EMU. It stipulated that no other EMU country or the ECo was obliged to help a government with financial problems. At the same time, the ban on budget financing by the ECB applied. It was not understood that in the EMU, as in normal currency areas, an institution was needed which, as Goodhart (1995: 452) calls it, provides “revenue of last resort” for public budgets (De Grauwe 2011). At the last minute, Greece was helped by loans, but on condition that the country submits to the conditions of the newly-created Troika (officially called the Institutions from 2015 on). It was composed of members of the ECB, the ECo and the International Monetary Fund (IMF). The Troika’s support was also needed by Portugal, Ireland, Spain and Cyprus. To implement the aid, in 2010 the European Financial Stability Facility was established as a temporary fund, and then in 2012 the European Stability Mechanism (ESM) was established as permanent funds. Other countries, such as Italy, voluntarily followed the Troika’s policy in order not to have to officially ask for support. The Troika’s conditions followed the logic of the Washington Consensus, i.e. a neoliberal programme with the elements of fiscal discipline, deregulation and liberalization, and privatization. These measures were not sufficient to calm financial markets. The rescue programmes were too limited in quantity. Also, the ECB introduced the Asset Purchase Program (APP) from 2010 onwards to help crises countries. But it was limited as well and met fierce resistance from German members of the ECB’s

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Governing Council, including resignations. The crisis only came to an end shortly after Mario Draghi took office as President of the ECB, when he announced in a memorable speech in 2012 that the central bank would provide revenue of last resort without limitations. In the same year, the Outright Monetary Transactions (OMT) programme was introduced which allowed for the unlimited intervention of the ECB on secondary markets for government securities of member countries who submit to conditions set by the Troika. The EMU could have avoided high economic, social and political costs if a lender of last resort also for governments had been created right at the start of monetary union. After the Great Recession, the ECB massively stabilized economic development (Fig. 6). The ECB’s balance sheet total was around e800 billion at the end of 1999, then rose to e2000 billion in 2008, e4671 billion at the end of 2019 and e6636 billion in June 2020 (ECB 2020). Several factors have contributed to the explosion of the balance sheet. In 2008, the money market between financial institutions also collapsed in the EMU. At the same time, many EMU countries still had high current account deficits and were hit mainly by capital flight to Germany or the Netherlands. Deficits and capital flight were financed by money creation in the respective national branches of the ECB. From September 2014, the interest rate for the ECB’s main refinancing operation was 0.05%, after banks had been able to limitlessly refinance themselves via this instrument since 2008 and the quality of the collaterals required for this purpose had been continuously reduced. Finally, in 2016 the interest rate for main refinancing operations fell to zero and remained at this level. In particular, huge Asset Purchasing Programs (APPs) were launched from 2016 onwards, which pumped liquidity into the economy with fixed monthly net purchases of assets. Government securities were

Fig. 6 Consolidated balance sheet of the Eurosystem. Source ECB (2020), retrieved from: https:// www.ecb.europa.eu/pub/annual/balance/html/index.en.html

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purchased, but also credit claims to companies. In fact, the ECB became an important financier of budget deficits. Additional programmes were aimed at increasing loans to the corporate sector (for a detailed overview see Heine and Herr 2021). Finally, in 2020, the additional Pandemic Emergency Purchasing Program (PEPP) led to the expansion of the central bank balance sheet. This last programme abandoned the rule that interventions in the different countries had to be carried out according to the members’ capital share at the ECB. Since 2008, monetary policy has failed to raise the inflation rate to its target value, despite zero interest rate policy and massive interventions—this was mainly caused by insufficient wage cost increases. The ECB also failed to stimulate sufficient credit growth and investment. In some EMU countries, especially in Germany, the credit-investment process got back on track after 2012, but not in other countries. Overall lending to the private sector stagnated after 2008. In the EMU, the volume of annual nominal fixed capital formation fell from just under e600 billion before the Great Recession to e500 billion in 2013, only to return to pre-crisis levels in 2019 (OECD 2020). It was confirmed that the power of central banks is asymmetrical. They can stop an upswing, but they cannot force an economic recovery if the banks are unwilling to lend and/or the willingness of companies to invest is low. The ECB’s monetary policy has produced a number of negative effects. These include not only the difficulties of insurance companies and financial institutions, which have seen their profits melt away with the zero interest rate policy, but especially asset market inflation. The stock markets have recovered after their crash in 2008 despite unsatisfactory real economic development. And in Germany in particular, property prices have risen sharply with the risk of a bubble (OECD 2020).

2.4 Fiscal Policy Has Failed In the 2010s, the ECo’s budget amounted to around 1% of EU GDP—in the USA the federal budget has been just over 20% of GDP for decades and still rises in times of crisis (OECD 2020). In the EU, about 90% of revenues are transferred from member states, and the possibility of taking out own loans was extremely limited until the COVID-19 crisis. When the EMU was founded, no efforts were made to create a second supranational institution alongside the ECB that could have conducted fiscal policy for the currency area. The philosophy of the EMU was rather to restrict the fiscal policy of member states. This is understandable, since in a monetary union the fiscal policy of one member country has an impact on the other member countries. But restricting the fiscal policy of member countries without creating a central institution for active fiscal policy is dysfunctional. Since Germany in particular did not trust the no-bail-out clause of the Maastricht Treaty, the Stability and Growth Pact (SGP) was established even before the start of EMU. It stipulated a maximum budget deficit of 3% and public debt of 60% of GDP, apart from exceptional emergencies. Reporting and sanction

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mechanisms were created to guarantee compliance with the rules. However, the SGP failed after only a few years, as countries like Germany also violated it. After the Great Recession, Germany in particular stepped up efforts to make the Pact more binding. As early as 2009, Germany’s parliament passed the “debt brake”, which provided for a structural deficit of no more than 0.35% of GDP. The German constitution, which until then had laid down the “golden fiscal rule”,3 was amended. On EU-level 2011, the Sixpack came into force. Four of the measures tightened the SGP, and two were aimed at preventing macroeconomic imbalances. In addition, for EMU countries the Fiscal Compact in 2013 introduced a debt brake following the German model. It allows a long-term maximum structural budget deficit of 0.5% of GDP. An elaborate system of information, requirements and sanctions within the framework of the European Semester was intended to monitor the rules and enforce compliance with them. Instead of pursuing a common fiscal policy, a jumble of rules was established, resulting in little fiscal flexibility. The rules are often arbitrary or highly controversial. For example, there is no argument why government debt should be 60% of GDP. Also, countries with different GDP growth rates can have completely different budget deficits relative to GDP without any change in the debt ratio, so that a 3% rule is missed.4 In addition, there are a number of arbitrary factors in the calculation of structural budget deficits. Finally, the budget balance is a variable that cannot be controlled by governments. If rules are to be applied, then a spending rule for public investment or the golden fiscal rule would make more sense. There is no doubt that the recession in the EMU in 2012 and 2013 was due to fiscal consolidation. The far too early fiscal restriction, including the Troika’s policies, were not only questionable from a socio-political point of view, but also economically wrong. Figure 7 shows the development of public debt as a percentage of GDP. In 2007, the debt ratio for the euro countries was 66%; in 2019 in spite of austerity efforts 84%, 177% in Greece, 135% in Italy, 118% in Portugal, 98% in France or 95% in Spain. In Germany, however, the ratio fell (OECD 2020).

2.5 Unfinished Banking Union During the Great Recession, it became clear that a monetary union without central financial market supervision pre-programmes instability. Moreover, during the crisis, 3 The

rule allows public debt to finance public investment. D as government debt, D as budget deficit (net borrowing) and GDP as change in GDP, the debt stock ratio (b = D/GDP) by definition does not change if government debt and GDP grow at the same rate: D/D = GDP/GDP. Dividing the left side of the equation in the numerator and denominator by GDP, defining a = D/GDP as the deficit ratio and g as the growth rate of GDP, yields a/b = g and b = a/g, respectively. Growth of g = 3% allows a deficit ratio of a = 3% without the debt ratio b increasing. If GDP growth is 5%, the deficit ratio may be 5% so as not to change the debt ratio.

4 With

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Fig. 7 Government debt in per cent of GDP in selected EMU countries, 1999–2019. Source Eurostat (2020), “General government gross debt” (DG_17_40)

each country stabilized its financial system in isolation with high fiscal costs. As a result, steps were taken towards a European Banking Union (BU). In 2014, the single supervisory mechanism transferred banking supervision of large banks in the EMU to the ECB. The ECB also got the power to intervene in the supervision of small banks. This element of the BU must be seen as a major advance. The single resolution mechanism came into force in 2015. Its aim is to ensure the orderly restructuring and winding up of financial institutions with problems. Also, shareholders of banks and big creditors, who are not covered by deposit insurance schemes, should shoulder some of the financial losses. A Single Resolution Board was founded as a central organisation to manage restructuring. In 2016, the Single Resolution Fund was established to deal with cases where private sources are not sufficient to rescue or wind up a bank. With one per cent of covered deposits, the Fund is much too small. A European deposit insurance scheme does not exist. As soon as banks in one country of the EMU come into crisis wealth owners will immediately shift their monetary wealth to stable banks in other parts of the EMU. Thus, in the EMU regional banking crises with capital flights are much more likely and much more severe than in normal nation states.

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3 Lessons from Historical Developments In the COVID-19 crisis, the ECB has immediately assumed its role as lender of last resort and the SGP has been suspended. In addition, the ECo and the European Council have proposed, among other things, a reconstruction programme of 750 billion euros. It is to be welcomed that over half of the sum is to be awarded as nonrepayable grants to particularly affected countries. This reconstruction is financed by borrowing by the ECo, and repayment will be made via the EU budget, i.e. jointly. In addition, funds from the ESM of around 240 billion euros will be used to support countries mainly for health expenditure. The aim of this section is to discuss the medium-term prospects of the EMU and to point out potential risks. The history of past economic crises shows that it is not enough to pursue active monetary and fiscal policy when a crisis breaks out. To avoid long-term stagnation, additional policies are needed. Especially a coordination of wage, fiscal and monetary policy is needed. In order to substantiate our thesis, we will examine two economic crises of the past, first, the Great Depression, which began in the late 1920s/early 1930s and could only be overcome with the financing of the war preparations for the Second World War in the early 1940s, second the Japanese crisis from the 1990s onwards.5

3.1 Wage and Deflation The idea that labour market rigidity is a major contributor to crises is still popular. Bernanke (2000), for example, assumes that the reasons for the extremely high unemployment in the USA during the Great Depression are to be found in the insufficient cuts in nominal wages. In the early 1930s, the notion that rigid wages at least exacerbate crises has shaped policy in all crisis countries. Nominal hourly wages in the USA fell by more than 20% between 1929 and 1933. In Japan, nominal wages stagnated, in the twenty years after 1998 in 50% of the years the nominal wage level decreased. Between 1998 and 2018, the index of unit labour costs fell from 128.6 to 103.9 (OECD 2020). Dominance of firm-based trade unions and wage negotiations as well as pressure in Japan to liberalise the labour market has contributed to this development (Ohmi 2010). Recommendations for wage cuts as a policy to combat unemployment are based on the neoclassical paradigm, according to which the level of the real wage inversely determines the level of employment. This approach is neither empirically nor theoretically convincing. Historically, nominal wage cuts were accompanied by a significant increase in unemployment. For example, in the US the unemployment rate rose from

5 The

detailed empirical data on which the following explanations are based can be found in Dodig and Herr (2015), see also Herr and Kazandziska (2011).

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3.2% in 1929 to a dramatic 24.9% in 1933.6 Theoretically, wage negotiations are conducted on nominal wages. How real wages develop depends on price level developments, on which wage negotiations have no direct influence. As has been shown, changes in the price level depend on various factors, but in the longer term mainly on unit labour costs. If, under the economic conditions of insufficient demand on the goods markets and rising unemployment, nominal wage developments lag behind labour productivity increases, there will be no additional demand for goods or labour, but a deflationary process. Deflation dramatically exacerbates economic crises and has the potential to lead to a cumulative process. First, it increases the real debt burden of all debtors in domestic currency (Fisher 1933). Second, it negatively influences expectations of companies, with the corresponding consequences for investment. Third, social and political consequences of deflation are devastating since unemployment and reductions in nominal income affect social groups in different ways. Unfortunately, the institutional structure of the EMU is in no way suitable to avert the risk of deflation. As has been shown above, there are no institutions that would allow a coordinated wage policy between the member states. There are no common unemployment insurance, social assistance or labour market policies which, as in usual currency areas, ensure that the wage structure remains relatively stable and that the wage anchor for securing the price level does not break. There is also the danger that individual countries will attempt to increase their competitiveness by means of internal devaluation and thus launch wage dumping competition.

3.2 Fiscal Policy as a Long-Term Task Fiscal policy in Japan became expansionary with the onset of the crisis in the early 1990s to the extent that cyclically induced deficits were accepted. Since 1993, Japan’s budget deficit has frequently exceeded 5% of GDP and public debt has risen from around 67% to more than 240% of GDP at the end of 2019. Without such fiscal policy, Japan would have been plunged into a scenario similar to the Great Depression. However, the Japanese government has been very careful not to let the budget deficits get out of hand. Consolidation of the budget was initiated immediately when economic situation improved. For example, when there were signs of an upswing in the mid-1990s, the Hashimoto government introduced reforms that had a clearly restrictive fiscal effect. For example, the consumption tax was raised from three to five per cent and social programmes were cut (Ohmi 2010). After 2003, the crisis seemed 6 In the USA, nominal wages began to rise again slightly from 1934. This was undoubtedly due to the

policies of Roosevelt, who was in charge of the government from March 1933. He tried to stabilize wage development with several measures. The National Industrial Recovery Act obliged companies to agree to “codes of fair competition”, the Social Security Act created the first basic social safety net in the U.S. the National Labour Relations Act granted workers the right to organize and bargain collectively as well as prevent them from unfair labour practices, the Fair Labour Standards Act introduced a minimum wage, maximum work hours and banned child labour.

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to have been overcome and renewed attempts were made to reduce budget deficits. The Great Recession of 2007/2008 put an end to these efforts. In the end, a longerterm expansionary fiscal policy would have been more helpful in Japan. However, it must be acknowledged that Japan accepted a massive increase in government debt with all of its negative effects. Significant for the negative development in Japan was that wage and fiscal policy did not pull together. While fiscal policy was essentially expansionary, wage development led to a deflationary constellation. This reflects a key element of successful economic policy: macroeconomic policies must pursue a common strategy if they are to be successful. During the Great Depression, fiscal policy was extremely dysfunctional. In Germany and the USA, there was no active fiscal policy at all. In the USA, the government budget remained roughly balanced and only became negative with the Roosevelt government in March 1933. This is all the more astonishing as the force of the crisis was enormous. The level of GDP at the end of 1929 was not reached again until 1940. But even under Roosevelt, budget deficits remained moderate, ranging from 4 to 5% of GDP until 1936. Between 1937 and 1940, the deficits were between 3 and 0% of GDP. Only in the context of preparations for war did deficits rise dramatically, reaching 12.7% in 1942. The USA in the early 1930s is a prime example of a country where both wage policy and fiscal policy were extremely dysfunctional. This explains the depth of the crisis (especially since monetary policy also contributed to the crisis, see below). With the onset of the COVID-19 recession, the EMU member states immediately switched to an expansive course and the ECo is also setting expansive impulses. In this respect, similar to the financial market crisis of 2007/2008, fiscal policy looks appropriate. However, in the past, the expansive fiscal course was abandoned as early as 2010 with the consequences of a second recession. Consequently, not only is it necessary to pursue an active fiscal policy in a recession but also in the medium- or even long-term. The question arises whether there are signs in the EMU that this time a more longterm fiscal path is being taken. Doubts must be allowed. For example, even before the agreement in the European Council to implement joint expansionary measures, the German Finance Minister, Olaf Scholz, demanded that the repayment of debts should be part of the next EU budget planning (Berliner Zeitung 2020).

3.3 Monetary Policy as Lender of Last Resort For several years after the end of the asset bubble in the early 1990s the Bank of Japan acted in a dysfunctional manner. It not only failed to combat the enormous real estate and stock market bubbles that began to build up from the mid-1980s onwards, it even actively encouraged them (Werner 2003). Only at a relatively late stage, when goods market inflation had increased, did it push up interest rates and triggered a crisis. After this, monetary policy was for too long not expansionary enough. It was

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only at the end of 1995 that the main refinancing rate dropped to 0.5% (OECD 2020). At that time, the crisis was already so deep that interest rate policy could not revitalize the investment-income process. The problem was compounded by the high debt quotas of private economic entities, which in the face of the crisis were trying to deleverage. Later on, the monetary policy of the Bank of Japan can be largely assessed as functional. But Japan also shows that monetary policy alone cannot overcome stagnation. In the USA, during the Great Depression monetary policy reacted completely inadequately. First, economic policy allowed the enormous stock market bubble in the 1920s driven by credit-based speculation—in addition to a real estate bubble in parts of the US earlier. The Dow Jones Index tripled between 1925 and 1929 (Weber and Wölfel 2013). The bubble burst in October 1929 and triggered the Great Depression. As the Hoover administration held on to the gold standard, the Fed initially remained passive and even raised its interest rates in the fourth quarter of 1931, with the aim of stabilizing the weakening dollar (FED 2013). At the same time, bank runs occurred as banks ran into problems due to the bursting of the bubble, the deep crisis and lack of Fed’s intervention. It considered the liquidity problems to be a solvency problem and did not take over the function of lender of last resort. As a result, about 9000 banks collapsed in the US between 1930 and 1933. The Great Depression in the US is an example of the destructive power that results when all areas of macroeconomic policy behave in a dysfunctional way. With Roosevelt, the USA moved away from the gold standard, so that a functional monetary policy became possible. Bank reforms such as the Glass-Steagall Act stabilized the previously insufficiently regulated financial system. Wall Street was politically disempowered and the New Deal was launched. In the EMU, after some mistakes, a functional monetary policy was launched with the presidency of Mario Draghi on 1 November 2011 (Heine and Herr 2021). Interest rates were cut quickly, liquidity was made available and the ECB was allowed to finance public budgets without limits under certain conditions. The ECB is obviously willing to continue the line of its predecessor under its new president, Christine Lagarde, who took office on 1 November 2019. One can only hope that this will remain so in the future. There are still determined opponents of such a monetary policy, especially in Germany.

3.4 Debt as an Obstacle to Future Development Economic crises and asset price deflation lead to non-performing loans (NPLs), and goods market deflation leads to an escalation of this problem. Credits judged as stable become doubtful. Following the logic of markets, in such a situation, financial institutions will stop giving credit to units in financial problems as they do not want to throw good money after bad. Strict credit rationing is the result. At the same time companies and households with high stocks of debt reduce credit demand and try to cut spending.

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The fact that high levels of debt and, in particular, high levels of NPLs after a phase of economic expansion with asset price bubbles can jeopardize recovery and upswings is well known (Minsky 1975). This was again confirmed in a comprehensive study of 88 financial market crises in 78 countries after 1990. “High and unsolved NPLs are associated with deeper recessions and slower recoveries” (Ari et al. 2020b: para 13; see also Ari et al. 2020a). This picture also emerged for the USA during the Great Depression. The nonmortgage debt of private households in relation to income had risen steadily since the beginning of the 1920s, from 4.7% in 1920 to 9.3% in 1929. With the crisis, debt quotas exploded. The debt-to-income ratios of households rose from over 60% at the peak of the bubble in 1929 to well over 80% in 1932. Aggregate net profits of US corporations dropped from $1.7 billion in July 1929 to minus $677 million in July 1932, and did not reach the pre-crisis level for the rest of the decade (FED 2013). At the same time, as mentioned, commercial banks did not receive any support from the Fed. The banks that survived rationed their lending. This made it difficult for companies to obtain urgently-needed loans, investment activity continued to falter and own debts could not be serviced. A similar scenario occurred in Japan, with the difference that monetary and fiscal policy was used to actively combat the debt problem. But the problem in Japan was that bailouts began too late. Koo (2009) has vividly described crisis management in Japan. He referred to this as a balance sheet recession and illustrated how Japanese companies focused primarily on repairing their balance sheets by deleveraging for many years after the collapse of asset prices occurred. He also pointed out that Japan did not only suffer from a classical credit crunch because also credit demand broke down. And the Japanese government found no quick solution for the NPL-problem after the implosion of the bubble in 1990. Only in 1996, the government was eventually compelled to take serious actions and injected capital into companies and set up two new institutions designed to take over most of NPLs. Almost seven years after the beginning of the crisis, the government started to solve the problems (Ohmi 2010). This demonstrated the reluctance of the Japanese government to undertake decisive political action, primarily because of redistributional concerns. The examples of the USA and Japan show that debt management is absolutely necessary to open the way for sustainable recovery. In the USA, the problem stemming from the Great Depression was solved above all by the extremely high growth rates from the beginning of the 1940s, when companies and households were able to grow out of debt. In Japan, on the other hand, the central bank has assumed the role of lender of last resort, but the non-performing loan problems was not solved for a long time. Japan also shows that there is no silver bullet for the solution of NPLs, since any debt relief implies distribution conflicts and ideological disputes. If the banks are capitalized, the taxpayer has to pay for it; if a part of the bank deposits is cancelled, the depositors are affected; if a bank is nationalized, the owners lose. These findings pose considerable risks for overcoming of the COVID-19 crisis. Compared to the financial market crisis in 2008, banks had higher capital ratios at the beginning of the COVID-19 crisis, but public sector debt ratios were significantly

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higher, banks were less profitable and the corporate sector was less stable. If the post-crisis recovery is muted, companies and households in many EMU countries could face serious financial problems; NPL problems could accumulate and trigger another banking crisis (cf. Ari et al. 2020a). Private debt levels as a percentage of GDP have been rising in the EMU steadily for years.7 At the end of 2018 the debt ratio of companies in the EMU as a whole stood at 77% of GDP and that of private households at 106% of GDP (ECB 2020). In many EMU countries, apart from Spain, debt levels were hardly reduced at all after the financial market crisis in 2008. Such a development makes the overall economic constellation fragile. In addition, although NPLs were reduced significantly after the Great Recession, some countries are still suffering heavily from bad loans. According to the ECB (2020: 68), the NPL ratio8 at the end of 2019 was 35% in Greece, 17% in Cyprus, 7.1% in Portugal and 6.7% in Italy. Overall, the NPLs amounted to 4.2% of EMU’ GDP. There is a risk that after the COVID-19 recession private sector debt ratios and NPLs will be high and that there is no political will to clean the balance sheets of companies and financial institutions and the over-indebtedness of private households. The consequence would be that credit-investment-income creation would not get off the ground and the EMU would fall in a Japanese scenario with low growth rates in the long run. If deflationary tendencies are then added to this, the NPL problem will become even worse. In the EMU, the problem is exacerbated by the fact that NPLs are likely to be concentrated in individual countries.

4 Conclusions for the EMU Following the COVID recession, the EMU faces major challenges that it can hardly solve within the current institutional framework. It is not the aim of this paper to make concrete proposals for reform. Therefore, a few key conclusions must suffice. Rapid steps towards an EMU finance ministry are necessary. The budget of the ECo must be increased significantly and the ECo should be empowered to levy its own taxes and take out loans. A much bigger ECo budget plus the power to levy taxes and issue bonds needs a much stronger political control by a stronger European Parliament. Fiscal policy must stimulate investment activity, especially in the long term, including public investment and providing European public goods. It should also include elements of industrial policy. This applies to both the joint development and

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debt in relation to GDP rose in France from 164% at the end of 1995 to 203% at the end of 2007 and 266% at the end of 2018; for Germany the corresponding figures were 149, 162 and 154%, for Greece 49, 115 and 128%, for Italy 123, 167 and 165%, for Portugal 160, 278 and 247% or for Spain 129, 276 and 198% (cf. OECD 2020). 8 Non-performing loans and advances as share of loans and advances.

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the structuring of key infrastructure areas, such as a European railway and transportation system in general or a common European energy policy. The de-industrialization of peripheral regions in the EMU or EU must be actively combated in this context (Simonazzi et al. 2019). If it is not possible to create comparable living conditions in the EMU, this will most likely trigger political distortions that are incalculable. The 1930s are also a lesson here. In the USA, the New Deal led to prosperity that continued for decades after the Second World War. In Germany and Italy, however, fascism came to power. European integration has so far been primarily integration for the economy and for capital. At its heart was the creation of economic freedoms such as the free movement of goods, capital and people. The social dimension was explicitly left out. Thus, there were no attempts to build a European social security system. Proposals such as the creation of an EMU-wide unemployment insurance scheme (Dullien 2015) were not implemented. However, steps in such a direction are absolutely necessary. Another construction site is the lack of institution building for a common EMU labour market. A nominal wage anchor should be established immediately via EMUwide coordinated minimum wages. Where possible, EMU-wide wage negotiations should be promoted, starting with highly concentrated industries. In general, wage bargaining at the industry level should be strengthened, coupled with extension mechanism also to create fair competition between companies. Finally, the BU should be completed. Joint deposit insurance is necessary to stop capital flight within the EMU and to create a real EMU banking system. Strengthening the Single Resolution Mechanism is also imperative to strengthen the joint support or liquidation of financial institutions. A common solution to the problem of bad loans must be found in the EMU. The joined Resolution Fund has to become much bigger. All in all, the COVID-19 crisis offers a chance for the institutional strengthening of the EMU. If such reforms are not supported by individual member states, further integration through different speeds between member states should be considered. If such reform steps fail, Europe will remain fragile and the EMU is in danger of breaking up.

Literature Ari, A.; Chen, S.; Ratnovski, L. (2020a): The dynamics of non-performing loans during banking crises: a new database, ECB Working Papers, No 2395, Frankfurt am Main. Ari, A.; Chen, S.; Ratnovski, L. (2020b): COVID-19 and non-performing loans: lessons from past crises, ECB Research Bulletin No. 71. Berliner Zeitung (2020): https://www.berliner-zeitung.de/wirtschaft-verantwortung/eu-corona-auf bauplan-scholz-stellt-umfang-infrage-li.86770. Bernanke, B.S. (2000): Essays on the Great Depression, Princeton, Princeton University Press. Bubbico, R.L.; Freytag, L. (2018): Inequality in Europe, European Investment Bank, https://www. eib.org/attachments/efs/econ_inequality_in_europe_en.pdf.

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Cabrillac, B. (2019): Integration and Convergence in the EMU: A Complex Dynamic, SUERF Policy Note Issue No. 100. De Grauwe, P. (2011): The European Central Bank: Lender of Last Resort in the Government Bond Market? CESIFO Working Paper, No. 3569. Dodig, N.; Herr, H. (2015): Financial Crisis Leading to Stagnation – Selected Historical Case Studies, in: Hein, E.; Detzer, D.; Dodig, N. (eds.), The Demise of Finance-Dominated Capitalism. Explaining the Financial and Economic Crisis, Cheltenham, Edward Elgar. Dullien, S. (2015): European Unemployment Insurance, The New Palgrave Dictionary of Economics, London, Palgrave Macmillan, 1–12. ECB (2020): Supervisory Banking Statistics, fourth quarter 2019, April 2020, https://www.bankin gsupervision.Europa.Eu/ecb/pub/pdf/ssm.supervisorybankingstatistics_fourth_quarter_2019_ 202004~4848fcfef2.en.pdf (accessed 5 June 2020). ESM (2020): https://www.esm.europa.eu/. Estrada, Á.; Galí, J.; López-Salido, D. (2013): Patterns of Convergence and Divergence in the Euro Area, in: IMF Economic Review, 61, 601–630. Eurostat (2019): Living conditions in Europe, October 2019, https://ec.europa.eu/eurostat/statisticsexplained/index.php/Living_conditions_in_Europe_-_poverty_and_social_exclusion. FED (Federal Reserve Bank of St. Louis) (2013): FRED Database, http://research.stlouisfed.org/ fred2/. Fisher, I. (1933): The Debt Deflation Theory of Great Depressions, in: Econometrica, 1, 337–357. Goodhart, Charles (1995): The Political Economy of Monetary Union, in: Kenen, Peter B. (ed.), Understanding Interdependence: The Macroeconomics of the Open Economy, Princeton, Princeton University Press. Hein, E.; Detzer, D. (2015): Post-Keynesian Alternative Policies to Curb Macroeconomic Imbalances in the Euro Area, in: Panoeconomicus, 62, 217–236. Heine, M.; Herr, H. (2021): The European Central Bank, London, Agenda Publishing. Herr, H. (2009): The Labour Market in a Keynesian Economic Regime: Theoretical Debate and Empirical Findings, in: Cambridge Journal of Economics, 33, 949–965. Herr, H; Kazandziska, M. (2011): Macroeconomic Policy Regimes in Western Industrial Countries, London, Routledge. Joebges, Heike (2017): The case of Ireland, IMK Working Paper, No. 175. Keynes, J. M. (1930): A Treatise on Money, Collected Writings, Vol. V., London, Macmillan. Koll, W.; Watt, A. (2017): A feasible conceptual and institutional reform agenda for macroeconomic coordination and convergence in the Euro Area, in: Herr, H.; Priewe, J.; Watt, A. (eds.), Saving the Euro—Redesigning Euro Area economic governance, Berlin, Social Europe. Koo, R. (2009): The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, Singapore, John Wiley & Sons. Minsky, H. (1975): John Maynard Keynes, New York, Columbia University Press. OECD (2020): OECD data, https://data.oecd.org/. Ohmi, N. (2010): The Japanese economic crisis of the 1990s, International Journal of Labour Research, Financial Crises, Deflation and Trade Union Responses: What are the Lessons? 2, 61–77. Simonazzi, A.; Celi, G.; Guarascio, D. (2019): Developmental industrial policies for convergence within the European Monetary Union, in: Herr, H.; Priewe, J.; Watt, Andrew (eds.), Still time to save the euro, Berlin, Social Europe. Slobodian, Q. (2018): Globalists. The End of Empire and the Birth of Neoliberalism, Cambridge, Harvard University Press. Stuth, S.; Schels, B.; Promberger, M.; Jahn, K., Allmendinger, J. (2018): Prekarität in Deutschland?, WZB Discussion Paper, P 218–004. Weber, C.S.; Wölfel, K. (2013): 100 Jahre Federal Reserve System, in: Wirtschaftsdienst, 93, 828– 834. Werner, R. (2003): Princes of the Yen: Japan’s Central Bankers and the Transformation of the Economy, New York, Sharpe. World Bank (2020): World Bank data, https://data.worldbank.org/.

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Michael Heine was Professor for political economy at the University of Applied Sciences, HTW Berlin until 2015 and from 2006 to 2014 its president. His fields of expertise are monetary and economic policy with particular focus on post-Keynesian theory. He has widely published on these issues. This year, the book “The European Central Bank” written together with Hansjörg Herr will be published. Hansjörg Herr is a Professor Emeritus at the Berlin School of Economics and Law, Germany, in the field of “Supranational Integration”. He is an expert in development economics including trade, global value chains and financial systems. He also works in the field of labour markets, minimum wages, wage bargaining systems, as well as the development of the international monetary system and the European integration. He is one of the founders of the Global Labour University which carries out activities under a trade union perspective together with the International Labour Organization. Hansjörg Herr has been teaching in many universities around the world.

Europe at the Crossroads of the COVID-19 Crisis: Integrated Macroeconomic Policy Solutions for an Asymmetric Area António Mendonça and Sofia Vale

Abstract The economic crisis triggered by the COVID–19 pandemic once again raises doubts about the eurozone’s ability to deal with joint economic problems given its dissimilar dynamics and asymmetries. This chapter contributes to a paradigm shift in the governance of the euro area towards a more comprehensive and integrated approach. Two dimensions of this paradigm are considered. First, the need for a change in the economic policy concerning the recovery, from a supply-push to a demand-pull orientation, supported on a fiscal and monetary policy mix, integrated within a comprehensive macroeconomic approach. Second, we examine the need for a shift in external relations towards a more global integration-oriented policy, with the euro area positioning itself as an alternative to the current polarization between the United States and China. Our conclusions point to: (i) giving priority to growth and employment; (ii) promoting long-term economic sustainability based on integrated macroeconomic policies, the reduction of income concentration, and the reconstitution of strong middle classes; (iii) reorientating international relations into a perspective of cooperation; (iv) reinforcing regulation and global governance; and (v) eliminating exceptional situations and ways to evade economic controls. Keywords European Union · Euro · Economic crisis · COVID-19 JEL C65 · F4 · F5 · H63

1 Introduction Forecasts published by national and international institutions at the end of the first semester of 2020 confirm what was anticipated: the COVID-19 economic crisis will A. Mendonça (B) ISEG—Lisbon School of Economics and Management, University of Lisboa, Lisbon, Portugal e-mail: [email protected] S. Vale Department of Economics, ISCTE—IUL, Lisbon, Portugal e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_3

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cause dramatic falls in output and employment fuelled by the combined contraction of consumption, investment, and international trade, along with the consequences on public deficits and debts. The European Commission (EC) revised the Spring estimates downward, pointing to a GDP decline between 8.3 and 8.7% and inflation between 0.6 and 0.3% for the European Union (EU) and the Euro Area (EA), respectively. The forecasts also show a wider divergence, with countries including Italy, Spain, France, and Portugal facing drops between 10 and 11%, while Finland, Netherlands, Germany, Luxemburg, and Malta, remaining between 6 and 6.8% (European Commission 2020b). However, it is too early to draw definitive conclusions. These effects will tend to last over time, depending on the evolution of the disease itself, and on how the confidence of consumers, investors, and other economic agents will recover—and notably on the economic policy measures that are to be adopted, at both international and national levels. As the economic downturn deepened, the comparison with the 2008–2009 global economic and financial crisis grew more widespread, with a consensus around the idea that the consequences will be much more profound, despite economic projections of institutions such as the International Monetary Fund (IMF), the European Central Bank (ECB), and the EC suggesting the possibility of a quick recovery as early as 2021—the “V-recovery” (IMF 2020; ECB 2020a, European Commission 2020a). The impacts can go far beyond these forecasts if no radical measures are adopted. At the end of 2019, with no signs of what the pandemic would become, economic forecasts for 2020 pointed to a significant reduction of the international economic dynamics. Comparisons with the previous crisis may not be enough to be fully aware of what is at stake.1 It is also too early to detect how the pandemic will affect the role and ability of international institutions. In this area too, the signs are contradictory. On the one hand, the enormous role that international institutions can play in managing this global crisis is evident; but on the other hand, there is also a temptation for unilateral, bilateral, or ad hoc group interventions, striving for opposite goals, diminishing the ability and legitimacy of these institutions to intervene. What is happening in Europe is also far from what would be expected. The ECB’s timely and focused intervention continues to work, but the European Council and even the European Commission have been slow to react, and even then with shallow actions. This essay discusses the current economic crisis triggered by COVID-19, seeking to capture similarities and specificities with previous crises, and with the 2008– 2009 crisis in particular. We highlight the factors that arose from this crisis and that have projected their influence until the present and are discouraging the ability to manage the recovery process, undermining the very role and raison d’être of European institutions. Finally, we discuss the need for a change of the macroeconomic 1 Preliminary flash estimates for the second quarter, published after the writing of the current chapter,

confirm the worst scenarios: GDP down by 12.1% in the euro area and by 11.9% in the EU and − 15.0% and −14.4% respectively compared with the second quarter of 2019 (Eurostat 2020).

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policy at both fiscal and monetary levels, incorporating the experiences of the last decade, especially those resulting from the ECB unconventional monetary policy. Section 2 discusses global economic trends that were triggered by the 1970s crisis and gave rise to qualitative changes in the dynamics of the global economy. Section 3 focuses on the European economy, aiming to capture the process of real convergence and changes in the income distribution between countries. The challenges to European governance posed by the COVID-19 crisis are discussed in Sect. 4. Section 5 focuses on the need for monetary policy reform—a recent decision announced by the ECB. Section 6 concludes.

2 COVID-19 Crisis: Exogenous Shock Versus Cyclical Crisis We could ask ourselves if it makes sense to compare the economic crisis triggered by the COVID-19 to the economic and financial crisis triggered by the American subprime events. The answer is “yes”—not in the sense that the current crisis can be considered as a mechanical expression of the world economy dynamics, as some forecasts at the end of 2019 pointed out, but in the sense that how it develops today and the recovery that may occur are intrinsically linked to the response that was given to the previous crisis and to how the world economy has developed from then until today.

2.1 The Cyclical Dynamics of the Post-1973–1975 Crisis The two crises can be inserted into a new dynamic of the world economy, triggered by the oil crisis of the early 1970s, which interrupted the cycle of continuous economic growth that had lasted since the end of the Second World War (Mendonça 2018a, b, 2019). At the time, the cyclical sequence of crises and recession that characterized the world economy before the Second World War, and whose paradigmatic expression was the crisis of 1929, was thought to be over. After the 1970s, the business cycle reemerged, as can be attested by the successive crises of the early 1980s, the early 1990s, the beginning of the new millennium, in 2008/2009, and most recently in 2020, with a regularity that can be quantified between 8 and 11 years (Fig. 1). Since the end of 2018, the European and world economies were showing signs of deceleration, forcing central banks, and the ECB in particular, to strengthen their countercyclical monetary policies as if the world economy was just waiting for a new crisis. In the 2008–2009 crisis, the American subprime crisis was the trigger and contagion resulting from free capital movements, that spread the crisis like an oil slick across the world economy and throughout the global financial system. In the 2020 crisis, the spark was COVID-19 and the contagion that spread

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through the free movement of people, affecting the economic system in turn. Two types of freedoms that are at the origin of the current global economic crisis and characterize it. It is worth noting the average growth rates by periods (Fig. 2), taking as reference important events in the process of European integration and the evolution of the world economy: the 1974–1975 crisis; the Single European Act in 1986; the creation of the euro in 1999; the 2008–2009 crisis. It is evident how the 1970s crisis represents a decisive turning point. From then on, all major economies suffered an intense reduction in performance that tended to 10

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be accentuated in each subsequent period, and that in Europe was especially evident following the creation of the euro. The performance of the American economy is noteworthy. The least energetic economy at the time (with growth rates of about 4% between 1961 and 1974) demonstrated high resilience, managing to maintain growth rates above those of the euro area in the successive periods until the current crisis. Also impressive is the slowdown of Japan (exacerbated at the end of the 1980s), which is currently one of the economies with lowest growth rates. Figure 2 also shows the loss of dynamism of the Portuguese economy, despite the relatively good performance from 1986, the period from the entry into the European Communities until the creation of the euro. This is unlike its neighbour, Spain, which reveals a remarkable capacity for adaptation. From the 2008–2009 crisis, the retraction has been widespread, with the American economy showing greater resilience.

2.2 Consequences for the Global Economy The collective performance of the most developed economies has had important consequences for the global economy. The 2008–2009 economic and financial crisis interrupted a process of globalization propelled since the 1980s by an unprecedented scale of financial leveraging, hegemonized by the United States and fuelled by the forces of the so-called twin deficits (internal and external). The COVID-19 crisis, on the other hand, interrupts a process whose hegemonies are difficult to characterize, but in which there is evidence of growing power of the Chinese economy. The stability of the shares of advanced, emerging and developing economies in the world GDP, measured in PPP, started a sustained reversal process during the early 1990s crisis, which was accentuated by the crisis of the early 2000s and saw a turnaround following the 2008–2009 crisis (see Fig. 3). Three qualitative features arise from this trend: a greater relative loss of the European Union countries, when compared to the United States; a marked emergence of China, accelerated by the 70

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2008–2009 crisis; and the persistent erosion of Japan. Along with these developments, there was a retraction of the initiatives to organize the western-matrix globalization, such as the Transatlantic Trade and Investment Partnership Agreement (TTIP) and the Trans-Pacific Partnership Agreement (TPP), and an expansion of initiatives carried out by China, such as the “Belt and Road Initiative”. The extent to which the COVID-19 crisis may worsen the broader crisis of the globalization model that emerged in the aftermath of the 2008–2009 crisis is still an open question. The answer will depend on how the COVID-19 will affect the system of international relations and how the economic and political leaders will respond to the problems of the international institutions that should govern the global economy.

3 The European Union Integration: A Distressed and Divergent Process This section deals with the European integration process, discussing its effects on the convergence of GDP per capita and income distribution across countries, and the asymmetry that exists in the current account balances between euro area member states. These effects are examined herein at a global level, but its European features can be seen as a consequence of the economic and political policies followed over the last decades, including the architecture of the euro system.

3.1 Real Convergence and Inequality Figure 4 shows the average logarithm of GDP per capita between 1960 and 2017 using Penn World Tables (PWT) data,2 version 9.1, for the charter members of the euro, the euro area, and the European Union. Even though Greece is not a founding member, having entered on January 1, 2001, it is included in the first group (EA-12). Given the absence of data, the larger groups of the 19 euro area (EA-19) and 28 European Union (EU-28) member states are represented from 1990 on. The dashed vertical line marks the 2008–2009 crisis. The figure shows GDP per capita increasing on average for the EU-28, although with periods of marked deceleration immediately following major crises, as in the early 1970s and 1980s. The EA-12 countries saw a halt in growth and even slight drop in average GDP per capita following the 2008–2009 crisis, in comparison with the average growth rate of either EU-28 or the EA-19 members, suggesting different 2 The preference for the PWT dataset (Feenstra et al. 2015) is justified based on the need to establish

comparisons between economies that have their economic activity expressed in different national currencies. The data used in this analysis correspond to the logarithm of the expenditure-side real GDP at chained purchasing power parities and measured in millions of 2011US$, divided by the total population.

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convergence speeds within the EU. Figure 5 presents the coefficient of variation for the three groups, confirming that following the 1970s crisis EA-12 countries ceased convergence, to regain it in the second half of the 1990s. The introduction of the

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euro caused divergence between their incomes per capita that was intensified with the 2008–2009 crisis. Between either EA-19 or EU-28 countries real convergence was a fact from the early 2000s, which most likely indicates the catching-up of lower-income countries from Central and Eastern Europe to the EU. That process was interrupted by the 2008–2009 crisis. Crisis episodes affect countries differently given their idiosyncrasies. By identifying homogeneous groups within the EU it is possible to enhance the analysis of real convergence and how this was affected by crises. We selected five EU groups. The first includes five of the founders of the European Union (EA-5) that can be identified as the EMU core. Italy is not included in the light of this country’s sovereign debt sustainability issues following the 2008–2009 crisis. The second group corresponds to Greece, Italy, Portugal, and Spain (GIPS), which share in common their recent sovereign debt performance and having been forced to adopt contractionary policy measures. Ireland is not included in this group because of its exceptional and divergent performance in recent years. The new EU members that joined the EMU from 2007 to 2015 (Cyprus, Estonia, Latvia, Lithuania, Malta, Slovakia, and Slovenia), form the third group (new EA). The new entrants that have not adopted the euro (new non-EA), corresponding to Bulgaria, Croatia, Czech Republic, Hungary, Poland, and Romania, form the fourth group. Groups 3 and 4 represent the lowerincome countries of the EU and that have been benefiting from EU-funds to promote their long-term sustainable growth. However, Group 3 went through an additional convergence effort to adopt the euro. Finally, Denmark, Sweden, and the UK (DSU) represent old members of the EU with high-income levels and that have opted to keep their national monetary independence. These countries comprise Group 5. Figure 6 confirms average GDP per capita differing between EU groups. If the euro core followed closely by the three monetary-independent countries keeps the income per capita lead, the GIPS countries assume an intermediate position, but following 2014 are overtaken by the new entrants in the EMU. The new entrants that are not in the EMU are at the bottom of the income distribution in the region. The GIPS caught up with the core, narrowing their GDP per capita gap in different stages up to the 2000s. The introduction of the common currency slowed this process and culminated in a diverging path triggered by the 2008 financial crisis and the consequent sovereign debt crisis. In their turn, the Eastern European countries also suffered from the 2008 financial distress but recovered their convergence path, showing a steep increase in their average GDP per capita in the aftermath of the crisis. Sigma-convergence in these groups is in Fig. 7. These groups, often assumed to be homogeneous, do not reveal linear convergence processes amongst them. The core group converged up to the 1970s, when a divergent process began to appear and was mostly intensified by the introduction of the euro. Southern European countries are seen to diverge between the early 1970s and the mid-1980s, when they entered a convergence era that finished with the adoption of the euro and is even more evident after 2008. The new member states follow a convergence path until about 2013, and diverge thereafter, while the lower average GDP per capita group experiences the most pronounced convergence process. As expected, the average dispersion within each of these sub-groups is never as high as their average dispersion towards the

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European Union, indicating greater proximity between them than amongst each of these groups and the rest of the European Union, and suggesting the existence of a multi-speed Europe. It is striking how each economic crisis represents a break in the European Union convergence process, with major events such as the 2008–2009 crisis increasing the divergence within the whole group. Despite several episodes of stress, the core managed to maintain its lead. The countries that lag and whose convergence process was mainly sustained by the transfer of European funds tend to experience sharper drops and to move away from the main growth path, exacerbating the multi-speed Europe and cultivating tension in the integration process. The last 20 years have been particularly strained, the adoption of the single currency halting the European growth path of its 12 founders and promoting real divergence between them. Aggravating matters further, the disruption of the financial crisis followed by the adoption of contractionary policy measures that were more severe in certain non-core members added to the asymmetry of performance paths within the euro area and EU. GDP per capita gives a perception of each country’s average performance. The recent discussion on inequality has brought to the fore the divergence of income between households within the same country. Countries may be growing richer while increasing the polarization between the rich and poor in their own population. To investigate how polarization is taking place in EU countries, this analysis now looks at the Gini coefficient for disposable income retrieved from the Standardized World Income Inequality Database (SWIID) by Solt (2016). The data for the 12-euro area founders are available between 1983 and 2017, and from 1988 on for the 28 EU countries.3 The most salient feature in Fig. 8 is the significant increase in the average Gini coefficient in the last 30 years, implying a strong increase in inequality, transversal to all EU countries. As a consequence, Fig. 9, which displays the coefficient of dispersion for the distribution of disposable income, points to an increase in the convergence between countries. Combined, these indicators point to societies in the European Union that are less equal. The 2008–2009 crisis has caused inequality to increase across the EU. In a close-up analysis of the Gini coefficients of disposable income for the five groups described above, once more the multi-speed Europe stands out, as is visible in Fig. 10. The GIPS (the group that has recently faltered in the GDP per capita convergence process) are the most unequal countries. The richer countries, either belonging or not to the euro area, correspond to the most equal societies, although continuing to increase their average Gini coefficients, especially after the 2000s. Between the extremes stand the new member countries, mostly former socialist economies that have seen a substantial rise in their income inequality following the change of their political regimes. For all groups, the 2008–2009 crisis caused 3 Malta

is the exception, data for this country starting in 1999. The coefficient of variation for the EA-19 was calculated considering 18 countries until 1998 and adjusting for Malta data thereafter. Bulgaria and Romania have data from 1989 on, making data for the EU-28 to start there, and the coefficient of variation was again adjusted for Malta following 1999.

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an increase in the average Gini coefficient, suggesting that within each country the lower economic growth has prompted increased inequality. Figure 11 reveals a stronger similarity in inequality amongst the GIPS, displaying low dispersion and increased convergence of their Gini coefficients. The core euro area members show a propensity to converge at this level. The degree of inequality

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between the new member countries is diverging, especially amongst those that are not part of the euro area. In sum, the European integration process has two major challenges to deal with. First, how to close the recently widened gap between its members’ GDP per capita. This problem is of special concern for countries following a divergent path, especially as a consequence of the most recent crisis. Paradoxically, the euro, the tool that should

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promote convergence, seems to have aggravated the asymmetries that already existed. A new problem is how to distribute income equitably amongst households within each country, an issue that grew worse following the last crisis, contributing to stagnation in middle-class income and compromising the ability of the EU to fight recessions with the traditional policy tools designed to stimulate aggregate demand.

3.2 Euro Area Current Accounts This section ends with a reference to the euro area current accounts (Fig. 12), focusing on the 12 oldest countries. At first glance, there is a symmetric evolution of the current account of Germany and the euro area excluding Germany, a dynamic of opposition that began in the 1970s, following the oil crisis. The German current account evolved favourably during the 1980s, until its reunification and throughout the 1990s, when the positions were reversed reflecting Germany’s economic adjustment, which negatively affected its net exports and had a positive impact on the other euro area countries’ net exports. At the beginning of the new century, coinciding with the creation of the euro, a new inflection occurs, marked by a sharp rise in the German current account and a sharp fall in the other countries. The 2008–2009 crisis reshaped these dynamics, by breaking up the inverse relationship, as a result of both the policies designed to correct the existing external deficits and the redirection of trade towards world markets. The effect that the creation of the euro had on German external dynamics is clear— undoubtedly favourable in comparison with the other countries that reveal a negative shock. Germany benefited from the introduction of the single currency, strengthening its external competitiveness and avoiding the otherwise inevitable appreciation of the 300 250 200 150 100 50

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mark against the other European currencies. This feature has been maintained and reinforced until today, despite the recovery seen in the other countries.

4 The Current Crisis: Challenges for European Governance It is time to prepare the economic recovery and correct the structural weaknesses that for long have interfered with the functioning of national, European, and international institutions, and worsened after the 2008–2009 crisis. This goal should be articulated with an economic recovery plan that can deal with the structural problems that have been contributing to the EU’s weak economic growth. In parallel, it is vital to start a process of institutional and policy reforms that will allow Europe to recover its internal vigour and capacity for international affirmation.

4.1 Immediate Responses Notwithstanding the initial hesitations, the ECB showed once again that it is at the forefront of combating the economic consequences of the COVID-19 pandemic, reinforcing the unconventional quantitative and qualitative monetary policy measures, thereby guaranteeing the channels and flows of liquidity supply to the economies. On March 18 the ECB advanced with the Pandemic Emergency Purchase Program (PEPP), a new temporary asset purchase program (APP), in the amount of 750 billion euros, in addition to other measures already underway. On April 30, in the face of a deteriorating economic environment, the ECB reduced the interest rate on the new specific liquidity-providing facility, under particular conditions, to negative levels that could go to −1%, while easing the collateral, extending lending terms at negative rates, and launching a new series of non-targeted long-term refinancing operations (Non-Targeted Pandemic Emergency Longer-Term Refinancing Operations— PELTRO). Facing worsening economic conditions, on June 4 the ECB decided to increase the PEPP envelope by an additional 600 million euros, to a total of 1350 million euros, in addition to reaffirming the continuation of measures in a time horizon compatible with the response to the development of the crisis. The most interesting feature about the ECB’s general stance is its analysis of the current economic situation and the priorities that must be established to combat the crisis, namely the need to take into account the legacy of the previous crisis, that is, the constraints imposed by high public debts and weak growth. On March 20, after a first major announcement of measures, and the reference to a “flexibilization” of the Stability and Growth Pact, while reaffirming the countries’ needs to assume their “full responsibility”, the President of the European Commission clarified its position. It was considered that, for the first time since 2011, when the

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restrictive budgetary measures were introduced, Europe met the conditions to activate the so-called escape clause, which allows exceeding the 3% limit on the budget deficit (European Commission 2020b; European Council 2020a). In early April, Ecofin announced a package of 540 billion euros to combat the crisis distributed as the instrument SURE, a temporary line to support the effects on employment comprising 100 billion euros, 200 billion euros to support SMEs, managed by the European Investment Bank, and 240 billion euros to finance direct and indirect costs from measures taken to contain, cure, and prevent COVID-19. These measures were included within the framework of economic and fiscal coordination and surveillance which, in practice, means falling within budgetary constraints (European Council 2020b, c). Even if limited, these measures reveal and strengthen the contradictions that have marked the European economy since the 2008–2009 crisis and that are at the basis of its identity crisis. As a consequence, the opposition between a “frugal” North and a “spending” South reappeared. To establish the modalities of support for economic recovery, a painful process of discussions began, resulting in the announcement of drip-feed measures and, culminating at the end of May in a new financial package worth 750 billion euros. The most decisive aspect of this package is the opening, for the first time in the history of European institutions, to the possibility of issuing European common debt. Even though the intervention of the Commission and the European Council is an ongoing process, some preliminary remarks can already be made. First, measures that should have a quick decision process, and be precisely-focused, transparent, and easy to apply, turn out to be the opposite, with no guarantees that they will be implemented effectively and sufficiently, especially if the economic environment worsens beyond what is expected. Note that the final decision on the 750 billion euros package was scheduled to be made almost two months after announcing the program to the public. Second, despite the publicized amounts, the economy is still effectively sustained by the comprehensive and in-time intervention of the ECB. Third, notwithstanding the link between financing and structural reforms and the promotion of growth based on the green and digital economy, a consistent action programme, that responds simultaneously to immediate problems in an integrated way and to the structural constraints facing the European Union and the euro area, is still lacking. This is reflected in the weak economic performance of the past two decades. Fourth, there is no certainty that the current lavishness will not turn into future “frugality”. The gradual change in the speech by the same national officials who previously advocated a radical change in the position of the European institutions may be an indication in this regard. Finally, a more positive aspect is the opening up for the possibility of issuing common debt, which could be a beginning of more robust fiscal integration and macroeconomic management in the euro area. However, it is not yet clear how this whole process will take place, nor how the distribution of responsibilities will be decided upon.

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4.2 Short-Term Challenges A structural problem that reduces the leeway for the several Member States is the size of public debts and the impact that the expected generalized increase in public deficits will have on them. Some of the efforts to find a consensus for the economic recovery programme result precisely from the last crisis spectrum, when the solutions approved to reverse the downturn led to the emergence of the sovereign debt crisis and the subsequent adoption of austerity policies. The European Union needs an effective economic recovery plan, articulated with recovery programs at the national level. If influenced by public debts inherited from the previous crisis, and whose dimension, to a large extent, is the result of the tightening policies adopted since then, the risk of failure is great and may even bring about the implosion of the euro. The immediate goals must be to safeguard incomes and restore the economy, taking “all measures that are necessary” to ensure that this is achieved. The economic policy priority should be the recovery of employment, ensuring that the employmentincome-expenditure circuit recovers momentum in parallel with setting the foundations for the recovery of the longer-term investment-growth circuit (Mendonça 2020). These dynamics need to be restored at the European level, and on a global scale, requiring broader institutional coordination and increased responsibility of international institutions, such as the IMF and the World Bank, especially concerning the coordination with developing countries.

4.3 Medium- and Long-Term Challenges: A New Marshall Plan? Under circumstances of severe economic struggle like the current one, the Marshall Plan is easily seen as a reference. However, it is worth underscoring the differences between today’s situation and the aftermath of the Second World War. First, the world is not suffering physical destruction of facilities, buildings, equipment, infrastructure, transportation, and logistics systems. Nor is there any inoperability of research and technological development systems, of financial systems, or national and international institutions, as was the case following the war. Presently, the challenge is not the physical reconstruction of economic structures, but restoring normal economic circuits. This requires a more qualitative, flexible, and decentralized intervention, and thus finer tuning and greater dependence on macroeconomic management, at both the fiscal and monetary levels. Today there is a huge amount of human, physical, technological, institutional, political, and natural resources that, if properly combined, are capable of answering all problems, including health needs. Above all, there are European and international institutions with extensive experience created precisely to respond to these problems and with the ability to think about the long term. There is also the awareness that the way out of the present crisis

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will influence the European and international economy in the coming years, if not decades, and the development of the European project itself. The Marshall Plan, closely linked to the Bretton Woods monetary system, was a fundamental vehicle for the injection of the international liquidity that allowed the recovery of European economies, and in particular, the reconstruction of the German economy, setting it on course to where it is today. If the model followed by the United States contributed to the crisis of the 1970s, it did not fail to favour the rapid recovery of the world economy and to generate high growth rates, for about two decades, until the 1970s crisis. Today, having at its disposal a remarkable instrument—the euro— created with an eye to the Bretton Woods model, the euro area should assume the inheritance of what this agreement represented for the world economy. This means that any immediate economic recovery plan in Europe must be articulated with a strengthening of economic integration, fulfilling the goals of economic development and correcting asymmetries while, at the same time, introducing flexibility, paying attention to idiosyncrasies and reinforcing the idea of common interest. Another aspect to be recovered, present in the broad guidelines of the Bretton Woods economic policies, is the concern with income distribution, insofar as it works as a demand stabilizer, as it did in the three decades that followed the end of the Second World War. From the 1980s, with the emergence of supply-side policies, income policy was relegated to a secondary plan. The advance of globalization, with the entry into the game of emerging economies, with emphasis on China and other Asian countries, encouraged the transnationalization of companies, the expansion of the so-called global value chains, the parallel development of the financial sphere, and the free movement of capital, goods, and people, beyond all previously known limits. If, on the one hand, these changes allowed new economic vitality, on the other hand, they limited income progression in advanced economies, leading to greater concentration of wealth. A European economic recovery plan in the spirit of the Marshall Plan needs to be free of the current dominant references of economic thought, subordinated to simplistic reasoning of competitiveness-costs, and adopt a production-income logic that ensures the medium to the long-term stability of demand. This European plan has to include and coherently integrate the different national plans. The financing that is necessary to combat the pandemic and to respond to the economic breakdown is not compatible with the traditional and limited mechanisms, nor with the simple relaxation of the rules of the Stability and Growth Pact. Deficits and debts will skyrocket, which will require very long-term financing to be supported either by the ECB’s monetary policy or by common debt issuing, something that has been done under the name of unconventional monetary policy. And inflation is the “least bad” thing that can happen to the economy, given the prospect of “biblical destructions” (Draghi 2020), or a collapse of the European project.

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5 The Monetary Policy Reform In January 2020, the ECB opened a review process of the monetary policy strategy (ECB 2020b). This review, which was initially planned to take place throughout 2020 and later extended to 2021, was conceived to cover a range of issues such as the quantitative formulation of price stability, the set of monetary policy instruments, economic and monetary analysis, and communication practices. Other matters such as financial stability, environmental sustainability, and employment were to be considered as well, which was a subtle way of linking monetary policy to a broader concept of economic policy. This review decision follows a relatively long period of ECB practices in which the traditional stance has been called into question (e.g. Draghi 2012, 2017; ECB 2019).

5.1 Rethinking Monetary Policy: Tools and Targets The quantitative formulation of the inflation target, set by the Governing Council of the ECB at a first stage as “below 2%”, and, following the strong disinflationary trends caused by the 2008–2009 crisis, as “below, but close to 2%”, is currently, in a context of deflationary threats, defined as “symmetric convergence at 2%”. The evolution thus revealed is towards favouring a medium- to long-term approach, seeking to incorporate the possibility of alternating periods of inflation above and below 2%, to maintain an average of 2%. Given the recent experience of low inflation, it is questionable whether it makes sense to place it at the centre of monetary policy as a primary goal. In a logic of greater integration of monetary and fiscal policies, it is reasonable to prioritize growth and employment goals and to ease the inflation target. Acknowledging the urge to restore growth and income stability, the inflation target should be put at a secondary level at the current stage of the euro area economy. Moreover, it is critical to rethink the instruments used by the ECB to manage the money supply. After 2008, in order to ease credit conditions and ensure the functioning of the monetary transmission in the context of a “liquidity trap”, the ECB and other central banks adopted the fixing of the interest rate. The experience has shown that the setting of the interest rate is a better way to monitor the achievement of predefined macroeconomic goals. Another matter of concern is whether the ECB should leave to commercial banks the prerogative of money creation through loans and the constitution of reserves, or introduce other forms of money creation, such as through the financing of public investment. The ECB must assume its role as the creditor of last resort, including financing fiscal policy, especially regarding public investment. Evaluating the recent experience of the private financial sector, there is no valid reason—neither theoretical nor practical—to justify the discrimination of the public sector, as long as adjusted rules and control mechanisms can be established.

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To overcome current constraints, the ECB must continue to use the instruments of unconventional monetary policy, particularly the direct channels of relationship with economic agents, to ensure that its goals are achieved (efficacy), good instruments are used (efficiency), and the results are sustainable (effectiveness) (e.g. Mendonça 2017). Its statutes should be adapted accordingly. In parallel to the measures mentioned above, monetary and fiscal policy must be considered in their interactions, converging to an integrated and comprehensive macroeconomic policy within the space of the monetary zone, evaluated by the degree of fulfilment of predefined macroeconomic goals. More doubtful is the link between monetary policy and selective policy options as the green or digital economy, as recently defended. In our view, this is a macroeconomic policy matter lato sensu, and not for the monetary policy alone. Monetary policy is meant to accommodate macroeconomic goals, and not to replace policies that, in principle, are better suited to manage specific issues. Finally, in the context of a transnational, asymmetric, and multigovernmental monetary zone with fragmented fiscal policies, as is the case of the euro area, the degree and quality of Central Bank independence should be reconsidered. In the case of the United States, there is a federal government, an integrated fiscal policy, and a National Congress to which the Central Bank must present semi-annual reports on the conduct of monetary policy. In the case of Europe, mixed feelings arise. On the one hand, the ECB should move closer to the American model, integrating monetary and fiscal policy in a more convergent logic, without losing the respective and necessary independence. On the other hand, the ECB’s independence was crucial for the adoption of unconventional policies that saved the euro area from an economic catastrophe, notwithstanding the dominant tightening speech. The new ECB model will be the outcome of how European institutions and their reform evolves. Despite the changes that occurred in the post-2008–2009 crisis period and the positive impacts that monetary policy brought to the economic context, many problems persist; in particular, growth anaemia that amplifies all the other problems related to the initial architecture of the single currency. For example, the persistence of high interest rate differentials concerning public debt is unacceptable, as this situation asymmetrically benefits and jeapardizes economies that share the same currency. Nevertheless, it is also true that this was a fertile innovation period that needs to be evaluated and introduced in the “toolboxes” of monetary and macroeconomic policy in general. It is especially necessary to discuss how to strengthen the articulation of monetary and fiscal policy to overcome the limitations of the “liquidity trap” into which economies have fallen in the context of the “zero lower bound” and, more recently, of negative interest rates. The revision of the monetary policy strategy announced by the ECB should be an opportunity to correct the weaknesses of the architecture of the euro system that have been preventing the single currency from being an efficient internal and external adjustment mechanism, and that transformed the 2008–2009 crisis into a highly asymmetric shock that hindered economic recovery.4 Under the presidency of 4 For

a more in-depth discussion of this subject see Stiglitz (2016).

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Mario Draghi, the ECB was able to reinvent itself through unconventional monetary policy, becoming the real support of the post-crisis European economy until the COVID-19 crisis and thereafter. The ECB’s independence must be reinterpreted in the sense that it cannot be captured by any country, no matter how large its weight in the single currency. Independence must be understood as the capacity to recognize the interest of the euro area as a whole, considering differences between countries and safeguarding the overall consistency of monetary policy with the integrated macroeconomic goals. The ongoing review of the monetary policy strategy is a unique opportunity to adjust the ECB’s rules and statutes to what has been the practice of unconventional monetary policy, freeing it from the attachments that prevent it from exploring its full potential and preparing it for the economic transformation that the euro area needs in order to consolidate and assert itself. The ECB needs to be more oriented towards stimulating growth, employment, and economic cohesion, aware of euro area imbalances, and less concerned with inflation, which, in the current phase of the European and world economy, is not a problem.

5.2 Rethinking Public Debt in the Long-Term The measures to combat the economic and social crisis from COVID-19 will inevitably produce deficits and increase public debts. The problem is even more serious within the euro area since, in the wake of the 2008–2009 crisis, debts have escalated unequally, projecting themselves until the present moment, and creating an asymmetry that undermines economic recovery. However, without expansionary fiscal policies at the national and euro area levels one cannot think of a wide economic recovery that can promote sustained growth. As with the Marshall Plan, financing the European economic recovery must be seen from a long-term perspective, which implies a new approach to deficits and public debts (a discussion in greater depth can be found in Kelton 2020). First, current debt levels should not be a gate-keeping factor to access European funds by countries of either the European Union or the euro area, nor should it imply the adoption of tightening policies in the medium or long term, as happened in the previous crisis. Second, Europe’s economic recovery plan must include a restructuring of public debts, which comprises extending repayment terms and the ECB’s guarantees that there will be no discrimination in the access to finance by different countries. Third, a process of mutualization of the euro area debt should be prepared, starting with new debt from the post-COVID-19 economic recovery plan and being progressively extended to total debt contracted after the operation of the single currency period. In this perspective, a Euro Area Public Debt Agency should be created within the framework of a common macroeconomic policy that includes mutualized debt management. Finally, and as a corollary, the ECB must be called upon to play its role as the creditor of last resort. This stand is in line with what turned out to be the economic needs of the 2008–2009 post-crisis period, namely concerning the

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malfunctioning of the monetary policy transmission mechanism. There is no reason to defend that money creation should be linked only to commercial banks interventions and not to the economic policy options of each member state, provided that adequate mechanisms of control and supervision are created.

6 Conclusions The COVID-19 crisis risks being a structural turning point for the global economy, questioning everything accepted as normal until now. It should be an opportunity to rethink the European integration project in depth. First, its priority goals should be growth and employment, economic and social cohesion, and an income policy oriented to rebuilding the dynamics of an innovative middle class, with interest in macroeconomic results and a strong democratic and European culture. The European Union and the euro area must recover the foundational ambition of a long-term Development Plan—a plan designed at the European scale, but that can reconcile and integrate the strategic plans defined at the national scale. In this framework, a general principle of flexibility should be introduced that takes into account countries’ idiosyncrasies and their needs for different periods of adjustment. The founding idea of a European Union and a euro area, as a tool for deepening the European identity and building a common interest, must be redeemed. The relationship between enlargement and deepening should be managed with care, by accepting the principle of different speeds and adjusting institutions accordingly, allowing to accommodate different situations, such as Brexit. Regarding the global economy, Europe should assume an active role, striving to be a leader. It is important to strengthen ties with developing countries and reinvigorate the role of international institutions. At this level, it is justified to promote a major international conference in which the theme of inequalities, growth, and governance of the global economy should be central. The ongoing review of the monetary policy strategy should be an opportunity to correct the initial architecture of the euro system. The euro should be an instrument to correct asymmetries, which implies integrated macroeconomic management of the monetary zone, taking into account differences between countries. For this, priorities must be reviewed, recognizing that inflation is not a central problem at the moment, and that growth and employment demand more attention. The integration of monetary, fiscal, and income policies, within the framework of overall macroeconomic management of the euro area, should be a priority. Accordingly, a European ministry of economy and finance should be created, with competences and abilities to intervene both in the currently prevailing framework and in the long-term strategic planning. The ECB statutes should be revised to incorporate the unconventional monetary policy, including the possibility of financing the public sector following specific supervisory rules and mechanisms. Accordingly, the ECB must assume the role of creditor of last resort.

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A process of mutualization of public debts must be discussed, including the restructuring of the current debt, with the extension of maturities and amortizations in line with the evolution of growth in each country. Under no circumstances should the current amount of debt be a differentiation condition for access to funding within the framework of Europe’s economic recovery plan or other programs that may be launched. To summarize, European policy makers should (i) give priority to growth and employment; (ii) promote long-term economic sustainability based on integrated macroeconomic policies, the reduction of wealth concentration, and the reconstitution of strong middle classes; (iii) reorientate international relations into a perspective of cooperation; (iv) reinforce regulation and global governance; and (v) eliminate exceptional situations, such as offshores, tax havens and ways to evade economic controls. The COVID-19 crisis can be the opportunity to rebuild the European project with more solid foundations and with renewed goals to meet the new challenges of social and economic development.

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Mendonça A (2017) The unconventional monetary policy of the ECB and the international crisis: effectiveness versus exhaustion. In: Costa Cabral, et al (ed). The Euro and the Crisis: Future Perspectives for the Eurozone as a Monetary and Budgetary Union. Springer International Publishing, Switzerland, pp 223–247. Mendonça A (2018a) Portugal, Spain, the Euro and the International Financial Crisis. Lusíada. Economia & Empresa, (II, 24): 31–55. Mendonça A (2018b) A few notes on the economic and financial crisis in the Eurozone and the role of the European Central Bank. In: Caetano, J. M. and Rocha de Sousa, M. (ed) Challenges and Opportunities for the Eurozone Governance. Nova Science, New York, pp xiii–xix. Mendonça A (2019) A caminho de uma recaída da economia mundial? Ainda algumas notas sobre a natureza da crise económica e financeira de 2008–2009 e os seus impactos na economia europeia. Lusíada. Economia & Empresa, (II, 26): 31–66. Mendonça A (2020) Coronacrise 2020: Que crise?. Lusíada. Economia & Empresa, (II, 28): 11–42. Solt F (2016) The standardized world income inequality database. Soc Sci Q, 97.5: 1267–1281. Stiglitz J (2016) The Euro: How a Common Currency Threatens the Future of Europe. W.W. Norton, New York – London.

António Mendonça is a Professor of Economics at the School of Economics and Management— University of Lisbon (ISEG–ULisboa). President of CEsA—Centre for African and Development Studies. Director of the Master’s in International Economics and European Studies. Coordinator of the Scientific Area of International Economics and Development. Research fields: Macroeconomics, International Economics, International Financial Economics. Invited Professor in France, Bulgaria, Brazil, Angola and Cape Verde. President of the Regional Board of Centre and Alentejo of the Portuguese Economists Council. Former Minister of Public Works, Transport and Communications. Former Dean and President of the School Council. Sofia Vale is an Assistant Professor at the Department of Economics of ISCTE—Instituto Universitário de Lisboa and a member of BRU—Business Research Unit. Her current research interests are on macroeconomics, growth, income distribution, and households’ wealth. She has published in journals such as Economic Modelling, Empirical Economics, and Journal of Economic Studies.

From Deadlocks to Breakthroughs: How We Can Complete the Banking Union and Why It Matters to All of Us Karen Braun-Munzinger, Jacopo Carmassi, Wieger Kastelein, Claudia Lambert, and Fatima Pires

Abstract The establishment of the banking union was a crucial step for European integration and for the Economic and Monetary Union. Together with stronger capital and liquidity requirements under the European single rulebook, the introduction of the Single Supervisory Mechanism and the Single Resolution Mechanism, alongside new macroprudential tools, made the banking system more resilient and better prepared for crises. The banking union facilitated a fast, strong and coordinated response to the unfolding coronavirus (COVID-19) crisis that would have been unthinkable in the institutional setting existing in 2008. At the same time, the banking union is still incomplete and progress is needed: there is no European deposit insurance scheme, the backstop to the Single Resolution Fund has to become operational, and we need a common framework for the provision of liquidity to banks in resolution, as well as adjustments to the crisis management framework. Additionally, despite progress until 2015, financial integration within the euro area has not improved in recent years. Synergies between the banking union and other policy initiatives, such as the capital markets union, could further improve financial integration to the benefit of the European project and European citizens. Keywords Banking union · Regulation · Financial stability · Financial integration · Capital markets union

K. Braun-Munzinger · J. Carmassi · W. Kastelein (B) · C. Lambert · F. Pires European Central Bank, Frankfurt, Germany e-mail: [email protected] K. Braun-Munzinger e-mail: [email protected] J. Carmassi e-mail: [email protected] C. Lambert e-mail: [email protected] F. Pires e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_4

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1 Introduction Banking is a powerful driver of economic development. But banking is also inherently vulnerable to crises, and the costs of that fragility do not necessarily fall most heavily on those who cause it or those able to influence risk-taking. For example, cross-border banking offers benefits in terms of financial integration, but it may also create negative spillover effects across countries if there are no adequate rules and proper oversight. Recognising this, jurisdictions have, over time, introduced standards for banks in their economies, aiming to prevent costly bank failures. But these national rules proved insufficient to deal with failures of banks with significant cross-border activities—and in Europe they fell far short of what was needed in an economic and monetary union (EMU). This is because banking crises can be propagated more strongly when there is greater integration: distress of banks in one Member State can have a direct impact on the economy of another Member State, if the banks operate across borders—so market openness has to be accompanied by common and robust standards that are credibly enforced. This need is reflected in the single rulebook and the role given to European supervisory authorities to ensure its sound application, as well as governance measures to ensure cooperation and joint decision-making through college structures. A banking crisis could also trigger an economic crisis in the banks’ home jurisdiction which, in an EMU, could affect other Members States—a potentially even greater risk. To deal with this interdependency, a stable set-up requires a centralised approach to supervision and resolution, as well as institutional agreements on backstops when other tools have been exhausted, building on common standards. Together, these elements form the banking union: a common regulatory framework founded on the single rulebook aims to ensure banks are resilient; institutional structures deliver common supervision and resolution; and back-up arrangements are put in place (still incomplete) that offer additional safeguards when supervision and resolution tools are not enough. This chapter will first review the origins of the banking union and then progress up to July 2020, including in the context of the coronavirus (COVID-19) crisis. Then, we will focus on areas where more work is needed to complete the banking union. Finally, we will discuss euro area integration and explain how initiatives such as the capital markets union complement and reinforce the aims of the banking union.

2 The Origins of the Banking Union The banking union would likely not exist in its current shape if not for two formative events: the 2007–2009 global financial crisis and the 2010–2012 sovereign debt crisis in the euro area. After the collapse of Lehman Brothers, faced with the dilemma of whether to impose a high cost on public finances or trigger systemic repercussions in the event of the collapse of a financial institution which, in turn, would likely

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lead to yet higher public costs, governments and public authorities were left with no options but to intervene and provide extensive support. Even so, the macroeconomic costs of the recession triggered by the banking crisis were substantial. The bailouts prevented further economic harm, but inflicted a large burden on public finances and exacerbated the “too-big-to-fail” problem. It was clear that banking required substantially stronger supervision and regulation, including with a macroprudential scope, which led to a first wave of regulatory and institutional reform in the EU, following agreement on a fundamental reform of banking regulation at the international level. The 2010–2012 euro area sovereign debt crisis highlighted the dangers of excessively close interlinkages between banks and sovereigns. Bailouts have a negative impact on public finances and may trigger or exacerbate a sovereign debt crisis. In turn, banks can be affected by a sovereign debt crisis, directly should they hold sovereign debt, and indirectly as a downturn in the economy negatively impacts the value of domestic bank assets. Thus, weak banks and weak sovereigns may amplify each other’s problems in a bank-sovereign “doom loop” (Farhi and Tirole 2018). In a monetary union such as the euro area, such problems can spill over national borders.

2.1 The Two Crises Highlighted the Need to Equip the EU with a Stronger Financial Architecture The two crises underlined the institutional shortcomings in the EU, and particularly in the euro area. The governance arrangements, mandates and tools were not appropriate for cross-border banks. Despite the increasing interconnectedness of financial systems, regulation and supervision had remained predominantly areas of national competence, and, even at the national level, incomplete (e.g. an effective bank resolution framework was generally lacking), leading to a “financial trilemma” (Claessens et al. 2010; Schoenmaker 2011): financial stability and financial integration cannot be combined with national financial policies—only two of the elements can be combined, while the third must be dropped. National supervisors did not have the full picture, which made it difficult for authorities to identify all risks. Even where authorities could identify risks, they might not have the right mandate or incentives to take into account and mitigate risks to other Member States. There was also concern that national authorities might exercise forbearance when it came to taking measures for “national champions” facing a crisis. As banking had become cross-border but controls and rules had remained mostly areas of national competence, decision-makers agreed that alignment at the European level was needed to tackle the risks to financial stability stemming from the asymmetry between bank activity across European and international borders and the design

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Fig. 1 Overview of banking union key events. Notes See Footnote 3 for an explanation of some of the acronyms used in this figure. “CMU” refers to capital markets union

of regulation and supervision which was still largely a national competence.1 Moreover, in order to break the bank-sovereign doom-loop, measures to deal with ailing banks should be channelled via a European entity, not via national governments. Reflecting this need, in a Euro area summit statement published in June 2012, euro area leaders proposed that the European Stability Mechanism (ESM) could have the possibility to recapitalise banks in the euro area directly with a precondition of establishing an effective Single Supervisory Mechanism (SSM), involving the European Central Bank (ECB). A wider vision was set out in the Four Presidents’ report, also published in June 2012 (European Council 2012). These documents paved the way for the creation of the banking union, a framework in which banking-sector policy is conducted at the European level consisting of three pillars: (1) supervision under the SSM, (2) common resolution arrangements under the Single Resolution Mechanism (SRM), and (3) a European deposit insurance scheme (EDIS)—all underpinned by a single rulebook of harmonised rules at the European level. Section 3 explores progress in these areas.

3 Banking Union: What Has Been Achieved so Far? The legal foundation of the banking union is the series of legislative texts that were adopted in 2013 and 2014. The first pillar is based on the SSM Regulation (SSMR) and the second on the SRM Regulation (SRMR). The third pillar—EDIS—is not yet in place and is discussed in Sect. 4. Figure 1 provides a timeline of key events on the

1 Policy-makers

and scholars were aware of the challenges posed by this asymmetry before the global financial crisis (see, for example, Nieto and Schinasi 2007).

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banking union. From a regulatory perspective, the single rulebook has harmonised the banking regulatory framework across the EU.2

3.1 The First Pillar of the Banking Union: A European Approach to Banking Supervision The SSM became operational in November 2014, only two years after the presentation of the European Commission proposal in September 2012. The scope of the SSM—and of the banking union—included at its inception all euro area Member States. EU Member States outside the euro area may also join through a “close cooperation” agreement between the ECB and national competent authorities (the first close cooperation agreements were announced in July 2020, simultaneously for Bulgaria and Croatia). The SSMR has tasked the ECB with a wide range of microprudential supervisory functions, as well as assigning it macroprudential powers (see Fig. 2). Microprudential policy aims to safeguard the stability of individual financial institutions, and is complemented by macroprudential policy which is focused on preserving the stability of the financial system as a whole. With regard to microprudential powers, the ECB is responsible inter alia for the authorisation of banks, for ensuring compliance with European rules on prudential supervision, for consolidated supervision, for carrying out prudential evaluations, including stress tests, for carrying out supervisory tasks related to recovery plans and for early intervention measures. On the macroprudential side additional capital buffers, such as the capital conservation buffer and the countercyclical capital buffer, and other macroprudential requirements were introduced to mitigate the excessive build-up of risk owing to external factors and to make the financial sector more resilient. Both the ECB and national authorities play an important role. National authorities must notify the ECB of their intention to impose macroprudential buffers (e.g. countercyclical capital buffer) or other macroprudential requirements, to which the ECB can object. The ECB may also decide to apply higher requirements for capital buffers or more stringent requirements than those applied by the national competent authorities (sometimes referred to as “top-up” macroprudential powers) to ensure that systemic risk is adequately addressed at the SSM level (Article 5 of the SSMR). The SSM is not composed of a single entity but is rather a mechanism for cooperation between the ECB and national supervisors. The ECB has been entrusted with direct banking supervision of significant institutions which comprise the most relevant credit institutions in each participating Member State (see Article 6, SSMR for 2 These common rules encompass prudential capital requirements through the Capital Requirements

Regulation (Regulation EU No 575/2013, CRR) and the Capital Requirements Directive (Directive 2013/36/EU CRD), rules on bank crisis resolution (through the Bank Recovery and Resolution Directive, Directive 2014/59/EU, BRRD) and rules on deposit guarantee schemes (through the review of the Deposit Guarantee Schemes Directive, Directive 2014/49/EU).

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EU ECB (euro area / SSM countries) SSM (incl. national authorities) Macroprudential policy Financial stability

European Systemic Risk Board (ESRB)

Monetary policy Price stability Microprudential policy Soundness of individual banks

ESAs: EBA, ESMA, EIOPA

Fig. 2 Selected components of the EU institutional framework. Notes “ESAs” refers to European Supervisory Authorities; “EBA” refers to European Banking Authority; “ESMA” refers to European Securities & Markets Authority; “EIOPA” refers to European Insurance and Occupational Pensions Authority. Source Based on Constâncio et al. (2019)

details on how significant institutions are identified). The other banks, called less significant institutions fall under the direct supervision of national supervisors. For these banks, the ECB retains some powers, e.g. it can issue regulations, guidelines and instructions to national supervisors and it can take over direct supervision from the national competent authority where necessary to ensure high supervisory standards. In terms of governance, a Supervisory Board has been established within the ECB. The SSM is separated from the monetary policy arm of the ECB, to avoid possible conflicts between supervisory and monetary policy objectives. The SSM introduced consistent supervision and a common approach to ensure the safety and soundness of the European banking system. As shown in Fig. 3, the key risk metrics for significant institutions in the banking union have all significantly improved since 2014. For example, the treatment of non-performing loans (NPLs), i.e. loans that borrowers have not been able to repay for some time, has been a supervisory priority for the SSM and one where sustained supervisory effort and issuance of guidance saw strong progress. The ratio between NPLs and total assets has significantly decreased from 2014 to 2019. Figure 3 also shows that, overall, capital resources of banks in the banking union have substantially increased since the inception of the banking union. Capital plays the key role of absorbing losses: the stronger the capital position of a bank, the

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(Quarterly data; Q4 2014 – Q4 2019) 12%

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Fig. 3 Key risk metrics for significant institutions in the banking union (Quarterly data; Q4 2014– Q4 2019). Notes The net NPL ratio is the ratio of NPLs and advances, net of allowances and credit risk adjustments, to total net loans and advances. Common shares and retained earnings are the key components of CET1 capital. The CET1 ratio is calculated with reference to risk-weighted assets, a risk-based measure of the riskiness of a bank’s assets. CET1 capital is part of Tier 1 capital, to which additional Tier 1 capital instruments also contribute. The leverage ratio is calculated as Tier 1 capital over the so-called leverage exposure measure, which takes into account both on-balancesheet and off-balance-sheet exposures. Unlike capital ratios that refer to risk-weighted assets, the leverage ratio is an unweighted measure of a bank’s capital strength. The liquidity coverage ratio is the ratio between the stock of high-quality liquid assets, consisting of cash or assets that can be converted into cash with little or no loss of value in the markets, and the expected liquidity needs for a 30-calendar-day liquidity stress scenario. Source European Commission Services, ECB, SRB (2020)

stronger is its financial situation and its resilience to shocks.3 This will help the bank to better support the real economy and to continue to do so even in a crisis. Finally, liquidity ratios have also increased and remained strong over the same period. While the supervisory pillar is well advanced, the framework needs to keep pace with financial stability risks, particularly for the macroprudential side as we gain experience with the post-crisis toolkit. Additionally, European implementation of the finalised Basel III package is outstanding—this will further strengthen the prudential rulebook. And as the framework matures, measures to make risk-sharing across borders easier—for example through giving the SSM flexibility to apply capital and large exposure waivers—would be desirable, while providing host countries with adequate safeguards. Furthermore, more harmonisation is needed in areas such as the “fit and proper” tests to assess the suitability of banks’ board members.

3 The SSM also carried out a targeted review of internal models, which aimed to ensure that the use

of such models does not lead to heterogeneous capital requirements across banks for the same risks and the same portfolios.

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3.2 The Second Pillar of the Banking Union: Banks Can Exit Without Disruption The creation of the second pillar of the banking union, the SRM underpinned by the bank crisis resolution framework, has considerably strengthened the European crisis management framework. The introduction of special resolution tools, including the bail-in tool, enables authorities to resolve a bank in an orderly manner and without using taxpayers’ money. The SRM introduced a single, centralised system for bank resolution for Member States participating in the banking union. The goal of the SRM was to address “divergences between national resolution rules in different Member States and corresponding administrative practices and the lack of a unified decision-making process for resolution in the banking union” in order to “ensure the predictability as to the possible outcome of a bank failure” (Recital 2 of the SRMR). The SRB is at the core of the SRM and endowed with a Single Resolution Fund (SRF) which serves the purpose of financing resolution actions. The BRRD introduced a common set of resolution tools which was made available to the SRB via the SRMR. This toolkit includes: (i) the possibility for the resolution authority to sell a failing bank, or parts of it, without shareholders’ approval; (ii) the possibility of creating a bridge bank to preserve the “good” parts of a bank in resolution and its systemically important functions, with a view to selling it in the market; (iii) the option of bailing in shareholders and creditors, i.e. reducing the value of an ailing bank’s capital or debt or converting debt claims into equity; and (iv) an asset separation tool, allowing the resolution authority to take out bad assets of a bank’s balance sheet (but, only in conjunction with one or more other resolution tools, to ensure restructuring and avoid breaching state aid rules). In order to make the bail-in tool effective and credible, a minimum requirement for own funds and eligible liabilities (MREL) has been introduced, to ensure that sufficient resources are available if the tool is used. MREL targets aim to ensure the resolvability of a bank by requiring it to hold a minimum amount of capital, subordinated debt and other unsecured debt—creating a cushion both to absorb losses and to recapitalise the bank in resolution. The BRRD required the setting-up of national resolution funds in Member States, while the SRMR created the SRF, which replaced national resolution funds for Member States participating in the banking union. The goal of these national funds and the SRF is not to rescue the shareholders of the failing banks, but instead to facilitate the implementation of resolution actions, for example, by providing resources to capitalise a bridge bank. Consistent with the overarching principle that the private sector should take a fair amount of first losses, the resolution fund can be used only after shareholders and creditors have borne losses amounting to at least 8% of total liabilities and own funds. The contributions from the funds are also capped at a maximum of 5% of total liabilities and own funds. The SRF pools contributions from credit institutions in the banking union and has a target size of at least 1% of the total covered deposits of all authorised credit institutions in participating Member States,

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which must be reached by the end of 2023 (the corresponding amount should be about e 70 billion; as at July 2020 the collected amount stood at e 42 billion). Initially organised into national compartments for eight years, the SRF is being progressively mutualised, on the basis of an intergovernmental agreement. The establishment of the SRM, with the SRB and the SRF, has aligned responsibility and control at the banking union level so that resolution actions will now be taken at the same level as supervisory actions (on complementarities between supervision and crisis management, see Angeloni 2020). In this context, the pooling of contributions to the SRF from banks across the banking union area ensures that the financing of resolution actions is carried out at the banking union level. Although the number of resolution cases has been very limited to date and the new framework has not yet been tested by a severe crisis, the ability of the banking system to withstand shocks has substantially improved given the increase in loss-absorbing capacity, which enhances the strength of the bail-in tool, and the availability of additional resources from the SRF (Carmassi et al. 2019).

3.3 The Banking Union Proved Its Value in the COVID-19 Pandemic, Facilitating a Swift, Unified and Coordinated European Response The COVID-19 pandemic highlights the importance of the banking union. While the ultimate consequences of the COVID-19 crisis remain uncertain, the euro area was in a very different situation at the COVID-19 outbreak than at the onset of the 2008 financial crisis. The policy toolkit and governance framework of the banking union allowed the SSM to take a number of crucial policy decisions swiftly, which had a major impact on the banks’ ability to withstand potential losses while continuing to be able to serve the real economy by providing credit to households and viable businesses and corporates hardest hit by the economic fallout. For instance, these measures included dividend restrictions and the possibility of operating below capital and liquidity buffers. This was achieved by using the flexibility available within the framework without undermining the previously agreed reforms. The fact that decisions were taken at the banking union level increased coherence, consistency and coordination. This has been of the essence to ensure an effective response, avoiding a patchwork of different national measures and a high degree of fragmentation of actions along national lines, as happened in the 2007–2009 financial crisis.

4 Completing the Banking Union The lack of the third pillar—EDIS—is probably the most glaring shortcoming of the current banking union architecture. Under the current framework, national deposit

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guarantee schemes (DGSs) remain in place. After the 2007–2009 financial crisis, the DGS Directive was revised to foster harmonisation across Member States. While harmonisation has certainly helped to strengthen the effectiveness and credibility of national deposit insurance funds and goes some way towards facilitating crossborder banking, retaining deposit insurance at the national level is not the optimal arrangement within the banking union for several reasons. A European scheme and fund may be less vulnerable to local and systemic shocks than national schemes and funds. In a crisis requiring a given amount of financial resources, a national deposit insurance fund might be exhausted sooner than a European deposit insurance fund. The European fund would be larger in absolute terms, would benefit from the pooling of resources at the European level, and would reap diversification benefits. It could also help to tackle the bank-sovereign nexus, because the exhaustion of a national deposit insurance fund could require a public intervention at the national level to protect depositors. Moreover, with national schemes only, depositors could perceive there to be differences in the protection for deposits related to the fiscal strength of the sovereign—which would jeopardise the level playing field within the banking union. Uniform depositor protection, regardless of where a bank is located in the banking union, would increase depositor confidence in the safety of their deposits, which in turn would better protect banks against funding shocks, contribute to financial stability and promote financial integration. In addition, a centralised European mechanism would also help to minimise coordination costs, thereby allowing swift actions in times of crisis (as done by common supervision at the onset of the COVID-19 pandemic), and it would ensure that the responsibility for deposit insurance is aligned at the same level as responsibility for supervision and resolution. This would mean that the level which is responsible for bearing costs in a crisis is also the level that has oversight responsibility before a crisis materialises. The current misalignment needs to be urgently corrected as it could lead to national DGSs having to bear the costs of decisions taken at the banking union level by the SRB. In 2015, the European Commission published a proposal to establish an EDIS, with a European deposit insurance fund which would reach in the steady state (by the end of 2023) a target size of 0.8% of covered deposits in the banking union. The proposal entailed a progressive mutualisation of the scheme’s resources in three stages: first reinsurance, then co-insurance and ultimately a fully fledged scheme to be introduced in 2024. In the first phase—reinsurance—national DGSs would be first in line to cover pay-outs and losses, while EDIS would cover liquidity needs and losses only after national funds are exhausted and subject to certain caps. In the second phase—co-insurance—pay-outs and losses would be shared between the relevant national DGS and the European deposit insurance fund both contributing on a pro-rata basis, with an increasing share for the European fund relative to the share of the national DGS. In the final stage, EDIS would be fully fledged, providing full insurance for both liquidity and losses. The fund would be built up gradually over time with banks’ contributions being calculated on the basis of their risk profile, following a “polluter-pays” approach. EDIS would be managed by the SRB.

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Discussions ended in a deadlock, however, owing to fundamentally divergent views between Member States regarding the appropriate degree of risk-sharing and the correspondingly necessary degree of risk reduction. Some Member States argued that further risk reduction should be carried out before embarking on mutualisation of risks. There were concerns that some Member States—or, more precisely, the banking systems in some Member States—might be called upon to pay for bank failures in other Member States, triggering some form of cross-subsidisation across countries within the banking union, which in turn would create moral hazard issues. To avoid such a situation, it was proposed that further progress should be made on measures to reduce risks before moving to risk-sharing via an EDIS. Proposed risk reduction measures included further reductions of NPLs, the building-up of bank capital and of MREL cushions, and changes to the regulatory treatment of sovereign exposures. Other Member States have argued that the degree of risk reduction already achieved is sufficient to move ahead with risk-sharing and that EDIS should therefore be established as soon as possible, while risk reduction could continue in parallel. The ECB has argued that the dichotomy between risk reduction and risk-sharing is to a large extent artificial and that these two goals are rather mutually reinforcing (Draghi 2018). In order to try to break the political deadlock resulting from these opposing views, in October 2017 the European Commission published a communication (European Commission 2017) outlining a more gradual approach under which in the reinsurance phase EDIS would provide higher liquidity coverage but no loss coverage. In addition, the transition to the co-insurance phase would not be automatic but would be subject to risk reduction conditions, e.g. reduction of NPLs and Level 3 assets. Once these conditions were met, the European scheme would not only provide liquidity but would also cover losses. More specifically, in the co-insurance phase national DGSs and EDIS would both cover losses in parallel while gradually progressing towards mutualisation starting with a 30% contribution from EDIS in the first year. Under this new proposal, full insurance would still be on the table, but the details, timing and path of mutualisation for the move from co-insurance to full insurance were not specified. However, even this proposal for a more gradual approach did not succeed in breaking the deadlock. Several other proposals were put forward by policy makers as well as economists (e.g. Bénassy-Quéré et al. 2018; European Parliament 2016; Garicano 2019; Schnabel and Véron 2018; Schoenmaker 2018). Most of these proposals argued in favour of a reinsurance mechanism whereby the European deposit insurance fund could only be tapped once national funds are exhausted.4 The key rationale behind this approach was the attempt to tackle the potential moral hazard which could be created by an EDIS. Several of the proposals called for country-specific risk components (e.g. the

4 Schoenmaker

(2018), however, made the point that keeping national compartments in a European deposit insurance system might trigger destabilising effects in a crisis: once the national compartment was exhausted, banks surviving the crisis would be called upon to replenish the fund, which could prove burdensome especially in a time of crisis.

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Not in place

Pillar 1: Single Supervisory Mechanism • •

Establishment of the SSM Capital requirements (CRR/CRD)

•

•

Strengthened mechanisms to balance the interests of home and host supervisors of cross-border banking groups Further regulatory harmonisation

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Establishment of the SRM Adoption of the BRRD

• • • •

Backstop to the SRF: agreed, to become operational Adjustments to crisis management framework Provision of liquidity in resolution A harmonised framework for liquidation of banks of all sizes

Pillar 3: European deposit insurance scheme •

Harmonisation of standards for national deposit guarantee schemes

•

European deposit insurance scheme

Fig. 4 State of play as regards banking union. Source Based on Tordoir et al. (2020)

quality of the insolvency framework) to be included in the calculation of risk-based contributions to the European deposit insurance fund. As the deadlock continued, a High-Level Working Group (HLWG) on EDIS was established in 2019, under the aegis of the Eurogroup Working Group, with the goal of breaking the stalemate. At the end of 2019, the Chair of the HLWG sent a letter to the President of the Eurogroup (HLWG 2019) outlining a roadmap for political negotiations. This roadmap included, inter alia, the gradual implementation of EDIS through a hybrid model, providing liquidity support within certain limits and possibly with a gradual increase in loss coverage in line with progress made on risk reduction. This component would be accompanied by, among other things, improvements to the crisis management framework and possible changes to the regulatory treatment of sovereign exposures. At the time of writing (July 2020), the deadlock persists. The stalemate is political in nature. From a technical point of view, for some of the concerns raised on the establishment of an EDIS it is difficult to identify quantitative evidence to support those fears. On the contrary, empirical analyses have shown that, for example, risks of cross-subsidisation—i.e. some banking systems systematically contributing less to EDIS than they would receive from it—would be extremely limited (Carmassi et al. 2018; Carmassi et al. 2020).

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4.1 Not Only EDIS: Other Elements Need to Be Finalised, Mostly in the Second Pillar EDIS is not the only missing piece (see Fig. 4). As mentioned before, with regard to the supervisory pillar, future areas for improvement include more regulatory harmonisation as well as measures to facilitate free flows of liquidity and capital within the banking union alongside mechanisms to balance the interests of home and host countries. Other elements mostly relate to the second pillar. First, the common backstop to the SRF needs to become operational to ensure the effectiveness and credibility of the resolution framework. In the case of resolution of small numbers of banks, the SRF resources should be sufficient, but in the event of the failure of multiple large banks or a severe crisis, the amounts available via the SRF might not be enough and a further line of defence might be needed. For this reason, European leaders agreed as early as December 2018 on the key features of the common backstop and in December 2019 reached an agreement in principle on the legal documents implementing those key features (ESM 2019a, b). The backstop would be fully operational in 2024 and would be provided by the ESM; the ESM Board of Governors may decide by unanimity, on the basis of a request by the SRB, to grant a loan to the SRB for the SRF, in the form of a revolving credit line; the loan would have a maturity of three years, with the possibility of being extended to five years (although the initial maturity for liquidity support would be 12 months); the size of the backstop would be aligned with the target size of the SRF, but could not be higher than a nominal cap established by the ESM Board of Governors, which would initially be set at e 68 billion; and the backstop resources could be mobilised to support the application of the resolution tools, complementing the SRF firepower. Any recourse to the common backstop would be a last resort, i.e. it could only be accessed after creditors had been bailed in and the SRF had been depleted. The principle of fiscal neutrality over the medium term must be respected, implying that the SRB, also relying on the repayment capacity of the banking system, should fully repay the loans granted by the backstop in the medium term. The agreement of December 2018 also provides for the possibility of an early introduction of the common backstop, i.e. before 2024, but this could only happen if certain risk reduction objectives are met, notably on the reduction of NPLs and the building-up of the MREL. Furthermore, the crisis management framework still requires a viable mechanism for the provision of liquidity to banks in resolution. When banks are placed in resolution, a temporary lack of access to market liquidity may hinder the ability of the institution emerging from resolution to operate successfully. To this end, other jurisdictions such as the United Kingdom and the United States have established public arrangements to provide liquidity to banks in resolution in line with the Financial Stability Board guiding principles that foresee a public sector backstop funding mechanism to promote market confidence (Financial Stability Board 2016). At the banking union level, no comparable arrangement exists yet.

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Both the SRF and the common backstop to the SRF could also provide liquidity support. However, their combined size in the steady state, based on the expected evolution of covered deposits and on the nominal cap for the backstop, could potentially reach, at least in the first few years in the steady state, around e140 billion. This amount, although sizeable, might be insufficient to cover liquidity needs in cases where one or more mid-sized or large banks are in resolution. The ECB could close this liquidity gap, but it can only do so if collateral requirements are met. However, the bank emerging from resolution might lack sufficient high-quality collateral to be able to access the ECB’s liquidity operations. While liquidity assistance can also be obtained from national central banks under the emergency liquidity assistance (ELA), this tool serves a different purpose, which is to provide liquidity support to solvent banks. Additionally, a decentralised solution based on ELA is not optimal because it would not be aligned at the banking union level. In other words, none of the aforesaid solutions are entirely sufficient. The key outstanding issue in identifying additional resources is who would be the ultimate risk-taker. A public sector European/banking union backstop would appear to be preferable to a national backstop as the latter would involve national authorities in a European resolution process and would exacerbate the bank-sovereign nexus. The discussion in the relevant European policy fora is currently still ongoing. Another area for further improvement in the crisis management framework is bank liquidation. When a bank is declared “failing or likely to fail” (FOLTF) and no supervisory or private sector measures are available to restore the bank to viability within a reasonable timeframe, the SRB must assess whether or not the so-called public interest test is met. A resolution action is considered to be in the public interest if: (i) it is necessary to achieve the resolution objectives, including the need to ensure continuity of critical functions, the preservation of financial stability and public finances and the protection of guaranteed deposits, and (ii) normal insolvency proceedings would not meet these objectives to the same extent. If the public interest test is met, then the bank can be placed in resolution under the SRMR rules and procedures, but if it is not met, then the fallback option is for the bank to be wound up in accordance with the applicable national rules (see Article 32b of the revised Bank Recovery and Resolution Directive). This may lead to different outcomes and different treatment of creditors in different Member States. A more harmonised approach to liquidation would avoid this scenario but would require significant changes to national insolvency frameworks. The harmonisation of liquidation frameworks is not the only challenge related to the bank insolvency regime: the current rules leave room for a “limbo” situation after the FOLTF declaration if the public interest test is not met. This situation can materialise when the conditions that triggered the FOLTF declaration are not sufficient to trigger insolvency under the respective national framework. With regard to the inconsistency across national insolvency frameworks, a possible avenue to explore in order to ensure a consistent approach to bank liquidation across Member States could be the establishment of an “orderly bank liquidation tool”, a common insolvency procedure that could be added to the European banking toolkit, following the model of the US Federal Deposit Insurance Corporation (FDIC). The SRB could be assigned the task of managing the liquidation of FOLTF banks that do

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not meet the public interest test. Its functions in this regard could resemble the FDIC liquidation powers, with special administrative (rather than court-based) procedures and tools for bank insolvency.

5 Where Do We Stand on Financial Integration in Europe? The new architecture of banking union in the euro area is an important step towards greater integration. First, the banking union enhances integration by increasing the resilience of banks and ensuring that integration in the banking sector and capital markets leads to better risk diversification, thus preventing the transmission of shocks through the sector. Second, a policy framework that is more conducive to crossborder banking can help to maximise the benefits of integration. Recent analysis also confirms that more centralised supervision endogenously encourages banks to integrate more (Colliard 2020). Banks that are centrally supervised expand their cross-border activities and are more likely to borrow from foreign sources than banks with similar business models but which are supervised at the local level. Following the financial and sovereign debt crisis, and in particular after the announcement of the banking union, there was a strong reintegration trend in the euro area until 2015 (see Fig. 5). But overall, financial integration within the euro area has not improved in recent years. Convergence of asset prices across the euro area has seen substantial volatility. In addition, the post-crisis reintegration of crossborder asset holdings, referred to as quantity-based integration, has stalled since 2015 (ECB 2020). The slight pick-up in the quantity-based indicator in 2019 to levels similar to those seen in 2015 can be explained by slight increases in cross-border interbank lending and bond holdings. Similarly—going beyond assessing financial integration and focusing on the euro area financial structure—we observe that cross-border retail lending gradually increased to levels above those seen in 2015 but was offset by the recovery in cross-border interbank lending (see Fig. 6). Recent empirical studies show that risk-sharing in Europe between Member States works less well compared with risk-sharing between states in large economies such as the United States. Recent analysis shows that in Europe only 20% of shocks to GDP can be cushioned through cross-regional diversification effects, whereas in the United States 60% of the shocks can be mitigated, in particular through risk-sharing via the credit and capital market channel (Pires 2019; Cimadomo et al. 2018). In the euro area, the credit channel played an important role for risk-sharing before the financial crisis and has started to play a bigger role since 2015 for the euro area on average (ECB 2020). There are significant differences across euro area countries and in some countries the contribution to risk-sharing via the credit channel is even negative, limiting their ability to insure against shocks (ECB 2020; Cimadomo et al. 2018). Thus, having a true and complete European banking union with cross-border risksharing, in particular via the credit channel, could strengthen the resilience of the euro

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area economy. This is because cross-border lending and borrowing bring important stability and risk-sharing benefits through their effects on risk diversification. In the past, the dominant view was that banks and capital markets were competing with each other for a limited amount of viable investment opportunities. The rationale behind this is that market-based and bank-based systems each have different comparative advantages and that borrowers will turn to the option that is most beneficial to them. For instance, market-based systems provide cross-sectional risksharing advantages, while bank-based systems have intertemporal risk-smoothing advantages (Allen and Gale 1997). However, the view that banks and markets compete for a limited amount of opportunities lacks strong empirical support (Demirgüc-Kunt and Maksimovic 1996; Song and Thakor 2010). More recent studies show that banking integration and capital market integration are complements (Hoffmann et al. 2019) providing good reasons to view banking union and capital markets union together and to capture the synergies between them. On the one hand, capital markets union creates a diversification channel that helps to smooth out incomes, while consumption via cross-border holdings of financial assets contributes to expanding sources of finance for our economies and ultimately can make banks more resilient. On the other hand, a more resilient and integrated banking system would support the smooth functioning and further integration of capital markets. From a policy perspective, the banking union and capital markets union are the central policies with a high potential to have a positive impact on financial integration. To reap the synergies between banking and capital markets union, progress in related legislative domains, such as insolvency law, company law and tax legislation, is needed. In addition, the continued integration of financial markets calls for European-wide supervision of capital markets with a stronger mandate to address macroprudential concerns. Regulators need to be able to tackle risks that will not stop at national borders, in order to prevent vulnerabilities in the non-bank sector from contributing to systemic risk.

6 Conclusions The banking union was created as a response to the 2008 financial crisis and to the 2011–2012 sovereign debt crisis, and it is an important step towards a genuine Economic and Monetary Union. Owing to the introduction of stronger capital and liquidity rules, the introduction of macroprudential policy tools and the supervisory role of the SSM, “banking union banks” have become stronger and safer. As shown in the context of the COVID-19 crisis, the new architecture facilitates swift and coordinated responses in times of crisis, ensuring the effectiveness of policy actions and avoiding fragmentation and inconsistencies within the banking union. However, despite the remarkable achievements accomplished in its first few years, the banking union project is still incomplete: some key missing elements should be introduced, while other features should be completed or refined.

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Completing the banking union will strengthen the banking system during and beyond the coronavirus pandemic. More integration and better risk-sharing will allow the banking union area to better deal with current and future shocks, both in systemic crises and in the case of idiosyncratic shocks. Furthermore, there are clear synergies with other policy initiatives to catalyse financial integration in the EU, in particular the capital markets union. Strengthening the cross-border dimension of investments provides for increased international risksharing, which can ultimately enhance the resilience of the euro area. The banking union and capital markets union should be treated as two mutually reinforcing initiatives to strengthen the Single Market for financial services, with beneficial effects for the European project and European citizens. Finally, the COVID-19 pandemic poses formidable challenges for the European economy and for European financial integration. Many European initiatives have been adopted or are under discussion. First, e540 billion has been made available for Member States via the ESM, the European Investment Bank and the instrument for temporary support to mitigate unemployment risks in an emergency (SURE), targeted at sovereigns, corporates and workers respectively. Second, the ECB has adopted far-reaching monetary policy decisions—including a e1350 billion pandemic emergency purchase programme (PEPP)—to lower borrowing costs and increase lending in the euro area, always with a view to its primary objective of inflation. Discretionary fiscal measures adopted by Member States have also been very significant; however, a further European coordinated fiscal response was also needed to close the financing gap, which is why European leaders agreed in July 2020 on a e 750 billion Recovery and Resilience Facility. The facility aims to repair the economic and social damages caused by the COVID-19 pandemic, promoting a symmetric economic recovery across Member States and reviving the EU economy for the benefit of all EU citizens. It represents a collective EU response in the spirit of (unprecedented) solidarity and responsibility, a sign of the strength of a united Europe that can face the challenges ahead and emerge stronger from this crisis. Acknowledgements We would like to thank the following people for their useful comments or their assistance with data: Simona Dodaro, Joachim Eule, Wojciech Golecki, Carl-Wolfram Horn, Malte Jahning, Philippe Molitor, Fabian Nemeczek, Maddalena Perretti, Pär Torstensson, Steven de Vries, Florian Walch and Balázs Zsámboki. Any error or omission remains ours. The paper represents our personal opinions and does not necessarily reflect the views of the institutions with which we are affiliated.

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European Stability Mechanism (2019a), Draft guideline on the backstop facility to the SRB for the SRF. Available via: https://www.consilium.europa.eu/media/41668/20191206-draft-bac kstop-guideline.pdf. Accessed 29 July 2020. European Stability Mechanism (2019b), Draft Board of Governors Resolution for the Nominal Cap and the provisions on the procedure for the verification of compliance with the condition of the permanence of the legal framework for bank resolution (version agreed in principle at the Eurogroup meeting of 4 December 2019). Available at: https://www.consilium.europa.eu/media/ 41669/20191206-draft-bog-resolution-1-nominal-cap.pdf. Accessed 29 July 2020. Farhi E, Tirole J (2018), Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops, Review of Economic Studies 85 (3): pp. 1781–1823. Financial Stability Board (2016), Guiding Principles on the Temporary Funding Needed to Support the Orderly Resolution of a Global Systemically Important Bank (G-SIB). Available at: https:// www.fsb.org/wp-content/uploads/Guiding-principles-on-the-temporary-funding-needed-to-sup port-the-orderly-resolution-of-a-global-systemically-important-bank-%E2%80%9CG-SIB% E2%80%9D.pdf. Accessed 29 July 2020. Garicano L (2019), Two proposals to resurrect the Banking Union: the Safe Portfolio Approach and SRB + , Paper prepared for ECB conference on “Fiscal Policy and EMU governance”, Frankfurt, 19 December 2019. High-Level Working Group on EDIS (2019), Letter by the High-Level Working Group on a European Deposit Insurance Scheme (EDIS) Chair to the President of the Eurogroup—Further Strengthening the Banking Union, Including EDIS: A Roadmap for Political Negotiations, Brussels 3 December. Available at: https://www.consilium.europa.eu/media/41644/2019-12-03-letterfrom-the-hlwg-chair-to-the-peg.pdf. Hoffmann M, Maslov E, Sorensen B, Stewen, I (2019), Channels of risk sharing in the Eurozone: What Can Banking and Capital Market Union Achieve?, IMF Economic Review, 67(3) pp. 443– 495, https://doi.org/10.1057/s41308-019-00083-3. Nieto MJ, Schinasi G J (2007), EU Framework for Safeguarding Financial Stability: Towards an Analytical Benchmark for Assessing Its Effectiveness, IMF Working Paper, No WP/07/260, November. Pires F (2019), Non-banks in the EU: Ensuring a Smooth Transition to a Capital Markets Union, Suerf Policy Note, Issue 103. Schnabel I, Véron N (2018), Breaking the Stalemate on European Deposit Insurance. Available at: https://voxeu.org/article/breaking-stalemate-european-deposit-insurance. Accessed 28 July 2020. Schoenmaker D (2011), The financial trilemma. Economics letter, 111(1): pp. 57–59. Schoenmaker D (2018), Building a Stable European Deposit Insurance Scheme, Journal of Financial Regulation, 4(2), pp. 314–320. https://doi.org/10.1093/jfr/fjy004. Song F, Thakor AV(2010), Financial system architecture and the co-evolution of banks and capital markets, Economic Journal, 120(547), pp. 1021–1055. Available at: https://DOI.org/10.1111/j. 1468-0297.2009.02345.x.

Karen Braun-Munzinger heads the Financial Policy and Regulation Division in DG Macroprudential Policy and Financial Stability at the European Central Bank (ECB). She joined the ECB in 2016 from the Bank of England, where she led work on a range of financial stability issues. Previous to that, she worked at HM Treasury, contributing to the government response to the great financial crisis and as one of the Chancellor’s private secretaries. Karen holds an M.Sc. in Economics from Birkbeck College and a Ph.D. in Physics from the University of Oxford, which she attended as a Rhodes Scholar. Jacopo Carmassi is a Senior Financial Stability Expert in the Financial Regulation and Policy Division, DG Macroprudential Policy and Financial Stability, at the European Central Bank. He is a Fellow of CASMEF, the Arcelli Center for Monetary and Financial Studies, University LUISS

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Guido Carli, and of the Wharton Financial Institutions Center, University of Pennsylvania. Previously, he worked as an Economist at Assonime, the Association of Joint Stock Companies incorporated in Italy, and at the Italian Banking Association. He holds a Ph.D. in Law and Economics from University LUISS Guido Carli. He published extensively on banking and financial regulation topics. Wieger Kastelein is a Financial Stability Expert in the Financial Regulation and Policy Division, DG Macroprudential Policy and Financial Stability, at the European Central Bank (ECB). He joined the ECB in 2019. Prior to this, he worked as a Policy Advisor at De Nederlandsche Bank and was a member of a number of policy fora, including the European Forum for Innovation Facilitators and the European Banking Authority’s Subgroup on Governance and Remuneration. Wieger studied business administration and holds a master’s degree from the Rotterdam School of Management, Erasmus University Rotterdam. Claudia Lambert is Team Lead-Financial Stability in the Financial Regulation and Policy Division, DG Macroprudential Policy and Financial Stability, at the European Central Bank. She previously worked as a Professor of Finance at the Berlin School of Economics and Law and as a Research Associate in the macroeconomics department at DIW Berlin. Prior to this, she worked as a Project Manager and Consultant in financial risk management at KPMG and ITGAIN Consulting. She holds a Ph.D. in Economics from Goethe University Frankfurt and a M.Sc. in Economics from Maastricht University. Fatima Pires is Deputy Director General of the DG Macroprudential Policy and Financial Stability at the European Central Bank. She serves as a member of the Policy Development Group of the Basel Committee on Banking Supervision (BCBS), Network on Greening the Financial System, European Banking Authority, as an alternate member of the BCBS, FSB Standing Committee on Supervisory and Regulatory Cooperation, and is active in other international and European policy fora, including in Eurosystem, European Commission and Council working groups. Before joining the ECB in 2003, she worked in the Portuguese Ministry of Planning/Finance and at the Banco de Portugal.

A Rule-Based Monetary Strategy for the European Central Bank: A Call for Monetary Stability Juan E. Castañeda

Abstract The 2020–2021 review of the ECB strategy will shape monetary policy in the Eurozone in the years to come. Crucially, it will also determine the scope and capabilities of the ECB within the ever-evolving architecture of the euro. As in the aftermath of the Global Financial Crisis and the subsequent Euro Crisis, Member States are discussing new mechanisms to enhance economic recovery and further integration which, one way or another, will involve the support of, or the coordination of fiscal policymakers with the ECB. The impact of the new ECB strategy in the current debate about the future direction of the single currency should not be overlooked. In this chapter, we offer a proposal for the reform of the ECB strategy incorporating the lessons learned in the recent crises. We discuss several options for the ECB and set up a rule-based strategy suitable to operate in an environment of persistently low inflation and near-zero interest rates. Under our proposal, monetary stability becomes the guiding principle for providing macroeconomic stability over the medium and long term, as well as for enhancing the transparency of the ECB communication policies. Keywords ECB monetary strategy · Euro architecture · Price stability · Monetary policy rules · Monetary stability

1 The 2020/2021 ECB Strategy Review and the Debate on the Unfinished Architecture of the Eurozone The European Central Bank (ECB) launched a comprehensive review of its monetary policy strategy in January 2020, which was meant to be completed initially by the

Chapter in the forthcoming book: New Challenges for the Eurozone Governance: Are There Joint Solutions for Common Threats? Caetano, Vieira and Caleiro (Eds.). Springer. J. E. Castañeda (B) Institute of International Monetary Research, University of Buckingham, Hunter Street Campus, Buckingham MK18 1EG, UK e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_5

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end of 2020 (ECB 2020a), though now the deadline has been extended until mid2021 due to the disruption caused by the coronavirus pandemic. The policy strategy of the ECB was first set up by its Governing Council in the Autumn of 1998, prior to the start of the single currency—and with it a single monetary policy—on 1 January 1999. The original strategy was then ‘clarified’ in the Spring of 2003 and involved two significant changes. Firstly, as regards the quantitative definition of price stability, the ECB made it clear that its aim was to achieve a Harmonised Index of Consumer Prices (HICP) annual rate of inflation ‘below but close to 2%’. This was to reaffirm the commitment of the ECB to avoid deflation,1 thus setting an implicit lower bound to disinflation in the Eurozone. And secondly, the ECB stopped publishing the ‘reference value’ for the annual growth of a broad monetary aggregate (M3); that value being compatible with the ECB official definition of price stability (Trichet 2003). As explained in more detail in the next two sections, rather than being a mere clarification of the ECB strategy, these changes have had very relevant implications in the way in which the ECB has been making monetary policy decisions since then, particularly but not only in the 2004–2007 period (see Castañeda and Congdon 2017). The remit of the current review of the ECB strategy is quite extensive and covers 11 areas, including the impact of climate change, the digitalisation of the economy, how globalisation affects the functioning of the economy and how changes in productivity, innovation and non-bank financial disintermediation affect the Eurozone economy and monetary policy decisions. As regards the core of the review, the ECB will revisit the measurement of price stability and assess ‘alternative approaches to achieving price stability’, the so-called monetary policy ‘toolkit’, the gaps in current economic models to process information in order to understand how the eurozone economy works, its communication policies and the interactions between macroprudential policies and monetary policies (see ECB 2020b). We cannot assess here in detail the implications and challenges of the ECB strategy review in all these areas; we will rather focus on those monetary policy issues closely related to the core of what central banks currently do2 and how they communicate their decisions to the public. The discussion of the economic policy responses to the coronavirus crisis in the Eurozone has shown once again the fragility and inconsistency of the euro architecture, as well as the constraints the single currency carries out. Unlike other countries with full monetary sovereignty (i.e. with their own national currency and monetary 1 The

fear of deflation is a common feature among central banks in our days. Following Bordo and Filardo (2004), what they actually fear is an ‘ugly’ or recessive-type deflation, such as that in the Great Depression years. However, there are other (productivity-driven) ‘good’ deflations which central banks should not fight against but welcome; these are deflations where the fall in prices is the result of an increase in the supply of goods and services in competitive markets (see Selgin 1997). An expansionary monetary policy to avoid this type of benign deflation will create an excess in the amount of money in the economy and eventually destabilise the markets (see Castañeda and Wood 2011). This is an intrinsic flaw in the strategy of most inflation-targeting central banks in our days. 2 Of course, it is undeniable that the other areas which the ECB is looking into under the review are indeed very relevant to the understanding of the Eurozone economy and the transformations that will impact monetary policy in the future.

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policy), Member States in the Eurozone cannot resort to their national central banks to coordinate the economic responses to a crisis episode. As the recent ruling of the German constitutional court (5 May 2020) has highlighted, the ability of the ECB to engage in asset purchase programmes is not as straightforward an issue as in a nation with full monetary and fiscal sovereignty. Since the ECB started to implement the Asset Purchase Programme (APP) back in 2015, it has always maintained that these purchases are in line with its legal mandate and the EU constitution (which prohibits the monetary financing of Member States, see Art. 21, ESCB Statutes), and they constitute an essential means for the proper implementation of monetary policy decisions in the Eurozone. The German constitutional court ruling states that the Asset Purchase Programme (in particular, the Public Sector Purchase Program (PSPP)) does not violate the prohibition of monetary funding of Member States; but it does violate the ‘principle of proportionality’, according to which ‘the content and form of Union action shall not exceed what is necessary to achieve the objectives of the Treaties’ (see Buiter 2020). In this legal and institutional context, both the discussion and the final outcome of the review of the ECB strategy become key to understand the future of the Eurozone, the availability of suitable tools and mechanisms to respond to a crisis in the future and, ultimately, the preferred model for the euro as a single currency. In particular, the outcome of the review should define much more clearly the sort of model of a central bank the ECB aims to be: whether the one envisaged in its original Constitution and in the Treaty of Maastricht, or that of a ‘modern’ and fully-fledged central bank, able to coordinate with the fiscal policymaker(s) and thus help the national treasuries in times of crisis. The former model is more compatible with a decentralised monetary union, while the latter would signal the intention to create a traditional nation state central bank; one with a single currency, a meaningful federal treasury able to set up countercyclical policies and to assist Member States in crisis (see further details in Castañeda 2018). Both models are feasible but it is vital for the success of whichever is chosen that the EU institutions and their policies (indeed, including the ECB’s) are consistent and in line with the preferred option. One of the lessons of the euro crisis has been the fundamental role played by the ECB in maintaining confidence in the euro, be it by its commitment to support the euro in public statements3 or by the actual implementation of programmes to purchase Member States’ sovereign debt (2015–2018). The changes made to the EU’s macroeconomic institutions in the aftermath of the crisis4 and the implementation of the APP programme by the ECB signal the trend towards the creation of a central bank more able to support Member States in times of crisis, but not only. The current COVID-19 crisis is another (major) test on the Eurozone architecture and on the roles and policy strategy of the ECB. Whatever the final design of this more ‘modern’ 3 Such as Mario Draghi’s (former President of the ECB) statement on 26 July 2012 in support of the

euro: ‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro’ (Draghi 2012). 4 Such as the increased macroeconomic coordination under the Macroeconomic Imbalances Procedure and the new ‘Fiscal Compact’.

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central bank model, it would mean granting more leeway to the ECB to buy the debt of the Member States; thus, to some extent, implying the mutualisation of their debt.5 Within this model, a fully functional monetary policy would need a solid new strategy to fulfil its tasks; one that has the necessary tools and objectives compatible with the preferred architecture of the euro in the years to come. We will continue with the discussion of the options as regards the new strategy of the ECB in the next two sections.

2 What Price Stability Means: How Should We Better Assess the Performance of the ECB? Given that the ECB has a clear mandate in its statutes (see Art. 2, ESCB Statutes)6 to prioritise the preservation of price stability over all other macroeconomic objectives, the review of the definition of what price stability means becomes key to understanding both the scope and the direction of the changes in the current ECB strategy review. As shown in Fig. 1, the annual rate of inflation in the Eurozone (as measured by the Harmonised Index of Consumer Prices, HICP) remained quite stable and around 2% from 1999 to 2007 and has been lower and much more volatile since then. One of the issues under review should be the measurement of inflation; is the HICP a good measure of inflation? The HICP does not include housing prices directly but rental costs and other repairs.7 The trend in consumer inflation as measured by the HICP since the outbreak of the Global Financial Crisis—and during the subsequent Eurozone crisis—has been low, indeed below the ECB’s definition of price stability. Overall, since the start of the single monetary policy in 1999, the monthly year on year average rate has grown by 1.68%, with an average of 2.19% in the pre-crises years (1999–2008) and 1.24% from 2009 onwards. In the light of these figures, has the ECB run a monetary policy compatible with price stability and therefore effectively fulfilled its mandate? Even more, should the ECB’s definition of price stability be reviewed? These are the questions we address in the remainder of this section. 5 See Codogno and Noord (2020) and Vaubel (2020) for further details about those both in favour and

against policies and mechanisms for the mutualisation of the Member States debt in the eurozone. accordance with Article 105(1) of this Treaty, the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2 of this Treaty. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4 of this Treaty.’ Statutes of the ESCB and the ECB, accessed online at https://www.ecb.europa.eu/ecb/pdf/ orga/escbstatutes_en.pdf. 7 One option to reflect one of the major expenses in an average household’s budget would be to include housing costs directly into the HICP (see ECB 2016 for more details on this issue). Rather than adding asset prices to a consumption good and services’ prices index such as the HICP, we will opt for giving a greater role to changes in the amount of money; so that we can capture the effects of monetary policy on asset prices over the medium to the long term. 6 ‘In

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5 4 3 2 1

-1

1998Jan 1998Nov 1999Sep 2000Jul 2001May 2002Mar 2003Jan 2003Nov 2004Sep 2005Jul 2006May 2007Mar 2008Jan 2008Nov 2009Sep 2010Jul 2011May 2012Mar 2013Jan 2013Nov 2014Sep 2015Jul 2016May 2017Mar 2018Jan 2018Nov 2019Sep

0

HICP annual inflaƟon rate

DefiniƟon of price stability, ECB

Fig. 1 HICP annual rates of change (%), Eurozone: 1998–2020 Source: Data from the ECB website. Accessed in June 2020

2.1 A New Policy Rule for the ECB? Price Level Targeting, Nominal Income Targeting and Inflation Targeting The ECB has an ample range of options available as regards the re-definition of its policy target, which are summarised in Blot et al. (2019). It is clear from the postcrises years that the ECB has struggled to keep HICP inflation close to a 2% annual rate. There are several monetary strategies that will allow the ECB to pursue a more active monetary policy, particularly during and after a major crisis.

2.1.1

Price Level Targeting

One of them is a ‘price level stability rule’, one by which the central bank effectively targets the steady growth of the price level at an x% rate.8 The main difference with a standard ‘flexible inflation targeting’ (see Svensson 1998; Bernanke 20179 ) rule is the treatment of deviations from the target: in contrast with an inflation targeting rule where ‘bygones are bygones’, a price-level targeting rule prescribes the reaction of the central bank to offset any deviation of the price level from the announced level (‘bygones are not bygones’). In case of a deviation of the price level from the desired 8 One

option being the adoption of a zero rate of inflation. Following the seminal estimate of this bias for the US economy back in the 1990 s in the ‘Boskin report’ (see Boskin Commission 1996), estimates of the inflationary bias of the CPI have been made since then for other economies, varying from one to two percentage points. Therefore, targeting a zero rate of inflation, as measured by the CPI, would actually mean the adoption of a one to two per cent rate of deflation. 9 ‘A price-level targeter, by contrast, commits to reversing temporary deviations of inflation from target, by following a temporary surge in inflation with a period of inflation below target; and an episode of low inflation with a period of inflation above target’ Bernanke (2017).

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target level in the past (either if too much inflation or too little), the application of the rule would force the central bank to correct those deviations, by either an inflationary policy in case of a recorded deflation (or too little inflation), or a deflationary policy if a recorded inflation. Provided that the central bank adopts a credible commitment to a price level target, in case of a negative demand shock and falling prices, agents would expect an expansionary monetary policy in the future to bring the price level back on target. Under the current mainstream New Keynesian models, a credible price level targeting strategy would increase both inflation expectations and current inflation; therefore, the central bank will successfully manage to lower real interest rates (see Hatcher and Minford 2014). This is one of the main advantages of this strategy as an effective policy tool in fighting a recession when nominal interest rates are in the near-zero territory. The effectiveness of monetary policy in such an environment of virtually zero nominal rates is even clearer if we use a monetary model—one that assesses the effects of changes in the amount of money on asset prices, which will ultimately affect companies’ balance sheets and agents’ spending decisions (see Congdon 2005). If changes in nominal interest rates have been exhausted as a policy tool, the central bank can tailor the amount and timing of its asset purchases programmes (i.e. QE) to achieve its price level target. Therefore, if following a credible price-level targeting rule, in the context of a severe demand-side recession and falling prices, the central bank would always have margin to increase the amount of money in the economy by as much as needed to restore the pre-crisis price level. As compared to the rather discretionary approach followed in the aftermath of the Global Financial Crisis, this strategy would provide a consistent rule-based monetary policy to react to any severe crisis scenario. This was the strategy proposed by Bernanke (2017) as a temporary solution, when interest rates have reached the lower nominal bound. If credible, a price level targeting rule would indeed enhance true price stability, but it would require frequent changes in monetary policy to offset any price deviations from the target; in particular, a monetary policy-led deflation any time the economy registers a positive rate of inflation. This would mean a degree of price and (nominal) wage flexibility which modern economies and their populations are not used to anymore. In the absence of such flexibility in goods and labour markets, the adjustment of the economy to a deflationary policy by the central bank will likely imply more job and output losses.

2.1.2

Nominal Income Targeting

Another monetary strategy option would be the adoption of a ‘nominal income targeting rule’, either in the form of a rate target or a level target. If a rate, now the central bank, rather than adopting a price level target or an inflation target, would choose a rate of growth of nominal income in the economy over the next few years. This strategy virtually allows the central bank to choose any combination of inflation/deflation and real income growth as a target. As constrained by its statutes, the ECB would likely choose as a target the combination of the rate of nominal income in

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the Eurozone compatible with price stability (0–2% inflation rate, as measured by the ECB) and the real rate of growth of the economy sustainable over the long term.10 As with the price level targeting strategy, the adoption of a nominal income target would also offer a consistent approach to running a more expansionary monetary policy in the aftermath of a severe demand shock and falling prices (see Sumner 2020). In such a recessive scenario, the central bank could keep its long term commitment to maintaining low inflation (below 2%) while effectively targeting a 4–5% rate of inflation in the short term (see Frankel 2012). In addition, in times when the economy is growing over its long term sustainable rate, it would also provide a consistent rule for limiting the growth in the amount of money in the economy, therefore likely to be successful in maintaining a more stable rate of growth of money in the economy along the cycle. As compared with a price level targeting rule, a nominal income rate targeting central bank would not have to offset any deviation of prices from a target; in particular, as regards those coming from supply side shocks to the economy. If the economy is expanding and thus producing more goods and services for the market, we can expect a ‘natural’ disinflationary trend that would not require a response by the central bank if prices remain within the 0–2% range. Similarly, a negative supply shock would reduce output in the market but also increase inflationary pressures in the economy. In this scenario, the central bank would not need to offset inflation if it remains within the said range. One of the major challenges of a nominal income rate targeting strategy is choosing the value for the long term or sustainable real rate of growth of the economy. This rate is not a once and for all estimate as it depends on the expected rate growth of the economy with no inflation; which is a rate that varies with structural and other institutional changes in the economy. As a proxy, this value can be extracted ‘ex post’ from the historical trend of the rate of growth of the GDP over a long period of time. However, arguably the rate must change particularly after a significant shock in the economy (i.e. the Global Financial Crisis). If a negative shock is deemed to have affected the long-term capabilities of the economy, adopting a nominal GDP target similar to the one in the pre-crisis years would force the central bank (artificially) to over-expand the amount of money in the economy, therefore likely resulting in inflation.11 In any case, the adoption of a nominal income target rule requires the input of the expected sustainable rate of growth of nominal spending in the next few years. In choosing this target, what it is important to remember is the commitment of this strategy to maintaining macroeconomic stability over the long term. This is not

10 Of course, this strategy would allow the ECB to revisit and explain to the public what ‘price stability’ means, as mandated in its Statutes. In principle, there is no explicit rule preventing the ECB from adopting a mildly deflationary inflation target (i.e. −1%) in the context of a growing economy. 11 Even more so if the central bank adopts a nominal income level target, which would force the central bank to restore the level of nominal income prior to the crisis. If the pre-crisis spending levels were not sustainable over the long term (i.e. distortionary), the adoption of the same target would actually mean the running of an aggressive inflationary monetary policy, thus accelerating the recurrence of a series of ‘boom and bust’ cycles.

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a strategy suitable for a central bank willing to fine-tune the economy or to intervene frequently to stabilise output and prices along the cycle. Another important challenge is the availability of nominal income data in real time. In contrast with HICP data, available every month and very rarely revised, the first estimate of the nominal GDP12 is released with a 3-month delay and it is frequently revised few months later; it is worth noting that the revision of the initial estimate may not be trivial. This makes it more difficult for the members of the monetary policy committee to assess the actual estate of the economy in real time. However, as stressed above, a nominal income target rule can (and should) be implemented with a clearer focus on the long term stability in the rate of growth of nominal income; therefore minimising the need to make frequent changes in monetary policy. In this vein, the availability of data in real time is still a challenge but less so as compared with the adoption of a more active, and potentially destabilising, monetary policy rule.

2.1.3

A Higher Inflation Target for the ECB? The Re-Definition of Price Stability

Another option is to review the current quantitative definition of price stability, within the same monetary strategy which the ECB has followed since 2003. On the one hand, the ECB may opt for increasing the rate of inflation compatible with price stability. As suggested by Blanchard et al. (2010) and Krugman (2012), rather than the longstanding consensus on a rate of CPI inflation of approximately 2%, the adoption of a 3% or a 4% rate would give more margin for the central bank to run expansionary policies within still moderate rates of inflation. One of the major reasons to reject this option is because of how this change in the inflation target would affect agents’ expectations of inflation over the medium to the long term. Once the commitment to low rates of inflation is relaxed, it will become easier for the policymakers to keep on increasing the target rate in the future if needed be (Volcker 2011); and thus, to break its original commitment to low rates of inflation. Even if made in small steps, such an approach may end up quite quickly with the adoption of inflationary policies and the end of expectations of low inflation. This was one the most damaging macroeconomic consequences of the inflationary policies in the 1970s, which required very firm and painful monetary policy decisions to counteract a few years later (see Volcker 2011).13 On the other hand, the ECB may decide to keep its definition of price stability but to change the way in which price stability is assessed. At the moment, the ECB aims at achieving price stability over an undefined ‘medium term’ period. In addition, as highlighted in Blot et al. (2019, p. 16), the former President of the ECB, Mario Draghi, in his last press conferences made it clear that the ECB would react with the 12 This is released on a quarterly basis, though in the last few years national statistics offices publish monthly GDP estimates with a two-month delay. 13 A similar argument has been made by Issing (2020) against the case for rising the ECB’s inflation target above 2%.

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same determination to any deviations of inflation either above or below the current definition of price stability; thus effectively making the ‘below but close to 2%’ rate of inflation not an upper limit but a symmetric target. This would mean a ‘de facto’ 2% average inflation target that the ECB may want to adopt formally in the review of its strategy. If formally announced as an average target, in the scenario of persistently low and below target inflation of the last few years, the ECB would have had ample margin to increase its inflation target temporarily to compensate for the undershooting of the target in the last decade. Unlike the ‘ad hoc’ decision to increase of the target discussed above, the adoption of an average inflation target over a period of ‘n’ number of years to be announced to the public, would be consistent with the anchoring of price expectations in line with the long-run target of the central bank. However, the communication of this new strategy to the public would pose some challenges; as the ECB would need to announce both its commitment to its longterm definition of price stability (say, 2% on average), and the temporary target for ‘n’ number of years. In addition, after an inflationary cycle the central bank would likely need to impose a deflationary policy possibly for several years. In economies with significant price and wage nominal rigidities, the application of this rule may likely result in costly deflationary policies in terms of jobs and output loses. In this scenario, it will become increasingly difficult for the central bank to stick to an average inflation target and agents will rationally anticipate a deviation from the announced commitment at some point in the future. The net result would be to harm the bank’s credibility and the effectiveness of the policy strategy. In the debate of the possible alternatives to the current strategy of the ECB, we need to consider the long-term implications of major changes in its policy strategy. Perhaps urged by the bleak economic performance of the Eurozone economy in the post-Global Financial Crisis years, in which central banks in major economies have desperately tried to find new policy measures to increase inflation, inflation expectations and nominal spending on a rather ‘ad hoc’ basis, the ECB may be willing to adopt new tools to run a more credible and effective policy in a time of severe crisis. However, the strategy of a central bank is a key framework for making policy decisions over a long period of time. In order to be credible and consistent, this is a core element of the central bank that should not be changed nor adjusted too frequently in response to the pressing circumstances of the day. Once the Eurozone recovers from the current COVID-19 crisis, a return to a period of higher inflation may occur in the next two years and then the ECB would be bound by the constraints of a price level rule, a nominal income target rule or an average inflation target rule; which, depending on the amount of inflation in the future, all of them (though, to a different extent) would prescribe a non-negligible contraction in the rate of growth of money in the economy. This is not necessarily a reason to reject any of these strategies, but a reminder that the new monetary rule, once approved, will be a core element of the long-term monetary strategy of the ECB; and indeed, the key to anchoring market expectations along the central bank definition of price stability.

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2.2 The Relation Between Money, Prices and Nominal Income As stated in the ECB official communications (see ECB 2020c) and in ample research made by the ECB staff since 1999, changes in the rates of growth of broad money do help to explain and forecast changes in prices over the medium to the long term (see Altimari 2001; Benati 2009). It is precisely ‘the medium term’ time horizon what the ECB uses (see ECB 1998; 2003) to fulfil its price stability goal. While in the short term, the so-called economic analysis (or ‘second pillar’) may well explain fluctuations in inflation, this information is cross-checked against the monetary analysis (the ‘first pillar’), so that the ECB can capture the medium to the long-term trends in inflation too. This is the rationale of the ‘mixed’ monetary policy strategy of the ECB since 1999; one that does not commit to inflation targeting fully or formally, nor to the adoption of an ‘intermediate target’ for broad money growth (see Issing 2020). However, this strategy was more transparent before 2003, when the ECB did give a prominent role to M3 annual rates of growth in anticipating changes in inflation over time. This is not the case since 2003 and the role played by changes in monetary aggregates in the ECB monetary policy decisions is more questionable now, if indeed it plays any meaningful role at all. This is a fundamental reason to welcome a review of the policy strategy of the ECB; one that clarifies the main rationale and benchmarks used by the central bank in making its policy decisions. It was a very good move for the ECB to assign a prominent role to changes in broad money in the assessment of inflationary pressures in the economy over the medium to the long term back in 1999. This had been a successful monetary strategy adopted by the most important central bank in the Eurozone, the Bundesbank, for several decades (see Issing 2008). As observed in Fig. 2, changes in M3 and nominal income in the Eurozone share similar trends.14 In addition, when the trend in the growth in the amount of money is compared with the prescriptions of a ‘price stability money rule’,15 the results suggest a clear pattern too. When the trend in money growth is systematically above the prescriptions of a price stability rule (i.e. a positive ‘money gap’) we can identify a period of building up of inflationary pressures (see 1999– 2008 in Fig. 2); whereas the years when the trend in money growth is persistently below the rate compatible with price stability (i.e. a negative ‘money gap’) would signal disinflationary or even deflationary pressures (2009–2019). It is important to stress that, in order to have a meaningful effect on inflation, the deviations of M3 from the price stability path must occur for a sufficient time period. This is why we use the trends in the rate of growth in both series in our assessment. And, even if the 14 In

Fig. 2, we have used the two-year moving average of nominal GDP growth and M3 growth to extract the medium-term information in the series. 15 We have calculated in Fig. 2 a so-called Friedman’s ‘K per cent rule’, compatible with the definition of price stability by the ECB (no more than 2% annually), a 2% trend growth of output in the Eurozone and a secular decline of money velocity of −1% per year. The difference between the prescribed M3 growth and the registered M3 growth can be taken as a proxy of the ‘money gap’ in the economy.

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12.00 10.00 8.00 6.00 4.00 2.00

-2.00

2000Q1 2000Q4 2001Q3 2002Q2 2003Q1 2003Q4 2004Q3 2005Q2 2006Q1 2006Q4 2007Q3 2008Q2 2009Q1 2009Q4 2010Q3 2011Q2 2012Q1 2012Q4 2013Q3 2014Q2 2015Q1 2015Q4 2016Q3 2017Q2 2018Q1 2018Q4

0.00

Nominal GDP annual growth (moving average) M3, annual growth (moving average) M3, price stability money growth rule Fig. 2 Broad money and nominal GDP annual growth (%), Eurozone: 1998–2019 (2-year moving average, monthly data). Notes The dotted line depicts the prescribed rate of growth of money compatible with a price stability rule with the following parameters; trend GDP real annual growth of 2%, trend fall in money velocity of 1% per year and annual rate of inflation at 2%. The period between the vertical blue lines corresponds to falling or stagnant money growth in the Eurozone. Source Data from the ECB website (accessed in June 2020) and own calculations of moving averages

deviations are persistent, the effects of an excess or a deficit in money growth will only be reflected in consumer prices after a two- or even three-year delay.16 The medium-term relation between changes in broad money and nominal income holds for the Eurozone as a whole, as observed in Fig. 2. On the one hand, particularly between 2004 and 2008, the amount of money grew far beyond the rate compatible with macroeconomic stability, therefore being inconsistent with sustainable economic growth. It is worth noting that the rate of growth of money in this period of four years was not followed by a proportional increase in the growth of nominal income. As we argue later on in the chapter, this lack of correspondence between these two variables was only apparent; since the excess in money growth was increasing financial companies’ cash holdings and pushing asset prices up quite 16 According

to the seminal work by Friedman (1970), the excess in money growth will first affect output in the short term (6–9 months) and prices later (12–18 months). As stated in Congdon (2003; 2005), an excess in cash balances (particularly in financial companies portfolios) will first bring asset prices up in the very short term, and later affect output and consumer prices to an extent that also depends on the stance of the economy; that is, on the value of the output gap.

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Table 1 Annual average rate of growth of nominal income and broad money (%), 1999–2019 1(a) Overall Eurozone GDP nominal

M3

1999–2003

4.16

6.72

2004–2008a

4.49

8.71

2009–2014

0.89

1.95

2015–2019

3.21

4.88

1(b) Periphery vs. core Eurozone economies GDP nominal 1999–2003

M3

Periphery

Core

Periphery

Core

3.2

1.39

11.06

10.56

2004–2008a

2.79

2.71

14.03

11.75

2009–2014

−1.6

0.50

−2.33

1.42

2015–2019

2.2

2.02

3.28

4.70

Notes Eurostat and ECB datasets, accessed online, June 2020. Own calculations of the average in the periods. a 2008 Q4 has been taken as the starting point of the Global Financial Crisis. Data on national contributions to M3 start in 2001 Under peripheral economies, we have included Italy, Spain, Greece, Ireland and Portugal; under core economies: Germany, France, Benelux countries, Finland and Austria

dramatically.17 On the other hand, from the end of 2008 and until 2019, the rate of growth of broad money has been too little and indeed not enough to maintain a trend rate of growth of output at stable prices. When we look in more detail into the rate of growth of M3 in the post-2008 crisis period, we see that the Eurozone as a whole did not resume monetary stability until when the ECB consistently applied APP (i.e. QE programme). In the 2009–2014 period, broad money grew on average by 1.95% year on year while nominal income remained fairly stagnant (0.89% average annual growth, see Table 1a). By contrast, from 2015 to 2019, the ECB’s QE programme managed to bring the rate of growth of money up to the 4–5% range (see Fig. 3), which coincided with the recovery of output in the Eurozone and the departure from deflation territory (nominal income annual growth stayed above 3%). It looks as if the ECB had decided the amount of its APP in accordance with a money rule ‘a la Friedman’ (see Footnote 15), although surely unintentionally. These trends are even clearer when we analyse the relation between trends in money growth and in nominal income at a more disaggregated level. Even though the ECB makes policy decisions based on indicators on the whole area, the 19 economies within the Eurozone display a considerable degree of macroeconomic asymmetry among them (see Castañeda and Schwartz 2020). If we split up the Eurozone as a whole into those economies most affected by the 2010s crises (i.e. 17 This is one of the main reasons why we would support the review of the current definition of price stability by the ECB, so it is not only based on the HICP measure but on a broader monetary measure.

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14 12 10 8 6 4 2 1-1-20

1-1-19

1-1-17

1-1-18

1-1-16

1-1-15

1-1-14

1-1-13

1-1-12

1-1-11

1-1-09

1-1-10

1-1-07

1-1-08

1-1-06

1-1-05

1-1-04

1-1-03

1-1-02

1-1-01

1-1-00

-2

1-1-99

0

-4 M3, annual growth Fig. 3 Annual growth (%) of broad money in the Eurozone (1999–2020) Source ECB data set online (accessed on 30 June 2020). The vertical line signals the start of the ECB’s QE programme (2015–2018)

peripheral economies) and those least affected (i.e. core economies), the relation between changes in the amount of money and in nominal income is even more informative, clear and consistent (see Table 1b). Core countries have experienced more monetary stability both before and after the outbreak of the Global Financial Crisis, while peripheral economies suffered from extraordinary monetary growth before 2007, followed by an average fall of −2.33% in the amount of money and −1.6% recession from 2009 to 2014. The adoption of the monetary policy framework suggested in this chapter would provide a clear rationale to interpret price developments at the current juncture, under COVID-19 crisis.18 In sharp contrast with the Global Financial Crisis years, since March 2020 both the ECB balance sheet and broad money in the Eurozone (measured by M3) have increased significantly for several months; which would indicate the building up of inflationary pressures in the economy in the medium term.19

18 See

Christensen (2020) for an excellent analysis of COVID-19 as a supply-side crisis and why its effects (and duration) will be very different from a demand-shock to the economy. 19 Notably, a monetary strategy that does not incorporate the analysis of monetary developments in the making of policy decisions would be unable to identify these inflationary pressures; therefore, increasing the risk of running too expansionary monetary policies with destabilising effects over the medium and long term. See Castañeda and Congdon (2020) for a more detailed analysis of the current surge in money growth in leading economies and its expected impact on prices and the business cycle in the next two/three years.

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Monetary Growth and Financial Stability

The knock-on effects of the observed money gaps in Fig. 2 on macroeconomic and financial stability over the long term are very notable. Either an excess or a deficit in the growth in the amount of money pose a threat to the stability of the economy over time. In the years running up to the Global Financial Crisis (2004–2007), too much money was created in the Eurozone and the economy was producing a level of output well beyond its long-term equilibrium or sustainable level.20 The opposite scenario can be observed in the aftermath of the crisis, when first a falling and then a stagnant and very weak monetary growth (below the rate compatible with macroeconomic stability) led to quite large negative output gaps from 2009 to 2015. The lack of enough attention to monetary (and credit) developments in the years running up to the Global Financial Crisis constituted one of the major flaws in the current models used by major inflation-targeting central banks (Issing 2020). As shown in Castañeda and Congdon (2017), the instability in the rate of growth of money played an important role in the building up of imbalances in the Eurozone economy right before 200821 and in the deepening of the recession once the crisis struck the Eurozone economies. If not in HICP prices, in which other prices did the money gap growth materialise? Between 1999 and 2007, residential property prices increased by 59% and immediately after the burst of the 2001 ‘dotcom bubble’, equity prices increased by 48% from 2002 to 2007 (see Fig. 4).22 From January 2003 to October 2008, money holdings (as measured by M3) by the financial sector in the Eurozone increased by 123% (see Fig. 4). These institutions held a substantial excess in cash balances in the years running up to the Global Financial Crisis, which may well explain the surge in asset prices in this period. A corollary of our analysis is that monetary instability has an impact on financial instability over the medium to the long term. Therefore, the analysis of changes in broad monetary growth provides valuable information on trends on asset prices in the short term and, in turn, on households and companies’ spending decisions over the medium to the long term. It is also important to note that the size of the ECB balance sheet does not necessarily determine the inflation rate in the Eurozone. An increase in the balance sheet should not therefore automatically be taken as a threat to price stability. This is one of the main lessons learned from the Global Financial Crisis years. As shown in 20 See

Jarocinski and Lenza (2016) for a survey of the estimates of the output gap for the Eurozone both before and after the Global Financial Crisis. Even though there are significant changes in the size of the gaps, they all share the same message as regards the trend of the output gap and most on its direction too: higher in 2007 by roughly 1% to 5%; and lower in 2014 by −2 to −6%. 21 Taylor (2009) and Selgin et al. (2015) make a similar assessment of monetary policy in the USA but using estimates of (policy) interest rates rather than money growth. 22 As we know, these prices are not included in a conventional consumer prices index such as the HICP and thus did not directly feature in the ECB’s definition of price stability. In the next section, we suggest a reform of the ECB strategy that does consider more explicitly the effects of money growth on CPI prices and also asset prices.

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230 210 190 170 150 130 110 90 70 50

200 150 100 50

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0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Asset prices

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S&P 500 index (1999=100)

ResidenƟal property prices (1999=100)

M4, financial insƟtuƟons (2003=100)

Fig. 4 Asset prices and money holdings by financial institutions in the Eurozone (1999–2019). Note Sectoral M3 holdings only available from 2003 Source ECB dataset, accessed online, June 2020

Fig. 5, the ECB expanded its balance sheet quite significantly from 2008 to 2012, with no noticeable effect on CPI inflation. Only when the ECB started to implement a systematic QE programme in 2015, both its balance sheet and the amount

6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000

1999W01 1999W46 2000W39 2001W32 2002W25 2003W18 2004W11 2005W03 2005W48 2006W41 2007W34 2008W27 2009W20 2010W12 2011W05 2011W50 2012W43 2013W36 2014W29 2015W22 2016W14 2017W07 2017W52 2018W45 2019W38

0

Fig. 5 ECB balance sheet (millions, euros): 1999–2020. Notes The vertical lines signal the start of the Global Financial Crisis (Autumn 2008) and the ECB’s Asset Purchase Programme (January 2015) Source ECB dataset online (accessed, 30 June 2020)

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of money (broadly defined) increased.23 Therefore, in order to assess the impact of the QE programmes on inflation, we need to make a distinction between those asset purchases that only increase the amount of bank reserves held by the central banks and those that increase the amount of bank deposits (i.e. the amount of money).24

3 A More Transparent Strategy for the ECB: A Focus on Monetary Stability and Nominal Income Stability Throughout the Cycle If the information cannot be fully obtained from conventional consumer price indices, how can we assess whether the ECB is running a monetary policy compatible with price stability and financial stability? A corollary of our analysis in the previous section points at a more comprehensive definition of price stability over the medium to the long term, one that relies more on keeping a stable and moderate rate of growth of money (i.e. the M3 aggregate in the Eurozone). This means that whenever the amount of money in the economy diverges systematically from its long-term stability path, there will likely be an impact in nominal income and thus eventually in consumer prices, even though with a delay. In practical terms, our proposed strategy for the ECB would consist of the announcement of a medium to long term nominal income target compatible with the sustainable rate of growth of real output with no inflation: assuming an annual long-term rate of growth of real output around 1.5– 2% and price stability as defined by annual changes in the HICP in the range of 0–2%, the ECB would announce a 3–4% nominal GDP annual growth (range) target for the next two to three years. In order to achieve its target, the rate of growth of broad money (M3) would provide a key reference to make policy decisions: by the application of the quantity equation, assuming a secular decline in money velocity of −1% per year, the central bank would announce a rate of growth of money of 4–5% compatible with a 3–4% nominal income growth over the medium to the long term. Persistent deviations of M3 growth from the 4–5% would be interpreted as a

23 Up to 2015, the ECB’s lending facilities to banks in the Eurozone did increase its balance sheet and bank reserves, but not the amount of money in the economy. In a deflationary period with high uncertainty, there was an increase in the demand for money for precautionary motives. In addition, banks had to increase their regulatory capital by 60% (according to the new Basel III regulations, see Ridley 2017), which constrained their ability to expand their balance sheets and added even more deflationary pressures to the economy (see Congdon Castañeda and Congdon 2017). In this context, changes in the balance sheet of the ECB or in the monetary base of the economy (i.e. cash in circulation and bank reserves) do not explain changes in the amount of money in the economy, nor inflation. 24 This is the distinction made in Congdon (2010) between narrow QE operations (in which the central bank buys assets from the banking sector and only increases the monetary base as a result) and broader QE operations (in which the central bank buys assets from other non-bank financial intermediaries and the Government, and thus increases the amount of deposits in the economy).

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‘warning indicator’ of macroeconomic and financial instability, as they would not be compatible with a sustainable rate of growth of nominal income in the Eurozone.25 One of the main advantages of this strategy is that it focuses the attention of policymakers on variables much more under their control, such as the impact of monetary growth on changes in nominal income over the medium to the long term; rather than on more loosely defined concepts such as CPI price stability measures. In addition, this strategy makes it easier for the central bank to explain and communicate changes in prices as a result of the occurrence of supply-side shocks: in case of a positive supply shock, the central bank can maintain the pre-announced path of monetary growth and nominal income if the increase in real output is accompanied by a fall in prices. Similarly, in case of a negative supply shock, the shortage in production will be followed by an increase in prices, therefore also keeping nominal income relatively steady. As a result, this strategy would mean less activism in the running of monetary policy along the cycle and more stability in the making of monetary policy decisions. Important caveats apply to the interpretation and potential application of this strategy. On the one hand, the deviations of the growth in the amount of money from the pattern of long-term stability must be persistent and not just a one-off. Also, small deviations from this pattern should not be a cause of concern, as it is the trend and direction of changes in the amount of money which would matter in making monetary policy decisions. This is particularly relevant in times of high uncertainty, when typically, the demand for money increases temporarily.26 Therefore, rather than a single target for the rate of growth of money compatible with nominal income stability and financial stability, the central bank should announce a range or average. This would reflect more clearly the degree of uncertainty the policymakers face as regards their ability to control the amount of money in the economy, as well as measurement errors. On the other hand, the assessment of the inflationary or deflationary effects of policies must be made within a sufficiently long time period so the excess or deficit in money growth can be fully passed onto the economy (i.e. on nominal income). As observed in empirical studies on this question for the Eurozone economy (Angeloni et al. 2002), the effects of monetary policies on prices and output can last for as long as two to three years. In addition, as discussed above, the distortionary effects of a monetary policy not committed to monetary stability will likely materialise in the medium to the long term in the form of financial instability. Therefore, in order to design a monetary policy committed to both monetary stability 25 In the current COVID-19 crisis, M3 growth in the Eurozone has very much exceeded this range (at the time of writing, July 2020, it is close to 9% annual rate of growth). This would signal the likely return of an inflationary boom in the Eurozone in the next two or three years, unless the ECB takes firm actions in the second half of 2020 to keep monetary growth in check. 26 In these circumstances, an excess of money growth may be offset by a fall in money velocity, therefore not showing inflationary effects for some time. However, once the level of uncertainty (and thus the demand for money) returns to more normal patterns, we would expect money velocity to revert to its long-term trend and the excess in money balances to affect prices and spending. In the context of the expected effects of the surge in money growth in the USA since March 2020, Congdon (2020) uses US data to confirm the reversion of money velocity to its trend.

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and financial stability, the policy time horizon should be extended, at least up to three years. This would imply a significant change in the focus of central banks, so they do not intend to minimise the fluctuations of output over short periods of time, but rather to establish a strategy compatible with the stability of nominal output over the medium to the long term. Our proposal is in line with the original monetary strategy of the ECB (1999– 2003), but it goes beyond it in the light of the lessons learned in the recent crises. Firstly, the ECB must have the ability to buy private and public assets in order to maintain a level of stability in the amount of money in the Eurozone. This is key for the proposed strategy to succeed. Undeniably the purchase of sovereign debt by the ECB carries political and financial implications within a multi-State monetary area such as the Eurozone. However, especially in an era of historically low interest rates, monetary policy must be able to resort to quantitative easing (and quantitative tightening, QT) whenever needed. It is for the Eurozone Member States to design the tools and mechanisms to facilitate it. As proposed in Castañeda (2018),27 a partial mutualisation programme of the Member States debt may be a reasonable approach to give the ECB the leeway needed to engage in asset purchase operations; while retaining the proper incentives to run a sustainable fiscal policy by the Member States. Anyhow, this is a political decision that should not be made by the ECB but by the EU Member States. If the ECB is to preserve its independence in the future, it must not interfere in Member States’ (national) fiscal policy. Secondly, our proposal would allow the ECB to conduct QE operations under a rule-based policy strategy, therefore, enhancing its transparency and accountability. The years following the 2008 crisis have witnessed a period of successive ‘innovations’ by major central banks to address the crisis, which have effectively meant a substantial deviation from any sort of policy rule or pre-announced commitment. As justified as this more ‘ad hoc’ approach to policymaking might have been in the midst of the crisis, it is now time to incorporate the use of the so-called unconventional monetary policy tools (QE being one of them) into the toolkit and policy rule of central banks. The more explicit use of the link between QE operations and their impact in the amount of money would result in a clearer and more binding strategy; and thus, it would enhance the transparency of the ECB and its accountability. The strategy proposed here for the ECB would allow the announcement of a more comprehensive policy with two main policy tools: changes both in policy rates (those applied in the standard open market operations) and in the amount of purchases/sales of assets (i.e. QE or QT) in any given time period. This will make clear the rationale of the central bank in expanding or reducing its QE programmes as they will be set in accordance with the achievement of its nominal income growth target. Therefore, the use of QE (or QT) as policy tools would become embedded in the set of policy tools of the new strategy of the ECB; so that the announced amount 27 In the proposal, it is suggested that up to 30% of the public debt of each Member State is guaranteed

by the whole Eurozone. This would be the debt which the ECB would be free to buy in case needed for monetary policy purposes. See De Grauwe and Moesen (2009) for the proposal of Eurobonds in the midst of the Eurozone crisis.

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of asset purchases would correspond with the expected effects on broad monetary growth and ultimately on prices and output (i.e. nominal income). Thirdly, as demonstrated in the last decade, the rate of inflation is not an indicator fully under the control of the central bank in the short term; even less so when inflation is measured by the CPI or similar indices, as many other important price indicators in the economy are excluded from the definition of price stability. The evidence available from the years running up to the Global Financial Crisis shows how excessive money growth can have inflationary and destabilising effects on other (asset) prices over the medium term, with significant implications on financial stability.28 This is why we would rather suggest focusing on significant and persistent deviations of broad money growth from price stability and nominal income stability long-term patterns. One consequence of this approach would be the lengthening of the time horizon of monetary policy.29 Rather than the current unspecified ‘medium term’ horizon of the ECB, we would suggest the announcement of a three-year time period in which to assess price stability and nominal income stability. This is a strategy designed to minimise the need to intervene in the market once the main policy tasks have been set up and announced for such a period.

4 The Debate on the Central Bank Strategy Reform and Political Economy Implications Central banks should not make policy decisions by following a mechanistic strategy but one that allows them to communicate their goals clearly and to incorporate learning in their decision-making process. These are vital elements in any transparent and effective monetary policy. Furthermore, as the former governor of the Bank of England, Mervyn King, put it few years ago, in the presence of unforeseeable events central banks need some range of manoeuvre to achieve their targets. But, in order to be credible this degree of freedom must be constrained within a credible monetary policy framework (therefore, a form of ‘constrained discretion’ is required, see King 2000). Conventional inflation targeting rules have not allowed central banks to address the challenges of the post-Global Financial Crisis years. Inflation targeting has demonstrated to be too narrow a strategy, particularly when consumer price inflation has been systematically below target and policy interest rates have reached the nominal zero bound. Following the consensus of the New Keynesian models, inflation-targeting central banks keep their focus on assessing the impact of socalled unconventional monetary policies on changes in nominal interest rates in the long term and the yield curve and tend to disregard the use of monetary aggregates for policy purposes. As evidenced in the last decade, they have not managed to find a more consistent and predictable way to communicate their policies to the public. 28 See

the historical evidence on this in Bordo and Lane (2013).

29 This is in line with Issing (2020), who suggests the adoption of a longer time horizon so financial

stability concerns can be incorporated into the design of monetary policy decisions.

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Rather, they have appeared to be reacting to the events rather than applying a coherent set of policy responses within a rule-based strategy. If this pattern is continued in the following years, it would dramatically harm the credibility of the central bank and thus the effectiveness of monetary policy. Following King (2005), central banks may find simple metrics useful as a sort of heuristic to summarise the main determinants of their decisions and thus enhance the communication with the public.30 This is in line with the review of the strategy of the ECB proposed in this chapter. This does not imply that monetary policy decisions are made mechanically or without incorporating further information and the personal judgement of the members of the relevant monetary policy committee. What the heuristics allow is to convey the main information and the rationale used to make a decision, therefore simplifying the communication with the public. In the same vein, the ECB should resume a more rule-based policy strategy compatible with monetary stability and financial stability over the medium and long term. This would imply a significant change in the way the ECB currently makes policy decisions. Our proposed strategy would set a longer-term target for money growth and nominal income, which may allow for prices to move up and down within certain boundaries. In addition, it would hold the ECB more accountable as regards the achievement of targets that are much more under its control. Acknowledgements I would like to acknowledge Alessandro Venieri’s research assistance in the collection of the data; as well as Geoffrey Wood, Charles Goodhart, Scott Sumner, George Selgin, Otmar Issing, Roland Vaubel, Tim Congdon and José Antonio Aguirre, who made very insightful comments on earlier drafts of the chapter. All remaining errors are entirely my own.

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Juan E. Castañeda has been the Director of the Institute of International Monetary Research since 2016. He earned his Ph.D. in economics in 2003 (UAM University at Madrid) and has experience working and researching in monetary policy and central banking. After 14 years at UNED University in Madrid, he joined the University of Buckingham as a lecturer in economics in 2012. He has worked with the European Parliament’s ECON Committee as an external expert. He has been an Honorary Senior Visiting Fellow at Cass Business School (London) and a visiting researcher at the Centre for Monetary and Financial Alternatives at the Cato Institute (Washington, DC) and at UFM University in Guatemala. He has authored and edited academic books and research articles on money, monetary policy and central banking. He is the Review Editor of the journal Economic Affair and a member of the Institute of Economic Affairs’ Shadow Monetary Policy Committee.

Searching for a New Balance for the Eurozone Governance in the Aftermath of the Coronavirus Crisis José Caetano, Paulo Ferreira, and Andreia Dionísio

Abstract The economic crisis triggered by the coronavirus exposed the gaps in the European Monetary Union (EMU) governance, creating fears to repeat the sovereign debt crisis. In view of the magnitude of the crisis and the financial interdependence inside that union, strong policy coordination and central measures are crucial. The discussion on debt mutualisation continued to be based on clashing political positions. This chapter identifies the instability recorded in sovereign spreads at the beginning of the crisis and reviews the structural factors that caused it. We discuss the limited role of the ECB answer. So, the issue of Eurobonds is revisited, bringing new arguments since the EMU faces an exogenous shock. We sustain that the approval of the European Commission’s original Next Generation EU programme on the European Council in July 21, could anchor a new governance model for the EMU, based on the principle of subsidiarity and the refusal of moral hazard arguments. Keywords Eurozone governance · Monetary policy · Sovereign debts · Eurobonds · Moral hazard

1 Introduction The sovereign debt crisis by 2009 left major marks on the European panorama and the Eurozone in particular. The crisis showed the structural divergences between the countries of the EMU. In particular, one of the relevant issues since then has been the sustainability of public debt in some member states. One answer to the sustainability J. Caetano · A. Dionísio CEFAGE, IIFA, Universidade de Évora, Évora, Portugal e-mail: [email protected] A. Dionísio e-mail: [email protected] P. Ferreira (B) VALORIZA—Research Center for Endogenous Resource Valorization, Instituto Politécnico de Portalegre, Praça do Município, 11, 7300-110 Portalegre, Portugal e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_6

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in countries most affected by the crisis was the obligation for them to continue on the path of budgetary discipline, through severe austerity programmes. Over time, the countries hardest hit by the crisis have improved their economic performance, and some of them have affirmed their path to debt reduction through surplus fiscal balances. As a result, markets have more confidence in these countries, which in recent years has allowed reduced spreads on interest rates on their debt vis-à-vis Germany and even an increase in ratings by international agencies. COVID-19 has changed this scenario: urgent support for economies to address health issues and support families and firms has become a priority. This intervention will have a direct impact on countries’ budget balances, not only through increased public spending, but also by reducing tax revenue. This, together with forecasts of sharp reductions in countries’ GDP, will imply worsening public debt. If there were doubts about the real sustainability of public debt in some countries, the current crisis has refocused on this issue, reviving previous debates. Over the past few years, many voices have argued that one of the problems in the Eurozone was it rules and design, with many countries not having the required conditions to take on the risks of a single currency, without inevitable episodes of instability. Furthermore, if the sovereign debt crisis was due to an asymmetric shock, the current pandemic crisis is clearly a global exogenous shock. Therefore, some sort of centralized action is required to avoid the fragmentation of the euro area. Based on several arguments, the solutions implicate different choices, from the monetization of budget deficits to the divisive mutualisation of sovereign debt. The challenge is enormous and may even lead to changes in the EU Treaties and/or in the statutes of the ECB and the European Stability Mechanism (ESM), compelling an understanding between members. Even so, there seems to be consensus that something has to be done in the governance of the Eurozone, to react to the situation and promote conditions for stability in financial markets. In this context, this chapter starts by searching for the basics of sovereign interest rate spreads volatility at the beginning of the crisis and discusses the structural factors that caused this (Sect. 2). Then, we revisit the sovereign debt crisis, debating its causes and successive changes in the EMU framework (Sect. 3). Section 4 focuses on the role assumed by the ECB since that crisis, and given its limited and controversial role we discuss the arguments regarding Eurobonds. We conclude by assessing the EC’s proposal for the Multiannual Financial Framework for 2021–2027, approved by European Council in July, finding its critical features in order to form a basis for a new governance of the EMU in Sect. 5.

2 The Dynamics of Bond Interest Rates in the Eurozone This section analyses the convergence between the yields of the 10-year bonds in some Eurozone countries, compared to German bonds, using correlation coefficients, in particular the coefficient from the Detrended Cross-Correlation Analysis (DCCA). Applying a sliding windows approach, we are able to witness the evolution of the

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Fig. 1 Evolution of the 10-year bond interest rate

correlations over time and to evaluate, dynamically, the convergence of interest rates and to identify the possible impacts of some crisis episodes. The DCCA was proposed by Podobnik and Stanley (2008) to compute the longrange cross-correlations between two different time series. Based on DCCA, Zebende (2011) proposed one correlation coefficient identified as ρDCCA(n). This coefficient shows the desired property of −1 ≤ ρDCCA(n) ≤ 1 and has the advantage of being usable even for non-stationary variables (Kristoufek 2014), besides the fact of being scale dependent, allowing the analysis in different time-scales. The properties and robustness of this correlation coefficient are described in Zhao et al. (2017). We also calculate the significance of the correlation coefficients, using confidence intervals for a level of 95% according to the values presented in Podobnik et al. (2011). In the original ρDCCA estimation, to avoid the occurrence of volatility bias, according to Horta et al. (2014) we applied filtered time series based on the conditional variance of a GARCH(1,1). Regarding the data, we retrieved the interest rates of benchmark bonds for a maturity of 10 years for 11 Eurozone countries from 1st January 1999 to 12th May 2020, a total of 5573 observations,1 with Fig. 1 showing the evolution of interest rates over time. For ρDCCA(n) estimation with a sliding windows approach (size 1000), we present the results for a time scale of 4 trading days, identifying the short term behaviour of the correlations (see Fig. 2).2 In that figure, we also show the starting 1 Greek

interest rates are only available from 1st April 1999, a total of 5509 observations. estimated correlations for other time scales, with the maximum one corresponding to 250 trading days, with results being qualitatively similar. Due to space constraints they are not shown but are presented upon request.

2 We

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Fig. 2 Evolution of the detrended cross-correlation coefficient between German interest rates and the remaining countries of the sample, for a time scale of 4 days with a size window of 1000 (Horizontal dashed lines represent the lower and upper limits of the confidence interval with a confidence level of 95%. The vertical dashed lines correspond to events and announcements: GFC the beginning of the global financial crisis; EDC the beginning of the Eurozone debt crisis; ECB1 the ECB’s allocation of 530 billion euros to the bank system [1st March 2012]; ECB2 as the successive announcements of the ECB to stabilize the markets [July 2012])

dates of the global financial and Eurozone crises as well as other episodes related to the ECB’s action to stabilize the financial system, such as its provision of e530 billion to banks (1st March 2012) and the cut of the key interest rate from 1% to 0.75% making a record in the Eurozone (5th July 2012) and Draghi’s speech indicating that the ECB is ready to do whatever it takes to sustain the EMU (Draghi 2012). Left panel includes the EMU countries belonging to the Central European block and the right one includes the most peripheral Eurozone countries. Before the global financial crisis, interest rates revealed high levels of convergence, even if at the beginning of the Euro the correlations were slightly lower. Somewhere between the global financial crisis and the Eurozone debt crisis, convergence levels started to decline, which was more obvious in the peripheral countries. From the beginning of the Eurozone debt crisis, bond markets became more fragmented. After several months of financial distress and total absence of convergence, the ECB intervened to reduce financial instability but also to increase the linking of Eurozone bond markets over time. However, for peripheral countries, the levels of convergence remained lower than at the beginning of the sample. The previous figure provides a global view of the convergence of bond yields, since the beginning of the Eurozone. However, it is appropriate to make a thinner analysis of the results. Therefore, considering exactly the same data for the 4-day time scale, Fig. 3 reveals the evolution for the time horizon starting in 2015. Firstly, considering Central European countries, the ECB measures are seen to allow their convergence to very high levels. However, in the case of peripheral countries, the situation is different. The gradual surge in convergence in Ireland is highlighted. This is because the crisis had different features in Ireland, namely in the banking sector. This allowed

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Fig. 3 Evolution of the detrended cross-correlation coefficient between German interest rates and the remaining countries of the sample, considering the horizon starting in January 2015, for a time scale of 4 days with a size window of 1000 (Horizontal dashed lines represent the lower and upper limits of the confidence interval with a confidence level of 95%)

Ireland to recover more quickly, giving a positive signal to the financial markets. Spain and Portugal showed increasing convergence. Identified as high-spending countries, the results prove that markets have recognized these countries’ efforts. Previous results can be related to other indicators of the bond market, such as those shown in Tables 1 and 2 of the Appendix. Table 1 shows the general government debt in different years. It is therefore easy to see that, between 2014 and 2019, almost every country showed reductions in the public debt burden. Although some countries showed a minor decline, others have relevant reductions, as is the case of Portugal, with an 11.4% reduction of the debt burden. The Table 2 complement the analysis, showing the 10-year bond interest rate spreads, the primary balance and the rating levels, in the case of S&P. Combining the previous remarks, it is noted that Central European countries have lower levels of debt, and therefore low spreads, in addition to higher rating levels. The recent behaviour of public debt and primary balances can explain the dynamics already mentioned. Figure 4 reveals that in the countries with primary

Fig. 4 Primary deficit/surplus between 2000–2019, in % of GDP, for the countries under analysis

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Fig. 5 Public debt, in % of GDP, for the countries under analysis

surplus the debt service is declining steadily. This means that countries with fiscal discipline have shown a strengthening of investor confidence. To this evidence, we add the fact that the public debt trend has been in general decline, as can be seen in Fig. 5, with two exceptions: Greece, where the structural problems of the economy were serious, but the country managed to stop the escalation of debt; and Italy, for the reasons that have already been indicated. Dashed lines represent the IMF forecasts for public debt in 2020. The results can be complemented with two more indicators linked with the specific risk of the banking sector: the percentage of public debt held by national financial institutions and the percentage of non-performing loans (NPL). The data for all the countries analysed in this chapter are in Table 3 of the Appendix. In the case of the weight of the debt held by national financial institutions, we conclude that since 2014 there has been a continuous decline in all countries. Regarding NPL in Fig. 6 the trend reveals a sharp decline in most countries, as Italy shows an average decline of 16.5% and Ireland reaching on 30.9% of decline per year, stating that the measures implemented had a significant impact on this indicator as well. Only the Greek case, despite a drop in the NPL shows a modest decline. At this time, it is crucial to take into account the forecasts for public debt in 2020. As expected, there are significant increases for all countries, because of the increase in deficits and the effect of the decline in GDP. In some countries, the effects will not be substantial, as their levels of public debt are quite low, but in cases such as Italy, Greece, Portugal and Spain, the increase is at least 17 percentage points, calling into question all the budgetary efforts of these countries. This whole picture shows the relevance of rapid and strong action by the authorities with the objective of sustaining the crisis that we are currently experiencing. In fact, the actions of the EU authorities confirm this relevance, as seen in Fig. 7, which illustrates the 10-year public debt spreads compared to Germany, during March 2020. After presenting some stability at the beginning, as fears about the risk of a

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Fig. 6 Non-performing loans, in percentage of gross loans

Fig. 7 Evolution of spreads, considering Germany as a benchmark, during March 2020

pandemic grew, the gaps widened, mainly on March 12th, when Lagarde stated that the ECB was not responsible for bond spreads. As a reaction, even on a day when the ECB reported increasing the purchase of assets, several stock markets fell sharply and spreads widened, namely in Italy and Greece. Spreads showed an upward trend by March 19, when the EC adopted a temporary framework facilitating state aid for the economy during the COVID-19 outbreak.

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The analysis of spreads’ convergence and their dynamics was carried out in this section using various indicators and plainly shows that public debt must be sustained through a multidimensional analysis. According to Pamies and Reut (2020), issues such as solvency, liquidity, uncertainty, debt structure, macro-financial risks and fiscal risks would be part of the analysis of debt sustainability. Moreover, the authors also highlight the role of international institutions in the analysis of public debt sustainability, in a context such as the current one. Similarly, the way spreads increased and the reactions to ECB statements to calm the markets reveal that feelings about potential public debt unsustainability still persist and should encourage authorities to act, as we will see in the next sections.

3 Revisiting the EMU Gaps Regarding the Sovereign Debt Crisis The fragmentation of financial markets in the Eurozone during the sovereign debt crisis exposed an incomplete monetary integration process. Despite some progress, structural divergences persist and some gaps in the EMU architecture are visible. In the previous section, we found that such divergences did not prevent 10-year bonds from fluctuating in the current crisis, showing that the origin of the turbulence in the financial markets remains. This justifies revisiting that crisis, looking for reasons for its deeper causes, as well as its social and economic consequences. If the right financial system operation is crucial for the EMU’s stability, European leaders should have learned the lessons from the traumatic experience of the crisis and they should have endorsed reforms in the Eurozone governance. That crisis should have clarified the political options on economic integration and the way countries share risks and obligations, as solutions to promote stability and efficiency, benefiting all EMU. Contrarily to the trend in the first period of the Euro’s life, the sovereign crisis deteriorates financial integration. The crisis forced a reversal of the direction of financial flows, from peripheral to central countries, as the costs of financing in those countries rose swiftly. This reduced the credit granted to families and SMEs, generating discriminatory conditions. The situation caused instability across the EMU and increased uncertainty on its continuity. The main issue was the sudden halt in the flow of foreign private capital in some countries, which later affected the costs of private. Economic growth fell and unemployment increased, falling current account deficits (Ferreira et al. 2018). There seems to be some consensus to the crisis causes, spotting the problem was the inability to avert the spread of the effects through the EMU. Baldwin et al. (2015) argue the stoppage in capital flows to the periphery stressed the degree of public and private debt, increasing these imbalances. The accumulation of domestic imbalances in some countries is structural in nature, but the responsibility should be also levelled at the EMU rules and the weak supervision by EU institutions.

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These institutions did not reveal concern on member’ levels of debt, nor incentives for their sustainability. There was a retroactive effect between sovereign debts and the banking systems themselves, fixing the spread of the risk between states and banks. So, a vicious circle was created, acting in distinct ways: first, the value of sovereign debt held by banks decreased when states’ risk augmented; second, the drop in the price of securities resulted in difficulty in accessing credit; third, the rise of sovereign risk caused a decrease in banks’ rating; finally, the increase in sovereign risk affected the value of public guarantees for banks, leading to a greater perception of risk in financial markets. This self-feeding mechanism expanded banks’ balance sheets, without ensuring the warranties on the viability of loans. Some banks had difficulties in getting credit, stressing the state/banks link, which evolved into a self-destructive doom-loop process (Farhi and Tirole 2018). The transfer of liabilities from banks to sovereigns reduced the sustainability of public debt and led to a surge in interest rates. Government guarantees to banks fuelled the instability, reducing the ability to provide cheap lending, putting pressure on the economy. Due to the high ownership of sovereign debts, banks stored risks, facing the collapse of the issuers, mainly the state itself. Yet, EMU members did not guarantee the redemption of the securities at maturity, exposing themselves to liquidity crises in the face of falls in confidence. Thus, countries’ degree of exposure to economic shocks was different, attested by the increase in cyclical divergences among EMU 2011. The asymmetry in the transmission of crisis amplified the shocks in countries more indebted, more deeply than in the countries that had their own currency. Could these effects have occurred in countries with monetary sovereignty? The explanation by De Grauwe (2011) is explicit, as he states the effects would be diverse. The crisis exposed the weakness of small open countries in a monetary area, where sovereigns do not control the currency in which their debt is issued. Without support from the ECB, markets forced sovereigns to socialize bank debt, as the country took on the role of the Central Bank as the lender of last resort. The surge in public debt was inevitable, increasing the interest rates in the economy. Agencies cut the rating on sovereign and bank debt, setting the countries as a status similar as emerging economies. The increase in sovereign debt spreads was inexorable and the dynamics of spreads damaged the insurance market and the banking sector in the EMU, rising systemic risk and striking hard challenges on regulators. This structural problem resulting from the architecture that supports the UMU’s action has limited monetary policy options, motivating the disparity in loan rates. Banks penalized firms with higher costs and stopped financing viable projects. Thus, the revision of financial risks accelerated market fragmentation. Since the peak of the crisis, the situation has improved, with the strengthening of financial integration, although the risks of a new crisis occurring have persisted, since some of the fundamentals that underpinned that crisis remain unchanged. There has been some progress in the creation of the Banking Union (BU) and a new regulatory framework for this sector, seeking to avoid greater exposure to risks, allowing an upgrading in banks’ sustainability due to the greater scrutiny of supervision by a single entity. Yet, the strong relation banks/sovereigns remain.

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Despite reforms and tries to reduce the risks of doom-loop, the breakdown the vicious circle lasts to be hampered by the weight of Public Debt held by domestic banks and by the amounts of NPL in banks’ assets, compromising their profitability and solvency. During the crisis, the belief that the BU was the right way for the sustainability of the EMU to provide financial stability was consolidated. Yet, the system of support to guarantee deposits has not reached consensus, and the uncertainty as to the setup of the Single Resolution Fund persists.3 This is one of the red lines dividing the EMU members, involving the refuse to mutualize banking risks. We mentioned the relevance of a European safe asset to preserve the state’s ability to finance itself at lower costs, allowing continuous access to markets and boosting the soundness of fiscal policies. To break the vicious cycle, it is crucial to find a solution for the structure of European Public Debt markets. The EMU’s safe assets would enable efficacious monetary policy and promote risk capital and investment. The Euro crisis stressed the flaws in the Maastricht model. The events put its existence at risk, but the leaders just endorsed timid reforms. Still, more changes must occur. So, staying halfway through the reforms is dangerous, as the upkeep of imbalances will make crises recurrent. A crucial issue is the sharing of sovereignty that countries are willing to assume, accepting greater sharing of risks in the EMU and to sustain economic convergence (Caleiro and Caetano 2018). EU institutions remain limited by the Treaties. We strongly believe that the dissolution of the EU would have higher costs than the consolidation of an effective EMU, integrating its social dimension (Caetano and Rico 2018). We recall Schumann words, for whom only real feats and solidarity-inducing tools could build a new EU. This is the time to give a new path to EU project and for countries to assume their responsibilities, as we will clarify in the next section.

4 Monetary Financing of Public Debt and Eurobonds Issue In the previous section, we realize that the EMU has endured a severe crisis, which has focused on the pressure on states’ sovereign debts and the instability in financial markets. Then, revising its causes and mitigating the effects of the crisis has been a priority for economists and politicians. The crisis caused effects with diverse intensity and amplitude, due to countries’ diverse structures, mainly regarding the sustainability of their debt and the fiscal consolidation. Despite some progress, uncertainty remained about how public finances would achieve sustainability. The events of the pandemic crisis and the need to rise public expenditure, in the face of a forecast fall in GDP of around 12%, especially in southern European countries (COM 2020a, b), increase the risks of some countries reversing the fiscal consolidation. In the EMU, monetary and exchange rate policies are no 3 Bénassy-Quéré

et al. (2018) propose a realistic approach to conclude the BU, as they labelled a Banking Union no-doom-loop.

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longer available and even fiscal policy is limited by the SGP rules. Also, there is no central crisis resolution device, nor is the sovereign debt mutualized. As a legacy of the crisis, some changes remained, anchored in dubious legal bases. Among these initiatives, the following stand out: The European Stability Mechanism (ESM) to allow access to financial support for countries and the ECB programme of Outright Monetary Transactions (OMT) to purchase the EMU members’ public debt in secondary markets. Now, despite the proven usefulness of the new governance structure, are these changes irreversible? The answer to the question is uncertain given the new and profound economic, social crisis. Some other questions could be framed. Will we have a breach of the principles preventing the monetization of public deficits by the ECB? Will we have solutions to mutualise public debts? Will the ongoing initiatives be of a temporary or definitive nature? Doubts on these questions are huge. Two issues will be crucial for the future, so it is on them that the analysis will focus. First, we will discuss the role of the ECB to manage monetary policy and supporting the fiscal state of EMU members; second, we will assess the relevance of sovereign debt sustainability in the EMU, as well as the role of the mutualisation of debt.

4.1 The New ECB Strategy for Monetary Policy Since 2012, the ECB’s strategy has been based on unconventional monetary policies, such as quantitative-easing, which has had significant effects. The ECB applied its Public Sector Purchase Program (PSPP), as stated by Mario Draghi “ECB decided to expand its asset purchase program to include government bonds after it became clear that there was a need for more monetary stimulus. Asset purchases are unconventional, but not unorthodox” (Draghi 2015: 1). Yet, the PSPP was more than an acquisition of sovereign bonds, as the fall in interest rates and spreads after its official announcement, producing a stabilizing effect on debt markets. The ECB was a central actor in the governance of the EMU because of its role in managing monetary policy. Though, without a formal role in the fiscal policies, the ECB challenged the prohibition on acquiring sovereign debt, opening up space for providing liquidity to countries. More, the ECB’s policies since March 2020 have shown this role in managing the crises in the financial system. In spite of the lack of the legal framework (TEU and ECB Statutes), these operations have caused legal conflicts, as was evident from the shock waves from the judgment of May 5, 2020 by the German Constitutional Court (GCC)4 on the legality of the PSPP. This decision requires the ECB to justify compliance with the principle of proportionality, regarding the main objective of keeping price stability. The GCC argues that to keep inflation close to 2%, the ECB caused collateral damage, bringing

4 See

https://www.bundesverfassungsgericht.de/SharedDocs/Pressemitteilungen/EN/2020/bvg20032.html, accessed on 31st July.

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interest rates to negative values, supporting EMU debtors and causing a devaluation of German pensioners’ savings. In addition, the GCC objects that the ECB did not justify the multiple impacts of the PSPP. Yet, monetary policy can suffer collateral damage from this legal conflict, limiting the ECB’s action in the future, especially since the GCC states that the purchase limit of 33% of each country’s debt and its proportional decision were not applied in the PSPP. So the massive ECB purchases since March 2020 are in danger of being disturbed by this legal war that looms to forbid the Bundesbank from participating in the ECB’s PSSP and poses a challenge to the German institutions to scrutinize that programme. The ECB’s action will not be illegal, as was recognized by the EU Court of Justice in December 2018. But the potential damage of the monetary policy cannot be devalued, and this is prohibited by the TEU. In fact, the ban on ECB financing of public institutions prevents monetization to no disrupt prices. Also, the no bailout clause ensures that a member’s public debt cannot be passed to the EU or to another state. The challenge for EU leaders to solve the incongruity between the legal framework and the need to ensure the functioning of the EMU has persisted, without any progress being made to solve it. The GCC rightly points out that the EU is not a federal state and there are limits that the technocracy cannot overcome. The conflict will subsist, postponing a solution to the eternal dilemma of the EMU: how to ensure its effective functioning in a paradoxical federal union of sovereign countries? We recall that in an urgent moment, Draghi’s speech “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough” (Draghi 2012: 1) successfully stated a new strategy. But not even the results obtained, which allowed the Euro to survive, can release politicians from the obligation to decide on the format of sharing resources, liabilities and risks, which in the end poses the query of sharing sovereignty. Despite this lack of definition, there was a consensus among economists that the monetization of debt is vital to ensure the markets stability. In fact, the current pandemic is causing a double shock in demand and supply of matchless intensity since the 1929 crisis, provoking a recessive spiral, facing sudden falls in GDP. There is urgency to ensure resources for banking sector in order not to break the financing cycle and states must act to save firms from bankruptcy, providing grants and direct support to workers to maintain their jobs and livelihood. In this scenario, a surge in Public Debt is certain, bringing the monetary financing of budget deficits to the EMU’s agenda. After timid responses to the crisis, EU states reacted with active strategies to support firms and employment, showing the asymmetry in the resources used by them, due to their budgetary margin. Faced with a symmetrical shock in its causes, but not in its effects, politicians were expected to forget old divergences and coordinate initiatives. But, coordination proved to be hard and the debates reopened fractures in the EMU architecture. The problem lies in the large-scale fiscal surges in some members, even though the EU suspended application of the SGP rules. The ECB’s action to cover economic effects from the shocks is also crucial. There is no alternative to support from states to avoid firms facing bankruptcy, illiquid banks and struggling families. The ECB

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used the OMT programme and removed some of the conditions associated with it. This was scarce according to De Grauwe (2020), who recommends the acquisition of sovereign bonds in the primary market, financing budget deficits. This action will prevent states from issuing new debt. The ECB provides liquidity by using the state budget as an intermediary, possibly starting a suitable way to apply the helicopter money idea (Reichlin et al. 2019). Government are the suitable entities to carry out this process, given its democratic legitimacy and awareness of economic needs. Only the strong delivery of liquidity can interrupt the deflationary dynamics in which some countries find themselves. There are objections to the ECB’s monetary financing. The main one is related to the exclusion of monetary financing of budget deficits. A solution could be to issue perpetual bonds with zero interest rates that would be placed on the primary market and then acquired by the ECB in the secondary markets, in a version close to the proposal by Giavazzi and Tabellini (2020). There are also doubts that monetary financing would rise inflation. In the current settings, inflationary risks are nearly non-existent, instead of the deflationary spiral that is the greatest strain. Monetary financing can stop this spiral, as the ECB, as one of the most independent entities in the world, has enough credibility to ensure a monetary policy aimed at stability. De Grauwe and Diessner (2020) argue that while deficit monetization would have some impact on inflation in the future, that would be a cost worth paying to avoid future sovereign debt crises in the EMU. Blanchard and Pisani-Ferry (2020) sustain that ECB programmes distribute the crisis costs, yet they believe it would be more clear to occur by budgetary channels. The PEPP will be useful given the volatility in markets, promoting convergence of expectations of self-fulfilling events, which can cause inefficient balances. Thus, the ECB’s action would be for a common good and benefit the entire EMU. Although the ECB has fought against the recession, it should not bear the whole cost of supporting recovery. For Beck (2020), public spending is a task of fiscal policy, so the burden must be financed and shared by society, either by taxing current generations or increasing public debt, which burdens future generations. For monetary policy to keep the cost of debt under control, quantitative easing must remain. Then, transferring fiscal policy functions to the ECB will affect its image as an independent and reputable entity.

4.2 Discussing the Viability of Eurobonds Creating conditions to preserve the sustainability of members’ debt in the EMU leads us to the controversial and complex debate on the debt mutualisation. Asymmetric economic shocks provoke sovereign debt crises, causing budget deficits and debt boom. The lack of confidence in fiscal sustainability brings instability to the financial markets, as risk premiums increase. EMU members have formal limits that avert them from acting on the causes and effects underlying a sovereign debt crisis.

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The mutualisation of sovereign debt implies joint guarantees to all members, including the onus to repay it at maturity. Two issues result from this, dividing economists and politicians. First, as the joint debt can worsens interest rates for better rated countries it raises the question of benefit sharing. As the reverse happens in worst-rated countries, there may be a transfer of costs. Second, when the most indebted countries are not committed to the cost of this and may be complacent in their behaviour, there is a moral risk that these countries will not carry out the necessary measures to avoid new debt. The literature on the mutualisation of Public Debt is vast and the analyses have increased after the Green Paper on the viability of Stability Bonds (EC 2011), which fuelled a debate on the Eurobonds feasibility. These papers condense the justifications for their advantages, the options for issuing, the fiscal framework of the securities issued and features related to their implementation. Van Aarle et al. (2018) study the stabilization of sovereign debt in the EMU, by considering two different regimes with endogenous risk premiums, without linearity in the risk premium, so the transition from an autonomous regime based on national tax discipline to a regime subject to collective discipline causes more than the mere repartition of debt charges, being a positive-sum game. They prove the joint debt leads to sharing duties, provoking a decline in risk premiums for higher debt countries, while those with low debt will have a slight increase in the risk premium. The average risk premiums in the EMU drop, causing a net benefit. More, if belonging to the EMU is an insurance, the debt mutualisation is an efficient option, as any country could have a low debt at one moment. Common debt averts countries from being penalized by the adjustment charges due to the increase in risk premiums in the autonomous regime. In this regime, based on domestic fiscal discipline, financial markets impose risk premiums on members based on their public debt and the belief that financial markets discipline countries. In the EMU, this regime assumes that the no bailout clause is credible to deal with moral hazard risks, preventing undisciplined countries from defaulting without punishment. If investors consider that clause is not credible in a highly unified area, mutualisation is a viable and efficient alternative. At first times of the Euro there was the inconsistency of fiscal policies by members’ market discipline, making convergence in bond yields till 2009. If Eurobonds came into effect, budgetary discipline would not be reduced to contain the incentives for opportunistic behaviour, swelling the moral hazard risk. The change in the EU’s fiscal surveillance has focused on the supervision of public finances. The SGP was boosted by Six Pack, Compact Fiscal and Two Pack, aiming to strengthen the credibility of the economic coordination, by transferring competences to the EMU. According to Darvas (2020), the current crisis calls for a concerted solution that promotes stability. To mitigate human suffering, the author considers that countries with low debt have a moral and social responsibility to support the most affected countries, based on strict criteria, but not be confused with stringent conditionality. Vaitilingam (2020) goes further, admitting that the Coronabonds may not even be necessary if the ECB acquires sovereign debt. To this proposal, some more sceptical voices were added, indicating legal and political harms in the ECB’s participation

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in this approach. Smaghi (2020) defends Eurobonds, despite he advises this is a controversial political matter, requiting the transfer of member’ sovereignty to the EMU. For Herzog (2020), the EMU is not a federal union, and so there is no central fiscal power, fading the Eurobonds option. The possibility of moral hazard is stressed, arguing that this is not in itself an abstract risk, but a reality in the EMU. The debate sometimes views Eurobonds as an exceptional step, creating a dangerous precedent in the EU. However, Horn et al. (2020) recalls that since the 1970s, the EC has placed a dozen community bonds in private markets, guaranteed by member states, the funds being distributed to countries in crisis and fully repaid at maturity. The current proposals include joint states liabilities, being more innovative than the devices based on maximum guarantee quotas. There are lessons to be learned from that, especially the perception that the EU budget played a central role to guarantee debt securities, with states’ guarantees acting on a second level. History leaves room for optimism, since all the EEC bonds were reimbursed in time. Thus, Coronabonds would follow a tradition of cooperation and financial solidarity, acting as a common good and benefiting the EMU. Gros (2020) goes further by suggesting a transfer of resources from the EU budget, excusing the most vulnerable countries to contribute. The consensus on the need to issue common debt is widening. Then, Hüther et al. (2020) propose issuing e1000 billion of joint securities. The funds would be distributed by some criteria, depending on the severity of the crisis and countries’ weakness. They argue that, being a supranational debt, markets would not realize it as a rise in countries’ debt. This asset would provide stability and liquidity, reinforcing the Euro’s influence in international markets.

5 Building a Sustainable Base for the EMU´S Governance The current crisis is having a devastating economic impact, as forecasts confirm (EC 2020). The recession will bring about the sharpest drop in GDP in Europe since the last World War, inducing the need for action to avoid amplified economic divergences in the EMU and distortions in the single market. It is an exogenous shock and its gravity justifies joint action to complement national actions. It should be noted that actions have been uneven, due to countries fiscal space, worsening divergences. So, it is urgent to act, mobilizing ample financial resources, which justifies the EC’s proposals at the end of May 2020, agreed by the European Council in middle of July, changing radically the Multiannual Financial Framework for 2021–2027. This proposal was leveraged in the agreement between Angela Merkel and Emmanuel Macron, which was decisive in unlocking the European Council. This agreement has effects across the EU, by proposing a Recovery Fund to support states in fighting the recession, and is based on non-repayable loans. The EC’s proposal had a plain political reach over EU fiscal policy, by breaking taboos that have damaged the discussion on the role of the EU Budget in the integration process. The first aspect is the financing through the EU issuing debt. The moral hazard rhetoric that Eurobonds does not boost structural reforms for fiscal sustainability

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will be overcome. The second issue is that the proposal implies larger centralization of fiscal policy and more tax revenue will be needed, doubling the burden of the EU budget. Third, the main novelty comes from the permission given to the EC to finance itself in the markets, going beyond the exclusive use of member states’ own resources and contributions, lying on the innovative disbursement logic. This new impetus for the European project is relevant. The concern on moral risk still exists. The fiscal measures imply transfers to eliminate bottlenecks are not limited to coordination or goodwill of the States. In the lack of a real fiscal union, the expenses to support economies are a national competence, being financed by national taxes. Also, specific solutions can be better applied at the domestic level, agreeing to the subsidiarity principle as Beetsma and Kopits (2020) suggest. The crisis arising from overloaded health systems and economic lockdown has evolved into an issue of stabilization across the EU, with the ECB bearing the adjustment cost so far, in the absence of a central fiscal authority. Yet, given the cross-border spillovers, all European institutions must participate. Grants financed by debt at low interest rates would not increase countries’ debt, despite some political resistance. Now, instead of transferring them to countries, it may be suitable and efficient, in terms of risk sharing, to direct them to target regions, defined on the basis of per capita indicators of morbidity and families and companies’ loss of income. Solutions may include mutual guarantee for national loans or, preferably, a loan such as Eurobonds. Yet, mutual guarantees and Eurobonds were steadily rejected due to the moral hazard argument. As Wyplosz (2020) rightly points out, in the current special circumstances, concern about moral hazard should be put aside, recommending a quick agreement on the EC proposal can be reached. Now, stringent conditionality is not compatible with the requests and objectives to recover from the crisis where moral hazard does not exist. So, the solidarity founded on grants, based on solid criteria to its disbursement put responsibility in the plan recently approved in the European Council, which have the potential to overcome problems of legitimacy as happened with the intrusive conditionality forced by the “Troika” in 2011. Acknowledgements Paulo Ferreira and Andreia Dionísio acknowledge the financial support of Fundação para a Ciência e a Tecnologia (grants UIDB/05064/2020 and UIDB/04007/2020).

Appendix See Tables 1, 2, and 3.

104.9

36.1

109.0

52.1

54.2

57.8

Greece

Ireland

Italy

Netherlands

Portugal

Spain

35.8

72.7

43.0

103.9

23.9

103.1

64.0

64.5

33.9

87.3

65.0

2007

100.7

132.9

67.8

135.4

104.4

178.9

75.7

94.9

59.8

107.0

84.0

2014

Legend acr—average change of rate Source Eurostat; European Central Bank; IMF

58.9

42.5

Finland

59.1

109.6

Belgium

Germany

66.1

Austria

France

2000

Country

99.3

131.2

64.6

135.3

76.7

175.9

72.1

95.6

63.6

105.2

84.9

2015

99.2

131.5

61.9

134.8

73.8

178.5

69.2

98.0

63.2

104.9

82.9

2016

Table 1 General government gross debt (as % of the GDP, Q4)

98.6

126.1

56.9

134.1

67.7

176.2

65.3

98.3

61.3

101.7

78.3

2017

97.6

122.0

52.4

134.8

63.5

181.2

61.9

98.1

59.6

99.8

74.0

2018

95.5

117.7

48.6

134.8

58.8

176.6

59.8

98.4

59.4

98.6

70.4

2019

63.3 155.5 58.3 135.0 113.4

– −9.0% −5.2% −7.6%

200.8

−2.7%

–

115.4 68.7

−5.0% −8.7%

114.8

−9.6%

70.0

84.6

−8.6% 1.6%

IMF projection 2020

acr 2014/2019 (%)

Searching for a New Balance … 131

32.1

38.4

21.3

15.1

–

61.7

17.2

44.4

14.2

39.2

29.7

Austria

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Netherlands

Portugal

Spain

87.1

102.3

58.7

142.2

127.21

227.8

–

46.3

54.1

82.5

89.7

2008

107.0

215.2

14.1

133.8

70.1

905.4

–

29.7

10.9

28.5

17.1

2014

65.6

63.5

13.1

150.1

9.5

210.0

–

27.1

23.5

28.4

21.3

2019

Source Eurostat and European Central Bank

2000

Country

4.5 −0.2 2.0

−1.5% −21.7% −9.3%

6.8

−32.9% 3.7

2.8

−25.3% 2.3%

1.6

1.6

−1.8% –

9.6

16.6%

1.6 6.6

−0.1%

2000

−7.7

2.2

−2.2

−0.7

1.6

0.3

−5.7 2.3

0.4

−1.7

−0.5

3.2

2.5

1.7

1.7

4.4

2.3

−1.8

AA+

AA

AAA

AA

AA+

A–

AAA

AAA

AA+

−0.3 −1.6

2.2 −2.5

AA+

AAA

2000

AAA

AA−

AAA

A+

AA

A

AAA

AAA

AAA

AA+

AAA

2008

BBB

BB

AA+

BBB−

A

B

AAA

AA

AA+

AA

AA+

2014

A

BBB

AAA

BBB

AA−

BB−

AAA

AA

AA+

AA

AA+

2019

3

3

1

1

2

2

0

0

0

0

0

Difference in # of rankings (2014/2019)

Risk notation (S&P, end of the year)

0.1

2.2

−0.3 0.1

2019

2014

−5.4

−0.4

5.6

−3.0

2.5

2.9

1.5

2008

Primary deficit/surplus (% of GDP, end of the year)

4.5%

tvm 2014/2019 (%)

Yields’ differential—10-year bonds (base points, last observation of the year)

Table 2 Yields’ differentials, primary deficit/surplus and risk notation from the countries under analysis

132 J. Caetano et al.

20.3

14.0

39.7

–

–

19.3

8.9

23.7

20.5

21.2

14.2

2015

11.2

20.4

20.1

34.6

–

–

16.7

8.1

22.0

17.0

17.1

11.7

2017

12.7

37.6

–

–

18.0

8.7

26.8

19.1

19.1

13.5

2016

Legend acr—average change of rate Source European Central Bank

22.2

–

Ireland

Spain

20.0

Greece

14.3

8.3

Germany

Portugal

28.1

France

–

21.7

Finland

41.1

22.6

Belgium

Netherlands

14.3

Austria

Italy

2014

Country

19.7

9.6

37.1

–

–

15.8

8.9

20.9

15.2

15.6

10.6

2018

17.0

8.9

35.7

–

–

15.5

9.0

19.0

13.8

13.6

9.1

2019

% of government debt hold by national MFI

4.2

−7.6%

16.5 3.4 16.6 8.1

– −9.0% −5.2%

21.6

−2.7%

–

3.9

1.6

−8.7%

39.7

4.3

−9.6%

1.6%

7.5

−8.6%

−5.0%

2014

acr 2014/2019 (%)

6.3

17.5

2.7

16.5

14.9

46.8

3

4

1.5

3.8

6.5

2015

5.7

17.2

2.4

15

13.1

46.3

2.6

3.6

1.4

3.2

5.1

2016

4.4

13.3

2.1

11.2

9.9

45

1.8

3.1

1.2

2.7

3.5

2017

3.7

9.4

1.9

8.4

5.5

41.6

1.4

2.7

1.5

2.3

2.6

2018

3.1

6.1

1.8

6.7

3.4

35.5

1.2

2.5

1.4

2.1

2.2

2019

Gross non-performing loans (% of gross loans)

Table 3 Percentage of government debt hold by national MFI and gross non-performing loans

−17.5%

−18.1%

−11.9%

−16.5%

−30.9%

−2.2%

−21.0%

−9.9%

−2.6%

−13.4%

−21.8%

acr 2014/2019 (%)

Searching for a New Balance … 133

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EC (2020) European Economic Forecast. Institutional Paper 132 | July. Available via https://ec. europa.eu/info/business-economy-euro/economic-performance-and-forecasts/economic-foreca sts/summer-2020-economic-forecast-deeper-recession-wider-divergences_en. Accessed 10 July 2020. Farhi E, Tirole J (2018) Deadly embrace: Sovereign and financial balance sheets doom loops. The Rev Econ Stud 85(3):1781–1823. https://doi.org/10.1093/restud/rdx059. Accessed 10 July 2020. Ferreira P, Caetano J, Dionísio A (2018) The Risk of Incomplete Financial Integration in the European Union. In: Caetano J, Sousa M (eds) Challenges and opportunities for eurozone governance. Nova Science Publishers, pp. 61–79, ISBN 978-1-53613-475. Giavazzi F, Tabellini G (2020) Covid perpetual eurobonds: Jointly guaranteed and supported by the ECB. VOX EU CEPR. Available via https://voxeu.org/article/covid-perpetual-eurobonds. Accessed 2 June 2020. Gros D (2020) EU solidarity in exceptional times: Corona transfers instead of Coronabonds. VOX EU CEPR. Available via https://voxeu.org/article/corona-transfers-instead-coronabonds. Accessed 12 July 2020. Herzog B (2020) Whither Coronabonds? The past and future of the EMU in the Coronavirus pandemic. Intereconomics 55(3):155–159. Horn S, Meyer J, Trebesch C (2020) Coronabonds: The forgotten history of European Community debt. VOX EU CEPR. Available via https://voxeu.org/article/long-run-view-coronabonds-debate. Accessed 12 July 2020. Horta P, Lagoa S, Martins L (2014) The impact of the 2008 and 2010 financial crises on the hurst exponents of international stock markets: Implications for efficiency and contagion. Int Rev Fin Anal 35:140–153. Hüther M, Bofinger P, Dullien S, Felbermayr G, Schularick M, Südekum J, Trebesch C (2020) Europe must demonstrate financial solidarity. Available via https://www.iwkoeln.de/en/ press/gastbeitraege/beitrag/michael-huether-europe-must-demonstrate-financial-solidarity.html. Accessed 12 July 2020. Kristoufek L (2014) Measuring correlations between non-stationary series with DCCA coefficient. Physica A 402:291–298. Pamies S, Reut A (2020) Assessing public debt sustainability: Some insights from an EU perspective into an inexorable question. In: EC (ed) Quarterly Report on the Euro Area, 19(1), pp. 27– 43. Available via https://ec.europa.eu/info/sites/info/files/economy-finance/ip130_en_chapter_ii. pdf. Accessed 10 July 2020. Podobnik B, Jiang ZQ, Zhou WC, Stanley HE (2011) Statistical tests for power-law cross-correlated processes. Phys Rev E 84:1–8. Podobnik B, Stanley H (2008) Detrended cross-correlation analysis: A new method for analyzing two non-stationary time series. Phys. Rev. Letters 100(8):084102. Reichlin L, Turner A, Woodford M (2019) Helicopter money as a policy option. VOX EU CEPR. Available via https://voxeu.org/article/helicopter-money-policy-option. Accessed 30 March 2020. Smaghi LB (2020) Coronabond—Great idea but complicated in reality. VOX EU CEPR. Available via https://voxeu.org/article/corona-bonds-great-idea-complicated-reality. Accessed 10 June 2020. Vaitilingam R (2020) European economic policy for the COVID-19 Crisis: Views of leading economists on lockdowns, Coronabonds and the ECB’s role. VOX EU CEPR. Available via https://voxeu.org/article/european-economic-policy-covid-19-crisis-igm-forum-survey. Accessed 8 June 2020. Van Aarle B, Engwerda J, Weeren A J T M (2018) Effects of debt mutualisation in a monetary union with endogenous risk premia: Can Eurobonds contribute to debt stabilization? Struc. Change Econ. Dynam 44:100–114. https://doi.org/10.1016/j.strueco.2017.11.004. Accessed 10 July 2020.

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José Caetano holds a Ph.D. in Economics from the University of Évora. He is an Associate Professor of Economics at the same university, the Director of the Master Programme in International Relations and European Studies, and a researcher at CEFAGE. His research interests are international economics and European integration, on which he published several articles in international journals and books. In 2018, he coedited the book “Challenges and Opportunities for Eurozone Governance”. Paulo Ferreira is an Economist and holds a Ph.D. in Management. With several peer-reviewed published papers in international reviews and technical books, his research is focused on the analysis of financial markets, although with research also in entrepreneurship and in financial integration. Currently, he is a Professor at the Polytechnic Institute of Portalegre, but with teaching experience in other higher education institutions. He is a Researcher at VALORIZA—Research Center for Endogenous Resource Valuation (Portalegre) and at CEFAGE (University of Évora). He is currently Subdirector of the Agrarian Superior School of Elvas, of the Polytechnic Institute of Portalegre. Andreia Dionísio is a Professor at the University of Évora, Management Department, specialized in statistics for business, data analysis, econometrics and econophysics and responsible for the Data Analysis courses. Her main areas of research have included the study of stock markets, global dependence, nonparametric methods and fuzzy set analysis. Over the last 15 years, she has been involved in several research projects. She is co-author of more than 20 research articles. Presently, she is the Vice-Director of Center for Advanced Studies in Management and Economics of the University of Évora (CEFAGE).

Surfing the Epidemic at the Zero Lower Bound: A Eurozone Fiscal Era? Esteban Cruz-Hidalgo, José Francisco Rangel-Preciado, and Francisco Manuel Parejo-Moruno

Abstract The Global Financial Crisis has diluted the previous consensus on monetary policy. The disconnection of the Interest Rate Policy for macroeconomic management motivated by the permanence of the zero lower bound has forced central banks to make incursions into unexplored terrain. Right at this historic moment, the epidemic shock has hit the economy, causing a drop in activity unprecedented since World War II. The monetary authorities are once again pushed to advance cooperation between the Central Bank and the Treasury. This is an especially difficult exercise in the Eurozone, where the different levels of resilience of the member states divert macroeconomic issues into the moral arena. An effective way to redirect the discussion for macroeconomic stabilization is to focus the debate on the development and strengthening of automatic stabilizers, which would dispel the discretionary image of public spending. That is the objective of this chapter, and against this background we immerse ourselves in the debates on Functional Finance in the context of World War II to present an automatic mechanism fixed to a clear policy rule. Keyword Fiscal policy · Automatic stabilizers · Zero lower bound · Secular stagnation · Job guarantee

1 New “Liquid” Normality We are living in exceptional times within the exceptionality. The social “new normality” imposed by the containment and security measures supervened by the pandemic hits the economic “new normality” left over from the Great Recession. The previous consensus on the Interest Rate Policy has been diluted in the face of the zero lower E. Cruz-Hidalgo · J. F. Rangel-Preciado · F. M. Parejo-Moruno (B) University of Extremadura, Badajoz, Spain e-mail: [email protected] E. Cruz-Hidalgo e-mail: [email protected] J. F. Rangel-Preciado e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_7

137

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bound. In this context, where hysteresis and secular stagnation play a leading role, a third element has come to the fore: the coronavirus. The empirical evidence regarding the macroeconomic effects of the unconventional measures of the central banks is undisputed regarding three results: (i) The money supply increased by this channel has not yielded vigorous macroeconomic results; (ii) quantitative easing has significant distributional effects that must be considered; and (iii) given the limited scope of monetary policy, fiscal policy must take a more active role in macroeconomic management. The persistence of the effects observed during these years threatens to be exacerbated by the shock caused by the COVID-19 pandemic. The urgency requires delving into the aforementioned unconventional measures, and doing so in a timely manner. We are not witnessing a “simple” supply shock. Yes, there is an inevitable temporary contraction in the production of goods and services. Citizens have been locked up for weeks, nonessential service workers have stayed home, and not all activities can accommodate teleworking, especially jobs that require a lower educational level. Many people have become ill, and the social distancing and safety measures implemented in the workplaces cause restrictions on activity that, in some cases, are total. These precautions will accompany us until we find a vaccine and the threat of collapse of our health systems is controlled. But, in addition, in parallel with the reduction in supply, there is a dramatic drop in demand. Enforcing compliance with social distancing means that a wide range of routine consumer activities simply no longer take place or will do so in a very restricted way. We are thinking here about sectors such as hospitality, tourism, physical stores, recreational activities, theatre, academies, and gyms. In the absence of a political response, the employees and owners of these businesses will lose their livelihoods. Those workers in the sectors that remain active will maintain their income but will not increase their spending. They will not buy more food, they will not get their hair cut more often, and they will buy more books, video games, televisions, or any other product. The money normally spent on activities that require social contact will, to a large extent, be saved. The drop in demand is amplified because households that lose their income also stop consuming even the most essential commodities, thus indirectly affecting employment in the rest of the economy. Financial fragility is spreading. Investment sinks in the face of lack of profit expectations, and employee–employer relationships are disrupted. This implies permanent social and economic costs for individuals, families, communities, and the economy as a whole. Considering the inefficiencies in the allocation of resources and the potential production that this causes, it is necessary to strengthen the coordination between monetary and fiscal policy that was already underway after the Global Financial Crisis. The COVID-19 pandemic must not lead to another pandemic, one that spreads rapidly through the vicious circle into which the economic circuit enters: unemployment. The lessons learned from the Great Recession, along with further evidence, show that this dual shock will only compound the threats already on the horizon, such as climate change, a collective problem that affects all social classes. The experience accumulated over the years does not constitute mere warnings, but rather, sufficient evidence of the importance of not letting

Surfing the Epidemic at the Zero Lower …

139

the economic discussion dissolve into a moral dispute between debtors and creditors, as the consequences will be serious for all. This debate is especially important for the Eurozone. Its particular institutional design ensures that the required coordination is slower and encounters more obstacles than in any other region of the world. Political restriction must therefore be considered. In this sense, the development and strengthening of automatic stabilizers is the best way to circumvent the vetoes and the alarmist paralysis on discretionary spending and the damage surrounding the dominance of parliamentary democracy over an independent monetary policy. With this consideration, the objective of this chapter is to briefly propose a rule-based automatic stabilizer: Job Guarantee. We have structured the chapter as follows. After this brief introduction posing the problem, we carry out in the second section a review of how hysteresis, secular stagnation, and the zero lower bound have had an impact on macroeconomic theory, contextualizing the terrain we are treading when talking about strengthening cooperation between fiscal and monetary policy. In the third section, we examine the first responses that economists have given on how economic authorities should act to deal with the pandemic. In the fourth section, we briefly explain how the current situation is vital to give a new opportunity to an idea that emerged in the middle of World War II: Functional Finance. Finally, we reflect on how a critical phenomenon can drive developments in economic theory, even from forgotten ideas.

2 Riding the Turbulences The Global Financial Crisis has brought new frictions and imperfections that alert the monetary authorities to aspects that will have a prolonged and persistent impact on the economy. In a scenario characterized by a “natural imperfection” that can last indefinitely, such as the zero lower bound (Summers 2015, p. 61),1 the notions of hysteresis and secular stagnation have come to the fore. Neither of these cases is a new concept; rather, they received lesser research efforts or were forgotten for decades because the attention was elsewhere (Blanchard and Summers 1986; Krugman 1998; Backhouse and Boianovsky 2016). While these aspects were left out of the information given by the observations, all the research could revolve around Taylor’s Rule (1993), which equates aggregate demand and potential production, and the search for better micro-foundations to escape from the Lucas critique (1976), that is, the introduction of nominal and real rigidities specified in terms of optimization of the behavior of individuals (Woodford 2003). 1 The

results of a long-term historical investigation by Schmelzing indicate that secular stagnation is not an unusual condition, but rather a theoretical consequence of a misleading approach to the relationship between investment and the real interest rate. History shows that lower real interest rates have coincided with a steady long-term rise in fiscal activity (Schmelzing 2020, p. 74). This is consistent with Stiglitz’s claim that secular stagnation is a consequence of political decisions that can be changed (Stiglitz 2018).

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Economists are beginning to accept the zero lower bound as more than just a temporary anomaly. This was happening just before the arrival of the COVID-19 pandemic. Investment has been disconnected from the interest rate, and the nominal interest rate instrument controlled by central banks can no longer go down. The political implications of permanently low real interest rates shift the focus from monetary policy to fiscal policy. This does not mean that monetary policy is in the background. It means that fiscal policy figures to stabilize the economic cycle together with monetary policy. Given the disconnection of the Interest Rate Policy, central banks have been forced to experiment with new artillery, expanding their balance sheets through the purchase of public and private assets, what is known as quantitative easing (QE). The theory leads us to think that an increase in reserves drives bank loans, following the logic of the monetary multiplier (Rochon and Vallet 2019).2 This drives real economic activity and inflation, pulling the economy out of the zero lower bound. The evidence is as follows: There is no work that establishes a link between QE and the final objectives of central banks (Williamson 2016, p. 929). Faced with this scenario, and according to Summers, the strategy to follow is to find ways to increase total spending, “no matter how contradictory it may be” and without reducing economics to a question of morality (Summers 2015, p. 65). Another topic that has attracted attention since the Global Financial Crisis is hysteresis, the notion that “monetary shocks leave permanent scars in the economy” (Mankiw 2001, p. 48). This principle, which could open a fissure in the classical dichotomy, is perfectly consistent with the traditional framework of analysis if it is only understood asymmetrically.3 That is, the introduction of long-term nonneutrality is only accepted as a result of the role that money plays in the allocation of resources. The challenge of hysteresis is to integrate into the analysis elements that help explain the “persistence” of monetary shocks over time. But once the presence of hysteresis 2 It

should be noted that the creation of money through Interest Rate Policy works contrary to what the multiplier theory says. However, QE shifts the focus of monetary policy to the quantity of money rather than its price. An alternative explanation for the mechanism that activates QE and that does not involve the creation of new credits directly is the following: the central bank buys a quantity of financial assets in the secondary market, usually government bonds. The sellers of these bonds will keep the deposits thus created, but they will probably not want to simply keep this money, but rather will use it to buy higher-yielding assets such as shares issued by companies. This increases the value of these assets and reduces the cost to companies of financing themselves in the financial markets, which will lead to greater spending in the economy (Bowdler and Radia 2012, p. 619). 3 For Solow “the long run and the short run…cannot be completely independent,” and he poses the question of “whether a major episode in the growth of potential output can be driven from the demand side. Can demand create its own supply?” (Solow 1997, p. 232). His answer is affirmative as long as there are two “special circumstances”: (i) if an economy has available labor that it can mobilize, and (ii) if strong aggregate demand can induce an increase in total factor productivity. The reason that in both of those cases demand can induce growth in supply is that workers gain skills as they employ them. In addition to learning (Chang et al. 2002), the other two channels in the literature that cause hysteresis are the power of unions to give a disproportionate weight between that part of the workforce that is employed and those that do not (Blanchard and Summers 1986), and the behavior of financial markets, which by contributing to booms and busts cause a distorted and persistent allocation of real resources (Borio 2016).

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is accepted, it becomes evident that the central bank’s policy of achieving a specific inflation target has high and permanent social costs (Ball 2009, pp. 25–26). When a shock such as the Great Recession or the COVID-19 pandemic occurs, the trend in total factor productivity is permanently lower than it would have been due to the drop in research spending, the erosion of capacities and workers’ skills, and even their exit from the labor market, reducing the estimated potential production. The unemployment mark cannot be completely reversed, but the longer unemployment persists, the more its perverse effects spread to the communities with the highest prevalence of this virus, and to the rest of the economy through the allocation of resources mobilized to deal with these effects. With little or no scope for traditional monetary policy, fiscal policy is making its way into studies of new unconventional monetary tools, displacing research on structural reforms (Blanchard and Leigh 2013; Fatás and Summers 2018). Evidence that fiscal multipliers are larger than previously thought appears to have facilitated this change, but the bottom line of the change in research is undoubtedly the new normality imposed by the zero lower bound (Christiano et al. 2011; Gechert et al. 2019). The triad of secular stagnation, zero lower bound, and hysteresis, viewed in its narrow context, has changed the economy since the Global Financial Crisis. As Eggertsson points out, in a scenario where the Interest Rate Policy is without effect, what is required is to increase aggregate demand through total spending, not supply. There are not enough buyers (Eggertsson 2011, p. 61). Or as Summers affirms, “we are very powerfully seeing a kind of inverted Say’s Law,” where demand creates its own supply (Summers 2014, p. 71). Central Bank governance in the economy is clearly entering a new stage (Goodhart 2011, p. 136). The independence of the Central Bank has never survived a crisis (Capie and Wood 2013, p. 379). The historical novelty is that this time central banks have learned that they must help governments to avoid legal restructuring; they have anticipated the reaction to undo this institutional divorce between the government’s left or fiscal hand and their monetary or right hand (Blancheton 2016, pp. 106–107).

3 What Level of Coordination Is Appropriate? There are three unanimous positions on the economic effects of the COVID-19 pandemic: (i) It is an external shock for which no country should be punished; (ii) externalities cross borders; and (iii) action must be taken quickly and decisively to contain interruptions in production and employment to avoid permanent scarring in the productive fabric, taking into account the interrelationships between sectors, with the labor market and with the financial sector (Laborda and Onrubia 2020, pp. 1–2). There is a widespread fear of the effects of hysteresis, and that is the fundamental concern in all the proposals issued so far. Along with the health objective of flattening the contagion curve, there is also a requirement to flatten the curve of the economic recession (Gourinchas 2020).

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The dilemma between health and economy is not present in a literature where the aforementioned fatal triad, formed by the zero lower bound, secular stagnation, and hysteresis, is repeatedly invoked. There is no trade-off between protecting life and defending business. Sick people neither consume nor produce, and the threat of contagion works as an inhibitor of demand for the entire population. Uncertainty about future incomes exacerbates the decline in consumption, and those whose incomes are not at risk do not compensate for “pessimistic animal spirits” (Fornaro and Wolf 2020, p. 8). Furthermore, the structural factors that operate to keep the economy at the zero lower bound are reinforced by epidemic phenomena.4 There is consensus that large public deficits will be created. Although the call to action is unanimous and, certainly, the temporary suspension of budget restrictions for governments is inevitable (EC 2020), the movements are cautious and calculating, looking askance at the public deficit and not wanting it to skyrocket. Conditionality must be very limited to allow a quick response, but the demand for medium-term adjustments is tacit, if not explicit (Blanchard 2020, p. 49; Alesina and Giavazzi 2020, p. 53). The commitment to adjusting the public budget once we leave the pandemic behind, which will surely occur when we find a vaccine, casts a long shadow, causing decision-making, transfers, and adoption of measures to be insufficient and delayed over time. This clearly is a problem. The fiscal policy of governments depends on their coordination with central banks. A closer permanent commitment is required for fiscal policy to be effective, not just temporary. Among the emergency measures approved by the European Central Bank (ECB) is the temporal program to purchase public and private assets with a global endowment of e750,000 billion until the end of 2020, called the Pandemic Emergency Purchase Program (PEPP), which has been expanded by e600 billion to a total of e1,350 billion until the end of 2021. The objective of this program is “to counter the serious risks to price stability, the transmission mechanism of monetary policy and the economic prospects in the euro area” (ECB 2020). In concurrence with Ayala (2020, p. 6), we believe that this program is insufficient and does not respond to the impact that the pandemic will have, either for short-term containment needs or for long-term reconstruction. In relation to the containment of the pandemic, it has exposed the depredation of natural resources and public space, inequality, and the dismantling of the welfare state, issues that are reflected in the lack of sanitary personnel and material, the impact of the pandemic in geriatric and elderly centers and in care as a whole, and also in access to healthy eating (Tapia and Bouza 2020, pp. 1–2). Business offshoring promoted by globalization has highlighted the need to source basic supplies and focus on productive bottlenecks, rather than moral risk (Wyplosz 2020, p. 25). We do not know if and how often the containment measures will return, so establishing an adequate supply of food and sanitary products also requires safe production planning, from the time workers leave their homes to go to the fields, factories, hospitals, and centers and sites where they provide care. These aspects will 4 Jordà et al. (2020) studied the rates of return of various assets through 15 epidemics that date back

to the fourteenth century. The historical experience of these pandemics suggests that the natural interest rate sinks after these phenomena, depressing investment opportunities.

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be equally important for long-term reconstruction. As Lustig and Mariscal (2020, p. 189) point out, the COVID-19 pandemic has made us aware of the vulnerability we are exposed to, not only to another virus or future SARS-Cov-2 outbreak, but also to those unknown risks caused by climate change that already had the status of global threat. This, and the fact that the fall in demand in various sectors never recovers on account of “natural precaution” (Dupor 2020, p. 1), in spite of much encouragement offered by governments, may require a different response from what is normally valued. We have classified the proposals presented in the literature to give an adequate response to the effects caused by the spread of the virus to the economy, attending to different levels of coordination between fiscal and monetary policy. Thus, we have weak, medium, and strong coordination solutions. Within the first group we have included the proposals for new agreements motivated by the asymmetric effects of the shocks to the structural differences of the countries, and which are usually presented as advances in european integration on the basis of a european demos based on solidarity and shared responsibility among members, commonly under the umbrella of the theory of optimal monetary areas (de Grauwe 2000; Tirole 2012). This is the case of the mutualization of risks associated with debt support between members, and also of an increase in the European Union fiscal budget that distributes individual costs to all countries. Regarding the second group, in the category of medium coordination solutions, we have included those related to the disconnection of the Interest Rate Policy for the management of monetary policy, that is, the well-known unconventional measures based on the extension of the E’s balance sheet. Here, we include the expansion of the Outright Monetary Transactions (OMT) or Indirect Monetary Financing program, either in the form of the individual debt of each country or jointly in the form of eurobonds through the reform of the European Financial Stabilisation Mechanism (EFSM), as well as the so-called monetary helicopter or Direct Monetary Financing. Finally, at the third level of strong coordination, we present the design of a new automatic stabilizer: Job Guarantee (hereinafter JG) or Employment of Last Resort. Focusing on weak coordination solutions, Gourinchas suggests issuing “coronavirus bonds” through the EFSM. These bonds would have two specific objectives: to finance health expenses and to prevent the spread of the pandemic to the economy. These bonds would allow “restoring economic confidence” against “monetary policy contortions,” suggesting a market decision. This is his first option, which can crash with the rejection of European policymakers. Then, as an alternative, he proposes the coordinated issuance of debt between 10 and 20% of GDP as part of an ECB emergency QE program (Gourinchas 2020, pp. 36–37). Garicano also mentions the issuance of Eurobonds via the EFSM reform to bypass restrictions on the proportion of debt of the countries that the ECB can buy in secondary markets (Garicano 2020, pp. 135–136). In his case, the proposal is to finance a “bazooka” of 500 billion euros at the European level to maintain jobs through a short-term job protection figure called Kurzarbeit. The general objective is for the link between employee and employer not to be interrupted (Garicano 2020, pp. 132–133). For Bénassy-Quéré et al. (2020, p. 126), the source of the funds does not include the ECB, but rather

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involves the mutualization of costs through the European Solidarity Fund and the European Globalisation Adjustment Fund, reallocations within the EU budget, and voluntary cooperation, organized in the same way as for the creation of the European Financial Stabilisation Fund (Bénassy-Quéré et al. 2020, p. 127). In relation to medium coordination solutions, all of them include the ECB indirectly or directly. Gourinchas (2020, pp. 36–37), Blanchard (2020, p. 50), and Wyplosz (2020, p. 29) mention the possibility of expanding the OMT program, but their positions differ in the terms. Gourinchas prefers to bet on mutualization before the “superfluous” character of conditionality that accompanies this program, while Blanchard suggests suspending conditionality but committing to the path of deficit reduction when everything has passed. For its part, Wyplosz believes that this conditionality to future adjustments is incompatible with the current situation. Wyplosz’s position is consistent with his proposal, made together with Pâris, for restructuring the joint debt of the Eurozone, carried out by consensus and presented to combat the Great Recession (Wyplosz and Pâris 2014). In that paper, the authors suggest a “debt monetization” sterilized by the Central Bank (Wyplosz and Pâris 2014, p. 15), connecting it with the proposal of Direct Monetary Financing popularly known as the “monetary helicopter,” supported by Galí (2020). Galí had already contributed to the breaking of this “taboo” in a publication prior to the COVID-19 pandemic (Galí 2019), and in an emergency moment like this, he believes that the time is right to put it into action. The mechanism consists, in short, of nonreimbursable transfers from the Central Bank to the account of the governments. This is equivalent to a purchase of government debt by the Central Bank that is followed by its immediate cancelation, without any increase in government liabilities (Galí 2020, p. 59). Such proposals always involve certain reservations about how much to spend, the time horizon of the various programs and mechanisms, and mistrust regarding the moral hazard involved, as well as negotiations that in many cases are slow and inopportune, with harsh conditionalities and expectations about future adjustments that limit the adequacy of the response. Avoiding muddles about discretion, sacrifices, and morality requires rules. The development of new automatic stabilizers represents a strong coordination solution that institutionalizes the response, as we expose in the next section.

4 Rediscover Functional Finance Calls to strengthen or design automatic stabilizers since the Great Recession have been recurring (Williams 2009, p. 29; Blanchard and Summers 2017, p. 28; Bernanke 2020, pp. 977–978). We cannot repeat the mistakes of the past, forcing governments to exercise austerity in their budgets, even deactivating automatic stabilizers that are already manifestly insufficient (de Grauwe and Ji 2015, p. 741). In the historical moment we are experiencing, characterized by the zero lower bound, secular stagnation, and hysteresis, and in the face of the triple threat of the COVID-19 pandemic, the plague of unemployment, and the climate alert, efforts should focus on what we

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must do with the real resources available that we can mobilize, rather than on getting caught up in untimely debates about the available fiscal space. The way to finance the mobilization of necessary resources and to avoid paralysis for the activation of projects is a closer coordination between the Central Bank and the Treasury based on rules. It is a complicated exercise to chase away the ghosts of deficit monetization in a discipline that is used to introducing the influence of money into the real economy through the back door of analysis, as a cause of rigidities and frictions. However, crises have always encouraged the development of monetary theory (Hicks 1967, p. 158; Cesarano 2014, p. 189). Perhaps, starting to ask what money is, how it is created, who creates it, and how it is introduced into the system, among other questions of an institutional nature, are observations that may yield new interpretations of the permanent natural imperfection where economy has installed. However, we do not believe that it is necessary to initiate an ontological discussion to expose the coordination solution presented here, relying on the strong empirical evidence found in the literature for a more active role in fiscal policy. It is enough to make two annotations in the institutional sense to Direct Monetary Financing: First, that the main asset used as a counterpart or guarantee by private banks when they require liquidity is, generally, some form of government financing (Vlieghe 2020, p. 13; Gabor and Ban 2016, p. 632), and second, we believe that setting a time period or discretionary size is problematic and inefficient. This goes against the establishment of clear rules to set the expectations of private agents and causes strong resistance to the alarm of falling into a regime of fiscal dominance. The rule we propose is based on Lerner’s “Functional Finance” (1943), articulated for a situation that was as turbulent as the COVID-19 crisis: World War II. Lerner’s rule is as follows: Both the volume of money stocks and the volume of public debt are only the consequence of the steps that will have to be taken to prevent the amount of spending from being either too small, which produces unemployment, or too large, which gives place to a continuous increase of the price level (Lerner 1957 [1951], pp. 112–113).

This does not mean indiscriminately throwing money out from a helicopter, but it also does not give rise to the discretion to set fiscal policy at a constant rate of money supply issuance (Friedman 1958 [1969], pp. 184–185), or at a rate of growth that allows the accumulation of debt to “melt” (Krugman 2020, pp. 215–216). But the implementation of Functional Finance requires specifying a mechanism, a clear rule that is prescriptive rather than merely descriptive (Friedman 1947, p. 416). As Lerner pointed out, Functional Finance is a framework, not a policy (Lerner 1957 [1951], p. 115).5

5 The

Chicago School, made up of figures such as Simons (1944) and Friedman (1948), subscribed to Lerner’s monetary and fiscal framework. As Aspromourgos (2014) shows, this understanding of the nature of fiscal and monetary operations was also shared by Keynes, who, despite joining the Functional Finance framework of his Chicago opponents, also made a distinction between theory and policy to question its implementation. The executing arm still needed to be developed.

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Extending Friedman’s thinking, economists in the postwar period were engaged in a search for rules of monetary policy management (Christiano et al. 2018, p. 117),6 although leaving aside the monetary-fiscal political framework accepted by him and others in the previous period. Returning to the institutionalist perspective set forth by Lerner, the way to build is to design mechanisms to manage public spending, understood as the residual element of economic policy, subject to higher macroeconomic objectives: full employment and price stability, and also, as the Great Recession has taught us, financial stability. These three goals are interdependent, and focusing on one of them in isolation causes unintended side effects on the other two, bidirectionally affecting the desired impact on the focus-of-focus. For better or for worse, the creation of financial imbalances has been the effect of the Interest Rate Policy and the wage repression of the stage known as the Great Moderation. The Debt Management Policy has saved the euro from breaking by giving a respite to the countries of southern Europe, and the maintenance of the Target Interest Rate requires an accommodation of the Central Bank with the bonds of the states as guarantees. In all cases, results are emergent and not directed. Monetary policy has more to do with fiscal policy and vice versa than is usually admitted (Greenwood et al. 2014; Tymoigne 2016). A prescriptive rule that follows the descriptive rule raised by Lerner is the JG (Cruz and Parejo 2018; Cruz et al. 2019). Broadly speaking, it involves governments acting as employers of last resort by launching direct employment programs to compensate for swings in private sector spending and investment. These programs set minimum working conditions that operate as an anchor for prices and wages in the private sector. The idea is for the programs to be transitory and for all social agents to participate in their operation, not competing with the employment and resources of the private sector (Kaboub 2008, p. 224). Instead of keeping unemployed workers and long-term unemployment affecting communities, private employers would hire workers employed in these reserve jobs by luring them in by offering better working conditions. Maintaining and improving individual skills and abilities compensates for this rise in wages, which, if it occurs, will only take place once, since the JG not only imposes a floor on working conditions but also anchors wages through managing the size of the employee stock so that an inflationary spiral does not start (Mosler 1997– 1998, pp. 177–179; Wray 2000, pp. 6–7). This built-in element of inflation control involves replacing an unemployed pool, which disciplines the fight for distribution, that is, the management of employee reserves by governments. Mitchell and Mosler have named the level of this employee pool that maintains stable inflation as NAIBER the Non-Accelerating Inflation Buffer Emplsoyment Ratio (NAIBER) (Mitchell and Mosler 2002). It is not about dropping money from a helicopter or priming the aggregate demand pump (Tcherneva 2014), because how money enters the economy matters. The strong coordination solution that provides an automatic stabilizer like JG introduces money into the economy in exchange for socially useful work demanded by individuals. This 6 In essence, it can be said that DSGE models are the culmination of Friedman’s “counterrevolution,”

which revolves around the Quantitative Theory of Money as a principle or guideline of thought.

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is achieved by altering the allocation of real resources that the pernicious effects of the unemployment mark impose on society as a whole due to the deterioration of the mental and physical health of unemployed workers, avoiding in the communities with the highest prevalence of long-term unemployment the spread of crime, drugs, pathological gambling or alcoholism, and the destructuring of families, all of which factors affect the development of the youngest (Tcherneva 2019). Instead, we can mobilize and direct resources toward the fight against climate change (Forstater 2003), the effective achievement of gender equality through the visibility and socialization of care (Todorova 2013), and, at a time like this, to fight against the COVID-19 pandemic in its triple dimension: health, economic, and social. If we consider all the aforementioned costs we can say, as Nersisyan and Wray (2019) show in their work on how to pay for the Green New Deal, that the job guarantee programs will pay for themselves. If the unemployment pool is a bottomless pit of social costs that ultimately translate into economic costs, JG is a source of resources that increases productivity and efficiency and frees up real resources for other uses. In short, the JG works as a nondiscretionary functional rule in the operational field—a constitutional rule “under the government of Leviathan” (Brennan and Buchanan 1981, p. 351), which allows for an active fiscal policy without falling under a regime of fiscal dominance and that enables us to face the threats we have to face as a society.

5 It Is the Moment Central banks and governments are by necessity moving toward closer cooperation, and the COVID-19 pandemic is a critical time. We are sure that Europe cannot afford another setback. If the moral aspects and the disciplinary logic on which the European institutions were designed are an insurmountable obstacle even at a time like this, it will be the end of the Eurozone. The longer it takes to do whatever is necessary, the higher the costs. The empirical evidence on the zero lower bound, secular stagnation, and hysteresis gives plenty of reasons to undertake new proposals in the fiscal field. At times like this, looking back through history to salvage ideas debated in analogous situations, regarding their effects on the economy, can be helpful. Functional Finance as a theoretical framework failed to gain attraction when it was introduced because it did not develop the implementation of the rule that derived from it. A clear communication about a mechanism such as the JG must explain that it operates as an automatic stabilizer subject to a Functional Finance rule. This approach would relax moral discussions and bind the expectations of economic agents. We believe that this solution contains in essence a good part of the points expressed by other economists in relation to how to face the new normality—for example, the management of productive bottlenecks (Wyplosz 2020, p. 26); the probable inappropriateness in the postpandemic context of basing the recovery strategy on stimulating demand through the traditional concept of the multiplier (Faria e Castro 2020, pp. 2– 3); the maintenance of jobs and the productive fabric (Garicano 2020, p. 130); the

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reconciliation of care (Odendahl and Springford 2020, p. 148); the consideration of the situation of lower-income workers, for whom teleworking is not a real option (Dupor 2020, pp. 2–3); and, above all, the importance of doing it in a timely manner. Certainly, the proposals that fall under the umbrella of what is understood as a monetary helicopter can be a short-term relief to maintain the income of those forced into confinement or in the event of a general quarantine, but they are not a solution in the medium and long term, being a potential problem if they have to be repeated, where a second part may not even be politically viable. We agree with McKee and Stuckler that the COVID-19 pandemic could encourage citizens to realize how interdependent they all are, and also that, when we talk about “global warming, inequality, or environmental degradation, it is swimming or sinking together” (McKee and Stuckler 2020, p. 642). A strong coordination solution like the one we propose can propel us on this path. At the same time, we must beware of mistrust, paralysis, and insufficient measures being taken. These missteps could result from clinging or being tied to a discipline that seems to give empirically few results and can even be detrimental, and from asking for more sacrifices from a generation that has already accumulated great wear and tear from the Great Recession. All this could lead to the scars becoming irreparable amputations.

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Gourinchas P (2020) Flattening the pandemic and recession curves. In: Baldwin R, Weder di Mauro B (Eds) Mitigating the COVID Economic Crisis, CEPR Press, London, p 31–40. Greenwood R, Hanson S G, Rudolph J S, Summers L H (2014) Government debt management at the zero lower bound. Hutchins Center Working Paper No 5. Hicks J R (1967) Monetary theory and history: An attempt at perspective. In: Hicks J R (Ed) Critical Essays in Monetary Theory, Oxford University Press, Oxford, p 155-173. Jordà O, Singh S, Taylor A (2020) Longer-run economic consequences of pandemics. NBER Working Paper No 26934. Kaboub F (2008) Elements of a radical counter-movement to neoliberalism: Employment-led development. Review of Radical Political Economics, 40(3):220–227. Krugman P (1998) It’s baaack: Japan’s slump and the return of the liquidity trap. Brookings Papers on Economic Activity, 2:137–205. Krugman P (2020) The case for permanent stimulus. In R. Baldwin, B. Weder di Mauro (Eds) Mitigating the COVID Economic Crisis, CEPR Press, London, p 213–219. Laborda J, Onrubia J (2020) Consideraciones sobre finanzas públicas y COVID–19: Bastantes interrogantes y algunas certezas. Apuntes FEDEA No 2020-05. Lerner A P (1943) Functional finance and the federal debt. Social Research, 38–51. Lerner A P (1957 [1951]) Economía del pleno empleo. Aguilar, Madrid. Lucas R (1976) Econometric policy evaluation: A critique. Carnegie-Rochester conference series on public policy, 1(1):19–46. Lustig N, Mariscal J (2020) How COVID-19 could be like the Global Financial Crisis (or worse). Baldwin R, Weder di Mauro B (Eds) Mitigating the COVID Economic Crisis, CEPR Press, London, p 185–190. Mankiw G (2001) The inexorable and mysterious tradeoff between inflation and unemployment. The Economic Journal, 111(471):45–61. McKee M, Stuckler D (2020) If the world fails to protect the economy, COVID-19 will damage health not just now but also in the future. Nature Medicine, 26:640–642. Mitchell W, Mosler W (2002) Fiscal policy and the job guarantee. Australian Journal of Labour Economics, 5(2):243–259. 1997–1998 Mosler W (1997–1998) Full employment and price stability. Journal of Post Keynesian Economics, 20(2): 167–182. Nersisyan Y, Wray L R (2019) How to pay for the Green New Deal. Levy Economics Institute Working Paper No 931. Odendahl C, Springford J (2020) Bold policies needed to counter the coronavirus recession. In: Baldwin R, Weder di Mauro B (Eds) Mitigating the COVID Economic Crisis, CEPR Press, London, p 145–150. Rochon L P, Vallet G (2019) Economía del Ave María: El modelo teórico detrás de las políticas monetarias no convencionales. Ola Financiera, 12(34):1–24. Schmelzing P (2020) Eight centuries of global real interest rates, RG, and the “suprasecular” decline, 1311–2018. Bank of England Staff Working Paper No 845. Simons H C (1944) On debt policy. Journal of Political Economy, 52(4):356–361. Solow R (1997) Is there a core of usable macroeconomics we should all believe in? The American Economic Review, 87(2):230–232. Stiglitz J E (2018) Where modern macroeconomics went wrong. Oxford Review of Economic Policy, 34(1–2):70–106. Summers L H (2014) US economic prospects: Secular stagnation, hysteresis, and the zero lower bound. Business Economics, 49(2):65–73. Summers L H (2015) Demand side secular stagnation. The American Economic Review, 105(5):60– 65. Tapia M, Bouza J (2020) Lo que la pandemia deja al descubierto: El COVID-19 en España. Espaço e Economia, 17. Taylor J (1993) Discretion versus policy rules in practice. Carnegie-Rochester conference series on public policy, 39:195–214.

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Tcherneva P (2014) Reorienting fiscal policy: A bottom-up approach. Journal of Post Keynesian Economics, 37(1):43–66. Tcherneva P (2019) The federal job guarantee: Prevention, not just a cure. Challenge, 62(4): 253– 272. Tirole J (2012) The euro crisis: some reflexions on institutional reform. Financial Stability Review (Banque de France), 16:225–242. Todorova Z (2013) Connecting social provisioning and functional finance in a post-Keynesian– Institutional analysis of the public sector. European Journal of Economics and Economic Policies: Intervention, 10(1):61–75. Tymoigne E (2016) Government monetary and fiscal operations: Generalising the endogenous money approach. Cambridge Journal of Economics, 40(5): 1317–1332. Vlieghe G (2020) Monetary policy and the Bank of England’s balance sheet. Bank of England, speech delivered April 23, 2020. Williams J C (2009) Heeding Daedalus: Optimal inflation and the zero lower bound, Brookings Papers on Economic Activity, 2:1–37. Williamson S D (2016) Current Federal Reserve policy under the lens of economic history: A review essay. Journal of Economic Literature, 54(3):922–934. Woodford M (2003). Interest and Prices. Foundations of a Theory of Monetary Policy. Princeton University Press, Princeton. Wray L R (2000). The employer of last resort approach to full employment. Levy Economic Institute Working Paper No 9. Wyplosz C (2020). So far, so good: And now don’t be afraid of moral hazard. In: Baldwin R., Weder di Mauro B (Eds) Mitigating the COVID Economic Crisis, CEPR Press, London, p 25–30. Wyplosz C, Pâris P (2014). Politically acceptable debt restructuring in the Eurozone. Geneva Special Report on the World Economy No 3.

Esteban Cruz-Hidalgo Ph.D. in Economics and Business (University of Extremadura, Spain). Most of his research activity has been directly related to Macroeconomics, History of Economic Thought and Monetary Economics. He has authored numerous papers in national and international congresses and contributions published in the form of specialized articles in prestigious scientific journals, as History of Economic Ideas, Iberian Journal of the History of Economic Thought, Revista de Economía Institucional, Revista de Estudios Políticos, Revista de Economía Crítica or Revista de Economía Mundial, among others. José Francisco Rangel-Preciado Ph.D. in Economics and Business (University of Extremadura, Spain) and Assistant Professor of Economic History and Institutions at the Faculty of Economics and Business of the University of Extremadura. Most of his research activity has been directly related to Economic History and History of Economics, although in recent years he has focused on the analysis of money, competition and economic policies. He has authored numerous papers in national and international congresses on economic history and economic thought, and numerous contributions published in the form of articles in prestigious scientific journals. Francisco Manuel Parejo-Moruno Ph.D. in Applied Economics (University of Extremadura, Spain) and Assistant Professor of Economic History and Institutions at the Faculty of Economics and Business of the University of Extremadura. Most of his research activity has been directly related to Agrarian History, although in recent years he has focused his research work on the history of Economic thought. He has been a visiting professor at the University of Sassari (Sardinia, Italy) and at the ICS and ISEG research institutes, both at the University of Lisbon. He has authored numerous papers in national and international congresses on economic history in contemporary age, and numerous articles in prestigious scientific journals.

Reforming Under Pressure: The Evolution of Eurozone’s Fiscal Governance During a Decade of Crises Dimitris Katsikas

Abstract The fiscal governance of the European Economic and Monetary Union (EMU) was the result of a political compromise. This led to an imbalanced and unsustainable framework, which contributed to the outbreak of the Eurozone debt crisis. During the crisis, European leaders embarked on a reform effort whose outcome has been criticized for its complexity and lack of effectiveness; moreover, despite its innovations, the reformed fiscal governance has not signified a substantial departure from the previous regime’s failed philosophy. Against this background, the COVID19 pandemic has posed a new fiscal challenge for the EMU. The massive fiscal intervention required to cope with the health crisis, the economic implications of the lockdowns, and the challenge of economic recovery has questioned the adequacy of EMU’s fiscal governance and has raised the prospect of a fragmented European economic landscape. The European Council’s agreement on Next Generation EU has been an undoubtedly positive development in terms of addressing short-term fiscal needs. However, its long-term impact on the supranational institutions of fiscal governance is limited and uncertain. The objective of this chapter is to review critically these changes in the design and evolution of EMU’s fiscal governance, through a decade of crises, under the analytical lens of political economy. Keywords Eurozone · Fiscal governance · Fiscal rules · Crisis · Next generation EU

1 Introduction Determining the optimal level and instruments of fiscal governance in a monetary union of sovereign states is not an easy task. A monetary union needs to have in place a comprehensive framework of fiscal governance, which allows enough flexibility to deal with asymmetric shocks in different member states; discourages fiscal mismanagement, and minimizes spillover effects when it occurs; provides the means D. Katsikas (B) Department of Political Science and Public Administration, National and Kapodistrian University of Athens, Athens, Greece e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_8

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for effective fiscal management over the business cycle; and builds the necessary mechanisms to deal with a common external shock. The fiscal governance of the European Economic and Monetary Union (EMU) does not meet these criteria. The EMU was the result of a political compromise. This led to an imbalanced and unsustainable fiscal framework, which along with other shortcomings of EMU’s broader economic governance contributed to the outbreak of the Eurozone debt crisis. Eurozone’s lack of institutional preparedness forced European leaders and policymakers to embark on a reform effort while they were trying to bring the crisis under control. The adverse economic and political environment put pressure for prompt decisions, often based on last-minute compromises, and more often than not, on the imposition of the will of member states enjoying an asymmetrical power advantage in an increasingly intergovernmental negotiation setting. The resulting fiscal governance framework has been criticized for its complexity and lack of effectiveness, and despite its innovations, it has obviously failed to signify a substantial departure from the previous regime’s failed philosophy. Against this background, the COVID-19 pandemic has posed a new fiscal challenge for the EMU. The massive fiscal intervention required to cope with the health crisis but also the economic implications of the lockdowns and the challenge of economic recovery has raised the prospect of a fragmentation of the European economic landscape. Some member states, mostly in the South, burdened with the legacy of the debt crisis, find it harder to employ the fiscal resources necessary to combat the pandemic, and most worryingly, are faced with the prospect of another debt crisis the day after. To avoid this, the EMU needs common fiscal and debt instruments, which however entail risk mutualization and a certain degree of fiscal transfers. Such proposals have traditionally foundered on the resistance of fiscally conservative member states of the European North. Following a déjà-vu of previous bitter disputes in the early phases of the pandemic crisis, a solution seems at last possible. The European Commission’s scheme based on a Franco-German proposal endorsed a more ambitious approach, which was adopted—with some changes—by the European Council on the 21st of July. The agreement is important because it seems to provide adequate resources for addressing the crisis in the short- to medium term. On the other hand, its long-term impact on the supranational institutions of fiscal governance is limited and seems uncertain at this time. The aim of this chapter is to explore these issues by reviewing the fiscal governance of the Eurozone, its evolution after the debt crisis, and its operation during the initial stages of the COVID-19 pandemic, against lessons derived from the theoretical and empirical literature on fiscal governance in a monetary union. The first part of the chapter engages with that literature. The second part focuses on the design and evolution of Eurozone’s fiscal governance, particularly following the debt crisis, while a final part discusses the fiscal implications of the pandemic and the way EMU’s fiscal governance has conditioned its response to it. The objective is to provide a critical examination of the design and evolution of EMU’s fiscal governance through a decade of crises under the analytical lens of political economy.

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2 Fiscal Policy in a Monetary Union EMU’s sui generis nature, where increased levels of economic integration and multilevel governance arrangements co-exist with sovereign nation-states, complicates the determination of its optimal fiscal governance. Despite its quasi-federal structure, Eurozone lacks characteristics typically found in federations, such as the high degree of human mobility and economic symmetry (Ribstein and Kobayashi 2006). However, these are the conditions identified by the Optimum Currency Area (OCA) theory (Mundell 1961; McKinnon 1963; Kenen 1969), as necessary for the successful operation and stability of a monetary union.1 In the absence of such conditions,2 the single monetary policy is not capable of effectively addressing asymmetric shocks, and fiscal policy becomes necessary for stabilizing the economy. The budgetary stabilization function can be exercised both at the supranational and the national level. At the national level, the functioning of automatic fiscal stabilizers contributes to the smoothing of consumption and limits the negative effects of an economic shock. Discretionary fiscal policy can also be used to stabilize the economy, but there are risks involved, which include further destabilization (Kamps et al. 2017), high fiscal deficits and the accumulation of public debt. High fiscal deficits and public indebtedness may, in turn, create cross-border spillover effects (Buiter 2006). The OCA theory supports the creation, at the supranational level, of a central, common budget, which can automatically use (increased) revenues from the economies on the upward phase of the economic cycle, in order to support the economies in recession (Kenen 1969). The creation of a common budget also has the advantage of removing pressure from governments to use their national budgets to stimulate the economy, avoiding the risk of running high budget deficits. However, the creation of a common budget has its own risks, and more specifically, the so-called moral hazard. Moral hazard arises from the alteration of the incentives of the governments receiving the cash flows from the central budget. Access to centralized funding relaxes incentives to promote reforms, which may be necessary, particularly when the economic shock is due to structural and not cyclical factors. For this reason, centralized budgetary transfers should have a limited duration and be used in short-term fluctuations of the economic cycle (De Grauwe 2009). There are two ways to address the risks associated with supranational fiscal governance and discretionary national fiscal policy within a monetary union: (a) fiscal rules and (b) coordination of national fiscal policies. The aim of fiscal rules is to place restrictions on the exercise of national fiscal policy to avoid excessive budget deficits and the accumulation of public debt. Their weakness is that their ‘rigidity’ restricts governments’ ability to exercise the stabilization function at the time when it is most needed, leading to a problem of time inconsistency for fiscal policy (Wyplosz 2012). Moreover, there is ambiguity regarding their effectiveness. A recent meta-regression 1 The

coincidence of these criteria should not come as a surprise given that typically federal states are also monetary unions. 2 Labour mobility is part of the wider criterion of labour market flexibility in OCA theory, which also includes the flexibility of wages according to economic conditions (Mundell 1961).

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analysis of 30 studies performed by Heinemann et al. (2018) points to overall positive results, which however lose some of their significance when methodological approaches become more sophisticated to account for factors of endogeneity. The experience of the EMU, as described in more detail in the next section, also gives a mixed picture and seems to provide support for the view that fiscal rules are most effective when they are compatible with government preferences, i.e. when they act as signalling devices for their incentives (Debrun and Kumar 2007), and not when they are used as ‘suppression’ mechanisms; in the latter case policymakers always find ways to bypass the rules (Koen and Van Den Noord 2005). The second option, the coordination of fiscal policies, is not bound by the rigidity of fiscal rules, and its effectiveness is amplified during a crisis (Frankel 2014; Alcidi and Gros 2014). Having said that, fiscal coordination is not easy to achieve given the different cyclical positions of member states in a monetary union; this could lead to a clash between the sustainability and stabilization objectives of different states (Kamps et al. 2017). A second aspect of fiscal coordination is that between national fiscal policies and the single monetary policy. The coexistence of a single monetary and multiple fiscal authorities creates a conflict of policy priorities and objectives resulting in a suboptimal overall policy mix. This inefficiency is likely to be magnified in the event of a crisis when the coordinated use of monetary and fiscal policy becomes necessary to restore macroeconomic balance (Corsetti et al. 2016).

3 Fiscal Governance in the EMU Before the Debt Crisis Fiscal policy was at the heart of the convergence process towards EMU, with fiscal rules (convergence criteria) laid down in the Maastricht Treaty. These appeared to work effectively, at least in part, since all the countries wishing to enter the EMU satisfied the criterion for a budget deficit of less than 3% by the end of the decade. On the other hand, the criterion for public debt (less than 60% of GDP) was clearly not met by three countries, Italy, Belgium and Greece.3 To overcome this problem, the criterion included an ‘override clause’, which allowed higher levels of public debt, provided that it was on a downward trend. The decision to override the debt criterion illustrates the political nature of the EMU, which was clear from the outset. When the decision to create the EMU was taken, it was obvious that the conditions for an optimal currency area were not met (e.g. Eichengreen 1990; De Grauwe and Heens 1993). EMU’s governance reflected more the preferences of certain member states and the balance of power in the EU at the time, rather than the dictates of economic theory. In particular, the pillar of monetary policy was, from the start, institutionally strong. The European Central Bank (ECB) had a clear mandate to maintain price 3 There

were other countries that did not meet the debt criterion but were close to it, which allowed the Commission to declare that, provided fiscal consolidation efforts continued, these countries’ debt would soon fall below the 60% threshold (European Commission 1998).

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stability, was equipped with all the necessary policy instruments and authority and was protected from political interference. The strong institutional guarantee of ECB’s independence and also its strict commitment to the objective of price stability were modelled after the German central bank and reflected Germany’s preferences in this field. On the other hand, the fiscal governance of the EMU was based solely on the Stability and Growth Pact (SGP), which set a medium-term target of balanced or surplus budget for the member states, establishing also a threshold (3% of GDP) for the start of an excessive deficit procedure, which could lead, under certain conditions, to sanctions for ‘undisciplined’ member states. EU’s leaders not only resisted the creation of a supranational fiscal capacity and a crisis resolution mechanism, but strived to render impossible any type of fiscal transfers, by inserting a ‘no-bailout’ clause in the Treaty, and forbidding monetary financing by the ECB. This institutional set-up soon proved to be ineffective; ironically, in 2003 it was Germany, which had pushed for the SGP framework, but also France, that refused to implement the Commission’s recommendations for budgetary discipline in the midst of a recession, and led a coalition of states in the Council which blocked the continuation of the excessive deficit procedure against them. In the wake of this conflict, the renegotiation of the SGP in 2005 introduced more flexibility, which was interpreted in many quarters as a weakening of the fiscal rules (Buiter 2006). In any case, the significance of the reform is questionable since SGP’s effectiveness was not substantially improved after the reform. For the EU-15, there were 14 cases of excessive deficit between 1999 and 2003 and another 16 cases between 2004 and 2007 (Begg 2011). Overall, according to recent estimates by the European Fiscal Council, compliance with fiscal rules in the Eurozone for the period 1998–2007 was 71% for the deficit rule and 41% for the structural balance rule (EFB 2019).4 It is equally evident that there was no EMU-wide fiscal stance and accordingly no coordination between fiscal and monetary policy before the crisis. Against a background of differential growth rates, driven by different institutional and economic dynamics (e.g. domestic consumption of non-tradables in the periphery vs exports of tradables in the core) and divergent fiscal policies, the ‘one-size-fits-all’ monetary policy became a ‘one-size-fits-none’ policy (Schmidt 2015). Economic growth in the countries of the periphery was sustained by credit flows, which contributed to the creation of asset bubbles. In the wake of the global financial crisis (GFC), the bubbles collapsed, credit flows stopped, and these countries were forced into an abrupt adjustment. There was no central crisis resolution mechanism which could deal with the shock. The EU’s budget, close to one per cent of GDP, was clearly insufficient—not that employing the common budget for stabilization purposes was ever seriously considered—while the ECB was unable, due to its mandate, to act as a lender of last resort, although it did introduce new instruments to enhance access to credit and liquidity for the European banking system.

4 The

structural aspects of the balanced budget rule were introduced with the 2005 SGP reform.

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In hindsight, it could be argued that the pre-crisis fiscal (and more generally economic) governance in the EMU was the result of a combination of national preferences, selective economic argumentation and economic short-sightedness. The stronger EU members acknowledged the differences in the institutional organization and potential of different economies, but they opted to ignore them—a decision necessary to achieve the political agreement of weaker member states—resting their hopes on a much anticipated ‘catching-up’ process, while also limiting their liability through the no-bailout clause and the prohibition of monetary financing. This political compromise was justified by a selective use of economic theory, whereby OCA theory’s dismal predictions were replaced by the more optimistic projections of the so-called endogenous theory of optimal currency areas, which stipulated that economic integration and symmetry could follow monetary unification (Frankel and Rose 1998), and by the belief that ‘market discipline’ would prohibit the emergence of large imbalances. However, the credibility of the no-bailout clause proved weak; instead, markets alleged the existence of an implicit bailout clause. As a result, increased financial integration instead of disciplining member states relaxed the funding constraints of weaker states, allowing the emergence of large fiscal deviations (e.g. in Greece), or hiding weak fiscal foundations (as was the case with the fiscal windfalls related to real estate bubbles in countries like Spain, Ireland and Cyprus). When the crisis hit, the decentralized ‘individual responsibility’ governance of the EMU had no institutional tools to handle it, forcing member states to engage in a major reform effort, amid economic difficulties and political recriminations.

4 Crisis and the Reform of EMU’s Fiscal Governance The outbreak of the Greek crisis in autumn 2009 acted as a catalyst for the wider Eurozone debt crisis that followed. The crisis revealed the limitations of the Maastricht compromise; dealing with cross-border spillover effects became a necessity when sovereign default turned into a likely scenario. The danger of default in the periphery threatened the solvency of European financial institutions at the core, while the default-induced exit of a member state from the Eurozone threatened the credibility and therefore survival of the entire monetary union. In this context, ‘bailing out’ countries under distress became necessary. The reluctant acknowledgement of this necessity did not alter the core countries’ previous attitude on fiscal transfers and a common fiscal capacity; on the contrary, it incentivized them to reduce their fiscal exposure as much as possible. The approach was justified by invoking the moral hazard that would result from the creation of stabilization or other ‘fiscal solidarity’ mechanisms at the supranational level; countries in trouble needed to have the proper incentives to reform. The handling of the crisis through national adjustment programmes with a view to ensure fiscal sustainability at the national level with the minimum pooling of fiscal resources at the supranational level led to a prioritization of austerity over all

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other policies, including structural reforms (Pisani-Ferry et al. 2013; Petralias et al. 2018). This in turn resulted in severe adverse economic and social consequences for the crisis-hit countries. What is more, the endorsement of austerity policies, even in countries like Germany, which did not face a debt crisis, led to a de facto EMUwide deflationary fiscal stance, which led the euro area in a double deep recession in 2012/2013. The asymmetry of the response was evident at both the national and euro area levels; fiscal sustainability took precedence over stabilization during a recession. The prioritization of fiscal sustainability also affected the design of EMU’s governance reform. Facilitated by the invocation of a fiscal irresponsibility narrative, that originated with the Greek crisis and was then erroneously applied to the other national crises as well (Buti 2020), the emphasis of the reforms lay in the fiscal dimension of economic policy (Pisani-Ferry 2015). Their aim was to ensure fiscal sustainability in member states and contain negative fiscal spillovers, minimizing thereby the need for the pooling of fiscal resources at the supranational level. These priorities reflected the preferences of the creditor countries, which enjoyed a highly asymmetrical negotiating advantage, allowing them to dictate the terms of the new fiscal governance (Schimmelfennig 2015). In order to ensure the desired outcome, reforms were often negotiated outside the EU’s legal framework; both of EU’s crisis mechanisms, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), and one of the most important fiscal reforms, the Fiscal Compact, were negotiated as international agreements. As a result, the main reforms in fiscal governance comprised mechanisms of enhanced national fiscal discipline and surveillance. The requirement of the Fiscal Compact for the incorporation of budgetary rules into national law, ‘two-pack’s’ requirement for the screening of national budgets by the European Commission before submission to national parliaments, the principle of a negative majority for the obstruction of sanctions on member states in the framework of the excessive deficit procedure, the obligation to create independent fiscal councils to supervise national fiscal policy and the enhanced surveillance procedures of the European Semester have created a fiscal framework which limits the budgetary discretion of national governments. At the same time, the stabilization function remained at the national level, with the main changes relating to the recognition of the need for greater flexibility to cope with fluctuations in the economic cycle. Moreover, proposals for the creation of a European safe asset did not progress, despite the fact that it could provide an effective mechanism for restoring access to funding for countries undergoing a crisis and prevent uncertainty-induced contagion to other member states (Gilbert et al. 2013). Furthermore, the coordination of fiscal policies remained an institutionally unrealized objective. The European Fiscal Council, which could assist in this respect, was established later, in 2017, and has only an advisory role. On the other hand, there were two important reforms with implications for fiscal policy. The first was the establishment of the ESM.5 The ESM provides funding 5 The

ESM was preceded by the EFSF and the European Financial Stability Mechanism (EFSM) established in 2010.

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to countries which lose access to the international markets and thus functions as a lender of last resort. The problem, however, is that it operates based on strict policy conditionality. Beyond its questionable economic outcomes (at least in the way that it has been applied hitherto), conditionality also reduces the ESM’s political appeal, which reduces its usefulness as a common funding mechanism.6 A second significant development was the establishment of the EU Banking Union, intended to limit the link between sovereigns and banks, which can prove detrimental in times of crisis for both sides. Although progress has been satisfactory regarding the establishment of a common supervisory mechanism and restructuring procedures in case of a banking crisis, agreement on the common deposit guarantee system has proved elusive thus far, which is not surprising, given the shared liability it entails. How has the new fiscal governance fared? Trying to ensure adequate flexibility to deal with asymmetric shocks, without committing resources at the supranational level has led to an ever-increasing number of overlapping rules and exceptions, which undermine both their operability and their credibility and allow room for political manoeuvering, not only by national governments, but increasingly by the European Commission as well (Claeys et al. 2016; Beetsma and Larch 2019). Indeed, the experience from the first few years of the new fiscal framework’s operation casts doubt on its credibility as the application of fiscal rules has been characterized by discontinuity and inconsistency (Begg 2017).7 This is demonstrated for example, by the system’s inability to enforce fiscal targets symmetrically, that is, not only for the deficit but also for the surplus countries, like Germany, which in the post-crisis years tightened its fiscal policy well above its SGP medium-term objective (Claeys et al. 2016). This undermines the ability to coordinate an EMU-wide fiscal stance and has significant distributional implications for other euro area member states. Given these problems, soon after its reform, an agreement seemed to be forming, that the EMU’s fiscal governance needed to be reformed again (Beetsma and Larch 2019). In view of this emerging consensus, the European Commission proposed new measures and a roadmap for the completion of EU’s economic governance (European Commission 2017). The European Commission’s proposals coming soon after the proposals of the newly elected French President Emmanuel Macron in September 2017, for a broader EU reform, triggered a public debate on the issue of EU’s economic governance.8 6 The

political ‘stigma’ associated with ESM’s conditionality was clearly illustrated by the public debate on ESM’s new e240 billion Pandemic Crisis Support scheme, see next section, p. 16. 7 A similar picture emerges in the field of macroeconomic coordination, where stipulations produced by both the European Semester and the macroeconomic imbalance procedure do not appear to be taken seriously by the member states (Alcidi and Gros 2014; Begg 2017). 8 A particularly influential paper in this context was the so-called policy paper ‘No 91’ of the prestigious Centre for Economic Policy Research (CEPR), in which 14 prominent economists from Germany and France put forward a series of proposals for reform (Bénassy-Quéré et al. 2018). These proposals received praise but also critique, from many quarters, primarily for their lack of ambition and their affinity to the official German position. See, for example, the Blueprint for a democratic renewal of the eurozone, Politico, 28 February 2018 (the counterproposals of another 14 economists and politicians), Merler (2018) and Messori and Micossi (2018).

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Although the terminology was slightly changed, the stakes in the discussion remained the same; the distribution of costs to restore balance in the European economy. The debate was now taking place in terms of actions necessary to reduce or share the risk, that is, the cost for dealing with the crisis’ legacy problems. The position on risk reduction, essentially that of the creditor countries, posited that restoring the balance should be the result of an adjustment process undertaken by the member states that face problems, which would alone bear the cost of this adjustment. Only when the imbalances faced by these states are addressed and therefore the risk of fiscal and other economic spillovers has been reduced, can the discussion on more ambitious risk-sharing initiatives proceed. On the other hand, those who argued in favour of risk-sharing contended that the creation of solidarity mechanisms would contribute to reducing risk, thus facilitating, and accelerating the national adjustment process. A particularly important element of this argument has to do with the fact that many problems that seem to be theoretically manageable can develop into uncontrolled situations due to the behaviour of financial markets (De Grauwe 2011). To the extent that part of the problem is the way financial markets operate, insisting on the adoption of tough national adjustment policies is not only unfair but also unlikely to be economically effective. For some commentators, the two options should be treated not as alternatives but as complementary: the existence of supranational solidarity mechanisms facilitates adjustment at the national level, which makes it less likely that they will actually be used. This interpretation was evident in the Commission’s 2017 proposals and has also been adopted by officials of all EU institutions, including the ECB (Draghi 2018), the European Fiscal Council (Beetsma and Larch 2019) and the European Commission (Buti 2020). In addition, to address the concern about the moral hazard of the creditor countries, many of the proposals included a series of measures to discourage their possible abuse. Despite the growing interest in the public debate, there was little progress in terms of reforms. The issue has been further complicated by the fact that the debt and the subsequent refugee crisis have strengthened Euroscepticism both in crisishit and creditor countries. The fate of the Joint Communication between France and Germany in Meseberg on 19 June 2018 confirmed the political difficulties of the project. The re-activation of the Franco-German axis, the traditional steering force of European integration, created hopes for a breakthrough, particularly given its unexpected proposal for a euro area budget. The proposal although unexpected was not radical. The proposed budget was linked to EU’s multiannual financial framework, which diminished expectations regarding its size, particularly in a post-Brexit context. Moreover, the proposed budget was meant to promote competitiveness and convergence and not function as a stabilization mechanism. However, the declaration did contain a proposal for a stabilization mechanism in the form of a European Unemployment Fund. As it happened, the Eurozone Summit of 14 December 2018 adopted the Franco-German proposals, approving the insertion into the multiannual financial framework of a fiscal tool specifically for the Eurozone, without however, any reference to the financing of a European Unemployment Fund. These decisions, inadequate as they are, signalled the high point of EMU leaders’ ambition in the

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area of fiscal reform; following their adoption the issue dropped off the agenda once again and there was no appetite for a renewed effort (Fleming and Khan 2019).

5 The COVID-19 Shock The coronavirus pandemic has brought the issue of fiscal governance in the EMU once again to the fore of the European public debate. Against a background of incomplete reforms and significant legacy problems from the previous crisis, the funding needs for combatting the virus and sustaining the recovery of the economies following the lockdowns, has posed a fiscal challenge without precedent for the Eurozone, and the EU more broadly. As the crisis spread throughout Europe, supranational fiscal intervention became literally a necessity for countries facing budgetary constraints and increased funding costs. The urgency of this realization became more pronounced due to the unfortunate coincidence that the first major outbreaks were in countries that carry a legacy of problems from the previous crisis, such as Italy and Spain. The high level of public debt for these countries creates a ‘doom loop’, as their indebtedness undermines their ability to employ the fiscal resources necessary to combat the pandemic, and at the same time a fiscal intervention of the magnitude required, would undermine the sustainability of their public finances further, hampering their future economic potential, and risking another debt crisis, after a decade of limited or no growth. The severity of the situation is further aggravated, by the dependence of these economies, and that of other Southern economies, on services such as tourism, which are disproportionally affected by the pandemic. The scale of the challenge was quickly perceived by the markets, that put pressure on the government bonds of these countries. In the early stages of the pandemic, before any major decisions were taken at the EU level, Italy’s bond yield increased by 1.45 percentage points, Spain’s by 0.74 percentage points and Greece’s by 2.69 percentage points (Fig. 1). By contrast, Germany, ranked 5th globally in terms of the number of coronavirus cases at the time, saw the yield on its 10-year bond fall further. As countries one after the other started closing their economies to stall the spread of the virus, the magnitude of the economic consequences started being realized. According to an early estimate by the OECD (2020), the direct impact of the lockdown measures employed, range, for most Eurozone member states, from 20 to 30% of GDP for the period of implementation. For a 3-month lockdown, this would translate into a 4–6% loss of GDP on an annual basis. In June, as most European economies were in the midst of a gradual re-opening process, growth forecasts, became even gloomier, as the Eurozone’s GDP was projected to decline by 10.2%, with Spain, Italy and France expected to record recessions of over 12% (IMF 2020).

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5.1 EMU’s Initial Reaction What has been EMU’s reaction to this unprecedent situation? Eurozone’s initial response to the crisis could be characterized as staggered—in all senses of the word. In the first instance, the bulk of the fiscal response was assumed by the member states themselves, which introduced an array of fiscal measures, whose size, according to the Eurogroup President M. Centeno, had already reached in early April, 3% of GDP, on average, while liquidity supporting measures (e.g. state guarantees for loans to businesses and tax deferrals) had reached 18% of GDP (Centeno 2020a). The adoption of such extraordinary measures was facilitated by the Eurogroup’s decision on the 16th of March to exclude these measures ‘when assessing compliance with the EU fiscal rules, targets and requirements’, making use of the SGP’s flexibility (Eurogroup 2020). Finally, on the 24th of March the Eurogroup endorsed the European Commission’s proposal for the activation of the ‘general escape clause’, which effectively suspended the fiscal rules for the EMU, providing maximum degree of fiscal flexibility for the member states to deal with the health crisis. At the supranational level, there was a prompt but clearly inadequate reaction, which could only be characterized, as an emergency ‘first-aid-toolkit’. This included the mobilization by the European Commission of e65 billion through a e37 billion ‘Corona Response Investment Initiative’ employing funds from the European Structural Investment Fund (ESIF), and another e28 billion redeploying structural funds. The European Investment Bank (EIB) also proposed to mobilize e40 billion through various mechanisms, mostly in the form of loan guarantees. Beyond the member states, the main burden of response fell once again on ECB’s shoulders. On the 12th of March, the ECB adopted an array of measures to enhance liquidity and sustain credit in the markets, and to support the prices of assets (including sovereign bonds). More specifically, the ECB added e120 billion to its existing, e20 billion per month, Asset Purchasing Programme (APP) and 4%

18/3: ECB announces PEPP 3%

25/3: ECB relaxes issuer limits

23/4: European Council adopts Eurogroup's proposals 27/5: Next GeneraƟon EU proposal

2%

1%

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-1% 05-03-2020

23-03-2020

10-04-2020 Greece

Germany

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16-05-2020 Spain

Fig. 1 10Y Government Bond Yields (28/2–30/6/2020)

Italy

03-06-2020 Portugal

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announced a new longer-term refinancing operations (LTROs) programme, at the (negative) deposit facility rate of −0.50%. Moreover, it announced an expansion of the existing targeted longer-term refinancing operations programme (TLTRO III), also improving its terms and increasing the volume of funds available to banks. Along the same lines, the ECB’s Supervisory Board relaxed some of the capital requirements for banks, providing capital relief of up to e120 billion. Despite these measures, market turmoil increased, when in an interview, the ECB’s new president refrained from re-affirming the ‘whatever it takes’ approach of her predecessor. Her remark, meant to put pressure on member states to step up with fiscal measures, sent Italian and other south European countries’ bond yields, already on the rise, soaring (Fig. 1). The ECB responded on the 18th of March with the e750 billion Pandemic Emergency Purchase Programme (PEPP), which complements its existing APP programme. Compared to the APP programme, the PEPP enjoys increased flexibility in terms of asset class, maturity and country limits; for all intents and purposes it is a limitless quantitative easing programme intended to offer relief directly to sovereigns and non-financial corporates.9

5.2 Trying to Step up the Fiscal Support: An Uncertain Compromise Eurozone’s initial reaction was fast, compared to the previous crisis, but it was clearly not adequate, as it continued to rely on an ‘individual responsibility’ approach. Member states’ fiscal expansion would result in massive new loads of public debt, through a recession, which in turn, would lead to serious debt sustainability problems in the medium-term for sovereigns that were already heavily indebted, particularly as yields continued to be elevated, despite ECB’s intervention (Fig. 1). The PEPP did not offer a remedy in this respect; states continued to issue debt on their own terms, which increased debt one euro for every euro raised. It was becoming increasingly clear that there was a need for substantial funding at the supranational level, in order to avoid another debt crisis. During this period, numerous proposals were presented in this respect by academics and officials, including monetary financing (Galí 2020), a common fiscal mechanism (BenassyQuere et al. 2020) and the issuance of coronabonds (Bofinger et al. 2020). However, some of these proposals would be against EU law, and most of them were a nonstarter for supporters of monetary orthodoxy and fiscal conservatism. This became clear on the 26th of March, when Germany and its allies rejected the request of nine European leaders, representing among others, the vulnerable countries of the South, for a ‘common debt instrument’. The decision was followed by a spat between the Portuguese Prime Minster and the Dutch finance minister. The divide had become more visible than ever before. The drama climaxed as the Eurogroup, assigned by 4 June 2020, the ECB decided to expand the programme’s size to e1.350 billion and extend its duration to June 2021. 9 On

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the European Council to come up with new proposals, failed to do so at its meeting on the 7th of April. A compromise was finally reached at the Eurogroup on April 9. It was based on a multi-pronged response including the European Commission’s Temporary Support to mitigate Unemployment Risks in an Emergency (SURE) programme, intended to fund labour market measures to the tune of e100 billion through debt issued by the EU based on state guarantees; a EIB scheme for private sector loans, also based on state guarantees, leveraged up to e200 billion; and new credit lines from the ESM of up to e240 billion. Without discounting the significance of the package, the compromise agreed has serious limitations, which soon became evident. Principal among them is the operation of the ESM funding, the most important part of the agreement, in terms of size. According to the Eurogroup’s statement, the funds would be used to cover ‘direct and indirect healthcare, cure and prevention related costs due to the COVID 19’ (Centeno 2020b). However, health care is only a small part of the pandemic’s economic costs. It was uncertain how the much higher cost of supporting the economy during lockdown and recovery would be covered; the fuzzy language employed allowed the Dutch finance minister to state that support for the economy—even for measures directly related to the pandemic—would come under conditionality, at the same time that the Italian finance minister was asserting that ‘conditionality was off the table’ (Fleming and Khan 2020).

5.3 A Game-Changing Agreement? Clearly, the compromise achieved in April was not enough, not only due to the ESM complications, but also in terms of size; the funds foreseen could perhaps be considered adequate for dealing with the health aspects of the crisis, but not for dealing with its economic implications. There seemed to be an increased acceptance of this reality even in the camp of fiscally conservative countries, as growth projections for the Eurozone became increasingly negative (Lagarde and de Guindos 2020). In this context, the Franco-German proposal for a e500 billion fund on the 18th of May, to be disbursed in the form of grants, marked a turning point for Germany, the pillar of fiscally conservative Europe. It seems that the German leadership realized the need to support the economies of the South, as a new debt crisis, against the background of increased Euroscepticism in certain countries, could threaten the integrity of the Eurozone. At the same time, rather ironically, the decision by the German Constitutional Court showed the limits of ECB’s creative policymaking, demonstrating the need for a more active fiscal policy at the supranational level. The European Commission’s proposed Next Generation EU scheme, presented the following week, was based on the Franco-German plan; it proposed a e750 billion recovery instrument, of which e500 billion in the form of grants and e250 billion as loans (European Commission 2020). According to the proposal, these funds would be sourced by the European Commission on behalf of the EU in the markets,

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based on state guarantees for an increased ‘headroom’, i.e. the difference between the ‘Own Resources’ ceiling of the EU budget and the actual spending agreed in the budget negotiations. In particular, the Commission proposed to increase the own resources of the European budget, using a combination of different policies, such as the introduction of a ‘digital tax’ for large companies, the implementation of the ‘carbon border adjustment mechanism’ included in the Commission’s Green Deal, as well as the extension of the European emissions trading scheme. The repayment of the bonds was proposed to start after 2027 and be completed by 2058. Following two months of intense behind-the-scenes talks between the proponents of the plan and the so-called frugal four,10 and an arduous five-day negotiation, the European Council finally reached an agreement on the Next Generation EU on the 21st of July.11 Despite its shortcomings (principal among them a substantial reduction of the share of grants to e390 billion), the agreement endorsed all the major components of the Commission’s proposal (extensive borrowing through EU bonds in the markets, a substantial share of grants and increasing own resources through the introduction of new ‘European taxes’), raising hopes for an effective handling of the pandemic crisis.

5.4 It Is Enough? There is no doubt that the agreed plan introduces several new and ambitious elements that break new ground, making it, potentially, a catalyst for further European integration. On the other hand, the plan, as repeatedly stressed by representatives of the group of fiscally conservative countries, is an ad hoc, temporary and extraordinary strategy to deal with an emergency. What is its likely effect on EMU’s fiscal governance? Although it is too early to make an evaluation based on facts, a few tentative remarks are possible. First, it should be noted that some elements of the proposal are unlikely to have a lasting impact on EMU’s governance. Thus, for example, the dispersion of hundreds of billions of emergency grants is not something expected to become a routine operation once the pandemic is over. Moreover, many of the elements of the proposal are not new; for example, proposals for an increased budget and new EU taxes are not novel; the Commission has often advocated both proposals

10 The ‘frugal four’ are: Austria, Denmark, the Netherlands and Sweden. Shortly after the announcement of the Franco-German proposal they circulated their own counterproposal, which insisted on loans instead of grants, accompanied by conditionality, and explicitly rejected debt mutualization. Available at: https://g8fip1kplyr33r3krz5b97d1-wpengine.netdna-ssl.com/wp-content/upl oads/2020/05/Frugal-Four-Non-Paper.pdf (last accessed on July 30, 2020). During the European Council negotiations, the ‘frugals’ became five, as Finland joined their position. 11 The European Council also reached a long-awaited agreement on the multiannual financial framework (MFF) for 2021–2027. For details of the entire package agreed, see the European Council’s conclusions, available at: https://www.consilium.europa.eu/media/45109/210720-eucofinal-conclusions-en.pdf (last accessed on July 30, 2020).

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in the past to no avail. However, the urgency of the current crisis could act as a catalyst for the adoption of previously discarded proposals; temporary solutions could over time become permanent, as was the case with the ESM in the previous crisis. Thus, the expansion of the EU’s budget ceiling, funded by new EU taxes, could be a reform of lasting and significant impact. These two changes are unlikely to be entirely removed once agreed; if so, there could be a much more substantial EU budget in the future, with the possibility to fund new fiscal mechanisms—perhaps separately for the Eurozone—of stabilization. Also, the increased headroom could be maintained as a form of callable capital to serve as guarantee for issuing common debt in case of need in the future, or even in a more stable basis, creating in effect a European safe asset. On the other hand, the agreement not only does not include any permanent fiscal reforms, but in reorganizing EU’s budget priorities, it cancels the only fiscal reform introduced in the post-crisis period, the Eurozone budgetary instrument. It is obvious that during the negotiation, ‘the battle’ was not so much over the necessity or the size of the fund, but over whether permanent features of ‘fiscal solidarity’ would be included in the EU and EMU governance. As it stands, the agreement does not offer anything new in this respect.

6 Conclusion: The Uncertain Progress of European Integration Through Crises In a monetary union of sovereign states, there is a need to monitor and control national fiscal policy, but also to support it in times of need. The fiscal governance decided at Maastricht was imbalanced and inadequate in both respects. Being the result of a political compromise, it instituted a decentralized ‘individual responsibility’ approach, with no effective compliance mechanism and no support facilities for times of economic turbulence. Its weaknesses, revealed by the global financial crisis, contributed to Eurozone’s deterioration into a second, debt crisis and a double dip recession. The lack of institutional provisions for dealing with the crisis turned its handling into a de facto political and therefore intergovernmental process where creditor countries, enjoying a highly asymmetrical negotiating advantage, dictated both the terms of the bailout agreements and the provisions of the new fiscal governance. Being essentially a reinforced version of the pre-crisis framework, the ‘reformed’ fiscal governance has tried to balance conflicting objectives with little success. As a result, a short few years after its implementation, the calls for a new reform have been multiplying. The urgency of reform increased dramatically due to the coronavirus pandemic. The initial reaction of the EMU, relied, like before, on states’ own fiscal efforts and on ECB’s activism. However, the limits of the former soon became apparent, while the limits of the latter were demarcated by the German Constitutional Court’s decision. In this context, the Next Generation EU agreement offers hope for a substantial

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response to the crisis, albeit a much weaker one for a substantial reform of EMU’s fiscal governance. There seems to be a window of opportunity for the former aspect, as Chancellor Merkel seems more interested in her political legacy, which has led her to endorse the compromising proposals of her social-democratic coalition partners. However, Germany’s position on more permanent interventions in the EMU’s fiscal institutions is unlikely to change dramatically. Even though the prospects for a substantial reform remain weak, there is hope that some of the changes introduced to combat the pandemic could prove difficult to undo, change the status quo, and potentially pave the way for deeper reforms. The court’s decision, despite its own weaknesses, revealed the imbalanced nature of the EMU; there cannot be a sustainable monetary union without a common fiscal capacity. Failure to reform would lead the Union down a road of continuous crises handled in an ad hoc manner; economies would be on very different fiscal and macroeconomic trajectories. In the absence of permanent common resources and fiscal mechanisms, the correction of these imbalances would require adjustment policies, igniting anew a clash over austerity that would delay economic recovery, weaken further EU’s already damaged credibility, and ultimately risk Eurozone’s break-up.

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Dimitris Katsikas is an Assistant Professor of International and European Political Economy at the National and Kapodistrian University of Athens. Between 2013 and 2020, he was Head of the Crisis Observatory at the Hellenic Foundation for European and Foreign Policy (ELIAMEP); he now heads its new Greek and European Economy Observatory. His research focuses on international and European political economy and economic governance. His most recent books include (ed.) Public Discourses and Attitudes in Greece during the Crisis: Framing the Role of the European Union, Germany and National Governments and Economic Crisis and Structural Reforms in Southern Europe: Policy Lessons, (eds.) with P. Manasse.

Essential and Non-essential Goods: A Dynamic Stochastic General Equilibrium Modeling of the Infectious Disease Coronavirus (COVID-19) Outbreak Nuno Baetas da Silva and António Portugal Duarte Abstract In this chapter, we propose a two-country, two-sector, New Keynesian model with essential and non-essential goods for the Euro Area to assess the macroeconomic consequences of a labor supply shock. Our model incorporates health status in the households’ maximization problem which depends on the time devoted to leisure. Health status is linked to the consumption of non-essential goods, such that the demand for non-essentials is decreasing with contemporaneous health. We calibrate the model for the case of Portugal and the rest of the Euro Area. Our simulations show that a labor supply shock affecting only the rest of the Euro Area reduces the demand for non-essential goods, generates inflation in the Portuguese economy and pushes both regions into economic recession, depriving households from essential goods. In addition, we also show that if the labor supply shock affects both economies, the negative income effect dominates the decreased demand effect for non-essential goods and that stagflation is a plausible scenario. Lastly, our calibration scheme allows us to conclude that the asymmetric effects across economies may be due to different price rigidities between sectors and to different production structures between countries. Keywords Essential goods · Non-essential goods · COVID-19 · DSGE · Euro Area.

1 Introduction The worldwide spread of the infectious coronavirus disease (COVID-19) and the following global shut down may lead to an unconventional recession. With a significant fraction of workers sick or in quarantine, confinement policies, changes in mobility N. B. da Silva (B) · A. Portugal Duarte Faculty of Economics, CeBER—Center for Business and Economic Research, University of Coimbra, Av. Dias da Silva, 165, 3004-512 Coimbra, Portugal e-mail: [email protected] A. Portugal Duarte e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_9

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trends, the closing of borders and adjustments in the structure of demand, guaranteeing access to essential goods is crucial to avoid economic collapse. However, while the demand for health care and certain health-related goods has increased sharply, as well as demand for communications, food, home delivery services, the demand for certain durable products (namely, cars) and many services (such as tourism) has slipped down. In a recent opinion article, Paul Krugman Krugman 2020 refers to the latter as non-essentials, which are associated with services that authorities may shut down to limit human interaction and hence the spread of the disease. During this coronacoma period, however, a significant share of the population may lose their jobs. Countries or economic regions that depend largely on non-essential goods sectors will be especially affected, most likely depriving its households from essential goods, even if the number of infected population is low. This may be particularly relevant in highly integrated markets, such as the case of the Euro Area countries. In this work, we follow a qualitative approach, using the aggregation criterion proposed by Ramos et al. (2020), to analyze the macroeconomic consequences of a labor supply shock brought about by a quarantine decision across Euro Area countries. Our objective is to find answers to the following questions: Will an economy with a large export non-essential goods sector be deprived of essential goods? What is the most likely macroeconomic outcome for the Euro Area countries facing a combination of a negative demand shock in the non-essential goods sectors and a negative labor supply shock? Are there significant differences if the shocks hit economies with distinct magnitudes? In order to answer these questions, we build a two-country, two-sector, dynamic stochastic general equilibrium (DSGE) model of a monetary union. We include health status within the household utility function, which depends on leisure hours. Households derive utility from consumption and health status, aggregating their consumption between essentials and non-essentials goods. The occurrence of an infectious outbreak, such as the COVID-19, assumed to be exogenous, will be reflected in the time devoted to leisure due to confinement measures, allowing households to increase their health status. A gain of health will change the consumption pattern between essential and non-essential goods because contact-intensive activities become unavailable. Firms produce essential and non-essential goods, demand domestic effective labor, which depends on labor health status. Government expenditures are included in the form of demand shocks, both in essential and non-essential goods. Finally, a monetary authority targeting union-wide inflation via a Taylor rule is also included. Monetary shocks are assumed to be symmetric. We calibrate the model for the case of Portugal and the rest of the Euro Area. Our simulations show that a labor supply shock hitting the rest of the Euro Area will spread to the Portuguese economy, leading to a decline in the output growth and a period of high inflation, depriving households from access to essential goods. We also show that the income effect of a labor supply shock affecting the whole Euro Area dominates the decline in demand for non-essential goods, drawing stagflation as a plausible scenario. The remaining of this chapter is organized as follows. Section 2 presents the recent literature on the macroeconomic effects of the COVID-19. In Sect. 3, we set

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up the model. Section 4 reports the calibration scheme employed and a discussion on the aggregation between essential and non-essential goods. Section 5 shows the simulations of the shocks. Section 6 concludes.

2 Related Literature A significant stream of literature has appeared and is still growing on the macroeconomic effects of the infectious disease coronavirus (COVID-19) outbreak. Guerrieri et al. (2020) show that pandemic-driven labor supply shocks can cause demand spillovers via intra-temporal effects under certain parameterizations of the elasticities of substitution. In their framework, the demand is endogenous and affected only by the labor supply shock, in a multiple-sector environment with low substitutability across sectors and incomplete markets, with liquidity constrained consumers. In our work, we model the labor supply shocks similarly, but the spillover effects are transmitted via an health status function affecting the consumption of certain (nonessential) goods. Fornaro and Wolf (2020) employ a small-scale New Keynesian model to show that a negative supply shock may depress aggregate demand through persistent effects on productivity growth. This is what the authors label as a supplydemand doom loop, which amplifies the initial supply shock on labor, opening the door to self-fulfilling pessimistic expectations, pushing the economy into a stagnation strap. We also take a more qualitative approach but focus on international trade, unlike any of the works above. It is also our intention to analyze the impact of the pandemic on highly integrated markets with a myriad of confinement measures at different stages in the intensity of the virus, such as the case of the Euro Area. Baqaee and Farhi (2020) study the effects of the COVID-19 crisis in a multiple-sector Keynesian model, with input-output interactions, calibrated for the US economy. They find that negative supply shocks are stagflationary and demand shocks are deflationary. Brinca et al. (2020) estimate a Bayesian Structural Vector Autoregressive (SVAR) model on growth rates of hours worked and real wages during the COVID-19 period in the US economy to decompose sectoral outcomes into labor-demand and supply sources. The authors find that the largest share of the decline in hours worked can be attributed to labor supply shocks but there is considerable heterogeneity across sectors, with Leisure and Hospitality being among the most affected ones. Ramos et al. (2020), using the World Input-Output Database (WIOD), aggregate goods into essential and non-essential sectors, which serves as the basis for the production structure in our model, to show that a symmetric exogenous ad-hoc demand shock to the non-essentials goods sector has asymmetric effects across countries. They argue that the change in the global consumption pattern brought about by the pandemic will have a greater impact in China, Indonesia and Malta, as measured by the Gross Value Added (GVA). Their estimates point to a 33.1% drop in global trade, and a significant deterioration in the balance of payments in some countries such as Luxembourg, Czech Republic, Taiwan and South Korea.

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A burgeoning body of work, motivated by the COVID-19 pandemic, makes contact with epidemiological models of contagion, integrating them into an economic framework. Alvarez et al. (2020) use the Susceptible, Infectious or Recovered (SIR) epidemiology model to analyze the intensity and duration of an optimal lockdown policy. Atkenson (2020) provides a useful overview of the SIR model and a series of simulations for the progression of COVID-19. In the model of Eichenbaum et al. (2020), people react endogenously to epidemic exposure risk by reducing their labor supply and consumption goods, in a real one-sector environment. These effects work together to generate a large, persistent recession. A trade-off between the severity of the recession and the health consequences of the pandemic is established. In contrast, Krueger et al. (2020), by extending the previous model with multiple heterogeneous sectors that differ in their infectious probabilities, show that the economic slump can be mitigated or even avoided due to smooth and quick transitions in the labor markets, where workers re-allocate to the (new) sectors in demand, while keeping the COVID-19 spread low.

3 The Model The literature on DSGE models, and particularly for modeling a monetary union, is vast. After the seminal work of Smets and Wouters (2003) for the case of the European Monetary Union, a plethora of papers has followed. Without being extensive, some examples in the literature are Fagan et al. (2005), Adolfson et al. (2007), Ratto et al. (2009), Rabanal (2009) or Quint and Rabanal (2014). The model we propose shares many characteristics of these models. Our modest contribution to this large literature consists on a two-country model featuring tradable essentials and tradable non-essentials sectors. To the best of our knowledge, this is the first DSGE model with such framework. We also departure from the consideration of a small open economy model, allowing for the calibration of any two-sized economies, under the same veil as Rabanal (2009) and Quint and Rabanal (2014).

3.1 Households Consider a monetary union composed of two countries, home (H) and foreign (F), populated by a continuum of households and a continuum of firms, with sizes s and (1 − s), respectively. The representative household is indexed by h ∈ [0, 1] in the home economy and by h∗ ∈ [0, 1] in the foreign economy.1 Following the functional form in Hall and Jones (2007) and Yagihashi and Du (2015), household members derive utility from consumption and health status in order to maximize expected 1 The

foreign economy is denoted with an asterisk as a counterpart of the same variable in the domestic economy.

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lifetime utility. The maximization problem is subject to a budget constraint, with revenues coming from labor income, returns on a single, one-period, risk-less, unionwide bond, denominated in euros and dividends from ownership of firms. The optimality condition for the representative household’s inter-temporal decision yields the standard Euler equation,2   μt = Et μt+1 + rt − πt+1

(1)

where μt denotes the marginal utility of consumption given by, μt = −σ ct (h)/(1 − b). σ > 0 governs the inter-temporal elasticity of substitution for consumption and b is the conventional exogenous habit formation parameter. πt = pt − pt−1 is the Consumer Price Inflation (CPI) rate and rt the nominal interest rate. For simplicity, we assume that health status (ht ) is only related with leisure hours (1 − lt ), such that, ht = κ(1 − lt )

(2)

where κ denotes the elasticity of substitution of health with respect to leisure hours and lt the (normalized) time spent working. The first order condition for leisure is given by, [κ(1 − φ) − 1](1 − lt ) = μt + wt + xt

(3)

where φ denotes the inverse of the inter-temporal elasticity of substitution for health status and wt is the nominal wage. xt is an exogenous disturbance to the utility weight of health status affecting the intra-temporal preferences of households and follows a univariate AR(1) representation in log-linear form: xt = ρx xt−1 + εx,t + εt

(4)

where ρx ∈ [0, 1], augmented with a union-wide shock, εt .3 A shock to either εx,t or εt increases leisure time, which is how households obtain health in our framework, ultimately reducing the supply of labor.4 The consumption index (ct ) is defined as a constant elasticity of substitution (CES) aggregate of essential (cE,t ) and non-essential (˜cN ,t ) goods indexes. Optimal demand for consumption from each sector can be written as downward sloping functions of relative sector prices:

2 Throughout all the variables are presented in percentage deviations from the non-stochastic steady

state. ∗ + ε∗ + ε . analogous disturbance for the foreign economy evolve as follows: xt∗ = ρx∗ xt−1 t x,t results can be obtained with a disturbance to the disutility of work (Hall 1997) in a more conventional approach. As noted by Justiniano et al. (2013), this intra-temporal preference or labor supply shock enters in the household’s first order conditions for the optimal supply of labor as a wage mark-up shock in a model with staggering wages.

3 The

4 Similar

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cE,t = −c (pE,t − pt ) + ct

(5)

c˜ N ,t = −c (pN ,t − pt ) + ct .

(6)

The parameter c > 0 denotes the elasticity of substitution between sectors. We link the consumption of non-essential goods with health status in the following way: c˜ N ,t = cN ,t + ξ ht

(7)

where ξ denotes the elasticity of non-essential goods consumption with respect to the health status. Note that, in the steady state (normal times), we have ht = 0 and c˜ N ,t = cN ,t . Quantities in (5) and (6) are combinations of domestically produced and imported goods in a CES nested structured. Let pHk,t and pFk,t denote sector k ∈ [E, N ] domestic and imported prices, respectively. Optimal demand for domestically produced consumption (cHk,t ) and for imported goods (cFk,t ), from each sector, can be written as follows: cHk,t = −ν(pHk,t − pk,t ) + ck,t

(8)

cFk,t = −ν(pFk,t − pk,t ) + ck,t

(9)

where ν > 0 governs the elasticity of substitution between goods from different countries. Therefore, households substitute their demands toward goods from countries with relatively low prices. Since c˜ N ,t depends on cN ,t , changes in the health status will affect the consumption of domestic and imported non-essential goods. There are a few points worth noting. First, the occurrence of an infectious disease outbreak (such as the COVID-19) is captured in our model as an increase in leisure time (or a decrease in hours worked) due to quarantine or lockdown policies (Eq. 3). This allows households to increase their health status (Eq. 2). Second, while stayat-policies have a direct effect on health status, some contact-intensive sectors will face a shrinkage in the demand as a consequence (Eq. 7). We label these sectors as non-essential. Third, our framework doesn’t allow for the distinction between supply and demand shocks, in so far as we couple these two effects under the same shock. However, this has the advantage of describing the potential consequences of a society-wide pandemic using a single shock.

3.2 Firms There is a continuum of monopolistic competitive firms in each sector k ∈ (E, N ). Brands of essential (E) and non-essential goods (N) are indexed by fk ∈ [0, sk ] in the domestic country and by fk∗ ∈ (sk , 1] in the foreign country. Each firm j in sector

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k uses labor, lk,t , as the only input. Aggregate output in domestic sector k can be written as yk,t = zk,t + lk,t

(10)

zk,t is a stationary and sector specific productivity shock: zk,t = ρZk zk,t−1 + εkZ,t .

(11)

Price setting by domestic and foreign firms is subject to monopoly supply power and sticky prices. In particular, firms set prices a la Calvo (1983) and Yun (1996). Let (1 − θk ) denote the probability that randomly selected domestic firms get to post new prices in sector k. The fraction φk ∈ [0, 1] of remaining firms indexes its price to last period’s sectoral inflation rate. The optimality condition implies the following domestic New Keynesian Phillips curve (NKFC): (1 + φk β)πk,t = φk πk,t−1 + βπk,t+1 +

(1 − θk )(1 − βθk ) (w¯ t − zk,t − pHk,t + pt ) θk (12)

where the real wage is defined as w¯ t = wt − pt and β denotes the household’s discount factor.

3.3 Aggregation, Fiscal Policy and Risk Sharing Goods produced in each sector k are consumed by domestic households, exported or purchased by the government, that is, ∗ ] + γG gk,t yk,t = (1 − γG )[γHk cHk,t + (1 − γHk )cHk,t

(13)

where γG is defined as the steady state ratio of government expenditures over output and γHk denotes the share of home produced k goods in the domestic basket. Government expenditures (gk,t ), consisting on essentials and non-essential goods, assumed to be fully financed by lump-sum taxes in order to ensure balanced growth, are modeled as exogenous shocks, according to gk,t = ρGk gk,t−1 + εGk,t .

(14)

Using the appropriate prices indexes we are then able to write the aggregate real GDP equation: y¯ t = γE (yE,t + pE,t − pt ) + (1 − γE )(yN ,t + pN ,t − pt )

(15)

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such that γE denotes the steady state weight of essential goods in the domestic consumption basket. The single, one-period, risk-less bond implies the perfect risk sharing condition (Chari et al. 2002). Thus, Euler equations between home and foreign households can be combined to obtain the following expression for the real exchange rate: rert = pt∗ − pt = μ∗t − μt .

(16)

Equation (16) establishes the relationship between the real exchange rate and the marginal rates of substitution and shows that, in the absence of nominal exchange rate fluctuations between the two economies, changes in the real exchange rate are due to inflation differentials, such that, rert = πt ∗ − πt .

3.4 Monetary Policy The model is closed with a specification for the monetary authorities. Following the usual approach in the DSGE literature, see, e.g., Smets and Wouters (Smets and Wouters 2003), Gali and Monacelli (Gali and Monacelli 2005), we assume that monetary policy can be approximated by a Taylor rule of the form: rt = ρr rt−1 + (1 − ρr )(γπ πM U,t + γY y¯ M U,t ) + εm,t

(17)

where ρr , γπ and γY are policy coefficient and εm,t is an iid monetary policy shock. With this setting, a single monetary authority targets both union-wide inflation (πM U,t ) and real output (¯yM U,t ). These are aggregated according to πM U,t = sπt + (1 − s)πt∗

(18)

y¯ M U,t = s¯yt + (1 − s)¯yt∗ .

(19)

After calibrating shares γE , γHE , γHN , γG and their foreign counterparts we are able to obtain endogenously the sizes of each economy, s and (1 − s).

4 Calibration The model is calibrated for Portugal and the rest of the Euro Area. For simplicity, we establish a set of common parameters and a set of country-specific parameters. The calibration scheme is shown in Table 1. Following Smets and Wouters (2003), the discount factor is set to 0.992 and the habit formation parameter to 0.6. Regarding σ , the value of 1 imposes a logarithmic preference specification on consumption. We set the elasticity of substitution between health and leisure hours at 0.7, an higher value

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than that used in Yagihashi and Du (2015).5 The elasticity between the consumption of non-essential goods and health status is set at 0.8, reflecting that the demand for this type of goods depends greatly on the health status of households. Taylor rule parameters are set at conventional values (Smets and Wouters 2003), with a long-run response to inflation of γπ = 1.5 and with a long-run response to the output gap of γY = 0.5. The coefficient on the lagged interest rate, i.e., interest rate smoothing, is set to ρr = 0.85. We had no a priori indication about any of the parameters regarding essential and non-essential goods. Our assumption was that the elasticity of substitution between these goods and between domestic and imported goods is constant and equal across economies. We set the elasticity of substitution between the two goods and between domestic and imported goods to c , c∗ = 0.5 and ν, ν ∗ = 1.5, respectively, following Atalay (2017) and Rabanal (2009), which are quite common values in the literature. Only calvo prices and price indexation coefficients are assumed to differ between sectors and countries. Our strategy was as follows: (i) Euro Area prices are less stickier than those in Portugal; (ii) firms in the non-essential sectors are allowed to adjust prices faster; (iii) the degree of price indexation is the same between sectors but higher in the Portuguese economy. In all cases, prices are reset optimally in less than 4 periods and the degree of backward-looking in the Phillips curves is between 0.45 and 0.4. In order to determine the shares of essential goods in the consumption baskets, we relied on the World Input-Output Database (WIOD). According to Ramos et al. (2020),6 non-essentials are broadly composed by Manufacture, Construction, Transport (by water and by air) services, Accommodation and food service activities, Art, Accounting, Legal, Architectural and Advertising related sectors. The description of each sector in this category is reported in the footnote of Table 1 using the WIOD nomenclature. As can be observed, the share of essential goods is higher in the Euro Area when compared to that of Portuguese consumers. In both cases, essential goods are more than 54% of total consumption. Portugal’s share of domestic essential and non-essential goods is higher than 80%, supporting the home bias postulate, and greater for the former. Euro Area non-essential goods imports reach 2%, showing the relative importance of these sectors, such as tourism activities, in the Portuguese exports structure. Therefore, a negative demand shock toward non-essential goods may have an important impact in Portugal’s exports.

5 Simulations We consider two extreme scenarios in our simulations. In the first one, we examine a shock to the labor supply affecting only rest of the Euro Area. In this case, we assume the implausible scenario that Portuguese authorities wouldn’t take any quarantine or adjust the steady state such that ht = 0, which implies c˜ N ,t = cN ,t . 6 We thank the authors for their commentaries and suggestions regarding the aggregation procedure, 5 We

in particular João Pedro Ferreira for his guidance using the WIOD. All the errors are our own.

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Table 1 Calibration scheme Country

Parameter

Description

Value

Common

β, β∗

Time discount factor Habit formation Inter-temporal elasticity of substitution (consumption) Inter-temporal elasticity of substitution (health status) Elasticity of substitution between health and leisure hours Elasticity of N goods consumption w.r.t. health Elasticity of substitution between E and N goods Elasticity of substitution between domestic and imported goods Interest rate smoothing coefficient; Taylor rule Response to inflation; Taylor rule Response to output; Taylor rule Share of E goods in domestic consumption Share of home E goods in domestic consumption Share of home N goods in domestic consumption Domestic government expenditures ratio Calvo prices (E) Calvo prices (N) Price indexation (E) Price indexation (N) Share of E goods in foreign consumption Share of foreign E goods in foreign consumption Share of foreign N goods in foreign consumption Domestic government expenditures ratio Calvo prices (E) Calvo prices (N) Price indexation (E) Price indexation (N)

0.992

b, b∗ σ, σ∗ φ, φ∗ κ, κ∗ ξ, ξ∗ c , c∗ ν, ν∗ ρr γπ γY

Portugal

γE γHE γHN γG θE θN φE φN

Euro Area

γE∗ ∗ γHE ∗ γHN

γG∗ θE∗

θN∗

φE∗

∗ φN

0.6 1 2 0.7 0.8 0.5 1.5 0.85 1.5 0.5 0.549 0.883 0.829 0.19 0.65 0.35 0.45 0.45 0.557 0.999 0.998 0.21 0.6 0.3 0.4 0.4

Essentials and non-essentials shares are calculated using the World Input-Output Database (WIOD). Non-essentials include sectors: B, C13–C18, C20, C22–C25, C27–C32, F, G45–G47, H50–H52, I, J58–J60, M69–M71, M73–M75, R, S and T. Own calculations

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Health Status

Labor Hours 0.2

0

0.1

-0.1

0

-0.2

-0.1 5

10

15

5

(N) consumption

10

15

(E) consumption 0 -0.05 -0.1 -0.15

0.1 0 -0.1 -0.2 5

10

15

5

10

15

Inflation rate

Output growth 0 -0.1 -0.2 -0.3

0.4

Portugal Euro Area

0.2 0 5

10

15

5

10

15

Fig. 1 Impulse response functions to a labor supply shock in the rest of the Euro Area. The figure ∗ (in percent deviations from the steady state). The shows the impulse responses to a 1% shock to εx,t persistence parameters are set at ρx = ρx∗ = 0.6 Own calculations

lockdown measures affecting the supply of labor. In the second scenario, the labor supply shock hits both economies with the same magnitude, a situation which one may label as a union-wide full lockdown. Figure 1 depicts the first scenario. This type of shock is analogous to an intratemporal preference shock, shifting the foreign labor supply curve in for both sectors. As a consequence, hours worked decline in the essentials and non-essentials sectors, driving wages up on impact. Since firms’ marginal costs increase, prices increase also. Foreign consumption falls (in an hump-shaped form due to habit persistance) since households’ income declines. Health status increases in rest of the Euro Area but by less than the increase in leisure time given our choice for the elasticity of substitution. The increase in health status amplifies the decline in the consumption of non-essentials goods. As a result of lower employment and decreased demand, output growth in the rest of the Euro Area declines sharply. One important thing to note is that the supply side shock dominates the decline in demand, leaving the economy in a stagflationary scenario. However, since firms in the non-essential sector adjust prices faster, essential goods consumption increases on impact and it’s partly directed to Portuguese exports.

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0.1

Health Status

Labor Hours 0.1

0.05

0

0 -0.1

-0.05 5

10

15

5

(N) consumption

10

15

(E) consumption -0.05 -0.1 -0.15 -0.2 -0.25

-0.1 -0.2 -0.3 5

10

15

5

10

15

Inflation rate

Output growth 0.05 0 -0.05 -0.1 -0.15

0.4

Portugal Euro Area

0.2 0 5

10

15

5

10

15

Fig. 2 Impulse responses functions to a union-wide labor supply shock. The figure shows the impulse responses to a 1% shock to εt (in percent deviations from the steady state). The persistence parameters are set at ρx = ρx∗ = 0.6 Own calculations

The effects of the lockdown are also conveyed to the Portuguese economy. Since Euro Area imports become relatively more expensive and exports relatively cheaper, the demand for domestic goods increases at the outset, leading to a decline in leisure hours, which has an impact in the domestic health status, and hence increased exposure to the infection, reinforcing the demand for non-essential goods. Firms adjust their prices up, albeit sluggishly, without loosing market share in both markets. The economy enjoys a brief period of output growth until the effects of declining demand materialize. As can be observed, the shock in the foreign economy is transmitted to Portugal since markets are fully integrated. Firms are able to maintain their prices above trend and households are deprived of essential goods because of higher price stickiness. Figure 2 shows the impulse response function to a shock to εt , a situation where the shock to labor supply affects both economies. The transmission mechanisms are similar to those described above. There are, however, a few differences worth mentioning. First, consumption of essential goods is lower in both economies on impact. This is explained by the fact that prices are stickier in this sector. Second, output growth declines more in the rest of the Euro Area since firms adjust prices faster, but we observe a longer recession in Portugal. Third, our findings suggest that both economies may be pushed into a period of stagflation.

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6 Conclusion In this chapter, we conduct a qualitative assessment on the macroeconomic effects of a labor supply shock in the Euro Area through the lens of a dynamic stochastic general equilibrium model. We propose a variation on the usual formulation of these models by incorporating essential and non-essential goods, in an environment where a labor supply shock affects the health status of households, which, in turn, is linked to the demand of non-essential goods. We calibrate the model for Portugal and the rest of the Euro Area and present simulations for two distinct scenarios. Our findings show that a labor supply shock affecting only the rest of the Euro Area is able to generate inflation in the Portuguese economy due to households’ substitution effects. This follows with an increase in hours worked and an increasing risk of infections (as read by health status). The positive output growth on impact precedes an economic recession as demand declines in both countries. Households are then deprived of essential goods partly because firms keep satisfying foreign demand and partly due to price stickiness. Once we consider a union-wide labor supply shock, we are able to show that the income effect dominates the demand shortage in the non-essential goods sector and that a stagflationary scenario is a plausible one. We strongly believe that our results are relevant from a macroeconomic policy point of view. The prospect of stagflation poses a laborious task for governments and the monetary authority, and highlights the urge for policy coordination among countries sharing the common currency. Upward pressure on prices in some essential goods, reinforced by hoarding behavior, may demand government intervention in order to avoid supply chains disruptions and ensure that those who have lost their jobs have access to these goods. Countries with a more non-essential oriented economic structure will be more affected. Workers can’t go to work, sales are close to zero and firms won’t be able to pay wages and taxes. As a result, the demand for loans will rise. All over the European Union, several national governments already opened credit lines to support companies, thus providing short-term liquidity and circumvent mass lay-offs and defaults. The response, however, must be faster, assertive and wider. Union-wide measures are critical to fight a common shock to ensure the political survival of the European Union in one of the most dark periods of its history. These are times that require crossing a political Rubicon, in which member states must commit to share the burden of the fiscal response. For now, mobilizing resources to fight the pandemic, mitigate the spread of the disease, provide liquidity to firms and save jobs should be the crucial matters in the agenda guaranteeing a swift and smooth transition once economies start to reopen. Using Krugman’s words, we need disaster relief not economic stimulus.

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References Adolfson, M., Laséen, S., Lindé, J., and Villiani, M. (2007). Bayesian Estimation of an Open Economy DSGE Model with Incomplete Pass-Through. Journal of International Economics, 72(2):481–511. Alvarez, F. E., Argente, D., and Lippi, F. (2020). A Simple Planning Problem for COVID-19 Lockdown. National Bureau of Economic Research, Working Paper 26981. Atalay, E. (2017). How Important Are Sectoral Shocks? American Economic Journal: Macroeconomics, 9(4):254–280. Atkenson, A. (2020). What Will Be the Economic Impact of Covid-19 in the US? National Bureau of Economic Research, Working Paper 26867. Baqaee, D. and Farhi, E. (2020). Supply and Demand in Disaggregated Keynesian Economies with an Application to the Covid-19 Crisis. National Bureau of Economic Research, Working Paper 27152. Brinca, P., Duarte, J. B., and Faria-e Castro, M. (2020). Is the COVID-19 Pandemic a Supply or a Demand Shock? Federal Reserve Bank of St. Louis, Working Paper 2020-011. Calvo, G. A. (1983). Staggered Prices in a Utility-Maximizing Framework. Journal of Monetary Economics, 12(3):383–398. Chari, V., Kehoe, P. J., and Mcgrattan, E. R. (2002). Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates? Review of Economic Studies, 69(3):533–563. Eichenbaum, M., Rebelo, S., and Trabandt, M. (2020). The Macroeconomics of Epidemics. National Bureau of Economic Research, Working Paper 6882. Fagan, G., Henry, J., and Mestre, R. (2005). An Area-Wide Model for the Euro Area. Economic Modelling, 22:39–59. Fornaro, L. and Wolf, M. (2020). Covid-19 Coronavirus and Macroeconomic Policy: Some Analytical Notes. Barcelona GSE Working Paper Series (1168):1–8. Gali, J. and Monacelli, T. (2005). Monetary Policy and Exchange Rate Volatility in a Small Open Economy. Review of Economic Studies, 72(3):707–734. Guerrieri, V., Lorenzoni, G., Straub, L., and Werning, I. (2020). Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages? National Bureau of Economic Research, Working Paper 26918. Hall, R. E. (1997). Macroeconomic Fluctuations and the Allocation of Time. Journal of Labor Economics, 15(1):223–250. Hall, R. E. and Jones, C. I. (2007). The Value of Life and the Rise in Health Spending. Quarterly Journal of Economics, 122(1):39–72. Justiniano, A., Primiceri, G. E., and Tambalotti, A. (2013). Is There a Trade-off Between Inflation and Output Stabilization? American Economic Journal: Macroeconomics, 5(2):1–31. Krueger, D., Uhlig, H., and Xie, T. (2020). Macroeconomic Dynamics and Reallocation in an Epidemic. National Bureau of Economic Research, Working Paper 27047. Krugman, P. R. (2020). Notes on the Coronacoma (Wonkish): This Is Not a Conventional Recession, and G.D.P. Is Not the Target, The New York Times, April 1st. Quint, D. and Rabanal, P. (2014). Monetary and Macroprudential Policy in an Estimated DSGE Model of the Euro Area. International Journal of Central Banking, 10(2):169–236. Rabanal, P. (2009). Inflation Differentials Between Spain and the EMU: A DSGE Perspective. Journal of Money, Credit and Banking, 41(6):1141–1166. Ramos, P. N., Ferreira, J. P., Cruz, L., and Barata, E. (2020). Os modelos Input-Output, a estrutura sectorial das economias e o impacto da crise da COVID-19. GEE Paper, 150(May). Ratto, M., Roeger, W., and in’t Veld, J. (2009). QUEST III: An Estimated Open-Economy DSGE Model of the Euro Area with Fiscal and Monetary Policy. Economic Modelling, 26(1):222–233. Smets, F. and Wouters, R. (2003). An Estimated Stochastic Dynamic General Equilibrium Model of the Euro Area. Journal of the European Economic Association, 1(5):1123–1175.

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Yagihashi, T. and Du, J. (2015). Health Care Inflation and Its Implications for Monetary Policy. Economic Inquiry, 53(3):1556–1579. Yun, T. (1996). Monetary Nominal Price Rigidity, Money Supply Endogeneity, and Business Cycles. Journal of Monetary Economics, 37(2–3):345–370. Nuno Baetas da Silva is a Teaching Assistant and Ph.D. Student at the Faculty of Economics of the University of Coimbra. Research Fellow in CeBER-Centre for Business and Economics Research and a former Researcher in GEMF-Group for Monetary and Financial Studies. He received a distinction from The Tokyo Foundation for Policy Research, under the Ryoichi Sasakawa Young Leaders Fellowship Fund (Sylff) Program, for his work on the alternative sources of Dutch Disease applied to the European Structural Funds. He is the Author of several book chapters and published articles in national and international journals. António Portugal Duarte Ph.D. in Economics, Senior Professor, Faculty of Economics, University of Coimbra, and Research Fellow, CeBER-Centre for Business and Economics Research. Honorary Visiting Research Fellow at the Birkbeck College, University of London, UK. Visiting Professor at the University of Economics in Bratislava, Slovakia and at the Belgrade Banking Academy, Serbia. He is the Author of the book “O Sistema Monetário Internacional: Uma Perspectiva Histórico-Económica”, and of several papers published in national and international journals. In the Faculty, he is currently the Academic Coordinator of International Relations Office; Coordinator of the Bachelor Degree, and member of Scientific Board.

Social Challenges for the Eurozone Antonio Jurado and Jesús Pérez-Mayo

Abstract The economic crisis caused by the COVID-19 pandemic will have a severe and persistent impact in the eurozone countries. Experience has shown that there tends to be an upsurge in inequalities and social exclusion in periods of deep recession, while they are slow to recover in expansion. Social issues are, therefore, potentially the hardest hit and most difficult to remedy in the later phase of the cycle. Poverty, inequality, exclusion and social protection indicators are needed to address this situation. The aim of this chapter is to help propose social policies that anticipate the harsh and asymmetric after-effects of the current crisis on households in the different eurozone countries. Although the prospects look very bleak for some countries like Spain or Italy, the other eurozone countries are not impervious to this shock. It is, therefore, necessary to monitor the problems addressed here in all the eurozone countries and to analyse any divergences occurring over the coming months. Discrepancies in social indicators already existed before COVID-19, and, therefore, their starting points need to be estimated to make predictions for different scenarios. This is a crucial issue when it comes to taking proactive measures related to social affairs. Keywords Poverty · Inequality · Well-being · Social impact · Deprivation

1 Introduction The 2008 crisis and the ensuing recession that lasted until 2013 was the longest and severest recession since the Great Depression that started in 1929. The first symptoms—a financial and real estate crisis caused by a long period of financial system deregulation, during which investment banks were allowed to take everincreasing risks—started to be felt in the United States. The same trend soon spread to the eurozone. Mistrust in financial systems went hand in hand with serious debt A. Jurado Departamento de Economía, Universidad de Extremadura, Cáceres, Spain J. Pérez-Mayo (B) Departamento de Economía, Universidad de Extremadura, Badajoz, Spain e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_10

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financing problems in countries like Greece, Ireland, Portugal, Italy or Spain. Many financial institutions and some governments had to be bailed out to assure the survival of the single currency. The above developments constituted the first major eurozone crisis. On top of an increase in their number (from 15 to 19 over the period from 2008 to 20201 ), the eurozone countries now face a second, and very different, recession. Apart from hundreds of thousands of deaths, the COVID-19 pandemic, imported from China, has triggered a severe economic and social recession. Both the 2008 economic recession and the 2020 health, and promptly ensuing economic, crisis has had painful social after-effects. It is always the most vulnerable population that suffers the worst effects in any economic crisis. Poverty and inequality rates tend to soar in such periods, and they will, often, take many more years to drop down to their pre-recession levels than they took to escalate. In view of the importance that the two crises have had (and the most recent is still having) on society in the eurozone, the reference points for this chapter are the beginning and end of the 2008 recession, as well as the start of the 2020 crisis. We focus on the social dimension of the possible impact of these recessions on the citizens of the 19 eurozone countries. The lessons of this period make it possible to anticipate what may happen after this pandemic if the social effects of the economic measures taken at European level are omitted or minimised. Moreover, the heterogeneity observed in the countries of the eurozone complicates the taking of measures. Even though they have all undergone a process of adaptation of their monetary, fiscal and pricing policies, they are countries that, generally speaking, still have very different demographic, macroeconomic and social variables. Therefore, each of the members of the euro area went into and came out of the crises very differently and this may affect internal political support for the measures needed to overcome the pandemic and even from the European institutions themselves. The virus knows no boundaries and therefore the response should work in the same way. Greater coordination of economic and social policies is needed by continuing the path of integration begun during the financial crisis when the debt and deficit criteria proved insufficient to prevent and deal with a complicated economic crisis. This chapter is structured as follows. The following section describes the evolution of the countries of the euro area with respect to poverty and inequality during the previous crisis. Later, the third section shows the importance of the role of the public sector, affected by the rules of governance, in improving social indicators. The fourth section contains the main contribution of this chapter, a set of estimates of the impact on poverty of expected changes in GDP and inequality. Finally, the main conclusions are presented.

1 Despite not being part of the eurozone during the whole period considered in the following section,

all the countries currently belonging to it are analysed to better describe their social conditions during the great recession.

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2 Learning from the Great Recession Among the conditions for optimal monetary integration, the ability to withstand asymmetric shocks is shown to be one of the most important. However, the record of the countries belonging to the eurozone (then and now) shows that it was far from being fulfilled during the Great Recession. Not only was a different evolution observed in GDP, debt or public deficit, but also in one of the factors with the greatest influence on the living conditions of individuals and, therefore, on the risk of poverty and social exclusion: unemployment. Thus, one of the most important consequences in social terms of the Great Recession was the destruction of employment and new job opportunities. Jobs are destroyed unequally across countries, regions (NUTS 2 or 3), productive sectors, age groups, sex, nationality, qualifications, contract type, etc., painting a multihued picture of poverty and inequality. Focusing on the eurozone, the jobs destroyed during the recession seem to have been recovered by 2019. In 2008, when the effects of the crisis on unemployment were not yet statistically significant, the mean rate was 7.5%, albeit with a large dispersion applicable to almost all variables. In most of the countries, the statistically severest effects of the crisis lasted until 2014, when the eurozone unemployment rate reached 11.6%. Again, it is very important to focus on the dispersion of this increase. There are countries where the unemployment rate more than tripled or quadrupled (Greece and Cyprus, respectively), more than doubled (Spain and Slovenia) or almost doubled (Italy or Portugal) over the above period, whereas the labour markets of other countries, like Germany, Luxembourg or Austria, did not feel any quantitative effects at all. In addition to this asymmetrical evolution in employment levels hidden behind the aggregate data, a different recovery can also be observed, with the most severely hit countries generally lagging behind their pre-recession situation. For instance, Greece only recovered 9.2 of the 18.7 points lost during the crisis, Spain recouped 10.4 of the 13.2 points that it had dropped, and Italy only regained 2.7 of the 6 points that it let slip. Portugal is an exception, as, by 2019, it had improved on its 2008 employment figures. Why studying unemployment? Because it is a crucial factor for understanding the problems of relative poverty and social exclusion. The lack of, or drastic reduction in, household income is unquestionably a key factor affecting the vulnerability of families. Therefore, some countries will have to face the social and economic consequences of the health crisis without having fully recovered from the previous crisis. The first social issue analysed in this chapter will be income poverty. The indicator traditionally used to measure poverty in Europe has, for many decades, been the rate of monetary poverty or the at-risk-of-poverty rate. This is a relative concept of poverty (as opposed to absolute poverty more commonly used in the United States

190 Table 1 At-risk-of-poverty rate (%). National poverty lines

A. Jurado and J. Pérez-Mayo %

2008

2014

2018

Euro area—19

16.1

17.1

17.0

Belgium

14.7

15.5

16.4

Germany

15.2

16.7

16.0

Estonia

19.5

21.8

21.9

Ireland

15.5

16.4

14.9

Greece

20.1

22.1

18.5

Spain

19.8

22.2

21.5

France

12.5

13.3

13.4

Italy

18.9

19.4

20.3

Cyprus

15.9

14.4

15.4

Latvia

25.9

21.2

23.3

Lithuania

20.9

19.1

22.9

Luxembourg

13.4

16.4

18.3

Malta

15.3

15.8

16.8

Netherlands

10.5

11.6

13.3

Austria

15.2

14.1

14.3

Portugal

18.5

19.5

17.3

Slovenia

12.3

14.5

13.3

Slovakia

10.9

12.6

12.2

Finland

13.6

12.8

12.0

Source EUROSTAT

and developing countries) estimating the percentage of the population whose equivalised disposable income2 is under 60% of the median of the country’s equivalised disposable income in the year in question.3 This is both a relative and a one-dimensional concept, focusing exclusively on household income. We will address other dimensions of poverty later. Table 1 shows the rates of monetary poverty in the two phases of the analysed economic cycle. As the 2019 data were not available for many eurozone countries at the date of publication, they have been omitted from this and subsequent tables. 2 Equivalised means that the OECD-modified scale was applied to account for the number of house-

hold members depending on age or principal breadwinner status. A per capita scale used to be used, dividing by the number of household members. Currently, household income is divided by a number output by adding 1 for the principal breadwinner, 0.5 for the remaining members of the household aged 14 and over and 0.3 for each member aged under 14. This accounts for economies of scale and the fact that children speak for a smaller part of the household budget than adults. 3 As it is a relative concept, the territorial space used as a baseline (region, country, EU-28, EA19…) plays a central role. While this is a very controversial issue addressed in many scientific publications, the baseline used by Eurostat, at the recommendation of the European Commission, is the median not of the EU or the EA but of each country.

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Whereas employment levels had recovered in the EA-19 by 2018/2019, the same does not apply to monetary poverty in some countries. Relative poverty and inequality are slower to recover in terms of years of expansion than they are to increase in terms of years of recession. The poverty rate grew from 16 to 17.1% over the 2008–2014 period and was still 17% in 2018, with hardly any mean improvement. The data depict a high level of dispersion. Even more, despite the economic recovery, most countries show an increase in their poverty rates. Regarding the peak of the recession, Spain, Estonia, Greece and Latvia were, in this order, the countries with the highest monetary poverty rates in 2014. They all surpassed 20% of the population as a result of the preceding years of recession. Whereas EA-19 only increased by 1.1% points throughout the crisis, Spain grew by 2.4, Estonia by 2.3 and Greece by 2 points. The behaviour of this variable is completely anomalous for Latvia: this country started with the highest rate in the euro area in 2008 (25.9%), which dropped during the period of recession and increased during the recovery. The same atypical behaviour also occurred in neighbouring Lithuania. We have to bear in mind the special characteristics of these two countries: they were the last to join the eurozone (2014 and 2015), have a small population, rank last and last but one of the 19 euro area countries in terms of per capita GDP, and have been net receivers of transfers since they joined the EU. In sum, there are no common patterns in cross-section poverty rates nor their dynamics for the whole eurozone. For example, the group of countries highlighted during the recession for their debt and public deficit problems—Portugal, Ireland, Greece, Italy and Spain—shows very different behaviours. While the former three report reductions in poverty during the cycle, the latter appear not to have fully recovered with increases in the poverty rate from the beginning of the recession. A similar case is that of the countries most reluctant to involve the entire European Union in a quasi-federal way in the recovery. Finland or Austria have fully recovered with poverty reductions, but Netherlands shows one of the higher increases in poverty rates and, simultaneously, Baltic States situation and dynamics are very uneven. In a second phase of the analysis, since in an economic and monetary union, decisions are taken for the whole, we present a variation on the previous analysis. In this case, the eurozone is considered as the territorial unit of reference, so the same poverty line will be applied for all member states, instead of the respective national thresholds. Based on the family of Foster-Greer-Thorbecke (FGT) poverty indices (Foster et al. 1984), whose simplest component is the poverty rate, the poverty rate in the eurozone could be expressed as the weighted mean of the rates of each member state weighted according to the respective population weights, as Eq. 1 shows. P=

K 

sk Pk

(1)

k=1

Accordingly, apparently high poverty rates will have less bearing on the whole if they apply to a sparsely populated territory. Therefore, Table 2 reports the poverty rates using a common poverty line—60% of the median—based on the equivalised income

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Table 2 Decomposition of poverty rate by country (2008, 2014, 2018). EA poverty line 2008 Rate

2014 ACa

RC

Rate

2018 AC

RC

Rate

AC

RC

Austria

0.1481 0.0037 0.0173 0.1044 0.0026 0.0114 0.1157 0.0030 0.0133

Belgium

0.1780 0.0057 0.0267 0.1315 0.0044 0.0188 0.1491 0.0051 0.0225

Cyprus

0.1930 0.0005 0.0021 0.3093 0.0008 0.0034 0.2702 0.0007 0.0031

Germany

0.1117 0.0277 0.1291 0.1214 0.0293 0.1260 0.0964 0.0234 0.1037

Estonia

0.6459 0.0026 0.0122 0.5245 0.0021 0.0089 0.3854 0.0015 0.0067

Greece

0.3874 0.0128 0.0597 0.6006 0.0196 0.0841 0.6343 0.0200 0.0888

Spain

0.2862 0.0396 0.1844 0.3432 0.0476 0.2048 0.3225 0.0446 0.1978

Finland

0.1071 0.0017 0.0079 0.0954 0.0015 0.0066 0.1022 0.0017 0.0074

France

0.1390 0.0255 0.1190 0.1332 0.0250 0.1076 0.1448 0.0275 0.1219

Ireland

0.1470 0.0020 0.0093 0.2270 0.0032 0.0136 0.1986 0.0029 0.0127

Italy

0.2319 0.0418 0.1947 0.2858 0.0523 0.2248 0.2871 0.0518 0.2296

Lithuania

0.7585 0.0074 0.0346 0.6653 0.0059 0.0254 0.5552 0.0047 0.0207

Luxembourg 0.0427 0.0001 0.0003 0.0653 0.0001 0.0004 0.0722 0.0001 0.0006 Latvia

0.7621 0.0050 0.0234 0.7029 0.0042 0.0180 0.5832 0.0033 0.0148

Malta

0.3289 0.0004 0.0019 0.2548 0.0003 0.0014 0.2557 0.0004 0.0016

Netherlands

0.1052 0.0052 0.0244 0.1259 0.0063 0.0272 0.1136 0.0058 0.0255

Portugal

0.5235 0.0169 0.0789 0.5192 0.0163 0.0702 0.5295 0.0163 0.0723

Slovenia

0.3216 0.0019 0.0089 0.2810 0.0017 0.0073 0.2549 0.0015 0.0068

Slovakia

0.8475 0.0140 0.0651 0.5912 0.0093 0.0400 0.7214 0.0114 0.0503

Euro area 19 0.2146 0.2146 1.0000 0.2326 0.2326 1.0000 0.2255 0.2255 1.0000 Source Own elaboration from EUROSTAT data a AC stands for Absolute Contribution and RC for Relative Contribution. While the former is the value in each country, the latter expresses its weigh in the aggregate, so that the sum of AC is the euro area poverty rate and the sum of RC gives 1

adjusted for purchasing power parities.4 The differences between the incomes of the member states cause high at-risk-of-poverty rates in countries with lower mean incomes like Estonia, Portugal or Slovakia using a common poverty line. When analysing the relative share of poverty, however, the denser populated countries of the eurozone play a more important role. Prominent in this respect are Spain and Italy, which, together, account for 40% of the risk of poverty observed in each and every one of the years covered by the study. The poverty data show that the eurozone is far from being a homogeneous territory, as would be advisable with a view to operating more like an optimal monetary area and better withstanding macroeconomic shocks. 4 To

cancel out the influence of different price levels in each country, which would prevent the comparison of incomes across member states, we apply the GDP purchasing power parities of each country published by Eurostat for the analysed years. The application of parities explains the differences between the results of Table 1 and 2 or Tables 3 and 4.

Social Challenges for the Eurozone Table 3 Gini coefficient of equivalised disposable income

193

(Scale from 0 to 100)

2008

2014

2018

Euro area—19

30.5

31.0

30.6

Belgium

27.5

25.9

25.7

Germany

30.2

30.7

31.1

Estonia

30.9

35.6

30.6

Ireland

29.9

31.1

28.9

Greece

33.4

34.5

32.3

Spain

32.4

34.7

33.2

France

29.8

29.2

28.5

Italy

31.2

32.4

33.4

Cyprus

29.0

34.8

29.1

Latvia

37.5

35.5

35.6

Lithuania

34.5

35.0

36.9

Luxembourg

27.7

28.7

33.2

Malta

28.1

27.7

28.7

Netherlands

27.6

26.2

27.4

Austria

27.7

27.6

26.8

Portugal

35.8

34.5

32.1

Slovenia

23.4

25.0

23.4

Slovakia

23.7

26.1

20.9

Finland

26.3

25.6

25.9

Source EUROSTAT

However, not everything depends on the population of each country. Thus, countries such as Greece, Portugal or Slovakia present high data in absolute terms, slightly minimised when taking into account their weight in the eurozone population. We even found that there are significant disparities between the most important countries in the eurozone in terms of population and economic size. Therefore, the economic policy decisions affecting the entire monetary area should consider these differences in order to foresee possible impacts on the living conditions of the citizens of all the member states. Poverty data, measured with both national and eurozone reference, describe a heterogeneous set. These differences are not only due to the possible asymmetry of the recession, but also due to the inherent characteristics of each country. Thus, countries with the same debt and public deficit problems have followed different trajectories, being even more successful in some that were bailed out. In addition to poverty, inequality is often included in the description of a country’s social situation. This issue is even more important in the area under analysis because of the definition of relative poverty used. As already mentioned, monetary poverty,

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being a relative concept, is one way of looking at inequality of part of the population with respect to the rest. But a thorough analysis of inequality within a population requires the use of a general index. On the grounds of simplicity and ease of interpretation, the Gini index is the most commonly used such index. Inequality indicators incorporate very interesting information on the incidence of economic growth, making it possible to go beyond a simple increase or decrease in GDP. For example, during a period of crisis it is possible to know whether it has fundamentally impacted a social class or if, on the contrary, its effects have been more or less evenly distributed among the different layers of society. Moreover, as Bourguignon (2003) shows, previous levels of inequality have a major influence on the impact of changes in GDP on the poverty rate. Again, heterogeneity is observed as a fundamental feature. Most of the eurozone member states show increases in inequality in the decade 2008–2018 and those where inequality decreases do not have a common feature that allows the identification of factors that explain these dynamics. However, if instead of studying the evolution of each country, convergence with the eurozone average is analysed, the group of countries formed by Belgium, Ireland, the Netherlands, Austria, Slovenia, Slovakia and Finland stands out, together with France, Greece and Portugal, where inequality was reduced or increased less than the average for the whole. The situation of two countries such as Spain and Italy, with a significant population weight, is very striking. Once again, as in the case of unemployment and poverty data, they are facing the exit from the previous crisis in a more complicated situation. It could be said that they will have to face the consequences of the pandemic without having recovered from the financial crisis ten years later. The analysis of the distributive impact of inequality can be completed by looking at the eurozone as a whole, considering the influence of the internal levels of inequality in each country, on the one hand, and the differences in income between member states, on the other. This joint analysis is convenient because, although social policy is, for the time being, more a national competence than a Union one, the rules and budgetary commitments of the governance of the Economic and Monetary Union imply a restriction in the decision-making of each national government. When analysing inequality within a territory composed at the same time of different lower-ranking territorial units, it is usual practice in the literature on income distribution to decompose it into two factors. Whereas the first factor reflects the income gap between each of the territories, the other accounts for the importance of each territory’s internal inequality. To perform this process, it is necessary to use an alternative inequality indicator because of the drawback of using decomposition for the Gini index. This provides another component that express the degree of overlapping between internal and external factors. The use of an alternative indicator does not affect the conclusions of the analysis because the most important thing is the study of trends and comparisons between countries, not the specific data for each country in one of the years. This index, which can be decomposed into the part that is due to inequality within countries and the part that is due to inequality between countries, is known as the generalised entropy or Theil index. It is expressed mathematically as follows:

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  c  n  xi 1 1 , c = 0, 1 Tc (x) = −1 n c(c − 1) i=1 μx    n  xi 1  xi Tc (x) = ln ,c = 1 . n i=1 μx μx   n xi 1 Tc (x) = ,c = 0 ln n i=1 μx

(2)

In this chapter, we apply the mean logarithmic deviation—output when the value of parameter c is 0. Table 4 reports the results of the decomposition of this index according to the following expression, supposing that K is equal to the number of member states of which the eurozone is composed: T =

K 

sk Tk + T0

(3)

k=1

where sk is the percentage of each country’s population compared with the total eurozone population, T k is the internal inequality of each member state, and T 0 is the inequality between their respective mean incomes. Therefore, the summation expresses the within-country component and the second term is the between-country component. The columns labelled AC and RC in Table 4 show each country’s absolute and relative share in total inequality, respectively. Table 4 reports a very relevant fact: the greater importance of internal inequalities compared to the weight of the differences between the average incomes of the member states. Although it decreases very slightly during the cycle analysed, this data was, in some way, expected given the information shown in Table 3. If heterogeneity is the fundamental feature when analysing inequality with a national reference framework, it is logical to expect that the internal dimension will be the most relevant in explaining inequality in the eurozone with a much greater weight of the most populated countries, highlighting fundamentally Spain and Italy again. In summary, the evolution of poverty and inequality in the countries of the eurozone in the decade 2008–2018 draws a very heterogeneous picture in the living conditions of its inhabitants. The crisis hit some countries harder than others in terms of GDP and unemployment, with its impact on higher deficits and public debt levels. This asymmetric shock resulted in disparate and unevenly distributed effects on the population, leading to increased inequality and poverty. Moreover, in some of them, such as Spain and Italy, the recovery has not been total either in social terms— with high and higher levels of poverty and inequality than before the crisis—or in terms of public accounts with less margin to face the new crisis as we will see in the following section.

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Table 4 Decomposition of inequality by country (2008, 2014, 2018) 2008 Index

2014 ACa

RC

Index

2018 AC

RC

Index

AC

RC

Austria

0.2027 0.0051 0.0217 0.2085 0.0053 0.0213 0.1892 0.0049 0.0200

Belgium

0.1847 0.0059 0.0252 0.1630 0.0054 0.0218 0.1628 0.0056 0.0227

Cyprus

0.1982 0.0005 0.0020 0.2711 0.0007 0.0028 0.1995 0.0005 0.0021

Germany

0.1971 0.0488 0.2074 0.1905 0.0458 0.1830 0.1875 0.0455 0.1853

Estonia

0.1936 0.0008 0.0033 0.2405 0.0009 0.0038 0.1806 0.0007 0.0029

Greece

0.2289 0.0075 0.0320 0.2847 0.0093 0.0372 0.2621 0.0083 0.0337

Spain

0.2460 0.0340 0.1444 0.2810 0.0389 0.1556 0.2515 0.0347 0.1414

Finland

0.1566 0.0025 0.0106 0.1445 0.0024 0.0094 0.1447 0.0024 0.0096

France

0.2029 0.0374 0.1587 0.2065 0.0390 0.1559 0.2022 0.0385 0.1568

Ireland

0.2041 0.0028 0.0118 0.2233 0.0031 0.0124 0.2151 0.0031 0.0126

Italy

0.2240 0.0403 0.1709 0.2615 0.0477 0.1905 0.2793 0.0502 0.2044

Lithuania

0.2377 0.0023 0.0099 0.2443 0.0022 0.0087 0.2648 0.0022 0.0091

Luxembourg 0.1921 0.0003 0.0012 0.2172 0.0003 0.0013 0.2505 0.0004 0.0018 Latvia

0.2736 0.0018 0.0077 0.2569 0.0015 0.0061 0.2540 0.0015 0.0059

Malta

0.1748 0.0002 0.0009 0.1722 0.0002 0.0009 0.1762 0.0002 0.0010

Netherlands

0.1735 0.0086 0.0366 0.1598 0.0081 0.0322 0.1696 0.0086 0.0351

Portugal

0.2577 0.0084 0.0355 0.2749 0.0087 0.0348 0.2323 0.0072 0.0293

Slovenia

0.1236 0.0007 0.0031 0.1437 0.0009 0.0035 0.1178 0.0007 0.0029

Slovakia

0.1541 0.0025 0.0108 0.1878 0.0030 0.0119 0.1555 0.0024 0.0099

Within Between

0.2105 0.8937

0.2234 0.8931

0.2175 0.8864

0.0250 0.0250 0.1061 0.0265 0.0265 0.1057 0.0279 0.0279 0.1136

Euro area 19 0.2355 0.2355 1.0000 0.2502 0.2502 1.0000 0.2454 0.2454 1.0000 Source Own elaboration from EUROSTAT data a AC stands for Absolute Contribution and RC for Relative Contribution. While the former is the Within component in each country, the latter expresses its weight in the aggregate. For example, the internal component of inequality in Austria in 2008 is 0.0051, which is 2.17% of 0.2105, the total Within component

3 The Role of the Public Sector The economic governance of the euro area affects the living conditions of citizens, measured by indicators of poverty and inequality, through the rules and commitments established for the governments of the member states. A breach of the public deficit limits may lead to an adjustment process that reduces social protection expenditure or an increase in taxes on a regressive (consumption) rather than progressive (income) basis. These decisions motivated by the need to comply with the rules have clear effects on poverty and inequality in each country.

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Fig. 1 Total and social expenditure in 2018 (GDP %). Source EUROSTAT

Focusing on the dimension of expenditure5 in terms of its impact on citizens’ living conditions, it highlights the diversity between the expenditure levels of the members of the euro area, as shown in Fig. 1, between 25.4% of Ireland’s GDP and 56% of France’s GDP. However, these values refer to the total expenditure of all levels of government in each country and not all functions are equally related to the standard of living of citizens. Differences between countries are more relevant when analysing social protection expenditure. In this case, the Western European countries, with the longest tradition in the European Union, mostly present expenditure levels of around 20% of GDP devoted to this function. In contrast, the countries of Central and Eastern Europe generally devote a considerably lower percentage. In some ways, this reflects the welfare state models put forward by Esping-Andersen in 1990. Income poverty and inequality are not some exogenous variables determined solely and inexorably by the evolution of the GDP and employment. The different policies for combatting poverty, including fiscal and monetary policies, applied by each government can have a major influence. Let us, for example, analyse the enormous bearing that social transfers have as poverty-reducing redistributive instruments. Table 5 shows some of their impacts on poverty and inequality. Transfers play a key and powerful role in the welfare state. Without transfers (column 1 in Table 5), the mean at-risk-of-poverty rates in the EA-19 would rise above 40% of the population. Besides, the increase in poverty rates before social transfers was on average much sharper than the growth in the rates of poverty after transfers over the 2008–2014 period. This is indicative of the fact that this transfer network plays an important role of containment in periods of economic recession. On the one hand, unemployment benefits and subsidies, acting as a parachute for the unemployed, and, on the other, retirement pensions, often, but not always, resistant to 5 Data

in https://ec.europa.eu/eurostat/web/social-protection/data/database.

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Table 5 Some indicators of social protection %

1

2

3

4

5

Euro area—19

43.7

24.9

14.9

51.0

35.4

Belgium

41.9

25.3

16.6

46.9

32.7

Germany

42.0

24.0

18.2

56.4

36.6

Estonia

38.7

29.9

46.3

44.1

34.1

Ireland

41.0

30.9

20.2

47.6

39.3

Greece

50.0

23.2

11.6

57.0

35.2

Spain

44.6

27.9

15.6

48.7

37.0

France

45.7

24.1

8.3

50.9

34.9

Italy

45.8

25.9

15.3

48.5

35.7

Cyprus

36.9

24.2

21.4

47.6

34.0

Latvia

39.1

28.8

45.7

48.1

38.2

Lithuania

41.8

29.7

37.7

51.1

40.6

Luxembourg

46.0

27.5

12.1

51.9

38.1

Malta

37.0

24.2

25.4

44.0

32.1

Netherlands

37.9

21.8

10.8

46.6

32.7

Austria

43.3

25.2

13.9

46.3

32.9

Portugal

43.7

22.7

17.7

56.5

35.2

Slovenia

40.5

23.4

18.3

42.5

28.8

Slovakia

37.1

17.7

6.4

37.2

24.3

Finland

43.2

25.9

13.2

48.8

34.4

Source of Data EUROSTAT 1. At-risk-of-poverty rate before social transfers (pensions included in social transfers) 2. At-risk-of-poverty rate before social transfers (pensions excluded from social transfers) 3. At-risk-of-poverty rate of older people 4. Gini coefficient of equivalised disposable income before social transfers (pensions included in social transfers) 5. Gini coefficient of equivalised disposable income before social transfers (pensions excluded from social transfers)

wage cuts, act as indispensable shock absorbers in this region. To single out the effect of pensions, column 2 in Table 5 shows the rates of poverty before social transfers, not including pensions. Almost half of the positive poverty-reducing effect of social transfers is thanks to pension systems. Remember that there are several types of country-dependent pensions: contributory pensions include retirement, permanent disability or death pensions, and non-contributory pensions usually denote some retirement or disability pensions. However, pension types vary depending on the country or even the region in decentralised countries. Pensions have the biggest effect in Greece, where the difference in the poverty rates with or without pensions was 26.8% points compared with the EA-19 mean of 18.8 points. It is followed by France with 21.6 and Portugal with 21 points. At the other end of the scale, with

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a weight of about 10%, are the Baltic countries and Ireland. As we can see, the poverty-reducing power of the different pension systems varies enormously. Two demographic characteristics, which are shared by most of the EA-19 countries and are common to the developed countries generally, are a high life expectancy and a low birth rate. This combination generates a number of social and economic problems that are only sometimes offset in part by much-needed immigration. There is a risk of population ageing forming pockets of poverty within the elderly population. Therefore, it is necessary to properly monitor the problem. Besides, as column 3 shows, the effect of pensions in supporting the living conditions of older population (aged over 65 years) stands out. Despite the former, the dispersion across countries is even larger than for the general poverty rates. The coverage and quality of the different pension systems paint a very different picture for elderly people depending on their country of residence. For example, the weakness of the pension systems for elderly people in the Baltic countries is confirmed, with poverty rates that are well over 40%. At the other end of the scale, we have, Slovakia, followed by France and the Netherlands. Whereas the latter two are rich countries with powerful retirement and/or widowhood pension systems, the case of Slovakia is different and warrants special mention. Although it is the last-but-one country within the EA-19 in terms of per capita GDP, it always ranks among the best on poverty and inequality, as we will see throughout this chapter. Pension income indisputably plays a key redistributive role when inequality is analysed. Transfers, and especially pensions, have an enormous bearing on the reduction of inequality levels. The rates are found to be almost double in many cases. Table 5 again confirms that the other social transfers have a much more limited effect on reducing economic inequality. However, this issue, the role of pensions and transfers, is limited not only by the possible need for adjustment arising from deficit and debt restrictions, but also by the sustainability of the pension systems due to the uncontainable growth of high levels of indebtedness caused by an inverted population pyramid with continuous population ageing.

4 Estimating the Impact of COVID-19 in Terms of Poverty The pandemic caused by the COVID-19 has caused a health crisis whose economic and social after-effects are as yet unknown. This chapter proposes a preliminary approach to dealing with its social impact based on Kakwani (1993) and De MiguelVelez and Perez-Mayo (2010). This methodology states that a change in a poverty indicator can be decomposed into the sum of two factors, the change in mean income and the change in income distribution, as follows:  ∂P ∂P dθk d y¯ + ∂ y¯ ∂θk k=1 l

dP =

(4)

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where P is the poverty indicator, y¯ , the mean income and θ k , the income distribution parameters.6 If η is defined as the elasticity of the poverty measure with respect to the mean income and, supposing a distribution-neutral macroeconomic shock on mean income, Eq. (4) can be expressed as follows: dP d y¯ =η P y¯

(5)

In the simulation reported here, we use the GDP growth forecasts published in the European Commission Spring Forecast (2020) and by the OECD (2020) shown in Table 17. The second estimation accounts for not only the aftermath of the original viral outbreak but also the possible effects of a new outbreak of the disease in late 2020.7 No matter which forecast we choose, the economic impacts measured by means of the GDP growth rate are significant in all the eurozone countries, where the most optimistic forecasts by the European Commission range from a fall of 5.4% for Luxembourg to 9.7% for Greece. On the other hand, for its most optimistic scenario— a single outbreak of the disease—the OECD calculates an even more negative trend across the board, which would be seriously exacerbated by a resurgence at the end of the year. In this case, the hardest hit would be countries like Spain or France, with drops in GDP of over 14%, and even Luxembourg, the least affected member state according to any of the predictions, would suffer a fall of as much as 7.7% in the most pessimistic scenario. Table 6 data also highlight the asymmetry of the shock. Even though this is a global pandemic—a disease affecting many countries—the effect on GDP is clearly uneven. This is, then, an asymmetric shock, one of the trickiest problems for any monetary union to tackle. First, in order to estimate the changes in poverty, we assume that the impact on income distribution is neutral in terms of inequality. Even though, generally speaking, macroeconomic changes do not have the same impact on all income groups, there are no estimates of these effects, so it is not possible to add the second term of Eq. (4). Therefore, we will apply Eq. (5). The changes in the at-risk-of-poverty rates8 in each of the member states shown in Fig. 2 are, in most cases, greater than 10%. On the one hand, it is estimated that there will be an increase across the board, as is to be expected in view of the forecasted drop in GDP, although the effects are not equal for all countries. This is the consequence not only of the asymmetric impact on economic growth but also of the divergences in elasticities with respect to differences in mean income. Spain and France are prominent examples with sharp increases in their poverty rates, a phenomenon that is even more significant in Spain as a result of the initial value of its at-risk-of-poverty indicator. Therefore, the European institutions need to make a 6 Equation (4) implicitly assumes that there is no relationship between income and inequality changes. Therefore, the results should be analysed bearing in mind this assumption. 7 This chapter was written before summer 2020. 8 As the official at-risk-of-poverty indicator used in the European Union is relative, we use a poverty line anchored on 2018, when the latest data were published.

Social Challenges for the Eurozone Table 6 GDP growth forecasts

201

Country

European Commission

Austria

−5.5

Belgium

−7.2

Cyprus

−7.4

Germany

OECD (single hit)

OECD (double hit)

−6.2

−7.5

−8.9

−11.2

−6.5

−6.6

−8.8

Estonia

−6.9

−8.4

−10.0

Greece

−9.7

−8.0

−9.8

Spain

−9.4

−11.1

−14.4

Finland

−6.3

−7.9

−9.2

France

−8.2

−11.4

−14.1

Ireland

−7.9

−6.8

−8.7

Italy

−9.5

−11.3

−14.0

Lithuania

−7.9

−8.1

−10.4

Luxembourg

−5.4

−6.5

−7.7

Latvia

−7.0

−8.1

−10.2

Malta

−5.8

Netherlands

−6.8

−8.0

−10.0

Portugal

−6.8

−9.4

−11.3

Slovenia

−7.0

−7.8

−9.1

Slovakia

−6.7

−9.3

−11.1

Euro area 19

−7.7

–

Source European Commission (2020) and OECD (2020)

concerted effort to coordinate member state policies and address the common risk suffered by all their members paying special attention to the protection of the most vulnerable population in the EU. Uncertainty makes it very difficult to estimate the specific effects on inequality. Not only is the impact different in each Member State, but also within each country it may be differential. Economic activities such as tourism, hotels and restaurants, leisure and trade are clearly affected by the risk of contagion, but they do not carry the same weight in the economic structure in all members. In addition, the health policy response has also differed between countries with different levels of confinement or restriction of contact between people. Nevertheless, the previous estimate of the impact on the poverty risk rate, despite the very interesting vision it provides about the near future, can be improved by completing it with the second term of Eq. 4, that is, with the influence derived from changes in inequality. This second estimate uses as benchmarks the changes in national Gini coefficients in the period 2008–2018 (full cycle) and 2008–2014 (economic crisis). Thus, we have a more pessimistic scenario, the second one,

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Fig. 2 Changes in poverty rates—neutral distribution (%). Source Own elaboration

Fig. 3 Changes in poverty rates—optimistic scenario (%). Source Own elaboration

together with a more optimistic one, the first one combining crisis and recovery in Figs. 3 and 4. Both scenarios allow the same conclusions to be drawn: there is a great disparity in the results. Agreeing on and taking the same decisions to solve a problem is easier if those who have to decide are in the same situation. On the contrary, if

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Fig. 4 Changes in poverty rates—pessimistic scenario (%). Source Own elaboration

they do not all suffer from it with the same intensity or have the same capacity to contribute, the decision is much more complicated. Once again, Spain stands out as a country that combines several factors that point to it as a risk for the eurozone: high initial poverty rate, strong forecast of economic impact on the GDP together with a situation of public accounts not yet recovered from the previous crisis. Although other countries can be observed in a complicated situation, they do not have the population or economic weight that Spain has in the euro area. A joint management of adjustment and recovery processes is key to understanding potential social and political movements in the coming years. The feeling of loss of living conditions and abandonment by European institutions in countries such as Greece, Italy or Spain gave rise to the emergence of social movements and populist political options. These options took advantage of the social effects of the adjustment measures to increase their social support, blaming the economic governance of the eurozone for the problems suffered by the population. It is not an old and outdated risk: it can happen again. The Eurobarometer survey on Public Opinion in times of COVID-19 published in July 2020 contains some very interesting results related to the effect of European response and joint actions. For example, 53% of respondents say they are dissatisfied with the solidarity between member states in the fight against the pandemic. This data is already bad, but it gets worse when we analyse its distribution by countries with clear differences between Ireland and the Baltic countries—more satisfied—and others like Spain and Italy— more dissatisfied. However, this pandemic may be an opportunity to improve the economic governance of the eurozone and of the European Union itself. There are, in this same survey, signs of hope. A relevant majority (68%) believes that the EU should have

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more competences to deal with crises like this one and another, slightly smaller one, believes that the EU should have more financial means to overcome the consequences of the Coronavirus pandemic. The most affected countries, both healthily and economically, should have more relaxed deficit and debt rules for a transitional period in order to be able to cope with increases in health spending, higher demands for unemployment benefits as well as income benefits for temporarily affected families and individuals. At the same time, the degree of monitoring should be increased and reforms to improve the fiscal performance of these countries should be adopted to facilitate support for those countries that are more satisfied with the previous situation and therefore more reluctant to adopt changes. This second set of measures would reduce the potential risk of free-riding when a country receives support from the others without adopting any change.

5 Concluding Remarks One of the requirements for the sound operation of a single economic and monetary area like the eurozone is the economic symmetry of the countries of which it is composed. However, as the economy is not a separate entity from the society in which it operates and social affairs influence the political debate underlying the workings of the economy, the social situation needs to be added to the evaluation of the economic performance of the eurozone. Social tensions caused by poverty and inequality can erode support for European Union initiatives, as well as boost nationalist stances aimed at destroying the effort made to unify the European economies. This, much neglected issue should be adopted as one of the major mainstays of the European Union in order to try to reduce the asymmetries uncovered by analyses of inequality and, more importantly, poverty. Although inclusive growth is one of the priorities of European Union policies, the results do not appear to confirm its primacy. Not only is mean income—that is, standards of living—different in nominal terms, the inequalities remain even when purchasing power parities are applied. Both poverty and inequality data describe a disparate situation between countries. Moreover, the experience of the previous crisis showed very different dynamics that, in some cases, have not even led to recovery despite good overall data. The pandemic is a challenge for European society, which is likely to become less inclusive, due to the estimated increases in poverty rates, and less cohesive, due to very different impact rates. It is necessary to stand together to face this test in order to remedy the observed weaknesses by establishing Europe-wide anti-inequality and anti-poverty instruments—a European unemployment insurance or a supranational guaranteed minimum wage—to protect the most vulnerable, as well as by supporting the necessary reforms in the member states to help reduce the asymmetries that drive and fuel the after-effects of the shocks. The integration of the above social dimension will put the eurozone back on the road mapped by the Treaty of the European Union. Otherwise, the social consequences of the economic crisis and the pandemic may

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politically erode the eurozone and the European Union if not properly addressed. This process should be used to reform economic governance in the direction of greater integration of member states’ fiscal policies and even incorporate social policies into the core policies of the European Union. Citizens should be presented with the rules of economic governance as a means to better organise their societies rather than as restrictions to prevent the development of their society. Acknowledgements The authors thank the financial support from Junta de Extremadura and the European Fund of Regional Development (GR18106). Besides, the analysis is carried out from EUSILC microdata supplied by Eurostat (RPP 123/2015-EU-SILC) and it is sole responsibility of the authors.

References Bourguignon, F. (2003). “The growth elasticity of poverty reduction: explaining heterogeneity across countries and time periods”. In: Eicher, T. and Turnovski, S. (eds.): Growth and Inequality, MIT Press, 3–26. De Miguel-Velez, FJ and Perez-Mayo, J. (2010) “Poverty Reduction and SAM multipliers: An Evaluation of Public Policies in a Regional Framework”, European Planning Studies, 18:3, 449– 466. Esping-Andersen, G. (1990), The Three Worlds of Welfare Capitalism, Polity Press, Basil Blackwell. European Commission (2020) Spring 2020 Economic Forecast, available at: https://ec.europa.eu/ info/business-economy-euro/economic-performance-and-forecasts/economic-forecasts/spring2020-economic-forecast-deep-and-uneven-recession-uncertain-recovery_en. Foster, J., Greer, J. and Thorbecke, E. (1984). “A class of decomposable poverty measures”. Econometrica. 3, 52 (3): 761–766. Kakwani, N (1993). “Poverty and economic growth with application to Côte D’Ivoire”, Review of Income and Wealth, 39 (2), 121–139. OECD (2020) Economic Outlook, The world economy on a tightrope, June 2020 in http://www. oecd.org/economic-outlook/.

Antonio Jurado is an Associate Professor at the Department of Economics of the University of Extremadura (Spain). He holds a degree in Economics and Business Science from the Autonomous University of Madrid since 1990, and he is Doctor in Economic and Business Sciences from University of Extremadura since 1996. He has published scientific papers in prestigious national and international journals (The review of Income and Wealth, Regional Studies, Social Indicators Research, Applied Economic Perspectives and Policy…) and book chapters (i.e. “Regional Policy, Economic Growth and Convergence” edited by Springer) on poverty, inequality and economic well-being in the territorial context. Jesús Pérez-Mayo is an Associate Professor of Public Economics at the Department of Economics at the University of Extremadura (Spain). His research is focused on poverty, inequality, deprivation and social exclusion and has been published in national and international journals.

Protecting Jobs and Incomes in Europe: Towards an EU Capacity for Employment Stabilisation in the Pandemic Period László Andor

Abstract The economic crisis associated with the COVID-19 pandemic leads to a substantial potential loss of personal incomes and jobs. European countries have given different answers to the rising challenge, which nevertheless point to the same direction. We give three examples of such courses of action, describing Austria, Spain, and the UK. In an early phase of the crisis, the European Commission put forward a new instrument financially supporting short-time work (STW), labelled SURE (temporary Support to mitigate Unemployment Risks in an Emergency). We discuss the main features and criticalities of SURE. While SURE is a step in the right direction, there is still room to grow: SURE is a safety net to jobs, but not to the unemployed. We examine and compare some of the unemployment insurance and re-insurance alternatives that could shape a future European unemployment benefit scheme. Keywords European union · Unemployment insurance · COVID-19 · Automatic stabilisers · Social safety net · Short-time work

1 Introduction In March 2020, the member states of the European Union (EU) were suddenly overwhelmed by the coronavirus (COVID-19) pandemic, apparently originating from the city of Wuhan (People’s Republic of China). Most national governments, together with leaders of the EU institutions, responded to this emergency with delays and inconsistency, due to the unprecedented nature of this health emergency. However, they quickly understood that the challenge is to tame a crisis in health care and the economy simultaneously, and also deal with the social consequences at the same time. The search for appropriate tools and strategies began.

L. Andor (B) Hertie School of Governance, Berlin, Germany e-mail: [email protected] Department of Economic Policy, Corvinus University, Budapest, Hungary © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_11

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Once it was understood that to eliminate the coronavirus, much of the economic and social activities have to stop, public attention shifted to the rapidly rising unemployment as one of the highest risk factors. Alongside national governments, the EU was expected to mobilise existing instruments and also quickly develop new ones. On, the European Commission duly put forward a proposal for the creation of a European instrument for temporary support to mitigate unemployment risks in an emergency, or as it is called in short SURE (European Council 2020). The field of employment has just been another example of the fact that appears to be a more general flaw in the structure of the European Union, namely that practically all emergency and stabilisation mechanisms are located at the national instead of the community level. The EU allows for free movement, which is a central component of the Single Market. Through this, it contributes to shared prosperity, but in “bad times”, when economic recessions or other types of crises hit the community, the member states can mainly rely on themselves, or bilateral deals. This was experienced during the 2010 financial crisis, the 2015 migration crisis, and most recently the 2020 COVID-19 crisis. All these crises, however, managed to push the EU towards building more emergency and stabilisation capacities, delivering “de facto solidarity”, as the late French foreign minister and EU founding father Robert Schuman called it. Recent developments in the wake of the coronavirus pandemic represent a new chapter in this history. In this chapter, we first outline the labour market consequences of the currently ongoing Coronavirus Recession and the economic challenges that it poses to European policymakers. A brief overview of the relevant data, with a particular focus on employment, is followed by a comparative analysis of national anti-crisis strategies highlighting the experience of Austria, Spain, and the UK (one country from the euro area core, one from the periphery, and one that is just leaving the EU). We then discuss the architecture of SURE, the new anti-crisis instrument of the EU, together with some key elements of the policy debate leading up to its introduction. Finally, we make the case for an unemployment-based insurance system of automatic stabilisers, for which the momentum has been slowly building up in the past decade.

2 COVID-19: Labour Market Shock and National Policies The COVID-19 pandemic produced an unprecedented, though orchestrated recession. As social distancing and institutional lockdown became the dominant strategy to tame the pandemic in March 2020, entire industries came to a sudden halt. The travel, hospitality as well as entertainment sectors have been particularly hard hit as a result. From a macroeconomic perspective, this represented a genuine “supply shock”, which on the other hand quickly turned into a “demand shock”, given the substantial potential loss of personal incomes.

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2.1 The Employment Effect of the Pandemic According to the OECD (2020), the impact of the coronavirus crisis on economic growth was immediate and heavy. Among its member countries, GDP substantially dropped1 in the first quarter of 2020, despite the fact that most governments in OECD countries put in place meaningful containment measures as early as the second half of March. The second quarter of 2020 recorded a dramatic fall in all OECD countries, without exception. On average, GDP was expected2 to fall by 13.2% in the second quarter of 2020 across the OECD, exceeding the rate of decline at the time of the Great Recession (2009). GDP fall was expected to be particularly severe in Spain and in the UK (−19%), but also in France and Ireland (−18%). However, through various forms of state interventions, which we discuss later in this chapter, European countries managed to avoid a dramatic rise in unemployment. According to Eurostat estimates, that just over 15 million people were unemployed in the EU in June 2020, and around 12.7 million in the euro area, where the unemployment rate normally exceeded the EU average. Even in the euro area, the unemployment rate remained below 8% in the Summer of 2020. For comparison, we can highlight that in the United States the number of unemployed increased by 20 million in one month, sending the unemployment rate from 4.4% in March to 14.6% in April 2020. This jump is even more striking if we appreciate that just before the COVID-19 crisis, the US unemployment stood at a 50-year low rate of 3.5% in February, which then suddenly quadrupled, up to the highest level in the history of the series (i.e. since January 1948). The US unemployment rate then fell to 13.3% in May and further to 11.1% in June. This suggests that part of the initial increase in unemployment can be reabsorbed if the pandemic is kept under control and the economy restarts. However, a part of the initial job losses became permanent as some businesses were not reopening after the lockdown, or as the opening of the economy is not as smooth as it theoretically could be. Across Europe, diverse patterns have been observed. As in the Great Recession, the Baltic economies experienced severe hits. Lithuania registered one of the largest increases (+3 percentage points up to May) followed by Latvia (+2.9 percentage points up to May). Meanwhile, the unemployment rate decreased up to May in Italy (−1.2 percentage points) and Portugal (−0.9 percentage points). This surprising result is more controversial than welcome, in as much as it reflects not so much of an improvement in the labour market, but a shift towards inactivity, as unemployed people stopped searching for a job during the pandemic. The International Labour Organization (ILO) also came forward with quick estimates about the pandemic damage to work. The COVID-19 crisis was expected to wipe out 6.7% of working hours globally in the second quarter of 2020—equivalent to 195 million full-time workers (International Labour Organization 2020). Exploring 1 Between

the last quarter of 2019 and the first quarter of 2020, GDP fell by 5.3% in France and Italy, 5.2% in Spain, 3.8% in the Euro area, 2.2% in Germany, 2.1% in Canada and 1.4% in Korea, 1.3% in the United States and 0.6% in Japan. See OECD (2020). 2 Projections published in the 2020 July OECD Employment Outlook.

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the impact on specific sectors, professions and job categories became an important task in order to develop appropriate and effective strategies against the crisis and specifically against unemployment.

2.2 Varieties of Crises—and Job-Saving Schemes While in principle there are a few basic policy replies to a job crisis, the experience can greatly differ among various professions and job categories, different types of crises as well as diverse national contexts. The lockdown itself had a hugely selective impact on various professions since some of those were possible to continue in “home office”, while others by definition were not. This factor immediately created an asymmetry in terms of income levels, since it was typically the higher-income jobs transferable to home office, while the lower-income jobs proving more difficult from this point of view. The pandemic also differentiated between conventional and atypical jobs. This has been a relevant question since in the last decade a majority of net new job creation took place in the “platform economy”. The lockdown maintained, and perhaps even increased demand in some segments of the platform economy (e.g. home deliveries), while it also turned out that a large number of gig workers and self-employed became increasingly disconnected from social security, and thus faced unexpected hardship in Spring 2020. It has been a critical question of whether various support schemes can or wish to address such atypical situations. Conditionality has been another differentiating feature. In many cases, the precondition for state subsidy was to exclude dismissals, although the sustainability of this was in question from the outset in sectors hard hit by the recession. Government subsidy schemes in some countries (Denmark, Spain, etc.) excluded those companies headquartered in tax havens and also banned the distribution of dividends to the shareholders of large companies receiving public support. Though in most European cases it has been recognised that the economic crisis response has to be coupled with a social one, this has also been a matter of governmental choice. The government of Hungary, for example, continued to insist on a 90 day limit on the eligibility for unemployment benefit and offered alternative options only in form of workfare schemes (providing significantly less than the minimum wage) or joining the military. But even without such extremes, we can speak about diverse national approaches in Europe, which will be highlighted below.

2.2.1

Austria: Euro Area Core

Austria represents one of the strong economies in the euro area which also has been a home of exemplary practices, whether it is about the quality of social dialogue, the effectiveness of the public employment service, or innovative solutions like the youth guarantee. Austria was also quick to respond to the COVID-19 crisis. Facing

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rapidly increasing unemployment, social partners in Austria negotiated a new and unique short-time work (STW) programme (Schnetzer et al. 2020). The centre-right government of Austria led by Sebastian Kurz introduced massive confinement measures on 16 March 2020. The labour market effect was immediate: unemployment soared by roughly 180,000 persons within two weeks (from a total of 400,000 unemployed at the end of February). Austria became on of the countries where unemployment in March 2020 hit an all-time high since the end of World War II, and the applications for short-time work by far exceeded the levels during the Great Recession of 2008–2009. “The most affected sectors were accommodation, where the number of unemployed persons climbed by 178% within two weeks, and construction (+64%). Moreover, personnel leasing workers have seen a rise in unemployment by 39%” (Schnetzer et al. 2020). To counter this rapid increase in unemployment, the Austrian social partners (organisations of employers and employees) negotiated a new short-time work model which was introduced on March 20. The new STW strategy introduced in Austria was capitalising on the hitherto experience with similar solutions. This time around, it included net income replacement (for 3 months, amounting to 80–90%), and a temporary reduction in working time to as little as zero hours. The financial conditions for the employment strategy were created in two steps, but relatively quickly. The budget for public income compensation was first limited to e400 million, but later was raised to e1 billion (about 0.25% of Austrian GDP) on 28 March. Through these measures, Austria managed to mitigate the effects of the economic crisis and enabled a very significant number of employees to keep their jobs and sustain their consumption levels.

2.2.2

Spain: Euro Area Periphery

Spain never properly recovered from the Great Recession, which made a quarter of the Spanish workforce unemployed and also pushed the youth unemployment rate above 50% at the time of the euro area crisis. The 2012 Labour Reform epitomised the bias for flexible work and internal devaluation. The Great Lockdown following the pandemic outbreak opened a window of opportunity for the centre-left government led by Pedro Sánchez to demonstrate that an alternative economic agenda is emerging strongly, that the state not only can but has an obligation to prevent mass lay offs and generate security and confidence in times of enormous uncertainty. (Rejón Sanchez 2020) Inspired by the German tradition of the Kuzarbeit, the Sánchez government has situated its short-term unemployment scheme, the so-called ERTE3 programme, at the centre of its response to the economic crisis. Faced with a near-total halt of economic activity, the scheme has enabled the state to protect millions of jobs that would have otherwise swelled the glaring unemployment figures. Incurring an overall cost of e3.3bn in direct transfers and e1.4bn in foregone social security payments, 3 ERTE:

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the state’s treasure assumes the payment of 70% of the employee’s salary and it exonerates employers from paying the social insurance costs associated with the hired workers. At the peak of the pandemic, the ERTE programme protected over 3 million workers and half a million of enterprises of all sizes. This unprecedented figure constitutes over one-sixth of Spain’s workforce. In no month between 2008 and 2013, the number of workers protected by the ERTE programme exceeded 60,000 people. Back then, the political response to an economic recession rested entirely on mass lay offs and enterprise closure. The current government has been determined to pursue an alternative path. In addition to a robust job-saving scheme, in May 2020, the government of Spain also approved a guaranteed minimum income scheme set to help 850,000 vulnerable families. Before the pandemic, 17 different schemes were run by the various regional governments. The distribution of those transfers followed very diverse patterns and only reached around 300,000 homes. The new scheme from the Social Security Ministry was supposed to triple that figure (Gómez 2020).

2.2.3

UK: Leaving the EU

In March 2020, the conservative government of the UK stood out in Europe by voicing its interest in achieving herd immunity first, without a severe lockdown. In the end, the UK government also followed the approach of the continental countries. Regarding the economic policy measures against a coronavirus driven recession, the UK government did not display similar ambivalence and presented a bold package of measures, in which the labour market shock was meant to be mitigated primarily by the so-called furlough scheme. The UK Job Retention Scheme (JRS, or furlough) presented by the Chancellor of the Exchequer, Rishi Sunak served its twin purposes of preventing massive job losses while protecting incomes (both of which were supposed to help the recovery). Any business, regardless of the scale of the direct effect of COVID-19, could furlough staff and claim the state subsidy. Wage subsidies were introduced by the government, so the replacement of the pre-crisis salary became possible up to 80%. Thanks to these extraordinary measures, by early May, 800,000 businesses furloughed 6.3 million staff in the UK. The government did not set eligibility criteria for accessing the JRS, for which, in international comparison, it can be considered as an outlier. While providing hugely significant support for struggling companies, employees, and families, furlough was meant to be something to be phased out, though there were various views about how exactly that should be done. Some wanted a targeted (or even a long) extension on a sectoral basis, for example to protect sectors like hospitality. Others focused on skill levels, arguing that the JRS in practice is often furloughing people in low paid, short hours, insecure and poor quality work, and in a likely new round of furlough the government intervention should focus on helping people get into good quality jobs in viable businesses, rather than paying them to remain furloughed in non-viable ones. In this latter scenario, the government would

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need to cut employer National Insurance Contributions (NICs) for everyone over the summer, and then focus on supporting job creation. Either way, one big gap in the UK government’s strategy was what to do to maintain incomes for those who can’t work for other reasons. Issues like benefit levels and speed of phasing out were bound to remain debated throughout a lengthy crisis. Like many welfare or assistance measures it, the UK furlough has grown way beyond its intent—becoming the means for maintaining incomes for parents that can’t work, and for people who need to shield. Furlough was also seen as a very blunt instrument: it didn’t have a sectoral dimension, no forward-looking assessment of the viability, no role for social partners in making decisions. Due to these features, the UK furlough remained different from most European models, though it also was a deviation from the neoliberal tradition of the UK, which made it unlikely to become a permanent feature (or even something that happens in future downturns). On the other hand, measuring the results of government interventions for employment and stabilisation in the UK will be more difficult in the UK than in continental Europe, due to the simultaneous progress towards a full Brexit, together with all different types of disruptive effects.

3 The European Union: The Spectacular Rise of SURE Shortly after the pandemic outbreak, on 2 April 2020, the European Commission put forward an entirely new instrument promoting the concept of short-time work (STW) and also financially supporting it. The name of this new instrument is “temporary Support to mitigate Unemployment Risks in an Emergency”, or SURE (European Council 2020). It is supposed to demonstrate European solidarity by helping the efforts of national governments to save jobs threatened by the coronavirus or the recession it has triggered. The core idea of SURE is that when a member state experiences a sudden severe increase in actual and planned public expenditure due to applying schemes aiming at the preservation of employment, it can request financial assistance under this new facility to cover a significant part of this additional expenditure. Relevant expenditure concerns the extension or creation of STW schemes or similar measures designed to protect workers from the risk of unemployment and loss of income. SURE thus comes as an incentive to apply the STW approach against the pandemic recession, but a judgement on its actual merits requires an assessment from various perspectives.

3.1 Kurzarbeit on the EU Agenda This is not the first time when the European Commission highlights the potential of STW solutions or, as they call it in the country of origin (Germany), Kurzarbeit. Already in 2012 April, when the Commission put forward the Employment Package

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to counter the labour market consequences of the great financial and economic crisis, “internal flexibility” was described as a better alternative to external one (i.e. reducing employment protection). By popularising Kurzarbeit at the time of the euro area crisis, the EU was applying an approach introduced at the time of the Lisbon Strategy (2000): identifying best practices at national level, and sharing them through various EU processes of coordination and “soft law”. Following the Employment Package, and capitalising on the experience of the mega-crisis experience, the EU was also moving towards defining a European labour model and creating an expert consensus around a hierarchy of adjustment possibilities in the labour market for periods of economic downturns. This quasi-consensus assumes that if the demand for labour drops due to a recession, adjusting through working time reduction is clearly superior to other options: reduction of wages, reduction of employment, or reduction of the labour force by lowering the retirement age (the last one being the least preferred option). Though very far from being uniform, Europe indeed showed some great examples of negotiated STW schemes coupled with training, in Germany, Denmar, and Austria in particular. This orchestrated internal flexibility provides a strong basis for an economic rebound once demand picks up, creating a competitive advantage, especially if we compare the European experience with that of the United States. Regarding SURE, the most important feature is that it aims at promoting internal flexibility at the time of a recession (as an alternative to external flexibility). This is seen as the royal road from economic as well as social point of view, without assuming that it would be a universal solution, or a kind of silver bullet. The STW arrangement is a much better option than unemployment, but it also has to be noted that this option does not exist everywhere. Based on the specificities of countries that have pioneered STW schemes, we can identify not only the merits but also the limitations of Kurzarbeit. It has three main preconditions to work well: (1) the economic downturn should be caused by a demandside shock, after which the same economic structure can bounce back, (2)strong partnership4 between employers and trade unions, and (3) financial capacity to provide support either from an unemployment fund or elsewhere. These pre-conditions cannot be found everywhere, due to diverse political economic frameworks and institutional traditions. Consequently, an EU scheme focusing on Kurzarbeit would be biased for the better off workers of countries with stronger industrial relations, and it would leave the more precarious workers in the precarious benefit schemes of precarious countries. Limiting EU solidarity to those workers whose jobs can be saved would raise questions. During the recession triggered by COVID-19, the number of unemployed is bound to rise simply because some companies die. Besides, many people had temporary contracts until the crisis, and in the circumstances of the emergency, most of these are simply not renewed, so a lot of people add to unemployment without 4 On

the example of Austria, Schnetzer et al. (2020) stress the importance of social partners in negotiation, and the resulting effectiveness of short-time work arrangements in the COVID-19 crisis.

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being dismissed either de facto or de jure. Most of those employees would be unlikely to be considered under STW schemes, similarly to the self-employed. It is therefore particularly important that the SURE initiative is open to programmes designed for the self-employed, but even this way it remains an exclusive support tool.

3.2 The EU Budget Perspective: Enhancing the Social Compartment The newly established SURE instrument aims to make available financial support, in the form of loans granted on favourable terms, to EU member states that need to mobilise significant resources for alleviating the socioeconomic impact of the pandemic through STW schemes or similar measures. Total loans could amount to up to e100 billion. The legal basis proposed by the Commission is Article 122(1) and (2) of the Treaty on the Functioning of the European Union (TFEU).5 SURE does not only bring a new budgetary tool to the EU but also a new way of raising and providing resources. It does not require any upfront cash contributions from the national governments. To back the lending scheme, member states would commit “irrevocable and callable” guarantees worth e25 billion to the EU budget, with each item of this guarantee calculated based on their respective share of EU gross national income (GNI). Backed by EU member states, the system will enjoy a high credit rating, enabling the European Commission to contract borrowings on the financial markets at most favourable conditions, with the purpose of on-lending them to the member state requesting financial assistance. On the other hand, the lack of a grant component, i.e. the fact that SURE would operate entirely through lending, is a break on this model. While borrowing under this scheme, the member state affected will have to cover administrative costs due to the need to organise the programme. So the actual material help from the EU is about delayed taxation. This may still make sense, but employers will only play ball if the benefits of organising STW schemes (i.e. keeping the entire workforce on board without changing contracts) would exceed the administrative and organisational costs which would need to be shared within the country anyhow. In addition, it should be noted that the EU has been open to support STW schemes introduced by its members states already. However, until now the national governments only had the possibility of financing STW schemes from the European Social Fund (ESF). However, after SURE becomes operational, the available volumes will be enhanced by the newly created borrowing framework. SURE will help EU member states in their efforts to stabilise employment (and the labour income that comes with that) for those whose jobs can be saved in a recession. On the other hand, the Fund for European Aid for the Most Deprived (FEAD) provides EU support for those who lack the means for buying daily food for themselves. The missing element, however, remains the EU capacity to top-up for national unemployment insurance funds during 5 See

D’Alfonso (2020).

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recessions. While the rise of joblessness can be sharp, related funding will continue to rely entirely on national resources (Andor 2020). This feature brings us closer to the question of fiscal capacity within the Economic and Monetary Union (EMU).

3.3 EMU Perspective: Towards Macroeconomic Stabilisation The size of SURE (EUR 100 bn) can be compared to that of the ESF which, in the new Multiannual Financial Framework (MFF) proposal became an ESF + with over 100 bn euros for seven years (Andor 2018a). This, however, is a false comparison, because the ESF only provides grants, while SURE will provide loans. In order to appreciate how bold this initiative is, another comparison should apply, namely, to the two instruments former EU Commission President Jean-Claude Juncker proposed for cyclical stabilisation: the European Investment Stabilisation Program6 and the Reform Support Program,7 which between them would have been able to disseminate EUR 55 bn. Having seen the modesty of the tools proposed by Juncker, the new President of the Commission, Ursula von der Leyen, just with a single instrument, goes well beyond her predecessor, which by the way highlights how unserious the previous exercise was. “Volume is key for any stabilisation, and so is speed” (Andor 2020). The promotion of SURE highlights this aspect, but more in terms of volume rather than speed. To disburse funds, there will have to be a procedure that involves the Council, and a certain conditionality8 will also have to be met (short-time work arrangement or similar scheme will have to be organised). In general, conditionality can be a good thing; it has been rightly introduced for the ESF itself, which originally and fundamentally is not a cyclical but a structural fund. For cyclical stabilisation, on the other hand, conditionality at the time of delivery causes delay, and this by definition makes the instrument weaker. With a clear conditionality that is linked to cyclicality, SURE delivers something that has been missing from the EU economic and monetary architecture: a countercyclical fiscal capacity. In other words, this can be seen as an opening step in the direction that eventually turn the MFF from its head to its feet, and lead towards a proper stabilisation role at the community level. On the other hand, unemployment re-insurance models that have been discussed in the past years (see in next chapter) 6 The

EISF was supposed to maintain the continuity of investment projects in times of crises. However, this was not supposed to happen through transfers but loans, in a way to compensate for interest rates potentially hiking in a turbulent period. 7 The RSP was designed so support structural reforms within the member states in line with recommendations outlined in the context of the European Semester. Apart from offering a Reform Delivery Tool and technical assistance, it also wanted to introduce a Convergence Facility to provide dedicated support to Member States seeking to adopt the euro. 8 Interestingly, Alcidi and Corti (2020) consider SURE unconditional, simply because a Memorandum of Understanding is not supposed to be involved. On the other hand, since a specific action has to be taken to access the EU funding, SURE can be classified as a conditional stabiliser tool.

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would also have required a coordinated improvement (in coverage, generosity, attached training services, etc.) of existing unemployment benefit schemes as well, which will not be the case here. Some will speak about a missed opportunity as a result. The fact that the newly established SURE instrument is based on Article 122 of the TFEU and is funded as a genuine European instrument—and not an intergovernmental instrument—is important. By not using the European Stability Mechanism (ESM) for this initiative, the Commission, at least temporarily, avoided interference with the (divisive) debate on whether or not the ESM should be the vehicle for European solidarity in the corona crisis.

3.4 Caveats and Limitations Regarding SURE While recognising the merits of SURE, some important caveats (Vandenbroucke et al. 2020) also have to be mentioned. First, the Commission proposed support in the form of loans to the member states that are in need. Support in the form of soft loans is better than no support, but without a broader EU initiative that avoids sharply increasing levels of public debt in countries like Italy and Spain, soft loans will do little to reduce the looming risk of debt unsustainability in those countries. This issue has been addressed through the “Next Generation” fund, which will allow transfers to COVID-19 ridden countries. At the same time, the review of the fiscal rules of the EMU will also have to go forward and improve the overall macroeconomic framework, to avoid a repeat of the austerity experience of the 2010–2012 period. Second, with the practical implementation of SURE, the European Commission is bound to face a dilemma. On the one hand, the current situation and the policy legacies in the member states are very heterogeneous, and there is no time to lose; hence, the Commission should not try to impose too detailed conditions on how short-time work is implemented. The Commission rightly allows a broad range of measures: SURE will cover “the costs directly related to the creation or extension of national short-time work schemes, and other similar measures they have put in place for the self-employed, as a response to the current crisis”. On the other hand, some guidance is necessary. As already said in the previous section: the quality of domestic policies and cross-border risk-sharing should support each other. But, discussing and imposing relatively detailed conditions will imply delays, which in principle one cannot afford in this emergency context. Third, schemes that avoid layoffs for a certain period cannot be the only answer to the coronavirus challenge in the domain of unemployment. Inevitably, workers are already and will be laid off: hence, in all member states, there should be sufficiently generous unemployment insurance for the laid-off and for those ineligible for short-time work. Besides, the imperfect coverage of self-employed and precarious workers in many member states underscore the urgent need for labour market reforms. These would need to establish universal access to adequate social insurance, including unemployment insurance, to all workers in the EU, in whatever type

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of employment relationship, sector or activity they earn their living. This is one of the key principles of the European Pillar of Social Rights, which was proclaimed in 2017. A Council Recommendation, i.e. a soft instrument of EU legislation on access to social protection for all, was agreed in 2019. Under the current circumstances, its effective and urgent implementation is badly needed. Implementing this principle in all member states should feature prominently in a roadmap that leads to an effective euro area unemployment re-insurance scheme. Establishing SURE is an important step forward in the organisation of European solidarity, but it does not dispense us of making progress towards a fully fledged European unemployment insurance scheme.

3.5 Getting Actions and Expectations Right By creating a new instrument called SURE in Spring 2020, the Commission put forward a bold emergency initiative. Its size and innovative nature signals not only that the economic and the social crisis response have to go hand in hand, but also that the COVID-19 crisis is calling for deeper EU integration, inviting new ideas. This innovative move must be welcome, but the actual profile and design of this new instrument requires thorough analysis and clarification in order to avoid misunderstandings, false expectations, and eventual disappointment. For SURE to reach its goals, Balleer et al. (2020) stress the need for clear rules. Provided those are followed, SURE can be seen as a potentially a cost-effective automatic stabiliser at the European level, and it may as well be the starting point for a more ambitious European unemployment re-insurance system (Vandenbroucke et al. 2020). In any case, the macroeconomic effect of SURE will not be robust and, at least for the time being, the EU role will only amount to providing modest and somewhat delayed supplementary facilities to the schemes of the member states. While knowing its limitations, the added value of SURE has to be acknowledged as EU citizens are looking for help at the time of a devastating pandemic. However, it is also important to avoid overselling this tool. Studying some earlier examples can be useful from this point of view. For example, when the Youth Guarantee was introduced (following the 2012 December Commission proposal and 2013 April Council decision), expectations were running high. Even if the Commission invested a lot in explaining what it can and what it cannot do, the hype and the misinformation around the policy caused some damage which is a big risk also now. SURE is supposed to be operated on the basis of requests by member states and the disbursement of support will depend on bilateral agreements and discretionary decision-making in the Council. This mechanism will not eliminate the demand for a European unemployment insurance or re-insurance scheme, which would be based on ex-ante solidarity and entails as much automaticity as possible. In a sense, SURE can be seen as a complement to “normal” unemployment insurance: it adds “job

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insurance” in the context of a specific temporary emergency, created by a largescale and exogenous disaster. So conceived, it might turn out to be a specific “plugin” to a genuine European unemployment insurance scheme, ready to be installed immediately in the context of exceptional emergencies.

4 Towards Real Unemployment Re-Insurance When the new SURE initiative was announced by EU Commission President, Ursula von der Leyen, the justification for this innovative instrument was embedded in the context of unemployment re-insurance. However, the differences between the two concepts were also quickly understood. Following her nomination, von der Leyen announced that during her mandate the Commission would introduce an unemployment re-insurance scheme. This promise then was included in the mission letter of two EU Commissioners: Nicolas Schmit (Jobs and Social Rights) and Paolo Gentiloni (Economy). While a scheme with a significant potential, SURE does not qualify as unemployment insurance or re-insurance. According to Fernandes and Vandenbroucke (2020), SURE can be best characterised as a job insurance scheme. It is a safety net to jobs, but not to the unemployed persons. The distinction between the two is meaningful. In unemployment insurance schemes, cash (and not loan) is received by unemployed individuals. SURE delivers loans and not cash, and not to unemployed people but to those who might be threatened by unemployment but this threat is mitigated by short-time work arrangements. On the other hand, to the extent SURE helps to lower the number of unemployed in a country, the national unemployment benefit schemes will cope better.

4.1 The Case for Stabilisation Capacity Linked to Unemployment Establishing a minimalist monetary union, and especially one without a fiscal union in Europe, was always controversial. The Maastricht model of the EMU can be qualified as minimalist because it drops the exchange rate from the economic policy toolkit, but it does not replace it with either a lender of last resort, or a central budget able to provide fiscal stimulus, or at least coordinated policies aiming to uphold aggregate demand across Europe through a revaluation in “surplus” countries. As a result, those economies experiencing balance of payments problems are bound to undertake internal devaluation to regain cost competitiveness in times of crises. This has adverse effects on overall growth, but also on the labour market and the social situation, leading to to unnecessary economic losses and a potentially devastating social impact at the same time.

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The rationale for setting up a stabilisation function for the EMU is compelling. As we have seen in two economic crises already, national fiscal stabilisers might not be sufficient to smooth the cycle within individual countries, maintain economic convergence and deliver the optimal fiscal stance for the euro area as a whole. This was very much the case during the 2011–2013 crisis when national budgets, even in countries with a sound and resilient underlying fiscal position, were overwhelmed in a severe crisis. The lack of adequate national fiscal stabilisation capacities, and the complete lack of such capacity at the EU level, harmed the whole euro area. According to the reformist logic, an automatic stabiliser at the EMU level would help uphold aggregate demand at the right time and without delays. Most importantly, it would prevent short-term crises from unleashing longer-lasting divergence within the monetary union. Such a fiscal stabiliser would not represent “more Europe” for its own sake, and certainly not more intrusion of the Brussels bureaucracy into national policy-making. It would rather constitute a mechanism that strengthens the autonomy of each member state precisely by stabilising the EMU, and making it more resilient on the basis of transparent rules. Arguably, the stabilisation capacity can be built in a way that it does not become a one-way support channel. Focusing fiscal transfers on the need to mitigate asymmetric cyclical shocks means that over the long term all participating member states are likely to be both contributors and beneficiaries of the scheme. This of course would not mean full symmetry, and even if the balance is not exactly zero after a certain period of time, the capacity of the system to reduce the duration and deepness of economic crises would provide a more stable macroeconomic environment for all, sustain aggregate demand and therefore improve growth perspectives for the whole area.

4.2 Early Pointers on Unemployment Insurance A Community unemployment fund, which is now on the EU agenda in the form of a re-insurance scheme, is not a new idea. It was first outlined in 1975 by a Report authored by the former Vice-President of the European Commission, Robert Marjolin. The concept was also supported by the 1977 MacDougall Report. These documents explored the budgetary requirements for a sustainable European economic integration which would also stretch to establishing a monetary union. While distant in time from the actual introduction of the single currency, the MacDougall Report highlighted the important link9 between monetary union and unemployment insurance. In essence, the question has always been how the Community can help member

9 The relevant quote from the MacDougall Report: “Apart from the political attractions of bringing

the individual citizen into direct contact with the Community, it would have significant redistributive effects and help to cushion temporary setbacks in particular member countries, thereby going a small part of the way towards creating a situation in which monetary union could be sustained”.

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states tackling cyclical unemployment which is linked to, and aggravated by, the lack of adjustment tools at an advanced stage of monetary integration. Those early documents of public finance analysis considered it self-explanatory that monetary integration requires unemployment insurance as a form of de facto solidarity, in the spirit of the 1950 Schuman Declaration. Unfortunately, the 1989 Delors Report and the subsequent Maastricht process ignored this early insight. The EU in the 1990s introduced a form of monetary union which only in techniques but not, in essence, went beyond currency board arrangements. While some young economists like Jean Pisani-Ferry and Alexander Italianer argued for robust automatic stabilisers, political leaders decided to take higher risk with an untested model. This model of the single currency is rightly qualified as incomplete due to the absence of both common financial sector regulation and a central fiscal stabilisation capacity.

4.3 Euro Area Crisis: Relaunching the Debate The design flaws of the EMU were brushed under the carpet for nearly two decades. However, when EU leaders looked into the abyss in 2012 and faced the risk of immediate Eurozone disintegration, the moment of truth came. Far-reaching reforms were announced, declaring the need for Banking Union, Fiscal Union, as well as Political Union. The Four Presidents’ report, the Commission Blueprint for Deep and Genuine EMU, and the Thyssen Report adopted by the European Parliament pointed to the same direction. In addition, the words of the 2012 Blueprint on automatic stabilisers were repeated in the 2013 October Commission Communication about the Social Dimension of the EMU. Subsequently, the European Parliament report by Pervenche Beres (French Socialist) and Reimer Böge (German CDU) confirmed the need for a central fiscal capacity with a counter-cyclical stabilisation function. The most important documents produced by the Juncker Commission on this matter, the 2017 Reflection Paper on the future of the EMU, highlighted the danger of economic and social divergence in the Eurozone, but in the absence of a political momentum only very modest reform proposals were put forward, especially concerning risk sharing. The election of Emmanuel Macron as President of the French Republic in 2017 raised hopes but did change the course of events. In May 2018, Jean-Claude Juncker proposed a new Multiannual Financial Framework (MFF) which would have embedded facilities serving the EMU stabilisation function into the seven-year EU budget but with tools that did not turn out to be convincing due to either size or profile. Juncker’s gadgets were silently dropped when the EU had to produce a serious budget to face the COVID-19 crisis. Should there be a consensus about the need for an EMU fiscal capacity and embedding it into the MFF with a stabilisation function at some point, it will be important to ensure that such an instrument allows for demand-side intervention, without major delays, and reach a large number of citizens affected by adverse macroeconomic developments. Unemployment insurance, or re-insurance, satisfies these criteria and should be considered either linked to the MFF or as a stand-alone

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mechanism. What was not the case at the time of the euro area crisis, decision-makers today can rely on a wide pool of research, analysis and simulations. Since the 2011–2013 period, a great deal of analysis, produced by the Commission itself and a host of think tanks and independent experts, has explored the problems of asymmetry and divergence, and run simulations. In 2013–2014, the European Commission, in cooperation with the Bertelsmann Foundation, held two public conferences about the possibility of EU level unemployment insurance. Important inputs were provided by Prof. Sebastian Dullien, whose book on the subject was published by Bertelsmann too (Bertelsmann Stiftung 2014). Without exceptions, all such studies point to overwhelming economic and social benefits of automatic fiscal stabilisers.

4.4 Exploring Alternative Models Between the two crises, EU level unemployment insurance was rarely discussed in the circles of politics, while the analysis continued. A consortium of researchers led by the Brussels-based Centre for European Policy Studies (CEPS) delivered multiple simulations and analysis explaining the justification as well as the feasibility of a reinsurance mechanism (Beblavy et al. 2017). Some researchers, on the other hand, continued to favour fiscal stabilisation unrelated to unemployment. One such study was presented to the European Parliament by Prof. Heikki Oksanen, following in the footsteps of Prof. Henrik Enderlein, who put forward an output gap based mechanism at the 2013 Commission—Bertelsmann conference. Another model was designed by a German and a Spanish MEP, Jakob von Weizsacker and Jonas Fernandez. The model they presented in the European Parliament combined modest transfers with loans, effectively trying to force member states to save in good times in order to be able to secure long enough and generous unemployment coverage in bad times. During these years of reflection, the partial pooling of unemployment benefit schemes as proposed by Sebastian Dullien was understood to be a more perfect form of integration, while a US-inspired re-insurance model was seen as one matching better the European way that respects subsidiarity but adds further layers if justified by extraordinary circumstances with a clear added value. The competing perspectives agreed on one key point: had either of these insurance mechanisms existed in the EMU from the start of the single currency, all member states would have been beneficiaries at least once for a shorter or a longer period. Countries experiencing a severe recession would have received fiscal transfers, helping them towards faster recovery. The economic benefit of this would have been boosted by a political benefit, which is to avoid a perception that for the EU arbitrary fiscal targets are more important than democracy and social rights. Altogether, an EMU unemployment insurance or re-insurance can deliver stabilisation in three ways. First, it can contribute to economic stabilisation by shifting demand and purchasing power to countries and regions which otherwise would need

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to implement fiscal “adjustment” and internal devaluation (cuts in wages and investment). Second, social stabilisation would also follow, as a result of directing the flow of funds towards more vulnerable social groups and helping to tame the rise of poverty, especially among the working-age population. The third type is the institutional stabilisation. Although the EMU is a rules-based system, the application of these rules has been the subject of major debates, in both academia and politics. Member states agreed on tightening the fiscal rules during the euro area crisis (2011), but pragmatic considerations have often pointed towards more flexibility. The 2016 cases of Spain and Portugal remain memorable controversies, and so does the 2018 dispute between the Commission and Italy. In early 2020, the Commission actually launched a review of the fiscal rules. While some experts recommend ignoring the rules and giving up on them entirely, it is more likely that a modus vivendi could be found through reforming them, while also introducing effective stabilisation tools that would allow the reconciliation of uniform fiscal rules with the need to maintain national welfare safety nets and social investment capacities. This might be one of the reasons why unemployment insurance has been more and more frequently mentioned as a necessary EMU reform, alongside various forms of eurobonds. Nobel Prize laureate Joseph Stiglitz also endorsed the idea in his book about the single currency (Stiglitz 2016) and also in a public debate with Eurozone President Jeroen Dijsselbloem. It is an irony in this story, that while some fear that Eurozone unemployment insurance would be a kind of anti-German idea, there is a long list of German economists who have been promoting research and public debate on this issue (apart from those already mentioned, like Dullien and von Weizsacker, reference can be made to Daniel Gros, Matthias Dolls, and Guntram Wolff).

4.5 Political Endgame It is a question how quickly the political process can follow the progress among experts. What events or developments can change the dynamic of practical reform, especially among the most critical group of officials, which is the Council of EU finance ministers. The first debate in that circle took place in September 2014, when the organiser Italy remained alone. At the time of the Italian presidency, a debate was organised in both ECOFIN and EPSCO councils. The latter generated a lot of interest and support, while in ECOFIN the mood in 2014 remained lukewarm. However, Italian finance minister Pier Carlo Padoan (2014–2018) embarked on a Quixotic campaign, arguing in favour of an unemployment insurance fund embedded in the MFF (Padoan 2015). In 2016, the Slovakia presidency of the Council relaunched the ECOFIN discussion and the picture among finance ministers was much more balanced. Shortly after Padoan stepped down as a minister, the former Hamburg mayor Olaf Scholz took over the finance portfolio in Berlin within the Grand Coalition of the centre-left and the centre-right. Scholz also took over from Padoan the coordination

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of the centre-left political tendency in ECOFIN, and he came out with his own version of unemployment insurance. It was based on loans rather than actual transfers, which risked presenting a more symbolic rather than a substantial version of solidarity. But at least from that point it was no longer a Germany against the rest type of EU political debate but an internal one in Germany, which was a major step towards practical reform. Scholz gave an interview to Der Spiegel in June 2018 (Reiermann and Sauga 2018) in which he committed to the idea of unemployment re-insurance which hitherto was an anathema in Germany. The significance of this should not be underestimated. If successful, this can not only pave the way to the next step in the slow-motion reform of Economic and Monetary Union (EMU) but also make the European Pillar of Social Rights (EPSR) more meaningful. Without this opening, the Commission President would have hardly included the promise in her programme in 2019. Various aspects of the scheme (loan versus transfer, interregional versus intertemporal stabilisation effects, governance structures, the necessary degree of labour market harmonisation, etc.) still need to be discussed. However, under the COVID-19 shock the debate probably reached a stage when it can only move forward rather than backwards.

5 Conclusions: From Undercurrent to Paradigm Shift The 2020 coronavirus pandemic immediately generated an economic recession in Europe and turned into an unprecedented challenge to employment. Individual member states relied on practices tested in earlier crises, in most cases making efforts to slow down job destruction and provide income guarantees. However, the effectiveness of such measures depended on the success of anti-pandemic policies as well as the capacity of EU level coordination and burden-sharing. Adequate funding as well as avoiding premature phasing out appeared among critical factors for successful interventions at both national and EU levels. Following the great lockdown and the temporary freeze on cross-border mobility in the EU, when all member states resorted to stabilisation measures within a national context, a variety of steps have been made to orchestrate a European recovery and deepen integration. Importantly, the European Commission came forward with a quasi-revolutionary recovery budget, aiming at bringing the stabilisation function to community level, and allowing the EU budget to borrow for that purpose. In July 2020 the European Parliament even endorsed the idea of a Health Union. With the establishment of SURE the EU started to support, and not only promote solutions that limit the labour market effects of a shock. The chosen model is based upon the best available practices of the EU, while it also faces limitations at both national and EU levels. Importantly, SURE cannot be seen as a substitute for EMU level unemployment (re-)insurance, which was considered necessary already in the 1970s, and became a promise of the Commission led by Ursula von der Leyen. Perhaps the most important message here is that while structural interventions, like SURE, can be important, they should not be seen as substitutes for the appropriate

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macroeconomic policies. Those have to be in place to ensure the fastest possible recovery in case of economic downturns. And today the COVID-19 pandemic not only compels governments to provide roads to recovery but it also urges European states to create new avenues for structural transformation at national as well as EU levels. While the overall dynamics of unemployment will remain functions of the fiscal and monetary mix, various structural interventions and institutional innovations can have mitigating effects and influence on working conditions. From this point of view, the EU can use the coronavirus crisis to deepen solidarity among its member states, and to accelerate the transfer of better practices across member states and make efforts that the positive effects of crisis response measures survive the period of emergency. Acknowledgements Research for this chapter has been supported by the European Union and Hungary and co-financed by the European Social Fund through the project EFOP-3.6.2-16-201700017, titled “Sustainable, intelligent and inclusive regional and city models”.

References Alcidi, Cinzia and Francesco Corti (2020). Will SURE Shield EU Workers from the Corona Crisis? CEPS In Brief , 6 April. https://www.ceps.eu/will-sure-shield-eu-workers-from-the-corona-cri sis/. Andor, László (2018a). Resources for a Prosperous Europe, WISO DISKURS 18/2018. https://www. fes-europe.eu/fileadmin/user_upload/WISO-Diskurs__ProsperousEurope-EN__RZ-Web__1809-27a.pdf. Andor, László (2018b). Scholz’s Choice. In Encompass. https://encompass-europe.com/comment/ scholzs-choice. Andor, László (2020). Europe’s Half-Empty Sandwich, Euractiv, April 15. https://www.euractiv. com/section/economy-jobs/opinion/europes-half-empty-sandwich/. Balleer, Almut et al. (2020). Guidelines for Cost-Effective Use of SURE: Rule-Based Short-Time Work with Workers’ Consent and Aligned Replacement Rates, VoxEU.org CEPR Policy Portal, 7 April https://voxeu.org/article/guidelines-cost-effective-use-sure. Beblavy, M., Lenaerts, K., & Maselli, I. (2017). Design of a European Unemployment Benefit Scheme. Centre for European Policy Studies. https://www.ceps.eu/ceps-publications/design-eur opean-unemployment-benefit-scheme/. Bertelsmann Stiftung (Ed.). (2014). A European Unemployment Benefit Scheme: How to Provide for More Stability in the Euro Zone. Bertelsmann Stiftung. Corti, Francesco and Amandine Crespy (2020). SURE: A Quick Fix to Be Welcomed in the Search for Long-Term Solutions, FEPS Covid Response Papers, 17 April https://www.feps-europe.eu/ resources/publications/723-sure-a-quick-fix-to-be-welcomed-in-the-search-for-long-term-soluti ons.html. D’Alfonso, Alessandro (2020). Temporary Support to Mitigate Unemployment Risks in an Emergency (SURE), European Parliamentary Research Service Blog, April 16. https://epthinktank. eu/2020/04/16/temporary-support-to-mitigate-unemployment-risks-in-an-emergency-sure/. Eurofound (2020) COVID-19: Policy Responses Across Europe, Publications Office of the European Union, Luxembourg. European Council (2020). Proposal for a Council Regulation on the Establishment of a European Instrument for Temporary Support to Mitigate Unemployment Risks in an Emergency

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(SURE) Following the COVID-19 Outbreak. https://eur-lex.europa.eu/legal-content/EN/TXT/? uri=CELEX:52020PC0139. Fernandes, Sofia and Frank Vandenbroucke (2020). SURE: A Welcome Lynchpin for a European Unemployment Re-insurance. Jacques Delors Institute Policy Paper No. 251. https://institutd elors.eu/en/publications/sure-un-catalyseur-bienvenu-pour-une-reassurance-chomage-europe enne/. Gómez, Manuel V. (2020). Spain Approves Guaranteed Minimum Income Scheme for Vulnerable Families, El Pais, May 29. https://english.elpais.com/spanish_news/2020-05-29/spain-toapprove-guaranteed-minimum-income-scheme-for-vulnerable-families.html. International Labour Organization (2020). COVID-19 and the World of Work. https://www.ilo.org/ global/topics/coronavirus/lang–en/index.htm. OECD (2020). OECD Employment Outlook 2020: Worker Security and the COVID-19 Crisis, OECD Publishing, Paris, https://doi.org/10.1787/1686c758-en. Oliver, Laura (2020). Coronavirus: What Does ‘Furlough’ Mean and How Will It Affect Workers Worldwide? https://www.weforum.org/agenda/2020/04/covid19-furlough-employersworkers-support-global/. Padoan, P. C. (2015). Couldn’t Brussels Bail Out the Jobless? The Guardian. https://www.thegua rdian.com/commentisfree/2015/jun/10/russels-bail-out-jobless-european-union-unemployment. Pickles, Charlotte (2020). Job Retention Scheme 2.0. In Reform https://reform.uk/the-reformer/jobretention-scheme-20. Reiermann, C., & Sauga, M. (2018). Finance Minister Olaf Scholz: ‘Germany Has a Special Responsibility’. Der Spiegel International. https://www.spiegel.de/international/germany/interv iew-with-finance-minister-olaf-scholz-a-1211942.html. Rejón Sanchez, Fernando (2020). Spain’s Fight for a Just Recovery, 29th July 2020. In Social Europe https://www.socialeurope.eu/spains-fight-for-a-just-recovery. Schnetzer, Matthias, Dennis Tamesberger and Simon Theurl (2020). Mitigating Mass Layoffs in the COVID-19 Crisis: Austrian Short-Time Work as International Role Model, VoxEU.org CEPR Policy Portal, 7 April. https://voxeu.org/article/mitigating-mass-layoffs-covid-19-crisis-austrianshort-time-model. Stiglitz, Joseph E. (2016). The Euro: How a Common Currency Threatens the Future of Europe, New York: W. W. Norton. Vandenbroucke, Frank et al. (2020). The European Commission’s SURE Initiative and Euro Area Unemployment re-Insurance, VoxEU.org CEPR Policy Portal, 6 April. https://voxeu.org/article/ european-commission-s-sure-initiative-and-euro-area-unemployment-re-insurance.

László Andor Secretary General of FEPS (Foundation for European Progressive Studies, Brussels). He was EU Commissioner for Employment, Social Affairs and Inclusion (2010–2014), and subsequently Head of Department of Economic Policy at Corvinus University (Budapest). He has also been lecturing at Hertie School (Berlin), ULB (Brussels) and Sciences Po (Paris) and is a member of various think tanks (EPC, RAND Europe, Friends of Europe). Between 2005 and 2010, he was a member of the Board of Directors at the EBRD (European Bank for Reconstruction and Development, London). He is Doctor Honoris Causa at Sofia University of National and World Economy.

Changes in Labour Market Institutions and Unemployment in European Countries: An Empirical Analysis on the Short- and Long-Run Effects of Flexibility Measures Giorgio Liotti and Federica D’Isanto Abstract The fight against unemployment has become one of the most important challenges that advanced European countries have faced in the last forty years. Economic literature suggests that the changes in labour market institutions—through the implementation of a set of flexibility measures—represent a useful tool to reduce unemployment. In this chapter, we estimate the short- and long-run effects of a change in the labour market institution on unemployment—using data about 28 selected European countries in the period between 2000 and 2017—with the aim of verifying the validity of the hypothesis that higher labour market de-regulation contributes to improving labour market performance. The empirical results—using the biascorrected least square dummy variables (LSDVC) econometric techniques—do not show robust evidence that higher labour market de-regulation is correlated with a reduction of unemployment rate. The policy implication of this chapter is that, face the likely increase in unemployment rate in upcoming years, due to the outbreak of the global COVID-19 pandemic, will require policymakers to implement different policies (investment in ALMPs and the adoption of ad hoc economic policies in order to increase the aggregate demand), rather than further reforms aiming to de-regulate the labour market. Keywords Unemployment · Labour market policies · European countries · Panel data models Jel Classification J64 · J08 · 052 · C23

G. Liotti (B) · F. D’Isanto Department of Political Sciences, University of Naples Federico II, Via Rodinò 22, 80138 Naples, Italy e-mail: [email protected] F. D’Isanto e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_12

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1 Introduction In the 1980s, the strong difference between the unemployment rate in the United States and Western European countries stimulated the debate around the institutional mechanism of labour market rules in the “new” and “old” world (Lazear 1990; Layard et al. 1991; Pissaridis and McCaster 1990). Some economists and international organizations (OECD 1994; Lazear 1990) pointed out that the difference was due to the differing labour market rules, highlighting that more flexible labour market institutions had allowed to the United States to achieve a lower unemployment rate compared to Western European countries, where the labour market was characterized by higher employment protection legislation. In other words, the hypothesis was that there was an inverse relation between flexibility measures and unemployment (Lewis 2009) Moreover, Monetarist and New Keynesian theory, using the concept of “natural rate of unemployment” and stating that only changes in the labour market institution can reduce structural unemployment, offered a theoretical explanation for relaxing the employment protection rules. Therefore, the adoption of flexible labour market rules has represented the “main way” for achievement of a full employment situation (Nickell 1998; Nickell et al. 2005; Blanchard and Wolfers 2000; Blanchard and Summers 1986; Blanchard et al. 2006). According to this context, one of the most serious obstacles to the European integration, at the moment of the creation of the Eurozone, was the discrepancy about the labour market rules among countries. The homogeneity of labour market institutions can represent a key feature for the future European economic integration. This issue is very important because, as stated by Bertola (2017), “Integration and deregulation…need to be supported clearly by political motives” (Bertola 2017, p. 5) and the implementation of labour market de-regulation (i.e. the adoption of flexibility measures) could allow to balance the asymmetric and negative effects on unemployment in Europe due to economic shocks. However, in our opinion the central issue is not the lack of labour market reforms, but the possibility that flexibility of labour market can represent a solution to unemployment problem of European countries. This should be the focus of economic debate prior to the implementation of any change of labour market institutions. By labour market institutions, we mean the set of rules allowing the normal functioning of the labour market. These rules can be stringent or flexible depending on whether they guarantee a higher or lower level of protection for workers (Betcherman 2012). There are at least three reasons according to which a high rigidity of labour market leads to an increase in unemployment: (1) higher labour market regulation increases the bargaining power of workers (Blanchard and Portugal 2001), preventing the “necessary” reductions in nominal wages and thereby stimulating firms to hire workers; (2) it causes high dismissal costs for firms in the case of economic downturn; and (3) it does not allow an adequate turnover among workers, and hence, it represents one of the causes of long-term unemployment (Hysteresis effect).

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According to this theoretical approach, many European countries began to change their labour market institutions in 1990s (Tridico 2018) through a set of reforms aiming to achieve a double objective: on the one hand, to reduce the high protection of workers with permanent contracts (reduction of the security in employment, Moreira et al. 2015) to prevent the segmentation of the labour market (Lindbeck and Snowden 1988; Blanchard and Summers 1986); and on the other hand, to lower hiring and firing costs of firms increasing, in such way, the competitiveness on international markets (Zemanek 2010; Bernal-Verdugo et al. 2012, 2013; Lucifora et al. 2005). The process of change of the labour market institutions in Europe accelerated the debate around the necessity to de-regulate the labour market after the outbreak of the economic crisis in 2008, and it is likely that due to the global pandemic—which will take the world economy into a recession—other measures and reforms will be claimed. The purpose of this chapter is to investigate whether these labour market reforms (in the short and long run) have improved employment performance in reality. In order to answer to this question, we will analyse the effects of changes in labour market institutions and unemployment rates for 28 European countries from 2000 to 2017. The chapter is structured as follows: in Sect. 2, we show the main indicators used for evaluating the changes in the labour market institutions and offer a short review of literature about the effect of these changes on unemployment. In Sect. 3, we describe the labour market indicator used in this chapter and focus on descriptive data statistics. In Sect. 4, we present the empirical model and the econometric results. In Sect. 5, we present the policy implications and lastly, Sect. 6 is offers some general conclusions.

2 Review of Literature In the last forty years, economic theory has focused on the impact of labour market institutions on unemployment (Betcherman 2012). Over time, the changes in labour market institutions have been analysed using many different indicators. However, despite the variety of indicators proposed to analyse the impact of changes in the labour market institution on unemployment, scholars focused mainly on two indices: minimum wage and employment protection legislation (EPL) (see Arestis et al. 2020). Concerning the effect of minimum wage, scholars suggest that it has negative effects on employment outcomes (Card and Krueger 1994, 1995; Neumark and Wascher 2007; Abowd et al. 2000; Montenegro and Pagès 2003; Del Carpio et al. 2012). The main hypothesis is that there is a strict positive correlation between the increase in minimum wage and the reduction of the competitiveness of firms in international markets which feeds the unemployment process. However, concerning the effect of minimum wage, some papers find that the effect on unemployment rate is or absent or very low. O’Higgins and Moscariello (2017),

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for example, using a Probit model, do not find statistically significant effects of an increase in minimum wage on unemployment rate. Moreover, Brown (1999) and the OECD (2006) find that the coefficient that identifies the impact of increase in minimum wage on unemployment is very low. Regarding EPL, it can be considered the whole of rules governing the initiation and termination of employment (Betcherman 2012). The EPL index is a synthetic indicator of the strictness of regulations on dismissals covering three different aspects of employment protection regulations (procedural inconvenience, notice and severance pay for no-fault individual dismissal, and difficulty of dismissal1 ). During the 1990s and 200s, many scholars found a positive relationship between EPL and unemployment was confirmed in several papers (Yu-Fu Chen et al. 2003; Hopenhayn and Rogerson 1993; Scarpetta 1996; Nickell and Layard 1999; Elmeskov et al. 1999). In other words, stringent EPL rules reduce employment and job creation rates. The International Monetary Fund (IMF 2003a) found that EPL causes increases of unemployment rates, but the effect tends to decrease in the presence of high union density. Balot and Von Ours (2000) conclude that high EPL increases the structural unemployment in OECD countries. Although in many developed countries the changes in labour market institutions (i.e. reforms which aim was to reduce the employment protection legislation) in the late 1990s, the flexibilization process accelerated during the period of financial crisis, through the implementation of new rules reducing dismissal protection for workers with permanent contracts (ILO 2012; Moreira et al. 2015). Despite the above cited scholars found a positive relation between the flexibility measures and unemployment, several authors were more sceptical about the real effectiveness of labour market de-regulation on employment outcomes (see Ferreiro and Serrano 2013; Ferreiro and Gómez 2018). For example, Barbieri and Scherer (2009) do not find any evidence that—concerning the Italian case—that higher labour market flexibility produces beneficial effects on youth employment. Vice versa, they found that the labour market reforms in Italy have stimulated firms to replace permanent and full-time contract workers with temporary contract and subprotected workers. Liotti (2020) and Liotti et al. (2018), analysing the Italian case, did not find empirical evidence that higher labour market de-regulation contributes to reduce youth and adult unemployment. Finally, Amable et al. (2011), using a dynamic model with fixed effects and an interaction term, find that with a low level of product market regulation (PRM), high EPL produces a positive effect on employment. Therefore, the review presented in this paragraph shows that the debate about the effect of labour market institutions on unemployment is still open.

1 For

more details see: https://www.oecd.org/els/emp/oecdindicatorsofemploymentprotection.htm

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3 Data and Statistical Descriptive In this section, we analyse the trend, over time, of two main variables (unemployment and changes in labour market institutions) for 28 European countries (Austria, Belgium, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, and the UK) from 2000 to 2017. In this chapter, as a proxy for changes in the labour market institution, we use the labour market regulation index (LMRI) produced by the Fraser Institute.2 This is an index composed of six sub-indicators taking into account the changes occurring in labour market institutions from the 1970s until 2017 in several areas, such as: (i) hiring and firing regulation, (ii) minimum wage, (iii) centralized collective bargaining, (iv) mandated cost of hiring, v) mandated cost of worker dismissal, and (vi) conscription.3 The value of LMRI goes from 1 to 10. The higher is the value, the higher is the degree of flexibility of the labour market. The use of the LMRI has two advantages compared to the EPL index: (i) unlike EPL (which focuses mainly on the employment protection regulations), LMRI takes into account several aspects of the labour market institutions, allowing us to analyse the changes in labour market rules from different points of view; and (ii) the availability of the data. Indeed, while data about LMRI are available for the period 2001– 2017, data on EPL (elaborated by OECD) stops in 2013. Moreover, looking at the data, it seems that the LMRI index is more suitable for the purpose of our chapter because, while the value of the EPL index remained unchanged from 1985 to 2012, the value of the LMRI varies over time, reflecting in a better way the changes of the labour market. Figure 1 considers the trend of the (average) unemployment rate4 in 28 European countries in the 2000–2017 period. When analysing the first year of our observation, we note that the average unemployment rate was about 8%. Before the outbreak of economic crisis in 2008, the average unemployment rate progressively reduced to 5.9%. However, from 2009 to 2013, the average unemployment rate increased from 5.9 to 10.3%. In the last four years of our observations, however, the average unemployment rate returned to 7.1%. However, since the dataset included countries with vastly different economic structures, it is worthwhile to analyse the trend in unemployment rate by dividing countries into three different groups: Central and Northern European countries; Southern European countries; and Eastern European countries.5 In the first group, we include the following countries: Austria, Belgium, Denmark, Finland, France, 2 https://www.fraserinstitute.org/economic-freedom/dataset?geozone=world&page=dataset. 3 For

details about the sub-indexes see Liotti (2020). on unemployment rate are available on IMF website: https://www.imf.org/external/pubs/ft/ weo/2020/01/weodata/index.aspx. 5 It is important to point out that the inclusion of countries in a specific group is not always linked to the specific geographic area, rather it depends on the general economic structure of the country and by the trend over the period 2000–2017 of the unemployment rate. 4 Data

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Fig. 1 The average unemployment rate in 28 European countries from 2000 to 2017. Source Authors’ elaboration on Eurostat data

Fig. 2 The unemployment rate by different European countries groups from 2000 to 2017. Source Authors’ elaboration on Eurostat data

Germany, Luxembourg, the Netherlands, Norway, Sweden, Switzerland, and the UK. In the second group, we include: Cyprus, Greece, Iceland, Ireland, Italy, Malta, Portugal, and Spain. Finally, in the last group, we include the Eastern European countries: Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic, and Slovenia. Figure 2 shows the different paths in average unemployment rates of the three groups.

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Fig. 3 LMRI in 28 European countries from 2000 to 2017. Source Authors’ elaboration on Fraser institute data

The Central and Northern European country group shows that the unemployment rate remains very stable (around 6%) during the whole period, with a peak of 6.8% in 2013. Regarding the Southern European country group, the trend is very different: in an initial phase, the unemployment declined from 7.1% in 2000 to 6.6 in 2008. Subsequently, as a consequence of the economic crisis, the unemployment started to increase, achieving a peak in 2013 (15.4%), at which point it then slightly reduced to 10.5 in 2017. Concerning the Eastern European country group, the initial level of unemployment was very high (12.8%). Then, it reduced by around 50% in 2008 (6.6%) but raised to 13% in 2010. From 2011 to 2017, the unemployment rate reduced to 6%, a value very similar to the Central-Northern European country group. Analysing the trend of LMRI (Fig. 3), we see that the process of the liberalization of the labour market has continued uninterrupted for the whole period. Indeed, Fig. 3 shows that in the period between 2000 and 2017, the value of LMRI increased by 31.5% (from 5.16 to 6.79). It is important to note that the majority of the change in LMRI was concentrated in the period before the outbreak of the economic crisis. Indeed, in the 2000–2008 period, the LMRI increased from 5.16 to 6.20. The increase in the LMRI in the period following the outbreak of the economic crisis was more limited (from 6.20 in 2008 to 6.79 in 2017). However, Fig. 3 does not show the trend across time of the change in LMRI for all countries of our dataset—nor does it allow us to see whether there are differences among country groups. Figure 4 shows that before the outbreak of the economic crisis, the value of LMRI was higher in the Central-Northern country group than in Southern group. However, after 2008 (with expectation for the years 2010, 2011, and 2012) the differences vanished, and from 2013, the value of LMRI is equal for both groups. The situation is very different for the Eastern European country group: indeed, until 2004,

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Fig. 4 LMRI in the three European country groups from 2000 to 2017. Source Authors’ elaboration on Fraser institute data

the value of LMRI of this group was very similar to the Central-Northern European country group. However, in the period between 2005 and 2014, the value of LMRI of the Eastern European country group increased from 6.2 to 7.18 (the peak), and only in the last three years of observation did the difference in the LMRI value with the other two country groups reduce to only 0.2 (6.94 for the Eastern European country group and 6.74 and 6.7, respectively, for the other two country groups).

4 The Model To analyse the short- and long-run effect of labour market regulation index on unemployment rate in 28 European countries, a very general empirical model is estimated: Ui,t = αi + β0 Ui,t−1 + β1 L M R Ii,t−1 +

1 

 βk X i.t− j + εi,t

(1)

j=0

Where Ut is the unemployment rate at time t, and Ui,t−1 is the unemployment at time t − 1. LMRI with a lag is our main independent variable, while X’ is the set control variables that can have some effects on unemployment, and i is the entities. β0 , β1 , βk are the coefficients, ε is the error term, and αi is the fixed effect taking into account the unobservable factors affecting the panel data entities. The empirical strategy assumes that the level of unemployment depends on their previous values, while the presence of our main independent variable (LMRI) at the right of the Eq. (1) is

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coherent with literature hypothesis (Choudhry 2012a, b) that the causality goes from flexibility to unemployment, and not vice versa. Besides the degree of flexibility of the labour market, other macroeconomic variables (which, in the literature, are assumed as determinants of the unemployment) are included in the model. These control variables are: (i) economic growth rate; (ii) inflation; (iii) government bond yield; (iv) unemployment benefits; (v) the active labour market policy per unemployed individual (ALMP/UNEMP); (vi) union density; and vii) change in the money wages. The source of the data is shown in the appendix (see Table 3). The rationality of including these control variables is as follows: (i)

Economic Growth: according to Okun’s law, economic growth is a key factor to reduce unemployment rate. The increase in growth reduces the level of the unemployment rate. (ii) Inflation: according to Choudhry et al. (2012a, b), the inflation reduces rate unemployment, because, given that the level of wages, a general increase of prices reduces real wages, allowing firms to increase both the level of profits and labour demand. However, Liotti (2020) considers also the opposite view: that is, the inflation could have negative effects on unemployment. Indeed, a general increase of prices, lowering the real wages of workers leads to reductions in domestic and international aggregate demand. If this second hypothesis is true, inflation could contribute to the increase of unemployment. (iii) Government bond yield: the general hypothesis is that an increase in government bond yield should have a positive (increase) effect on unemployment rate (Hernández and Barrios Garcia 2004). This effect could be because an increase in the bond yield rate stimulates private agents to buy financial assets instead of investing in the economy real sectors, having negative effects on production and employment. Moreover, since a raise in the bond yield rate leads to an increase in the debt/GDP ratio, it forces governments—in the future— to implement austerity measures to reduce it, with the consequences being a decline in aggregate demand, production, and employment (Canale and Liotti 2015, Canale et al. 2014). (iv) Unemployment benefits: high unemployment benefits increase the unemployment level for two reasons: (1) they reduce the job-searching intensity; and (2) they lower the economic cost of unemployment (Bassanini and Duval 2006). (v) ALMP: according to Martin (2014), there is a negative relation between ALMP policies and unemployment, because the probability of finding a job is positively correlated to the increase in the human capital (through schooling, training, and experience) of an unemployed person. (vi) Union density rate: according to mainstream theory (Toke and Zafiris 2002; Bertola et al. 2002; IMF 2003b; Nickell et al. 2005), a higher union density rate increases the bargaining power of workers unions (Piton and Rycx 2019), positively affecting money wages and increasing worker benefits. This should have a negative impact on firms’ production and unemployment rates (Ferreiro and Gómez Ferreiro and Gómez 2019).

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(vii) Change in money wages: this represents the change—in percentage points—of the average wages year by year. Average wages are obtained by dividing the national accounts-based total wage bill by the average number of employees in the total economy (see Liotti 2020). Finally, we also introduce into the model a dummy variable to estimate the specific effect of the change in labour market institutions on the three country groups. Data on Economic growth and Inflation are available on IMF website,6 while data on Government bond yield, Unemployment benefits, ALMP/UNEMP, Union density rate, and Change in money wage are available on OECD website.7 The empirical strategy used is a bias-corrected least squares dummy variable— LSDVC—(Kieviet 1995; Bruno 2005; Bruno et al. 2017). The LSDVC estimator is suitable for panel data with strictly regressors, and according to Bruno et al. (2017), for small N and finite T, it outperforms both LSDV and N-GMM estimators. In Eq. (1), β0 , β1 , βk represent the short-run coefficient measuring the immediate effect of a change in the variables. The long-run coefficient measuring the effect of the change in LMRI on unemployment is given by β1 /(1 − β0 ). The long-run effect of the set of control variables is measured by βk /(1 − β0 ). Obviously, the long-run coefficients measure the total adjustment on unemployment rate due to the change in the independent variables.

4.1 Empirical Results: The Short-Run Analysis In this paragraph, we show the impact due to the change in LMRI and other control variables on unemployment rate in the short run. Looking at Table 1, we note that the unemployment rate depends on its past value t − 1 (the coefficient of unemployment rate at time t − 1 goes from 0.867 (column 4) to 0.962 (column 2). Regarding the effect of the change in LMRI on unemployment, econometric results give mixed results. Indeed, only in three regressions (column 1 at 5%, column 2 at 1%, and column 6 at 5%) is the short-run effect of LMRI on unemployment rate statistically significant in a range between −0.155 and −0.193. These results are very important because—contrary to mainstream labour market theory—we cannot assume a clear effect of the flexibility measures on unemployment. These results could be explained by the fact that the introduction of flexible labour market measures produces a double effect—that is, if, on the one hand, higher flexibility can reduce unemployment, this allows people (especially younger individuals) to enter into the labour market and find a job. On the other hand, these measures contribute to make workers extremely sensible to the volatility of the business cycle. Moreover, as stated in paragraph 2, O’Higgins and Moscariello (2017) and Barbieri and Scherer (2009) show how the introduction of the labour market flexibility measures can produce 6 https://www.imf.org/external/pubs/ft/weo/2020/01/weodata/index.aspx. 7 https://data.oecd.org/.

444

(continued)

−0.383*** (0.145) 445

446

Observations

365

Dummy LMRIt−1 East. group 397

−0.057 (0.153)

−0.315*** (0.014)

0.946*** (0.020)

(7)

−0.071 (0.103)

−0.024 (0.018)

−0.193** (0.077)

−0.301*** (0.016)

0.942*** (0.018)

(6)

Dummy LMRIt−1 South. group

424

0.073*** (0.017)

0.005 (0.104)

−0.335*** (0.019)

0.951*** (0.025)

(5)

Dummy LMRIt−1 North. group

Change in money wage

Union density rate

−0.839** (0.411)

Almpt − 1

−0.099 (0.078)

−0.248*** (0.017)

0.867*** (0.021)

(4)

1.777*** (0.200)

0.231*** (0.027)

0.056 (0.075)

−0.250*** (0.016)

0.918*** (0.016)

(3)

Unem. benefits

Government bond yield

446

−0.155* (0.083)

−0.187** (0.077)

LMRI 0.058** (0.029)

−0.317*** (0.015)

−0.312*** (0.014)

Eco. Growth

Inflation

0.962*** (0.018)

0.949*** (0.017)

Unemt − 1

(2)

(1)

Variables

Table 1 The effect of LMR on Unemployment in Selected European Countries. Bias-corrected LSDV short-run estimates

Changes in Labour Market Institutions and Unemployment … 237

Num. of groups

(2) 28

(3) 28

(4) 28

(5) 28

(6) 28

(7) 28

Standard errors in parentheses. ***, **, * Reject the null hypothesis at 10, 5 and 1%. Bootstrapstandard errors based on 100 replications are reported under the coefficient value: *significant at 10%, **significant at 5%, ***significant at 1%. The initialization is based on AB, the Arellano and Bond (1991)

(1)

28

Variables

Table 1 (continued)

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the so-called substitution effect, that is, the substitution of stability and permanent workers with precariousness and temporary workers. Regarding the other control variables, econometric results show that economic growth contributes to reducing unemployment. Indeed, the short-run coefficients of economic growth are a range between 0.201 (column 8) and 0.335 (column 5), and they are always significant for all econometric models estimated. Regarding the other control variables, we note that government bond yield (column 3), unemployment benefits (column 4), and union density (column 5) contribute—in the short run—to increasing the unemployment rate. By contrast, active labour market policies (column 4) help to reduce the unemployment rate because they contribute to increasing worker skills and improving individuals’ human capital, which increases the probability to find a job for unemployed person. Regarding the effect of increasing the money wages (6), the coefficient is negative, but it is not statistically significant. Finally, we have added to the econometric model a dummy variable on LMRI to analyse the different effect of the introduction of flexibility measures on three country groups. Column 7 of Table 1 shows very interesting results: for the Central-Northern country group, the effect is negative (it reduces unemployment), but not statistically significant. Concerning Southern country group, a higher flexibility contributes to worsening the unemployment rate (since the coefficient is positive), even though it is not statistically significant. Only for the Eastern European country group does it seem that the flexibility measures have had a negative and statistically significant impact (−0.383) in reducing the unemployment rate. These results again confirm that flexibility cannot be considered a “panacea” for resolving the unemployment problem. The implementation of flexibility measures should be targeted, taking into consideration the whole economic, social, and political structure of each individual country.

4.2 Empirical Results: The Long-Run Analysis Table 2 shows the long-run effects of our independent variables on unemployment. The long-run effect of LMRI on unemployment has never been statistically significant (with exception of columns 1 and 6, with a statistical significance of 1%), even though the sign of the coefficient is in line with the main purpose of labour economics theory. The only significant effect of a change in LMRI on unemployment is on the unemployment rate of the Eastern European country group (column 7), where the coefficient is very high (−7.132), and it is statistically significant at 10%. By contrast, for the two other country groups, the coefficient is 1.323 and −1.066 for the Central-Northern European country group and the Southern European country group, respectively, but not statistically significant. The econometric results confirm that growth rate is one of the most important factors contributing to reduce the unemployment rate in the long run. The coefficient is in a range between −1.875 (column 4) and −8.376 (column 2).

−4.107 (3.014)

−3.737* (2.197)

LMRI

444

390

365 28

28

28

28

N. of groups

Standard errors in parentheses. ***, **, * Reject the null hypothesis at 10, 5 and 1%. Bootstrapstandard errors based on 100 replications are reported under the coefficient value: *significant at 10%, **significant at 5%, ***significant at 1%. The initialization is based on AB, the Arellano and Bond (1991)

28

28

Observations 28

−7.132*** (3.093) 445

446

Dummy LMRIt−1 East. group 446

−1.066 (3.029)

−1.868 (1.404)

−5.865*** (2.352)

(7)

Dummy LMRIt−1 South. group

−0.425 (0.316)

−3.398* (1.874)

−5.292*** (1.753)

(6)

−1.323 (2.003)

424

1.513* (0.856)

−0.111 (2.155)

−6.888* (3.653)

(5)

Dummy LMRIt−1 North. group

Change in money wage

Union density rate

−6.329** (3.043)

Almpt−1

−0.752 (0.612)

−1.875*** (0.368)

(4)

13.403*** (2.059)

2.844*** (0.613)

0.697 (0.950)

−3.087*** (0.709)

(3)

Unem benefits

Government bond yield

1.534 (1.216)

−8.376** (4.151)

−6.214*** (2.230)

Econ. Growth

Inflation

(2)

(1)

Table 2 The effect of LMR on unemployment in selected European countries. Bias-corrected LSDV long-run estimates

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Regarding the other control variables, we can conclude that government bond yield, unemployment benefits, and union density (in spite of the coefficient being statistically significant only at 1%) contribute to increasing the unemployment rate. By contrast, active labour market policies are able to reduce unemployment. Finally, our empirical results do not show a statistically significant effect of the latter two control variables (inflation and change in money wages) on unemployment rate.

5 Policy Implications Which are the policy implications of our results? What can we learn from learn for the future of the European governance? Regarding the first question, the results seem to highlight that the introduction of flexibility measures at aiming to de-regulate the labour market and guarantee the improvement of employment performance have missed their objective. There could be many reasons that could explain this failure but, in our opinion, the most important is that the international competition, due to the new globalized world, stimulates firms to use the flexibility measures not to create new jobs, but to reduce production cost through a reduction of wages and to replace permanent contract workers with atypical ones. This explanation has supported by the fact that the adoption of flexibility policies has generated a strong increase working poor in Eurozone in the last fifteen years (see Liotti and Canale 2020). Regarding to the second question, the empirical results can provide to policymakers different tools for improving employment performance. Indeed, one of the most important policy implication of this chapter is that—in anticipation of the future economic crisis due to the outbreak of the COVID-19 pandemic—policymakers should not focus only reforms concerning labour supply side, because there are other factors stimulating the increase of employment. Policymakers should focus, on the one side, on the adoption of economic policies ad hoc to sustain aggregate demand and economic growth, stimulating the labour demand of firms and, on the other side, to invest more resources in ALMPs, increasing workers human capital as a tool to improve labour market performance and fight the problem of unemployment.

6 Concluding Remarks In the last forty years, labour market reforms in advanced economies have been suggested—by mainstream labour market theory—as the main solution to the problem of unemployment. According to mainstream theory, policymakers of developed countries have started to introduce flexibility measures (renamed the “deregulation process”) in the labour market in an attempt to reduce the unemployment rate. The outbreak of the economic crisis in 2008 has accelerated debate about the necessity to implement a de-regulation process of the labour market in Europe,

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because it was seen also as a solution for the job loss caused by the economic downturn. According to this general context, the aim of this chapter is to analyse the shortand long-run effect of the change in labour market institutions (calculated using the LMRI) on the unemployment rate in 28 selected European countries in the 2000–2017 period. Empirical results—using an LSDVC approach—show that there is little evidence that in the short run, a change in the LMRI reduces unemployment. A significant effect of a change in LMRI on unemployment is found only for the Eastern European country group, while there is no evidence for the Central-Northern and Southern European country groups. Regarding the long-run effect, we do not find statistically significant evidence that LMRI contributes to reducing the unemployment rate as whole, while a strong negative effect is found with reference to the unemployment of the Eastern European country groups. Analysing the effect of the other control variables, we draw the following conclusions: (1) Economic growth and ALMPs contribute to reducing unemployment rates both in the short and long run. (2) Inflation and union density have a negative effect on unemployment only in the short run. (3) Government bond yield and unemployment benefits increase the unemployment rate both in short and long run. (4) Change in money wages seems do not have an effect on unemployment either in the short or the long run. In conclusion, the analysis developed in this chapter does not support the mainstream hypothesis that a higher labour market flexibility represents a useful strategy to solve the unemployment problem. Without a doubt, labour market reforms have produced beneficial effects in some cases and in terms of Eastern European countries. However, in this case, it is also likely that the beneficial effect is due to the entire re-organization of the economy due to the transition from socialism to a capitalist economy. However, it is important to warn the reader that the results are limited to European countries analysed in this chapter, and they cannot be taken as valid in general in any time and any place. We believe that the results of our chapter could stimulate other and in-depth analysis focusing on measures that can improve employment performance. This is very important in order to provide—also insight of the future and desirable economic integration among European countries—policymakers of further tools for guaranteeing the match between labour supply and labour demand.

Appendix See Table 3.

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243

Table 3 Variables description and data source Dependent variable

Definition

Source

Unemployment rate

The unemployment rate is the number of unemployed persons as a percentage of the active population (labour force)

IMF

Economic Growth

Annual percentages of constant price GDP are year-on-year changes

IMF

Labour Market Regulations Index

The LMR index is an Fraser Institute un-weighted average of these six measures and its value varies from 1 to 10

Inflation

Annual percentages of average consumer prices are year-on-year changes

IMF

Government bond yield

interest rates for long-term (10 years) government bonds denominated in national currencies

OECD *Data on Cyprus and Malta drawn on Eurostat

Unemployment benefits

Out-of-work income maintenance and support

OECD *Data on Cyprus and Malta drawn on Eurostat

ALMP/UNEMP

Expenditure on Active Labour Authors’ calculation on Market Policies per unemployed OECD data individual *Data on Cyprus and Malta drawn on Eurostat

Union density rate

It is the number of trade union OECD members who are employees as *Data on Cyprus and Malta a percentage of the total number drawn on ILO of employees

Change in money wage

It is the percentage change of Authors’ calculation on money wage at time t respect to OECD data time t − 1

Independent Variables

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OECD (2006) OECD Employment Outlook 2006—OECD. Pissarides C, McMaster I (1990) Regional Migration, Wages and Unemployment: Empirical Evidence and Implications for Policy. Oxford Economic Papers 42:812–31 Piton C, Rycx F (2019) Unemployment Impact of Product and Labour Market Regulation: Evidence from European Countries. IZA Journal of Labour Policy 9(2):1–32. Scarpetta S (1996) Assessing the Role of Labour Market Policies and Institutional Settings on Unemployment: A Cross-Country Study. OECD Economic Studies 26:43–98. Choudry M, Marelli E, Signorelli, M (2012b) Key Determinants of Youth Unemployment in OECD Countries. Toke, A, Zafiris T (2002) Unions and Collective Bargaining—Economic Effects in a Global Environment. The World Bank. Tridico P (2018) The Determinants of Income Inequality in OECD Countries. Cambridge J Econ 42:1009–1042. https://doi.org/10.1093/cje/bex069. Zemanek H (2010) Competitiveness Within the Euro Area: The Problem That Still Needs to Be Solved. Economic Affairs 30:42–47. https://doi.org/10.1111/j.1468-0270.2010.02020.x.

Giorgio Liotti is an Assistant Professor in Political Economy at the University of Naples “Federico II”—Department of Political Science. His research interests are: Fiscal and monetary policy, Labour market and inequality. His most recent publications are: Liotti G (2020) Labour market flexibility, economic crisis and youth unemployment in Italy, Structural Change and Economic Dynamics 54: 150–162; Liotti G, Canale RR (2020) Poverty and Labour Market Institutions in Europe, PANOECONOMICUS 67(3): 277–290, and Liotti G, Canale RR and Marani U. (2019) Structural public balance adjustment and poverty in Europe, Structural Change and Economics Dynamics, 50(2019): 227–236. Federica D’Isanto is an Assistant Professor in Political Economy at the University of Naples “Federico II”—Department of Political Science. Her research interests are in segregation and gender market discrimination. Her most recent publications are: D’Isanto F., Verde M. and Fouskas, Panagiotis (2016) Determinants of happiness among legal and illegal immigrants: Evidence from south Italy, SOCIAL INDICATORS RESEARCH, and Musella M. and D’Isanto, F. (2018). I Circoli viziosi della povertà, QUADERNI DI ECONOMIA SOCIALE.

Austerity, Human Rights Erosion and Political Radicalization: Implications for Eurozone Governance Reform Miguel Santos Neves

Abstract The chapter contributes to the analysis of the process of human rights and social cohesion erosion set in motion by austerity programmes in the Eurozone and to enquire about how this experience influences the current debate on the Eurozone governance reform in the context of COVID-19 crisis. The orthodox neoliberal adjustment policies imposed on several EU countries between 2010 and 2017 exacerbated economic recession, increased inequality and generated an extensive violation of human rights leading to far-reaching political radicalization. This experience has influenced the current debate on Eurozone reform functioning as a negative mirror of ineffective solutions and citizens’ distrust risks, which might contribute to the emergence of new and more adequate solutions. The main argument put forward if that a pragmatic governance reform of the Eurozone likely to be facilitated by a change in Germany’s position, is a necessary but not a sufficient condition to respond effectively to COVID-19 crisis insofar the EU has also to enhance the priority to human rights protection in order to regain citizens’ confidence and interrupt the trend of rising political influence of anti-EU radical parties which constitute one the most significant risks for the EU in the current crisis context. Keywords Human rights · Austerity policies · Eurozone governance · Political economy

1 Introduction The Eurozone sovereign debt crisis determined the imposition of neoliberal shocktherapy adjustment policies on peripheral countries, formally on Portugal, Greece, Ireland, Cyprus and informally on Spain and Italy, between 2010 and 2017 based on policy conditionality. Austerity policies exacerbated economic recession and had an overwhelming severe impact on human rights, social equity and cohesion.

M. S. Neves (B) Autonoma University Lisbon, Lisbon, Portugal e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_13

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This process had also dramatic political consequences across Europe paving the way to increasing distrust in the European Union (EU) and rising euroscepticism that fuelled the emergence of anti-EU extremist parties and governments originating an image of a turmoiled and weakened EU. This has in turn weakened the EU soft power as a global actor diminishing its influence and capacity to resist the USA and China’s attempts to divide the EU. The chapter aims at contributing, acknowledging the heterogeneity of adjustment countries, to a more in-depth analysis of the austerity process impact on erosion of human rights, social equity but also on EU politics and how far this influences the current debate on the Eurozone governance reform in the context of the EU response to COVID-19 crisis. The chapter is structured in three sections. Section 2 analyses and discusses the design and structural dimensions of adjustment programmes as well as its impact on growth and inequality. Section 3 addresses the impact of austerity on human rights, looking at the critical processes of violations and the political economy of adjustment to assess the web of conflicting interests behind it. Section 4 discusses the current process of Eurozone governance reform to ensure an effective response to the COVID-19 crisis, and to what extent the austerity experience during the previous crisis provides lessons to tackle the current crisis.

2 Adjustment Policies and Neoliberal Thinking The neoliberal paradigm in development thinking emerged in the 1950s under the leadership of Bauer in opposition to Keynesianism, modernization and structuralist paradigms that were then dominant (Hunt 1987). Neoliberal thinking is anchored on three major sources of influence: neoclassical economics focused on short-term efficient allocation of resources under an equilibrium theory; von Hayek’s new classical liberalism pointing out that political freedom and economic freedom are strongly intertwined; and monetarism associated with the Chicago school in the USA and the Institute of Economic Affairs in the UK, emphasizing the priority to control inflation and the belief that excessive government spending and the financing of state budget deficits is the main cause of inflationary pressures through its effect on interest rates. The neoliberal agenda includes three fundamental and interlinked dimensions. The first is the strong focus on short-term efficient allocation of resources as the fundamental factor for growth and prosperity. However, neoliberalism goes beyond the neoclassical short-term paradigm by extending it uncritically assuming it is also valid for the long run perceived as a mere sum of successive short-term periods. The second dimension relates to the “roll-back” of the State and its replacement by the efficient market discipline justifying far-reaching liberalization, deregulation of markets and radical privatization programmes. Thirdly, economics is regarded as a natural science anchored on econometrics and the mathematization of social reality, capable of carrying out “precise” predictions as if society was a “machine” submitted to social engineering.

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Neoliberalism had a considerable international influence chiefly through the international financial institutions originating the Washington Consensus, coined by Williamson to designate the convergence of views between the World Bank, the International Monetary Fund (IMF) and the US Treasury Department. The mechanisms of support to short-term balance of payments problems through the IMF stand by arrangement (SBA) were fundamental catalysts to press States to implement a neoliberal agenda. The SBAs are structured around two fundamental axes. The first relates to the choice, combination and balance between financing and adjustment which function according to a logic of both complementarity and substitution so that insufficient financing leads to over adjustment. The second axis concerns the strategy of adjustment and the choice between expenditure-reducing and expenditure-switching policies (Killick 1993). Expenditure-reducing involve monetary and fiscal policies aimed at reducing aggregate demand with a strong recessionary impact. Expenditure-switching policies include mainly exchange rate policy oriented towards currency devaluation and trade policies involving liberalization of foreign trade aimed at shifting the allocation of resources from non-tradables to the production of tradables.

2.1 EU Sovereign Debt Crisis and Adjustment Countries Following the impact of global financial crisis and the difficulties in getting access to financial markets, the IMF and the EU institutions, the EU Commission and the European Central Bank (ECB), worked out a Troika arrangement to provide emergency financing to Eurozone economies facing sovereign debt problems. This ad hoc response was primarily justified by the fact the EMU lacked any mechanism to bail out a Eurozone member which was not even possible in the face of art.125 of the Lisbon Treaty. The absence of an EMU mechanism and Germany’s interests led to a response strategy based on a mix of intergovernmental and national solutions as the Fiscal Compact and the rise of the Eurogroup informal intergovernmental coordination mechanism illustrate, weakening the community approach. In the Eurozone, four countries were subject to adjustment programmes: Greece (2010), with a 3 years SBA followed by a 4 years Extended Facility Arrangement; Ireland (2010); Portugal (2011); and Cyprus (2013) all with a 3 year Extended Facility Arrangement while Spain benefited from a different mechanism of technical assistance focused exclusively on the recapitalization of financial institutions. The programmes were different in terms of level of financial support—Portugal received a e78 billion loan (43% of GDP), Ireland e85 billion (41% of GDP), Cyprus e10 billion (55% of GDP) and Greece e302 billion in the 3 programmes (120% of GDP). Greece received three times the level of financial support provided to Portugal and Ireland, depicting a completely new approach never tried before because the objective was not so much to solve balance of payments crisis but above all to avoid a default in a country’s public debt (Colasanti 2016).

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A fundamental pillar was policy conditionality by which access to financing depends on the commitment to implement a set of policies combining fiscal consolidation, financial stability with growth and structural competitivenessenhancing reforms. Expenditure-reducing policies predominated with little room for expenditure-switching policies that were replaced by structural reforms requiring necessarily longer time to produce effects. This unbalance is justified by one of the fundamental inconsistencies concerning the fact that Portugal like Greece or Ireland could no longer use the exchange rate instrument as they belong to a monetary union. To address this problem, it was envisaged a strategy of internal devaluation as a substitute for currency devaluation, wrongly assuming the effects would be equivalent.

2.2 Impact on Growth and Growth Potential The austerity programmes in the 4 adjustment countries exacerbated the impact of international economic crisis leading to severe economic recession in the medium term and undermining long-term potential growth. The different adjustment countries, with the exception of Ireland, experienced a common recessionary trend with its peak in 2011–2013 though with varying intensities depicting three different levels: high (Greece), medium (Portugal and Cyprus) and low (Ireland). The most severe recessionary impact was experienced in Greece with a massive fall of −25.1% in GDP between 2010 and 2013, while Cyprus with − 11.9% (2012–2014) and Portugal with −6.7% (2011–2013) experienced a medium level recession, and finally Ireland did not experience recession but a brief stagnation followed by strong growth1 . All adjustment countries’ performance, with the exception of Ireland, was well below the Euro Area average until 2014, in contrast with the Eurozone core countries like Germany and France which had growth in line or above the Euro average, particularly Germany (Fig. 1). This depicts a considerable gap between adjustment and non-adjustment countries suggesting that austerity programmes were the main factor behind deep economic recession. This cycle of recession was explained by the decline in consumption but above all by a sharp decline in investment in 2011–2015 which has not only severely hurt medium-term growth but also undermined long-term growth potential. The rate of investment dropped in Portugal from 21% of GDP in 2010 to 14% in 2013 and in Greece the reduction was even higher from 18% in 2010 to 10% in 2015.2 The decline in investment rates compromises expansion of productive capacity combined with other three dynamics that developed as a result of austerity undermined long-term potential growth: loss of human talent associated with rising emigration outflows of young qualified professionals; declining incentives to invest in knowledge insofar rising income inequality hurts growth as OECD studies have 1 IMF

(2016, Table 1, p. 37). (2017, Fig. 3, p. 10; 2018, Fig. 4).

2 OECD

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30 25 20 15 10 5 0 -5

2010

2011

2012

2013

2014

2015

2016

-10 -15

Portugal

Cyprus

Greece

Euro Area Avg.

Germany

France

Ireland

Fig. 1 GDP Growth rate in Adjustment Countries and the Euro Area (2010–2016;%). Source Eurostat (https://ec.europa.eu/eurostat/tgm/table.do?tab=table&init=1&language=en&pcode=tec 00115&plugin=1)

argued—an increase of 1% in inequality could lower GDP by 0,6 to 1.1% (Causa et al., 2014); interruption of strategic expenditure in R&D and innovation resulting from indiscriminate cuts in public investment. Economic recession had a double effect on employment insofar it caused not only a sharp rise in unemployment in all countries, but also fundamental changes in the quality of employment. All adjustment countries registered a rapid increase in unemployment reaching the peak in 2013 with overall rates near 16% or above: Portugal 16.2%; Greece 27.3%; Ireland 14.7%; and Cyprus 16.1% in 2014.3 A fundamental feature of this trend was the disproportionate increase and historically high levels of youth unemployment that reached unprecedented levels in Portugal (42.5%), Greece (59.5%), Ireland (23.9%), Cyprus (40%) and Spain (57%) in 2013, representing between twice and three times the overall unemployment rate. Furthermore, the share of long-term youth unemployment increased significantly and more than doubled in comparison with 2010 accounting in 2013 for 30% of all youth unemployment in Greece, 22% in Spain and 14% in Portugal. Austerity programmes through the joint effect of labour market flexibility and “internal devaluation” also paved the way to a sharp decline in the quality of employment associated with the expansion of precarious employment characterized by temporary and insecure contracts, limited rights and low wages. This led to widespread “labour market segmentation” into two segments, permanent contracts and temporary contracts, and a large gap in protection between the two mentioned by the OECD as a serious problem. Temporary contracts increased during the crisis.

3 IMF

(2016, Table 1, p. 37).

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For instance, in Portugal 35% of the new jobs created in 2013–2015 were temporary and the overall incidence of temporary contracts was 21.5%.4 High youth unemployment and precariousness led in turn to a significant emigration of young qualified professionals from adjustment countries, particularly Portugal and Greece, to Eurozone core countries which were the main beneficiaries of this “talents transfer”, especially Germany. In Portugal, outflows reached a total of 485.128 people between 2011 and 2014 (Observatório da Emigraçao 2019), including a significant share of qualified human resources, mostly young people—emigrants below 29 years accounting for 55.3% of all permanent migrants—who left mostly to the UK, Switzerland, France and Germany. In Greece, emigration outflows between 2010 and 2015 were estimated at between 280,000 and 350,000 with a very high educational profile—2 out of 3 had a postgraduate degree, 28% a doctorate degree (Labrianidis and Pratsinakis 2014). The most important destination country was Germany that received around 98.000 Greek citizens between 2011 and 2014, followed by Sweden and the UK (Mavrodi and Moutselos 2017).

2.3 Austerity Impact on Inequality Traditionally the assessment of inequality is focused on income distribution. However, this is a limited perspective as there are many dimensions of inequality that have to be taken into account: wealth, human capital, access to health and education, social assets. The Eurozone peripheral countries under adjustment experienced an increase in income inequality between 2010 and 2014, with the exception of Ireland, when we compare secondary distribution of income (after taxes and social transfers) measured by the Gini coefficient, with the evolution of the Eurozone average and core countries like Germany and France (Fig. 2). Furthermore, Southern Europe peripheral Eurozone members suffered the sharpest decline in social justice in 2011–2014 not only in relation to the core Eurozone members but also to EU members that do not belong to the Eurozone like the Visegrad group (Czech Republic, Hungary, Poland, Slovakia), which have similar levels of development but maintain their monetary and exchange rate autonomy (Caetano and Caleiro 2020). Given the heterogeneity of adjustment countries, it is possible to depict different patterns. In the pre-adjustment period, while Cyprus and Ireland had a low level of inequality below the Eurozone average, Portugal and Greece registered some of the highest levels of inequality among Eurozone members. As a result of austerity policies Cyprus registered since 2012 the sharpest increase in inequality, changing from the country with the lowest Gini coefficient in 2010 to the one with the highest in 2014 but then declining rapidly to return to the pre-crisis level. In the cases of Portugal and Greece, there was a limited increase in inequality in the first stage followed by 4 OECD

(2016, ibidem, pp. 87–89).

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0.390 0.370

Portugal

0.350

Cyprus Greece

0.330

Ireland 0.310

Euro Area avg

0.290

Germany France

0.270 0.250 2010 2011 2012 2013 2014 2015 2016 2017 2018

Fig. 2 Household disposable income distribution Gini Coefficient 2010–2018. Source EUROSTAT (2020) EU-SILC Survey

stabilization until 2016. In contrast, austerity had no significant impact on Ireland’s level of inequality which remained stable and below the Eurozone average. Germany and France levels of inequality remained below Eurozone average and in general declined during the Eurozone crisis. The inequality in the primary distribution of income determined by the market, before taxes and social transfer, is considerably higher and gaps between adjustment countries more significant. This inequality reflects structural factors and is to a large extent determined by labour markets structure, regulation and wages differences. Moreover, inequality in primary distribution has increased sharply in the cases of Portugal and Greece from a Gini coefficient of 0.50 in 2011 to a very high level above 0.60 in 2014 well above the Eurozone average. This is partly explained by the impact of the internal devaluation strategy and the rapid development of precarious employment that exacerbated wages inequality. In contrast, Ireland experienced a significant decline in inequality to reach a level below the Eurozone average by 2015, while Cyprus registered a moderate increase having started from a much lower level and consistently remaining well below the Eurozone average (Fig. 3). A comparative analysis of the data suggests that there were factors of moderation that promoted some degree of redistribution in a context of rising inequality to offset the sharp increase in the primary distribution of market income. Some authors (Mushovel 2020) have argued that Greece and Portugal were interesting cases where contrary to previous experiences of structural adjustment inequality has not increased substantively but remained stable which suggests that redistribution through the welfare state has increased.

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0.700

0.650

0.600

Portugal Cyprus

0.550

Greece Ireland

0.500

Euro Area avg 0.450

0.400 2010 2011 2012 2013 2014 2015 2016 2017 2018

Fig. 3 Household disposable income before social transfers (pensions included in social transfers) Gini Coefficient 2010–2018. Source EUROSTAT (2020) EU-SILC Survey

This argument is not completely convincing not only because in terms of secondary distribution there was a moderate increase from high base levels, but also because it overlooks other dimensions of inequality which registered a substantive increase. That was the case of wealth distribution depicting a very high level of inequality for Portugal with a Gini coefficient of 0.67 and even higher for Cyprus 0.70 but lower for Greece 0.57 (EU Commission 2013). In sum, the austerity programmes did not produce the results they were supposed to deliver due to structural problems related to contradictory views within the Troika itself, shock-therapy approach rather than more gradualism, poor design and excessive complexity including far too many measures without neither a prioritization nor adequate sequencing, as recognized in the assessment carried out by the Independent Evaluation Office (IEO) of the IMF.5 Yet, the most critical factor that accounts for the depth of recession experienced by Portugal, Greece and Cyprus and the negative social and equity impact was the use of “internal devaluation” as a substitute for currency devaluation to enhance competitiveness, leading to drastic reductions in wages and social transfers thus exacerbating the effects of economic crisis and inducing social crisis.

5 See

IEO (2016, pp. 33).

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3 Human Rights and Austerity: Adjustment Without a Human Face The Troika programmes, just like traditional IMF programmes, did not consider the impact on people and human rights. Back in the 1980s and 1990s, IMF adjustment programmes implemented in developing countries were criticized for their high social and human costs and lack of success in restoring growth by institutions such as the ILO or UNICEF with Jolly’s seminal contribution to “adjustment with a human face” approach (Cornia et al., 1987) calling for alternative policies to protect the most vulnerable groups. This approach although concerned with human costs was not anchored on a comprehensive human rights approach insofar it did neither adopt a universality perspective, placing the focus on the most vulnerable groups, nor emphasized the obligations of States under adjustment. States have specific legal obligations with respect to human rights that cover six dimensions: (i) domestic implementation of international human rights treaties; (ii) respect, ensuring that state officials do not directly violate human rights; (iii) protect, avoiding violation by third parties namely non-state actors; (iv) fulfil, providing the budgetary and institutional conditions to ensure universal enjoyment; (v) prevention, by using early warning mechanisms, reducing risks and interrupting chains; (vi) reparation, of damages caused to victims and persecution of those responsible for violations. Austerity caused significant violations of human rights through different processes and with different consequences. Firstly, adjustment programmes led to civil and political rights direct violations by States such as the right of demonstration, freedom of expression or physical integrity, like the excessive use of force by police against Greek citizens, or the right of access to justice and to a fair trial as a result of the increase in legal costs that compromised economic accessibility in Greece and Portugal, precisely when citizens most needed access to remedies to challenge State acts. The right to participation in public affairs was also severely restrained as a result of top-down imposed policies without discussion of alternatives and citizen’s consent. Furthermore, States indirectly violated civil and political rights by failing to comply with their obligations to protect and prevent. The most serious and structural violation was the failure to contain the intensification of human trafficking (THB) carried out by organized crime, particularly in Greece, Cyprus and Portugal. The crisis context increased the risk of THB for labour exploitation in sectors such as agriculture, construction, fisheries or tourism, involving mostly seasonal migrant workers, as well as for sexual exploitation (Council of Europe 2017). However, due to cuts in public expenditure in the security area and support to victims, State response was insufficient to cope with the higher risks posed by organized crime’s intensification of activities and failed to meet State’s obligations regarding victims’ rights to rehabilitation, reparation, namely compensation, and social reintegration. Secondly, austerity generated an extensive violation of economic social and cultural rights, particularly the rights to work, social security, housing, health and

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education. Although these rights are subject to the principle of gradual implementation, there are two limits States must respect concerning the prohibition of retrogression and discrimination in implementation. Adjustment countries have violated both these limits as well as the obligations to respect, protect and fulfil. The implementation of austerity measures led to direct and indirect discrimination, hitting more some groups than others, in particular the most vulnerable groups, especially children, the elderly and disabled persons with less voice and capacity to react. Furthermore, States failed to protect citizens from violations of labour rights by enterprises due to the paralysis of labour inspection institutions, particularly the abuse of precarious contracts involving discrimination and violation of the “equal pay for equal work” principle. International human rights monitoring has been very critical of the impact of austerity programmes. At the United Nations level different human rights treaty bodies involved in the periodic review of adjustment countries, converged in the conclusion that austerity measures caused significant human rights violations. The Committee on Economic Social and Cultural Rights (CESCR 2014, 2015a, b, 2016) expressed the view that violations of enjoyment of social, economic and cultural rights were considerable in its periodic reviews of Portugal, Greece, Cyprus and Ireland, in particular in relation to the rights to work, housing, health, education and social security.6 Interesting enough the Committee proposed in the reviews of Greece, Cyprus and Ireland three relevant recommendations to prevent or deal with the consequences of human rights violations: (i) the creation of a human rights impact assessment; (ii) setting up a social protection floor below which it is prohibited to go, limiting decisions such as setting minimum wages or unemployment benefits below survival standards; (iii) restore rapidly pre-crisis social benefits and social services levels according to States’ obligations. Other two examples refer to persons with disabilities review of Portugal (CRPD 2016) concludes that austerity measures had a very strong negative impact on children with disabilities as a result of cuts in support services for the families of disabled children as well as cuts in transfers to support inclusive education7 ; and to the UN Special Rapporteur on the right to housing8 who concludes that austerity measures had a significant impact on the enjoyment of the right to housing generating higher rates of homelessness and unaffordable housing as well as increase in forced evictions which constitute gross violations of human rights law. This “adjustment without a human face” and the resulting widespread violation of human rights was exacerbated by three main factors. Firstly, the design flaws of programmes that lacked a “human rights clause” prevented safety mechanisms from being built-in the process. A human rights impact assessment carried out prior to the implementation of the programme ought to be integrated as part and parcel of the

6 CESCR

(2015a, p. 2, para. 7; 2015b, pp. 3–4, para. 11; 2016), p. 3, para. 11). (2016, p. 3, para. 19). 8 Human Rights Council (2017, paras 11–16, pp. 4–5). 7 CRPD

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process involving early warning indicators to be monitored to prevent and mitigate any possible negative impacts. Secondly, the failure of judicial review at both national and EU levels to control and stop illegal austerity measures, especially when they implied gross violations of human rights. The national judicial review was the only to be marginally activated but its effectiveness was limited. The Greek Council of State by and large considered the austerity measures legitimate and proportional and did not declare any measure unconstitutional although it warned that the burden should not be placed exclusively on public servants and retirees (Yannakourou 2015 and Psychogiopoulou 2015). Although the Portuguese Constitutional Court is considered to have been more active in blocking some austerity measures (Cisotta and Daniel Gallo 2014), in reality it has approved very harsh austerity measures included in the Budget Laws arguing they were transitory, thus not observing human rights law cumulative criteria for derogation of rights foreseen in article 4 (1) of the International Covenant on Civil and Political Rights and article 15 of the European Convention on Human Rights, namely emergency, necessity, proportionality, adequacy, non-discrimination and non-restriction of the right’s core nucleus, which are binding for the Portuguese State. Consequently, both Courts gave the green light to austerity measures even though they clearly violated the International Covenant of Economic, Social and Cultural Rights.9 At the European level, the Court of Justice of the EU (CJEU) and the European Court of Human Rights (ECHR) were inactive and very hesitant in scrutinizing austerity measures from a human rights perspective (Ghailani 2016; Koukiadaki 2014). In several cases related to Portugal and Greece austerity programmes’ impact10 the ECHR considered the cases inadmissible or surprisingly the measures justified due to exceptional circumstances. Similarly, the CJEU has been unwilling to analyse austerity measures related to the implementation of the Troika MoU in relation to the EU Charter of Fundamental Rights (Koukiadaki 2014). This seems to be explained by two sets of reasons. Firstly, the Troika is an ad hoc group without legal personality that uses a non-binding soft law instrument, thus the Court would be able to control only the acts of EU institutions but not the validity of the Troika acts. Secondly, although for the CJEU the binding acts of EU institutions can be challenged on the basis of article 263 of the TFEU, the access of “non-privileged applicants” (individuals and organizations), unlike for “privilege applicants”, is very restricted. Thirdly, the political symbolic factor, the shock therapy cum dramatization strategy and national Governments and EU institutions’ apocalyptic discourse led to citizens disorientation and traumatization inducing primitive anxieties and phantasies (Neves and Ferraz 2020). In addition, the manipulation strategy of blaming 9 For a contrasting case, see the Latvian Constitutional Court which declared that a law introducing

cuts in pensions should be considered invalid as it violated the right to social security foreseen in the ICESR—see Latvian Constitutional Court, 21 December 2009, case no.2009-43-01. 10 For example in relation to Portugal the case ECHR, 8 October 2013, da Conceição Mateus v. Portugal and Santos and Januario v. Portugal. Regarding Greece the case ECHR, 7 May 2013, Koufaki v. Greece and ADEDY v. Greece.

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citizens for the crisis generated a logic of punitive austerity and “purification” creating favourable conditions for a passive acceptance of unacceptable harsh austerity measures, weakening resistance to human rights violations. This path of austerity had a negative long-term human rights legacy related to precarious employment, increasing segmentation, structural rise in THB, degradation of education and health services and higher tolerance to lowering human rights standards. This is a dramatic legacy which was set in motion and wanted by a web of interests and actors with an agenda to use austerity as a pretext to change fundamental rules without democratic approval.

3.1 The Political Economy of Adjustment The adjustment strategy was not a mere technocratic decision, there is a political economy of austerity which explains how different actors and conflicting interests played out. Three structural dynamics were at work. Firstly, Germany´s consolidation as the EU dominant power after the financial crisis and the fundamental shift in the balance of power within the EU leading to the Germanization of the EU process anchored on Germany’s national interests. Germany gained leverage and room for manoeuvre by forging a strategic alliance with China, a true symbiosis based on a technology-for-markets swap: Germany needs the China market to grow and China needs the German technology to change into an innovation driven and green economy and prepare for the fourth industrial revolution (Kundnani and Parello-Plesner 2012). Exports to China became critical for Germany’s economic growth, the more so as the EU markets stagnated during crisis, allowing Berlin to remain stronger and gain leverage to press weakened EU Member States to accept changes in structural governance rules, like the Fiscal Compact, that in turn brought about the consolidation of Germany’s own power. Germany pushed for harsh policies as a way to display strong leadership, ensure credibility of the euro and appease markets but also to divert attention from its own weaknesses, namely the structural problems with its own banking sector. Furthermore, Germany opened the door to large-scale Chinese investment in strategic sectors in the EU, particularly in adjustment countries, as a way to nurture the alliance and simultaneously to reduce its own exposure. There was a power politics-led logic which saw citizens and human rights as a marginal aspect. Secondly, the deepening process of economic power concentration and unprecedented dominance of large economic and financial transnational conglomerates that abuse their market power and undermine States’ power. The EU institutions have facilitated this process in various sectors, namely in banking where the ECB continues to support banking concentration in spite of all the risks associated with corporate governance failure and the “too big to fail” syndrome. The conglomerates’ profit maximization strategy is based on a triple engine (i) large-scale tax evasion on profits; (ii) monopoly/oligopoly rents hurting consumers; (iii) dismantling the welfare state

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and restricting labour rights/taking advantage of human trafficking to reduce costs, all contributing to undermine human rights. Thirdly, the financialization of the economy and society led to the predominance of financial interests that often are on a collision course with real economy interests. The financial system developed its own logic and imposed on societies the perverse practice of privatization of profits and socialization of losses. To some extent adjustment programmes were fundamentally oriented to use borrowed public money to bail out the collapsing banking sector, like in Greece or Ireland, though failing to impose in exchange new and sound rules in terms of better corporate governance, commitment to finance the real economy and effective control of money laundering. The austerity outcomes had far-reaching political consequences. The depth of human rights violations, the sense that major decisions are taken without transparency and citizens’ feeling they are being left behind and not protected by the EU, led to the largest fall ever in the level of trust in the EU (31%) during austerity and a rise in euroscepticism reaching 50% in 2014 according to the Eurobarometer, meaning that both debtors and creditors countries lost faith in the EU. The level of trust has fallen even more dramatically in adjustment countries reaching in 2014 unprecedented high levels in Greece (−76%), Cyprus (−68%), Portugal (−51%) and Spain (−61%) traditionally EU supportive countries (Durach 2015). This dynamics, combined with the 2015 migration crisis, set the stage for the dramatic change in Europe’s political landscape with the rise of anti-EU, anti-immigration extreme right populist political parties in several countries, scoring high in national elections—above 15% in 9 countries and above 10% in other 4 including the AfD in Germany—acceding to power in 6 Member States (Italy, Austria, Hungary, Poland, Bulgaria, Slovakia) (BBC 2019) which constitutes a serious threat to EU integration, democracy and universal human rights of both migrants and EU citizens.

4 Towards a Better Eurozone Governance The Eurozone crisis and the EU response to it as well as the economic, social and political consequences exposed the design flaws, incompleteness and vulnerabilities of the Eurozone itself: the original problem of an Eurozone at two speeds; the incompleteness and unbalances in EMU where robust monetary union contrasted with a fragile economic union and the absence of a banking union; the drawbacks of asymmetric policy coordination where robust centralized monetary policy is at odds with a low profile exchange rate policy of the euro and decentralized fiscal policy poorly coordinated; democratic deficit and lack of transparency that persists in the Eurozone governance; the ambiguity of dualism associated with the coexistence of community and intergovernmental logics. In spite of the fact that the Eurozone introduced some reforms since 2012 to adapt to new circumstances, namely the creation of a banking union or strengthening economic coordination through reform of the European Semester process, there remain fundamental issues and opposing views on reform driven more by the

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“battle of interests” than the “battle of ideas” with France and Germany as the main players (Pisany-Ferry 2018). Taking into account the sovereign debt crisis experience, the Eurozone reform now under discussion should not be limited to improve the Eurozone architecture as if it was a separate container but should go beyond that to consider linkages with other EU pillars as well as the coherence and synergies of internal and external dimensions related to the EU’s role as a global actor. In this light reform should articulate three main axes. The first axis is focused on vertical coordination and overcoming the design flaws of the Eurozone and completing its architecture involving three components. The first component concerns the creation of a permanent stabilization mechanism to deal with crises and cushion large external shocks. The creation of a Eurozone central budget is critical insofar it might not only finance EU public goods but also operate as a stabilizer through both automatic stabilizers and discretionary fiscal measures that reduce the burden on national budgets and ensure effective counter-cyclical measures in severe recessions. There are different views in the Eurozone about the primary functions, stabilization vs. competitiveness-enhancing debate harmonized in the German-French 2018 proposal (Busch and Matthes 2019). The fact that macroeconomic stabilization is highly dependent on the coordination of national fiscal policies constitutes a serious vulnerability of the Eurozone (Caudal et al. 2013). To attain this objective, two conditions have to be met: the size of the budget must be significant and attain critical mass, some point to at least 6% of Eurozone GDP; central budget cannot be dependent on transfers from national budgets as is currently the case, but has to have autonomous revenue sources, a EU tax, i.e. on carbon tax or Internet transactions. The second component regards the debt mutualization mechanism crucial to support more fragile members to meet their debt responsibilities during hard times and to counteract market speculation and contagion within the Eurozone. Mutualization can take different forms either involving the mutualization of borrowing costs or mutualization of debt repayment. During the Eurozonet crisis the dominant logic was an ad hoc mutualization of borrowing costs linked to a very strict and intrusive policy conditionality leading to negative economic and social impacts as well as problems of political legitimacy on both debtors and creditors sides. This raises the need to move away from policy conditionality towards at least conditionality of purpose or even no conditionality (Eisl and Tomay 2020). The third component concerns greater coherence in policy-making in order to limit the dominance of neoliberal thinking and excessive reliance on monetary policy. To attain that, a central aspect is to consider the change in the ECB mandate lacking the necessary flexibility to respond to greater uncertainty and rising systemic risk. Price stability should not be the single primary objective, aggravated by the submission to a very restrictive 2% target. Consequently, the way forward is not a mere increase in the inflation target to say 4% or the creation of a fluctuation band, the ECB mandate ought to be enlarged to include employment, growth and competitiveness alongside price stability as priority objectives. Another critical aspect is that a more effective EMU needs to include a social pillar in articulation with the budgetary, economic and banking dimensions and to add real

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social convergence indicators to the European Semester so that the current EMU structure ceases to be a threat to social systems of more fragile countries (Caetano and Caleira 2020). This implies a human rights approach to build a preventive system within the corrective arm of the SGP in order to ensure social equity and human rights protection. This can greatly benefit from the adoption of an ex ante human rights impact assessment in the phase of policy design. The second axis involves the Eurozone’s political sustainability and the problem of democratic deficit which was further aggravated during austerity. The management of the Eurozone crisis has undermined national democracies and restrained the areas of national competences as budgetary decisions on public expenditure affected all policy areas. Moreover, the logic of internal devaluation to improve competitiveness of peripheral members has important political implications as it involves cuts in wages and social protection which violate human rights undermining political stability and support for the EU. In order to strengthen democratic legitimacy, it is crucial to enhance the role of national parliaments in the discussion of EMU reforms, to open new channels for citizens’ participation in the assessment of policy implementation and to improve the judicial review of EMU implementation acts at the EU level to control human rights violations. The third axis concerns horizontal coordination, the ways in which the Eurozone can enhance linkages and coordination with other EU policy areas in order to meet three key new challenges facing the EU: strengthening its role as a global actor; the transition to knowledge economy and the fourth industrial revolution; and the articulation with non-state actors, particularly large economic conglomerates and transnational organized crime. The Eurozone is not exclusively an internal EU process, it has strong links with foreign policy and conditions the EU’s role as a global actor insofar it is a basic pillar of its soft power and part of its international image. Adjustment outcomes contributed to damage the EU’s external image and credibility by pressing for an austerity path that caused human rights violations. In short, the EMU must be articulated with the CFSP and the EU’s strategy as a global player in order to ensure having a single voice in multilateral fora namely in international financial institutions such as the IMF and World Bank where the EU fails to act together. A more robust and visible exchange rate policy of the Euro and its ties with monetary policy, the participation in international mechanisms to fight money laundering and implications for bank regulation are relevant examples of the continuum and blurred frontiers between internal and external levels. The second challenge concerns the transition to the knowledge economy and the fourth industrial revolution anchored on artificial intelligence, robotics, big data and the Internet of things, requires greater flexibility in SGP rules so that strategic public investment is not compromised by fiscal discipline. In other words, EMU has to be positively articulated with Europe 2020 ending the experience of collision course, also because some of the structural reforms that enable peripheral members to become more competitive depend precisely on these strategic investments.

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The third challenge highlights that the Eurozone is not only about States and public institutions but also about non-state actors and the way States manage relations with big economic conglomerates and transnational organized crime whose decisions have enormous impact on Eurozone functioning. The autonomous and antisocial agendas of these non-state actors can be translated into high levels of profits tax evasion undermining fiscal discipline efforts, money laundering and shadow banking that undermine banking regulation or restrictions to market competition generating monopoly rents and inflationary pressures driven by profit maximization. The relevance of coordinated security policies to fight organized crime, a strong competition policy to fight monopolies and abuse of market power imply strengthening States’ institutional capacity. This requires a paradigm shift away from neoliberal thinking in the sense that instead of pushing for “minimal States” the EU has to invest in building “capable States”, a developmental state that effectively implements competitiveness-enhancing reforms in peripheral Eurozone members. The debate on, and progress in the Eurozone reform has been fostered by the need to respond effectively to the COVID-19 crisis so it is interesting to see whether the steps taken meet the reform axis mentioned above. To some extent the lessons learned from the 2010–2015 austerity experience have been considered and there are some signs of change regarding the recovery strategy. The Commission “Next Generation EU” proposal, particularly its first pillar and the emphasis on public investment revitalization, and the e750 billion NGEU recovery package together with the Multiannual Financial Framework approved by the Council on 21 July, aim not only at ensuring adequate financing for recovery with a total e2,36 trillion until 2027, thus reducing adjustment pressure, but also placing greater emphasis on grants and less on loans in order not to aggravate pressure on national budgets and debt burden. Moreover, the debt mutualization in the form of debt repayments has been admitted with the process of Commission’s borrowing reflecting a new solidarity. Although not considered at this stage, key issues such as the revision of the Fiscal Compact and ultimately of EU treaties will have to be taken up to ensure consistency with the new strategy. There are also signs of moving away from rigid and punitive policy conditionality in the direction of a new soft policy control approach more based on incentives (Eisl and Tomay 2020). Finally, it seems that the response to the current crisis is more anchored on a community approach and less on intergovernmental and national solutions as before. This evolution can be explained by the joint effect of three different factors. Firstly, the overwhelming scale and nature of the current crisis, which does not raise moral hazard issues so that Eurozone countries are all in the same boat. Secondly, the political radicalization of Europe brought about by past punitive austerity that fuelled unprecedented levels of distrust in the EU and the rise of radical populist, anti-European parties that threaten the EU project and democracy. To counteract this trend and rebuild its legitimacy it is crucial the EU acts together and proves it is relevant and can effectively protect societies and citizens. Thirdly, probably the most decisive factor, the change in Germany’s position which after ending the alliance with China is now more committed to strengthen the EU process aware that its own future

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prosperity will depend more on Eurozone’s prosperity in a context of post-pandemia de-globalization. Yet, there are no signs of progress in the second and third axis aimed at a more holistic approach and strengthening the coherence between EMU and other pillars, in particular how the Eurozone should evolve to contribute to greater effectiveness and external influence of the EU as a global actor. The COVID-19 crisis has vividly showed the vital role of States in economic recovery and social protection, the primacy of human rights, not only life and health but all interdependent rights, the critical importance of investment and restoring growth to prepare the future not price stability, and the need to have a flexible long-term crisis preparedness as crises are likely to be the new normal. This runs counter to the core of neoliberal thinking which has been so influential in the management of the Eurozone blocking the process of more ambitious governance reform. While the sovereign debt crisis was a moment of affirmation of neoliberalism, the present crisis might well mean the end of neoliberalism dominance in the EU, as a rigid and outdated approach lacking the flexibility to deal with an increasingly uncertain and riskier global system, opening the door to a less ideological, more pragmatic and plural reflection on the Eurozone governance. Although neoliberal austerity was an unsuccessful experience, it might have a relevant influence as a negative mirror in terms of the way in which the EU is responding to the current crisis, working as a reminder of past policy mistakes, citizens rights tolerance and political risks, so that the present crisis will not be the end of the EU project but an opportunity to revitalize it and prove to citizens it remains relevant.

5 Conclusions The EU sovereign debt crisis exposed the design flaws and inconsistencies of the Eurozone and in the absence of a EU solution the response was mostly based on intergovernmentalism and national solutions putting a heavy burden on Southern peripheral Eurozone members. Neoliberal adjustment programmes applied to Portugal, Greece, Ireland and Cyprus between 2010 and 2017 based on an intrusive and punitive policy conditionality focused on attaining short-term fiscal discipline and stabilize the financial system, lacked any real consideration for long-term growth, social cohesion, political legitimacy and human rights. Consequently, austerity policies, particularly internal devaluation as a substitute for currency devaluation, exacerbated the depth of recession, undermined future potential growth, increased inequalities and generated heavy social costs. Moreover, austerity caused direct and indirect violations of first- and secondgeneration human rights, particularly the rights to work, health, education, social security and housing, depicting a widespread violation of the States’ obligations to respect, to protect, to fulfil and to prevent. The depth of violation was exacerbated by the inexistence of a human rights impact assessment, the lack of an effective judicial review of austerity measures both at national and EU levels, and the symbolic punitive

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austerity mindset which led citizens to accept the unacceptable. This process affected the EU’s own values and identity as institutions enforced Eurozone rules at the expense of human rights. This undermined both internal support for the EU, paving the way to stronger influence of anti-EU populist and nationalist parties which proves that “passive” citizens still have a capacity to fire back through national democracies and vote for parties that might derail the EU project, and its soft power as a global actor. The path of adjustment was not only the expression of neoliberal thinking but also a result of the political economy of austerity that combined a set of complex interests: Germany’s desire for EU dominance; big conglomerates unprecedented power fuelling unlimited profit maximization strategies; and the parasite logic of the financial sector. This complex web of interests induced a dangerous long-term legacy in terms of human rights associated with greater tolerance to arbitrary restrictions of rights, a culture of precarious employment, structural intensification of human trafficking and degradation of public services. Although this “adjustment without a human face” proved to be ineffective, inequitable and politically unsustainable, it plays a relevant role in the present debate about the Eurozone governance reform as a negative mirror insofar it was an “experimental laboratory” whose results call into question neoliberalism, shedding light on the wrong policies not to be repeated and the long-term complex political and human rights implications which were ignored. In the context of the governance debate that gained momentum with the pressing need to respond to the COVID-19 crisis there are positive signs of change suggesting some lessons were learned from both crises although other fundamental reform issues are still missing. Progress is fundamentally explained by change in Germany’s position which is now convinced that its own prosperity in a scenario of a post-pandemia de-globalization will depend more on Eurozone’s prosperity in the future. The main argument put forward if that a pragmatic governance reform of the Eurozone, both of its architecture and articulation with other pillars, is a necessary but not a sufficient condition to respond effectively to the present crisis insofar the EU has also to enhance the priority to human rights, insofar by effectively protecting them EU and Member States are not only complying with their obligations but also regaining citizens’ confidence and ensuring political sustainability, thus interrupting the trend of rising political influence of anti-EU populist parties which constitute one the most significant risks for the EU in the current recession. This enhanced priority to human rights should aim at reversing the negative longterm legacy from past austerity and at controlling new risks, namely big conglomerates’ attempt to take advantage of present crisis to further crush citizens’ rights, starting with labour rights, or intensify market power concentration further suffocating fragile SMEs. For this it is not sufficient to channel financial resources, it is crucial to enhance national institutional capacity to regulate and implement the recovery package, ensuring timely actual disbursements so that funds can reach rapidly citizens, NGOs and enterprises. This requires “capable States” responsive to citizens’ needs, pragmatic simplification of both EU and national heavy bureaucratic

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procedures and effective control of the risks of corruption and discrimination, all likely to foster the human rights agenda.

References BBC (2019), Europe and right-wing nationalism: A country by country guide, BBC 13 November 2019. Busch, B. and Matthes, J. (2019), A Eurozone Budget—For which purposes exactly? in Forum, Summer vol 17, 11/2019. DICE Report II/2019, Summer vol. 17, pp. 23–27. Caetano, José and Caleiro, António Bento (2020), Have the recent dynamics of economic globalization biased social justice in the European Union? in Yilmaz Bayar (ed.) Handbook of Research on Social and Economic Development in the European Union, IGI Global. Caudal, Nicolas et al. (2013), A budget for the Euro Area, Trésor Economics nº 120, October 2013. Causa, Orsetta, de Serres, Alain and Ruiz, Nicolas (2014), Can growth-enhancing policies lift all boats? An analysis based on household disposable incomes, OECD Economics Department Working Papers, OECD Publishing, Paris. CESCR Committee on Economic Social and Cultural Rights (2014), Concluding Observations on the fourth periodic report on Portugal (E/C.12/PRT/CO/4). CESCR Committee on Economic Social and Cultural Rights (2015a), Concluding Observations on the second periodic report on Greece (E/C.12/GRC/CO/2). CESCR Committee on Economic Social and Cultural Rights (2015b), Concluding Observations on the third periodic report on Ireland (E/C.12/IRL/CO/3). CESCR Committee on Economic Social and Cultural Rights (2016), Concluding Observations on the sixth periodic report on Cyprus (E/C.12/CYP/CO/6). Cisotta, R. and Daniel Gallo, D. (2014), The Portuguese Constitutional Court Case Law on Austerity Measures: A Reappraisal, LUISS Academy, Working Paper, 4/2014. Colasanti, Fabio (2016), Financial assistance to Greece: Three Programmes, European Policy Centre, Discussion Paper, February 2016. Cornia, G. Andrea, Stewart, Frances and Jolly, Richard (eds.) (1987), Adjustment with a Human Face, vol 1 Protecting the vulnerable and promoting growth, Clarendon Press. Council of Europe (2017), GRETA Report concerning the implementation of the Council of Europe Convention on Action against Trafficking in Human Beings by Portugal—Second evaluation round. CRPD Committee on the Rights of Persons with Disabilities (2016), Concluding Observations on the initial Report on Portugal CRPD/C/PRT/CO/1, 20 May 2016. Durach, Flavia (2015), The transformation of Euroscepticism: A cross country analysis of Eurobarameter results 2007–2014 in Bargaoanu,Alina et al. (eds.) United by or against Euroscepticism? An assessment of public attitude towards Europe in the context of crisis, Cambridge Scholars Publishing, pp. 16–40. Eisl, A. and Tomay, Mattia (2020), European Debt Mutualisation: Finding a legitimate balance between solidarity and responsability mechanisms, Policy Paper nº 255, July 2020, Notre Europe, Jacques Delors Institute. EU Commission (2013), The distribution of wealth between households, Research note 11/2013, December 2013. Eurostat (2020), Gini Coefficient, EU-SILC survey, 30 July 2020. Ghailani, Dalila (2016), Violations of fundamental rights: Collateral damage of the Eurozone crisis? (1) OSE Research Paper No.32—December 20, European Social Observatory. Human Rights Council (2017), Report of the Special Rapporteur on adequate housing as a componente of the right to an adequate standard of living and on the right to non-discrimination in this context, 28 February 2017.

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Hunt, Diana (1987), Economic Theories of Development: An analysis of comparative paradigms, Prentice Hall / Harvester Wheatsheaf. IEO (2016), The IMF and the crises in Greece, Ireland and Portugal: An evaluation by the Independent Evaluation Office, July 2016. IMF (2016), Completes Ninth Review of Cyprus’ EFF, January 11 2016. Killick, Tony (1993) The Adaptive Economy—Adjustment Policies in Small, Low-income countries, EDI Development Studies, The World Bank, Washington. Koukiadaki, Aristea (2014), Can the austerity measures be challenged in supranational Courts—The cases of Greece and Portugal, ETUC University of Manchester. Kundnani, Hans and Parello-Plesner, J. (2012), Germany and China: Why the emerging special relationship matters for Europe, ECFR Policy Brief 55, May 2012. Labrianidis, Lois and Pratsinakis, Manolis, (2014) Outward migration from Greece during the crisis, Research Report, London School of Economic’s Hellenic Observatory. Mavrodi, G., Moutselos, M. (2017), Immobility in Times of Crisis? The case of Greece in Laffleur and Stanek (eds.) South-North Migration of EU citizens in Times of Crisis, IMISCOE pp. 33–48, Research Series, Springer. Mushovel, Fabian (2020), Fiscal consolidation and inequality in the distributive effect of fiscal reforms in Greece and Portugal in Campos, Nauro, Paul de Grauwe and Yumei, Ji Structural reforms and economic Growth in Europe, Cambridge University Press. Neves, T.S. and Ferraz, C. (2020), When shock is not shocking: Psychodynamics underlying the acceptance of austerity in Psychoanalysis, culture and society (in publication). Observatório da Emigraçao (2019), Emigraçao Portuguesa Relatório Estatistico 2019, Lisboa. OECD (2016a), Labour Market reforms in Portugal 2011–2015: A preliminary assessment. OECD (2017), Economic Survey Portugal, February 2017. OECD (2018), Economic Surveys Greece, April 2018. Pisany-Ferry, Jean (2018), Euro-area reform: An anatomy of the debate, Policy Insight nº 95, October 2018, Centre for Economic Policy Research.

Miguel Santos Neves Ph.D. from the London School of Economics and Political Science (LSE), MPhil in Development Studies and Economics from the Institute of Development Studies (IDS), University of Sussex. Associate Professor of International Law and International Relations at Universidade Autónoma de Lisboa, responsible for Ph.D. programmes on International Human Rights Law, Globalisation, Geoeconomics, Foreign Policy Analysis. President of the Network of Strategic and International Studies (NSIS), a private policy-oriented research think tank. Between 1995 and 2013, he was the Head of the Asia Programme and Co-ordinator of the Migrations Programme at the Institute of International and Strategic Studies in Portugal (IEEI).

The Politics of Covid-19: The Discourse on the Nature of the Economic Crisis and the Legitimization of EU’s Response António Leitão

Abstract Although Euro Area member states agree on the need to protect the Economic and Monetary Union against the threat posed by the Covid-19, they differ on how to do it. These differences are the result of competing strategies of representation and legitimization that aim to establish specific ways of looking at and responding to the crisis. Using a critical discourse analysis approach, we look at how the “South” and the “frugal four” developed competing strategies of representation and legitimization to steer and limit the way the issue is perceived and addressed. We focus on how the recontextualization of European integration history and values and the eurozone crisis link to the discursive practices employed to transform the possibilities for future action. We conclude by outlining how the Franco-German/Commission’s proposal served as middle ground to the agreement reached at the European Council of July 2020. By looking at how the battle lines are discursively drawn, we take a glimpse at the possibilities of future economic integration amidst the Covid-19 crisis. These cannot predict how the crisis affects the outcome of European integration, but they are helpful for understanding how actors and discourses shape the meaning of E(M)U. Keywords EU response · Covid-19 · Critical discourse analysis · Eurozone · EMU

1 Introduction The outbreak of the Covid-19 pandemic has posed significant health, economic, and political challenges to actors worldwide. Government measures to tackle the spread of the pandemic provoked the abrupt halt of the world economy. While the impact of the crisis in output remains uncertain (IMF 2020; World Bank 2020), the World Bank (2020) considers it to be “[…] the deepest global recession in eight decades, despite unprecedented policy support (p. xv).” Overall, expert opinion converges on key aspects. Despite the uncertainty surrounding the evolution of the crisis, its A. Leitão (B) International Politics and Conflict Resolution, Centre for Social Studies, Faculty of Economics, University of Coimbra, Coimbra, Portugal e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_14

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subsequent recovery path, and long-term effects, there is widespread agreement that it will have a greater impact on developing countries and those already worse-off in the economy (IMF 2020; World Bank 2020). At the European level, the outbreak of the Covid-19 exposed the inability of European authorities and the salience of national interest. While it is true that governments remain almost exclusively in charge of key policy domains, e.g., public health care or border control, the lack of coordination and solidarity merited criticism (Costa-Font 2020; Pena 2020), which was partially recognized by Ursula von der Leyen’s “heartfelt apology” to Italy (von der Leyen 2020). The European Commission has since then assumed a more proactive role, seeking to strengthen coordination among member states and taking initiatives toward the safe reopening of European Union’s (EU) internal borders and the resumption of economic activity (see European Commission 2020). The economic downturn provoked by this crisis presents yet again a challenge to Economic and Monetary Union (EMU). The European Commission (2020) expects a GDP contraction of 7.4 and 7.7% for the EU and Euro Area (EA), respectively, and although the economy is expected to rebound by 2021, this means that output levels will remain 2% lower than pre-pandemic levels, and even this too remains uncertain (ECFIN 2020). According to the Commission, the EU is facing a symmetric shock that will have an asymmetric impact across member states. This is explained by variations on the evolution of the health crisis and differences in economic profiles, policy responses, and capabilities of member states (ECFIN 2020). One of the differentiated impacts of the economic crisis on EA member states will concern their public finances. The policies implemented to address the economic and health crises, the role of automatic stabilizers, and the crises’ own adverse effects will have a heavy toll on the public finances of EA member states. The aggregate government deficit for the EA will surge from 0.6% in 2019 to 8.5% in 2020, and it is expected to drop to 3.5% by 2021 (ECFIN 2020). The debt-to-GDP ratio in the EA will increase from 86 to 103% in 2020, receding to 100% by 2021. This ratio is expected to be over 100% in seven countries and over 60% in another seven1 (ECFIN 2020). These pressures raised fears concerning debt sustainability as early as late February when sovereign spreads widened. The ECB’s announcement concerning the Pandemic Emergency Purchase Programme constituted a temporary reversal of this trend, but by late April, spreads in most EA member states were still higher than in pre-pandemic levels (ECFIN 2020). The crisis ensuing the Covid-19 pandemic brought back concerns over the sustainability of the EA, which derives from the lack of common budgetary and fiscal policies within the monetary union (Nicoli and Zuleeg 2014). The Covid-19 crisis has exposed yet again the incomplete nature of the EMU as fears of disintegration and political battle lines are redrawn. This chapter contributes to the literature on European integration by trying to understand how the different representations of the economic crisis provoked by the Covid-19 shape the European responses to it. To understand how the outcomes 1 Debt-to-GDP

ratios over 100%: Belgium, Greece, Spain, France, Italy, Cyprus, and Portugal. Debt-to-GDP ratios over 60%: Germany, Ireland, Croatia, Austria, Slovenia, Finland, and Hungary (see ECFIN 2020).

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of European integration are achieved, we look at how the different actors involved in this process articulate discourse to advance their positions while at the same time highlighting the boundaries imposed by discourse upon them. We deploy a critical discourse analysis (CDA) approach to the practices of representation and legitimization pursued by the actors involved. We argue that there are two main opposing groups: the “South” and the “frugal.” The South represents the crisis as an unprecedented and symmetric shock. It stresses the insufficiency of the current EMU architecture and the need for common action. This strategy seeks to neutralize arguments of moral hazard by stressing the limits of EMU in face of shocks that are independent from member states’ fiscal and economic policies. By demonstrating the inherent limits of shared monetary policy with limited fiscal and economic correspondence, even when fiscal discipline is pursued, defendants of further integration aim to advance risk-sharing across the EA and rebalance existing burden-sharing mechanisms. These countries seek to safeguard the sustainability of their own public debts and to avoid the possibility of austerity measures further down the road. The frugal four favor solutions under the existing framework. They fear free-riding behavior and argue lack of domestic support for further fiscal or budgetary integration by stressing that there is already an unbalanced distribution of EU budgetary positions. We conclude by looking at the Franco-German and the Commission’s proposals. Both recognize the need for a strong common European response, while at the same time stressing that this effort must be carried out within the existing budgetary rules, e.g., European semester, and with adequate conditionality. We conclude by showing how the solution adopted at July’s 2020 European Council is an outcome of it. Section 2 presents the principles, concepts, and assumptions underlying CDA, namely its understanding of discourse as social practice, the relationship between discourse and power, and the operationalization of the concepts of representation and legitimization strategies and recontextualization. In Sect. 3, we compare and analyze the different strategies put forward by the South and the frugal. We claim that the way both groups represent the crises seeks to limit the existing fields of action, and while they do present similar legitimization strategies, these are deployed differently according to their representations and use of recontextualization, namely concerning the eurozone crisis. Finally, we finish with the analysis of the FrancoGerman/Commission proposal. Although these two seem to reconcile both fields, the perseverance of historical representations suggests that the eurozone crisis might have left a heavy toll on EU’s future: a north–south divide.

2 A CDA Approach to EU’s Answer to the Covid-19 Crisis Critical discourse analysis is an approach to the study of how structures of power, ideology, or dominance are enacted, (re)produced, or challenged through discourse and the use of language (Wodak 2001b; van Dijk 2015, 1993). CDA addresses pressing social issues, such as inequality or injustice, by studying the relationship between dominance and discourse (van Dijk 1993; Flowerdew and Richardson 2017).

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It demonstrates how language is used to establish claims to authority (Flowerdew and Richardson 2017) and aims at helping social groups in their struggles for change (Fairclough 1989). CDA is a problem-driven (instead of theory-driven) approach: it is developed with a critical aim (Meyer 2001; van Dijk 2015, 1993) that should not be understood as either theory or method, but as a perspective (van Dijk 2015). It is an interdisciplinary effort that relates linguistic analysis to social theories to shed light into the role of language in the reproduction of power, focusing on specific social practices, structures, or processes (for an introduction, see Meyer 2001). This distinctive approach to the study of language and discourse rests on key assumptions that inform it and that provide valuable insights into the ongoing contention over the EU’s answer to the Covid-19.

2.1 CDA: Discourse as Practice CDA sees language use as a form of social practice (Flowerdew and Richardson 2017; Wodak 2001b), which is best translated by the concept of discourse (Fairclough 1989). According to Norman Fairclough (1989), we should neither understand language as a system of standardized rules that can be detached from the actual use speakers/writers made of it, nor should we focus solely on an individualistic approach. Instead, we should look at language use as “socially determined, as what I call discourse (p. 22)” (Fairclough 1989). Discourse, understood as social practice, has relevant implications. First, language is part of society and not something external to it. All linguistic phenomena are social phenomena, in the sense that when individuals speak/write, they do so in socially determined conditions and that their actions have social effects (Fairclough 1989). Since language is a practice, i.e., a systematic way of doing something, its use is subject to rules and procedures that derive from the relative position the practice takes within a network of practices (Fairclough 2001). The practice of discourse is not a neutral, voluntary action pursued freely by the speaker/writer, but is instead as highly regulated, socially, and politically determined one (Jäger 2001). In addition, many social phenomena are also linguistic phenomena: language activity takes place within a social context and it is not merely an expression of social processes but one of its constitutive elements (Fairclough 1989). CDA considers that all social practices have semiotic elements, i.e., ways of creating and communicating meaning (Fairclough 2001). CDA considers discourse a social process. CDA looks at texts as products of social processes of production, and which are then put to use by social processes of interpretation (Fairclough 1989). This means that the study of discourse includes an analysis of the conditions under which texts are produced, mobilized, and (re)interpreted socially: how they are used in human interaction (Fairclough 1989). Fairclough (1989) argues that discourses are socially conditioned by other social, non-linguistic elements. Individuals make sense of texts through cognitive elements that are influenced by broader social conditions that arise from the existing struggles and relations

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of force in society. A CDA approach is highly sensible to issues of context (Flowerdew and Richardson 2017; Wodak 2001b). On the one hand, because discourses are regulated practices, we need to account for how such regulation occurs: how their (re)production, circulation, and challenge takes place within the existing context. This account is done through a contextualization of discourse and the analysis of existing structures of power (Wodak 2001b). On the other hand, we must also look at how agents strategically make use of discourse to either reinforce or contest the existing status quo: how hegemony is challenged through discourse (Fairclough 1989). An analysis of the ongoing debate on the EU’s answer to the Covid-19 ought to consider how discourse shapes and is shaped by different actors in their practices. The way competing actors produce different representations of and present answers to the crisis is influenced by regulated (discursive) practices, which are in turn linked to other (non)discursive practices. The broader arrangement of these discursive and non-discursive practices constitutes the domain of governance of EMU (in this line see Diez 2001). This domain is sensible to continuous (re)contextualization and interpretation. Another important aspect of CDA’s take of discourse as social practice concerns its effects as an “instrument of the social construction of reality (p. 9)” (Van Leeuwen apud Wodak 2001b). Discourse and social reality are bound by a co-constitutive relationship: discourses not only represent social reality but also (re-)create the social reality they refer to (Flowerdew and Richardson 2017). Influenced by Foucault, Siegfried Jäger argues that knowledge constitutes a type of discourse used by individuals to both interpret and transform social reality (Jäger 2001). Although reality does exist outside the realm of discourse, discourse is in itself a material element that has “a reality of its own (p. 36)” (Jäger 2001) and which both influences our understanding of and is influenced by reality. CDA is not only concerned with interpretations of something which already exists, the attribution of meaning after the fact: it is also attentive to how (social) reality is produced through discourse (Jäger 2001). The study of discourse, and especially political discourse, is key to our understanding of how particular representations of the world are provided and challenged through language use (Wilson 2015). The discourses on the Covid-19 crisis and the answers to it are not mere translations of reality into words. They are representations that have an impact on how we make sense of the origins, effects, and solutions to the crisis itself. Inasmuch as they co-constitute social reality and shape our perceptions of it, they are both an instrument of and disputed by power. Controlling discourse does not mean controlling reality; but it does mean controlling how reality is perceived. This is one of the ways discourse and power are connected.

2.2 Discourse and Power CDA’s primary concern is with the relationship between discourse and power (van Dijk 1993; Wodak 2001b; Fairclough 1989). CDA studies how language enables specific forms of dominance, understood as a form of power that results in unequal

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social relations (van Dijk 1993). This reflects the critical ethos of CDA: the purpose of conducting research that is committed to expose and transform abusive power relations (Fairclough 1989; Wodak 2001b). CDA sees power as a social phenomenon: a property of relations between social groups that involves the control of one group by another and that can take numerous forms (van Dijk 1993). Today, this control is exercised in free societies by means of “persuasion, dissimulation or manipulation (van Dijk 1993)” that aim to establish the dominance of one social group over others. The concept of ideology in CDA refers to the ensemble of assumptions social groups take for granted in specific historical periods, and which condition the ways they perceive the world. Ideologies are reproduced by existing social relations of power, and language works as central element in this reproduction. Therefore, the study of discourse is essential to understand how power works (Fairclough 1989). The concept of hegemony reflects a state in which dominated groups came to accept the existing ideology, and subsequent social status quo because they consider it natural or legitimate (van Dijk 1993). In any case, domination is never absolute nor eternal: the use of language opens the possibility for contestation and challenge (Fairclough 1989; Diez 1999). In addition, the success of a hegemonic discourse depends not only on the relative power of actors or social groups that support it, but also of its congruence with other existing discourses, including those of different domains of practice, i.e., of its intertextuality (Fairclough 1992). This explains why and how certain discourses are highly contested. A political discourse that departs significantly from established discourses on the same object, particularly in free and democratic societies, becomes a target for contentious. The discourses of the US and Brazilian presidents on the Covid-19, throughout the first half of 2020, are clear examples: their political representations are disputed by medical and economic hegemonic discourses. According to Holzscheiter (apud Wodak 2018), the exercise of power in discourse can take three forms: power in discourse, power over discourse, and power of discourse. Power in discourse refers to how actors struggle with different interpretations of meaning (Wodak 2018). Discourses, and specifically texts, which are their basic unit of analysis (Flowerdew and Richardson 2017), reflect the existing social relations of force: they are “sites of struggle in that they show traces of differing discourses and ideologies contending and struggling for dominance (p. 11)” (Wodak 2001b). The way political groups offer different and competing representations of the world or particular events constitutes one of the examples of these struggles (Wilson 2015). Power over discourse highlights the importance of context concerning the communicative setting as a resource of power (van Dijk 2015). Issues of access to discourse constitute an important resource of powerful groups. This access might refer to issues of genre,2 forms, context, participants, or audience reach. The greater the access to and control over these resources, the more powerful institutions or social groups are 2 Genres

are “diverse ways of acting, producing social life, in the semiotic mode. Examples are: everyday conversation, meetings in various types of organization, political and other forms of interview (…)” (Fairclough 2001, p. 133).

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(van Dijk 1993; Fairclough 2001). Examples of this form of power can be illustrated through practices of exclusion that are enacted through the control of time, place, settings, rules of the communicative event, or access by participants (van Dijk 1993). Powerful institutions and elites reassert their status through the ongoing reproduction of discourses: Fairclough (2001) argued that increasingly interconnected transnational networks of governance and institutions were a major factor on the prevalence of neoliberal ideology and its legitimization (Fairclough 2001). The power of discourse refers to how social control is enacted through discourse (Wodak 2018). Different strands in CDA focus on distinct elements of how this is done. Teun van Dijk focuses on how discourse is used to access and shape socially shared representations of societal arrangements, groups and relations, as well as mental operations such as interpretation, thinking and arguing, inferencing and learning, among others. (1993)

Social cognition works as the mediator between the macro- and micro-levels of society: between discourse and action (van Dijk 1993). The Discourse-Historical Approach explains the language–power relationship by addressing the existing power dynamics and the actions of parties involved, with a focus on their interactions, the historical and intertextual sources, and the political and economic contexts in which discursive events take place (Wodak 2018). Siegfried Jäger’s Foucaultian-inspired approach stresses how discourses produce the objects they speak of (Jäger 2001). The author is concerned with how social groups actively produce reality, in the sense that they attribute meaning to it, through both discursive and non-discursive practices, via an analysis of dispositives (Meyer 2001; Jäger 2001). This approach is interested in how the connection between discourse and power establishes what can and cannot be said at a certain point in time (Jäger 2001). Despite the different approaches to the question of how the power of discourse is enacted, the study of text and discourse is central to all of them. From these different lines of research, two important elements stand out: the role of discursive practices of representation (van Dijk 1993; Wodak 2001a) and legitimization (Fairclough 2001; Jäger 2001; Wodak 2018; van Dijk 1993) on political conflict and social order. We argue that by studying how the South and frugal represent the Covid-19 crisis and legitimize a common European response to it, helps us understand the frameworks under which they constitute and project their own interests. Our study of the political discourse on the Covid-19 and the response to it intersects the concepts of representation and legitimization with the properties of (re)contextualization to show how discourse and power interact.

2.3 Strategies of Representation and Legitimization: Recontextualization in Discourse The debate on the response to the Covid-19 crisis reflects an ongoing struggle over the representation of the crisis, but also of the EU and its member states, and the

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legitimization of the responses to it. The analysis of representations is a key element in CDA (Fairclough 2001). The concept of representation refers to the way language produces reality by the mediation of sensory data: the way discourse refers to things that exist (Neumann 2008). Representations are also “social constructions of practices (p. 123)” (Fairclough 2001): processes through which actors attribute meaning to their own actions and those of others. Discourses have seldom one dominant representation and multiple competing ones, and it is the task of the discourse analyst to map and stress conflicts among them (Neumann 2008) and to elucidate how discourse operates the management of such representations (van Dijk 1993). The focus on representations is key to our understanding of how actors involved in discourse make sense of reality, bearing in mind that the outside world is only graspable to us through discourse itself (Jäger 2001). Representations are fluid elements of discourse, with varying durations throughout time. We suggest that the length of time of a dominant representation and the number of competing representations within a discourse reflect variable levels of power at work (Neumann 2008). Therefore, the way different groups of EU member states advance different representations on the Covid-19 crisis constitutes a political battleground, as “[the] control and domination of representations allow politicians to generate worldviews consistent with their goals, and to downgrade, negate, or eliminate alternative representations (p. 777)” (Wilson 2015). Our second operational concept is strategy of legitimization. As we have argued, the exercise of power in contemporary societies requires ever-greater forms of legitimization: the process by which dominance is perceived as just, natural, or necessary (van Dijk 1993). Legitimization practices answer to the question of “why should we do this [in this way] (Van Leewen 2008).” Built on Van Leewen’s (2008) categories of legitimization, we analyze the discursive strategies drawn by the two groups of member states engaged on the defense of their policy preferences. These categories are split into four major groups according to their foundational basis. Strategies of authorization are based on tradition, custom, law, or personal or institutional authority; strategies of moral evaluation are drawn from value systems; rationalization legitimization strategies derive from socially desired goals, practices, or knowledge to which is attributed validity; finally, mythopoesis strategies mobilize narratives that reward legitimate actions and punish nonlegitimate ones (Van Leewen 2008). The use of these strategies is non-exclusionary: discourses seldom make use of many of them, as the variety of elements mobilized to support them is complex and manifold. We argue that the binomial representation-legitimization grasps important political elements to the future of EMU and European integration. The establishment of a coherent account for the nature, causes, and solutions to the present economic crisis and the success of legitimization strategies are two central aspects to the future of the European project (see also Jachtenfuchs et al. 1998). Our operationalization of representation and legitimization strategies uses an additional auxiliar: the concept of recontextualization. According to CDA, the meaning of texts (or any speech event for that matter) cannot be separated from context (Wodak 2018). Context refers to the social, political, or cultural conditions and historical background under which texts exist. Context also includes other texts. Contextualization describes the dialectic relationship, between text and context, necessary for

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the creation of meaning (Flowerdew 2017; Hodges 2015). The existing social relations of power are an important contextual element in the sense that they may decide which meaning prevails among competing interpretations (Flowerdew 2017). Recontextualization allows us to study how representation and legitimization strategies are deployed in discourse. Recontextualization refers first to how an argument, topic, genre, or discursive practice is taken from its context (decontextualization) and then employed in a different one (recontextualization) thus generating new meaning (Wodak 2018; Fairclough 2001). Recontextualization also refers to the process whereby social practices are turned into discourses about social practices: when discourse starts to speak about the social world (Van Leewen 2008). Recontextualization is an important element of politics because control over it can determine how texts or discourse, in the present and the future, are interpreted. Meaning is not fixed to the text: it is rather produced by the relationship between text and context. Hence, it is always subject to contention, and a successful recontextualization is but a temporary victory (Hodges 2015). The politics of representation and legitimization we analyze reflect different mobilizations of cultural, political, and/or historical elements, in the specific background of our days, in an attempt to fix the meaning of the crisis and justify the need to act in specific ways. The social interplay between actors and these conditions both feeds, as well as it limits, their strategic possibilities. Our research analyses two divisive positionings at the outset of the Covid-19 crisis. We look at the political proposals advanced by both groups, namely by studying the Declaration of the 9 and the frugal four’s Non-Paper, in addition to public interviews or statements issued by leaders of these member states. We compare and describe the strategies used to represent and legitimize their positions as we try to make sense of them through the politics of distributional effects in the EMU, attentively looking at elements of recontextualization present in their discourse.

3 Representing the Crisis and Legitimizing a Common Response: Discursive Strategies in the Wake of the Covid-19 We address the way both the South and the frugal represent the crisis and legitimize their policy proposals. With the help of the concept of recontextualization, we aim at showing how their strategies seek to shape both the way the crisis is perceived, thus establishing a dominant framework for addressing it, as well as a mechanism to make the answer to it be perceived as natural, morally justifiable, and/or necessary. We must recognize some methodological challenges. First, because the object of study is an ongoing, short-lived event, the limited time frame of analysis naturally restrains the scope of the study, at the least at the level of primary sources. Secondly, the analysis we make relies on sources written in different languages: all mistranslations are our own faults.

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3.1 Unprecedented Times Call for Unprecedented Action: The South’s Discourse on the Crisis On March 25th, 2020, a group of 9 EA member states sent a letter to European Council’s president launching the discussion on the need for a common EU answer to the health and economic challenges posed by the Covid-19 crisis (Joint letter of nine EU leaders 2020). The crisis’ representation is twofold: as an unprecedented and extraordinary event and as a unique and symmetric sock. By characterizing this crisis as an unprecedented event, EU leaders seek to open the possibility for taking measures that have been so far politically difficult, namely the possibility for debt mutualization in the EA. The aforementioned letter urges leaders to “recognize the severity of the situation” for which the need of “unprecedented socioeconomic measures, with an unparalleled slowdown in economic activity” will require “extraordinary actions” (Joint letter of nine EU leaders 2020). Leaders from the South recurred to the historical recontextualization of past extraordinary events to make sense of the current one, labeling it an existential threat to the European integration project. This is clear in the metaphorical characterization of the Covid-19 as a “war to be won (Perrone 2020)” that is “raged against an invisible enemy (Sánchez 2020).” This process of recontextualization presents the European answer as a postwar reconstruction effort (Perrone 2020) with a specific historical reference to the Marshall Plan (Sánchez 2020) or as a decisive historical moment, such as the Schuman Declaration, to highlight the challenges ahead (Costa 2020). The second representation of the Covid-19 crisis engages more closely with the economic governance of EMU and is developed through a recontextualization of current events against the background of the eurozone crisis. The South represents the economic shock as a “global crisis” that requires a coordinated response. By representing the crisis as a symmetric shock, member states argue against comparisons with the eurozone crisis (Joint letter of nine EU leaders 2020). This allows them to reject the possibility of using existing instruments to address a problem which is fundamentally different in nature and reinforces their call for a new approach (Perrone 2020). The legitimization of South’s proposal for addressing the crisis runs along the lines drawn in its representation of it. On the one hand, they refer to the broad historical and political European project. On the other hand, they focus on the economic conditions and assessment of the current situation. The first set of legitimization strategies fall in the category of moral evaluation and are supported by existing discourses on what is morally good, natural, or desirable (Van Leewen 2008). By recontextualizing the present with the challenges European countries faced after the Second World War, and by referring to the multilateral steps taken to revive the European economy and preserve peace, the South is structuring the legitimacy of its response on the positive value of a “united European response” that should be made in the spirit of “solidarity” (Joint letter of nine EU leaders 2020). Solidarity is a key discursive element in this process. In a single text (Sánchez 2020), Pedro Sánchez makes three different usages of the concept: as a political requisite (“We need an undisputable solidarity.”), a

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legal binding principle (“Solidarity amongst Europeans is a fundamental principle in EU Treaties.”), and an economic solution (“This is the time to be supportive: to create a new mechanism for debt mutualization […]”). The vagueness, fluidity, and ambiguity of the concept and its use (Fernandes and Rubio 2012) does not make it useless: it is in fact its intertextuality and constant recontextualization that makes it so powerful. Another strategy of legitimization used by the South is instrumental rationalization, which refers to practices that are legitimized according to goals that have an underlying moral principle (Van Leewen 2008). The recontextualization of the EU’s response as a new “Marshall Plan” or the “Schuman Declaration” provides legitimacy through the sharing of properties between the early steps of the European project, and their latter effects toward mutual prosperity and peace in Europe, and the need for an equally strong and innovative response to the present crisis. The same kind of instrumental rationalization is present in the legitimization of South’s response as necessary to preserve the EU’s “raison d’être” and the expectations of its European citizens and populations (Perrone 2020) and its sustainability through cohesion (Sánchez 2020). On economic matters, the legitimization strategies used to support the proposals advanced by the South are based on practices of rationalization, both instrumental and theoretical. By theoretical rationalization, Van Leewen (2008) describes the way practices are justified according to theoretical accounts of how things are: according to the nature of things. When these are produced by specialized institutions and constituted bodies of knowledge, he labels them scientific rationalizations (Van Leewen 2008). Instrumental rationality legitimizes the need for swift action toward achieving a “rapid recovery tomorrow” (Joint letter of nine EU leaders 2020) for all of those countries which “benefit from the internal market” (Juliana and Lugilde 2020). The implementation of a common debt instrument is legitimized by an interplay of theoretical and scientific rationalizations: the symmetric nature of the shock means that no individual member state is responsible for the economic consequences that may come from addressing it (Joint letter of nine EU leaders 2020), therefore dismissing risks of moral hazard and the need or adequacy of strict conditionality in the form presented throughout the eurozone crisis (Juliana and Lugilde 2020; Perrone 2020). The South’s discourse operates a recontextualization of the eurozone crisis, not only as a referential for the legitimization of new actions, as in the case of debt mutualization and the inadequacy of using the ESM (Perrone 2020), but also as a justification of why such approaches are in general erroneous. As Pedro Sánchez puts it: “The United States responded to the 2008 recession with stimulus, while Europe responded with austerity. Today, we all know the results (Sánchez 2020).” This demonstrates the strategic recontextualization of the eurozone crisis made in the South’s discourse on the economic aspects of the crisis: at the one hand, it recognizes and acknowledges the existence of institutional and legal frameworks useful to deal with asymmetric shocks, but which are unhelpful to the present-day situation. On the other hand, it recalls the extremely adverse effects of having used those exact same instruments, even when the situation seemed to justify them, therefore leaving open the possibility for future contestation on seemingly stable elements of EMU.

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The representation of the Covid-19 crisis as an unprecedented and extraordinary event seeks to entrench a specific understanding of it: it contributes to the discursive social construction of reality. By claiming its novelty, the discourse of Southern European leaders reuses the adage “crisis as opportunity” (Sánchez 2020) and the mantra that crises have always been triggers of European integration, even if this is highly disputable (Parsons and Matthijs 2015). This representation aims to establish the boundaries of political discussion and push forward the EMU toward uncharted territories: the mutualization of debt. The legitimization of this move is produced through an amalgamation of strategies that mobilize the EU’s raison d’être and historical purpose, through the intertextuality and recontextualization of key historical moments such as the Marshall Plan or the Schuman Declaration, and is saturated by the concept of solidarity. Despite its much narrower focus, the South’s take on the economics of the crisis is also a representation, even though technical or scientific elements might make us forget that knowledge too is a discourse: a human product made through the use of language (see Jäger 2001). In this case, the recontextualization of the current crisis is immediately drawn against the eurozone crisis. The strategic move operated here is to underscore the symmetric nature of this shock: one for which no one is responsible, but which affects all. This operation makes illogical the claims of moral hazard and stresses the need to ensure cohesion as a foundational element of the EU and its maintenance. The uniqueness of this crisis also legitimizes the development of new instruments, different from the existing ones—namely the ESM. If the nature of the crisis differs fundamentally from the previous one, recurring to conditionality-based financial assistance cannot properly address the present challenge. The discursive battle lines run along the distributional effects of EMU.

3.2 The Frugal’s Take: Solidarity Within the Existing Framework. Proportionality, Moral Hazard, and Burden Redistribution The representation made by the frugal four of the Covid-19 crisis has a limited resemblance with the one put forward by the South. Despite the recognition and agreement on the necessity for a common response to a crisis that affects all (Frugal Four 2020; Valentino 2020; Prime Minister’s Office of Sweden 2020), there is considerable divergence on how the challenges are represented and the solutions legitimized. The globality of the adverse economic shock is represented as a menace that threatens all: this means that the EU’s response cannot overburden some member states to benefit others, because all are subject to mounting budgetary pressures (Frugal Four 2020; Valentino 2020). In a clear recontextualization of the eurozone crisis, Dutch premier Mark Rutte argued that because the crisis threatens the eurozone as a whole, [That] is why help is needed. But this must go hand in hand with an analysis of the past. Italy and Spain must answer the question: what can we do to be able to face the next crisis on our own? (Valentino 2020)

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This representation frames the Covid-19 crisis as an event that exposes the failures of domestic policies in some member states, which ought to address them in order to enhance their resilience and stability, and subsequently that of the eurozone (Frugal Four 2020). Despite recognizing the severity and symmetry of the shock, the frugal clearly reject the possibility for the mutualization of debt (Frugal Four 2020) and prefer using the existing frameworks to develop a response. Overall, adherence to Stability and Growth Pact rules and the European Semester, coupled with structural reforms, are again presented as the way out of the crisis (Frugal Four 2020). The representation of the current crisis is not extensively recontextualized through the themes of European integration history or similar metanarratives. In an article published by the frugal on the discussions over the EU budget (Kurz 2020), Austria’s premier Sebastian Kurts expressed the group’s commitment to the European integration project, recontextualizing it in terms of output legitimacy, rather than financial commitment to the EU’s budget. The legitimacy strategy put forward to sustain the policy proposals of the frugal four is unsurprisingly more focused on economic issues and rationales rather than on broader political considerations. Countering the proposals advanced by the South, the frugal openly oppose any form of mutualization. Kurz publicly spoke against any form of creating “(…) a debt union through the back door (Karnitschnig 2020),” which represents a form of moral legitimization that refers to the values of transparency and democratic accountability, and which are a recurrent theme because of their (perceived) absence in the EU (see Decker 2002; Follesdal and Hix 2006; Moravcsik 2004). Another moral legitimization strategy on the part of the frugal relates to the fairness of the distributional effects of the demands for further commitments to EU’s multiannual financial framework (MFF). Through a recontextualization of the debate on the MFF, in which the risk of economic unbalances due to an unfair distribution of EU budget resources is raised (Kurz 2020), the issue is reaffirmed in the Covid-19 debate (Valentino 2020). The defense of a “loans for loans” approach is justified with instrumental and theoretical rationalizations. Increasing the EU budget would drain national resources, which are needed to offset the effects of the economic crisis (Frugal Four 2020). This argument seems to recontextualize a sort of crowding out effect, occurring at different levels and among public entities. Another cornerstone of this approach resides on the need for economic reforms to be taken by all EU member states, which justifies conditionality. The theoretical instrumentalization of this strategy resides in moral hazard. Through a recontextualization of the eurozone crisis, the frugal argue that any support must be subject to control, in order to assure that the help provided is used to strengthen the resilience of recipients (Valentino 2020; Frugal Four 2020; Prime Minister’s Office of Sweden 2020). In Rutte’s own words: We need solidarity with the countries most affected by the pandemic […]. This means that states which need and deserve help must also ensure that they are able to deal with such crisis in a resilient way in the future. (Valentino 2020)

Because, if left unchecked, individuals or member states will have no incentive to pursue hard, but necessary, reforms, conditionality has been increasingly used as a

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policy tool by the EU. This is once more a recontextualization of the eurozone crisis (Jacoby and Hopkin 2019). The last strategic legitimization practice concerns the frugal four’s call for further adherence and respect to the existing fiscal frameworks. This legitimization is developed through an instrumental rationalization: the way toward greater economic growth, and therefore general well-being, resides on sound public finances (Valentino 2020; Prime Minister’s Office of Sweden 2020; Frugal Four 2020). The frugal four’s discourse on the nature of the Covid-19 and the response to it differs greatly from the one presented by the South. Based almost exclusively on a recontextualization of the eurozone crisis, the frugal represent strategically the crisis as a symmetric shock, which justifies limited assistance, based on preserving their own budgetary positions. At the same time, they stress that the asymmetric effects of the shock, which hurt some countries more than others, expose their endogenous fragilities, therefore justifying that resources be made available on a conditionality basis. A theoretical rationalization, based on the concept of moral hazard, and an instrumental rationalization, based on the idea of (neo)liberal reforms as the path toward growth, legitimize the proposal for a conditionality-based approach with external monitorization. The frugal four’s representation and legitimization strategies are pro-status quo discourses on EMU. Against the “loans for loans” relief approach, the frugal demand a time-limited, conditionality-based program, together with a reformed MFF that does not, however, imply an increase of future contributions nor opens the door for a debt union: something that would be morally illegitimate. In effect, they seek to crystallize the existing EMU framework, with its current distributional effects.

4 Conclusion This article analyzed the way two competing groups of EU member states, the South and the frugal four, strategically represented and legitimized their policy proposals in the face of an emergent crisis. Using CDA, we have shown how the discursive battle lines were drawn in the wake of the Covid-19 crisis. On May 18th, the French and German governments presented a common response that reproduces elements put forward by both groups. The proposal follows the representation of the crisis as unprecedented event (Franco-German Proposal 2020) and strategically legitimizes itself on the basis of role model authority and tradition. The policy also aims to reassure the frugal four, by stressing that the existing budgetary frameworks and rules will continue to prevail and, although it does not insist on debt mutualization, it associates conditionality to the attribution of grants (Franco-German Proposal 2020). The agreement reached at the European Council’s special meeting of July (2020) reflects said compromise. On the one hand, the representation of the crisis as “unprecedented” and a “challenge of historic proportions (p. 1)” whose “exceptional nature [legitimizes] exceptional measures […] (p. 2)” serves the strategy of the South. On the other hand, the agreement recognizes the targeted and time-bound nature of

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the policy and legitimizes it through conditionality-type processes, thus appeasing the demands of the frugal four. This article argued the importance of discourse in the analysis of politics. Discourses represent reality, both enabling our understanding of and limiting our ability to shape it. The study of future economic governance challenges requires the recognition that these too are objects of discourse, which are constituted through politically significant struggles. The EU’s response to the Covid-19 crisis (re)surfaced new issues. These include the allocation criteria of grants; the repayment of the funds raised by the Commission; the contention over EU’s own resources; and the role of other institutions on this governance apparatus (e.g., European Parliament). These challenges will be accompanied by their own strategies of representation and legitimization. Our purpose is to remind readers and students of the political nature of discourse, making them more aware of the effects of power on economic phenomena and the study of economic governance.

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António Leitão is a Ph.D. Candidate in International Politics and Conflict Resolution, funded by the Portuguese Science and Technology Foundation, at the Centre for Social Studies and the Faculty of Economics of the University of Coimbra. His research interests include the study of European integration theory, history and politics and the role of discourse and language in IR theory.

Institutional Rebalancing in the Wake of the Covid-19 Pandemic Paulo Vila Maior and Isabel Camisão

Abstract The chapter engages in a comparison between the Eurozone crisis and the pandemic crisis. The cartography of both crises follows two axes: endogeneity versus exogeneity, and symmetric versus asymmetric effects. It then focuses on the reactions of EU institutions to the pandemic crisis and their articulation with national governments. In the political-economic arena, discussions took place at the highest political level to mitigate the immediate effects of the crisis, trying to anticipate the likely overwhelming effects that would ensue. The chapter points out the different politicaleconomic rationale of the pandemic crisis, since the proactive stance of some of the actors involved (notably the European Central Bank and the European Commission) is consistent with an “events-politics” approach to the crisis. In contrast, hesitations in the European Council are instructive evidence of the fact that divergences between national governments perpetuate the clash between the wealthier, net-EU budget contributor Member States and the poorer, EU budget net-recipient Member States. The chapter concludes with an assessment of the institutional rebalancing of the EU, discussing its impact on European integration, particularly whether this was a missed opportunity for a great leap forward consistent with the complexity of the underlying challenges posed by the pandemic crisis. Keywords Pandemic crisis · European integration · Institutional recalibration · Economic policy mix · Adjustment

1 Introduction The ongoing pandemic crisis is fertile ground for scholars’ analysis on how the European Union (EU) has reacted. This is another episode of the multidimensional P. Vila Maior (B) Universidade Fernando Pessoa e CEPESE, Universidade do Porto, Porto, Portugal e-mail: [email protected] I. Camisão Faculdade de Letras da Universidade de Coimbra and CICP, Research Center in Political Science, Coimbra, Portugal e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_15

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crisis that seems to act as a paradoxical, perennial nurturing of European integration (Nanopoulos and Vergis 2019). The sanitary crisis encompasses many dimensions. In this chapter, we focus on the political-economic responses known until the time of writing (late July 2020), with an emphasis on their consequences for the EU and for the Economic and Monetary Union (EMU) in particular. The analysis is based on fresh evidence since the outbreak of Covid-19 on a twofold level: the role played by relevant EU institutions, and the interaction (or the lack thereof) between EU institutions and national governments. Section 2 addresses the theoretical framework that inspires our analysis. Section 3 presents a comparison between the Eurozone crisis and the pandemic crisis. There are substantial differences between these crises, which deserve to be highlighted in order to capture the underlying context of the current crisis and to understand whether its disparate nature (in comparison with the Eurozone crisis) gives rise to a differentiated political-economic response. The comparison is bidimensional: the ontological dimension aims at locating the source of both crises, taking into account two alternatives (endogeneity and exogeneity); the outcome dimension shows the dispersion of the effects of the crises, considering two extremes (asymmetric and symmetric effects). Following our previous analysis (Vila Maior and Camisão 2018) of the winners and losers within the institutional architecture of EMU in the context of the Eurozone crisis, the aim of Sect. 4 is to engage in a similar exercise restricted to the ongoing pandemic crisis. This is a provisional analysis, not only because the crisis is far from over, but also because the interaction of the several actors involved in the adjustment to the crisis is constantly evolving.

2 Theoretical Framework: From Reaction to Pro-action? The comparison between the pandemic crisis and the Eurozone crisis is relevant in order to measure relevant actors’ performance. The Eurozone crisis is the benchmark for assessing the extent to which the reaction to the pandemic crisis follows the same or a different pattern of political and policy reaction. The comparative exercise draws the attention to the differentiated nature of the Eurozone crisis and the pandemic crisis. We anticipate this conclusion from Sect. 3 as it helps to substantiate the unequal nature of each crisis and to understand that different political-economic responses make sense. The comparative exercise is anchored on an additional reason: the negative effects of the Eurozone crisis were heightened by the weaknesses of EMU’s architecture, but many authors emphasised how deadlock (at first) and a slow and reticent reaction characterised the adjustment to this crisis (Eichengreen et al. 2014), thereby hampering an efficient response to it. Institutional actors reacted to events instead of being ahead of them. This template of political-economic adjustment proved wrong since the crisis was protracted to the edge of inertia (Blyth 2013; Stiglitz 2016). It is therefore reasonable to look at the current crisis through the analytical lens of the previous crisis’ adjustment. Both crises are grounded on a different rationale

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(Sect. 3), but the experience of the previous crisis afforded some lessons to the future (Kamkhaji and Radaelli 2017). The pandemic crisis is this future dimension. The question is whether special circumstances of the pandemic crisis enabled a proactive political behaviour. First, it is widely accepted that muted, delayed reactions to events were not the appropriate strategy to deal with the Eurozone crisis. This plays an important role as a learning device for political leaders and practitioners when they were faced with the pandemic crisis (Jabko 2019). In addition, since the nature of the current crisis is different, a different approach is mandatory—an approach that shifts from reaction to pro-action, in order to anticipate as much as possible the uncertain effects of the pandemic crisis. Actors seem to have internalise the perception that the severity of the crisis is the critical juncture that justifies a different paradigm as far as the political strategy to accommodate the crisis is concerned. The first wave of the pandemic crisis was strictly sanitary, as the focus was on designing the best strategy to address the contamination and the deadly potential of the virus. Quarantine and restrictions to persons’ mobility (at the outset by closing borders; at a later stage, by forcing lockdown at the national, regional and local levels) aimed at restraining the propagation of Covid-19. Public health was the priority and resources were concentrated in addressing this challenge (Bouckaert et al. 2020). At the same time, lockdown involved a considerable decrease of economic activities. Some sectors virtually stopped. The second wave of effects stemming from the pandemic crisis involves an economic dimension (Fetzer et al. 2020), not only for the catastrophic effects on economic activity (with unclear forecasts on how recession will bite), but also for the expected negative impact on fiscal policy. Amidst uncertainty regarding the social and economic impact of the pandemic crisis, the first signs were mixed (Baker et al. 2020). National authorities’ narrowminded approach neglected cooperation, both within the EU institutional system and at the bilateral level. After some weeks of spreading disease, governments realised the massive externalities coming from the contagious effects of the pandemic crisis and the devastating social and economic effects yet to come. That was when they decided to articulate within the institutional system of the EU (in those cases where the stimulus and the initiative of EU institutions come from national authorities: the European Council and the Council of Ministers). Other EU institutions with a supranational nature (mainly the European Central Bank and the European Commission) acted on their own, with variable degrees of influence which depend on each institution’s leverage. Some lessons have been learned from the previous crisis. After the early deadlock and national reassurance, the emphasis shifted towards the EU level when actors began to acknowledge the unprecedented social and economic crisis expected in the short run. The point of contact with the previous crisis is slim, as this crisis is very different from the Eurozone crisis (Sect. 3). However, actors were aware that they could not rely on a reactive stance as before, not only because this had not been the appropriate answer to the previous crisis but especially because the pandemic crisis raised more anxiety. Actors realised that they needed to be proactive in order to anticipate the effects of an unprecedented crisis.

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The different approach is explained by actors’ awareness of their political role. This contrasts with the apathy, dubious positions and hesitations that marked most of the period covering the accommodation to the Eurozone crisis (Fitoussi and Saraceno 2010). The rising political profile of EU institutions on the brink of the pandemic crisis, notably when the stage was set for the still largely uncertain effects of the ensuing economic crisis, contrasts with actors’ behavioural pattern during the Eurozone crisis. This increases the salience of the EU and sends a message to citizens that actors are concerned with anticipating the soon-to-be economic crisis. This is consistent with a theoretical approach to the several episodes of crisis in the EU (Eurozone, Ukraine-Russia conflict, refugees, Brexit, and the cooling of the EU-USA partnership) that describes the response to ongoing events as an “events-politics” approach (van Middelaar 2019). Political actors recognised the complexity of the challenges arising from the pandemic crisis and provided political inputs that ought to reasonably accommodate countries and the EU to the following stage of the pandemic crisis. Events triggered political action, which is consistent with a proactive stance.

3 Two Crises Compared: An Endogenous, Asymmetric Crisis Versus an Exogenous, Symmetric Crisis For the purposes of this chapter, it is relevant to address the Eurozone crisis and the pandemic crisis in a comparative exercise. They are among the most recent crises that impacted European integration. Other episodes of crisis are left out of the comparison because one of the anxieties raised by the pandemic crisis is the severe recession forecasted for the second half of 2020 and for 2021. The emphasis is on the economic implications of the pandemic crisis. There is, therefore, a linkage with the Eurozone crisis, since the economic dimension was also in the limelight. The comparison is not restricted to economics, though. Although the cement of political activism of EU institutions and national governments has ensured the preventive accommodation to the severe crisis that is set to hit the EU, the origins of the crisis lie outside economics. Thus, the comparative exercise follows a twofold path. On the one hand, the ontological dimension of the crisis is addressed (where did the crisis come from?); on the other, its internal dynamics is analysed (how were countries affected by the crisis?). In the first case, exogeneity and endogeneity are the operative concepts. In the second case, symmetric or asymmetric effects are at stake. The first dimension surveys the context that gave rise to the crises under comparison. While the Eurozone crisis is considered an endogenous crisis (its name is self-revealing) (Schimmelfennig 2017), the same observation does not hold for the pandemic crisis. According to the mainstream analysis of the Eurozone crisis (for example, Mody 2018), the first episode of the crisis erupted outside the EU. The financial crisis started in the USA, in late 2007, early 2008. Subsequently, the crisis crossed the seas and became widespread. It then triggered contagious effects in production and consumption and became an economic crisis. It was only in 2010

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that the crisis witnessed an emancipation in the European continent, when Greece, Ireland and Portugal were affected by the sovereign debt crisis. This, in turn, lies at the heart of the Eurozone crisis. A mixed perception of the geographical input of the several episodes of the crisis emerges. In the early days, the crisis was exogenous. Nevertheless, when some Member States (MS) of the Eurozone were hit by unsustainable public indebtedness and the risk of default, the crisis became endogenous. After some hesitations and inertia fed by some national governments, a solution at the level of the Eurozone was agreed upon (the provisional European Financial Stability Facility, which gave rise to the European Stability Mechanism) (Henning 2017). The crisis became endogenous, with long-distant sources of exogeneity. Differently, the pandemic crisis is exogenous (Bongardt and Torres 2020). The first impact of Covid-19 was in China in late 2019, but soon the virus was widespread worldwide. It is not by accident that the word “pandemic” is used. Contamination affected MS of the EU unevenly, as Italy and Spain were severely hit in February 2020 when the virus travelled from the East to the West. Another axis encompasses symmetry and asymmetry. Here, the examination of the effects of the crises entails a geographical input. Did the crisis affect all countries in the same way? Did some countries escape the negative implications while others suffered the impact of the crisis? In the first case, the crisis is symmetric. In the second case, it is asymmetric. The Eurozone crisis was of an asymmetric type (Wyplosz 2013). The few MS of the Eurozone that were struck by the negative consequences of the crisis were (with a few exceptions) peripheral, medium-size, less wealthy countries. Since EMU was not equipped with a risk-sharing mechanism that helped countries affected by an asymmetric crisis to adjust, when the crisis was over the gap between the Eurozone’s average and the MS affected by the crisis widened (Giavazzi and Wyplosz 2015). This is why the Eurozone crisis encapsulates a double-edged asymmetric nature: few countries were affected, and the wide gap between these countries and the average was one outcome of the crisis. In contrast, the pandemic crisis is an example of a symmetric crisis (Tesche 2020). Effects cut across all the MS, albeit with variable degrees of intensity, as some MS were more affected by the sanitary crisis than others. The disease did not stop at national borders. It was transversal to all countries, not only in the EU but at worldwide level. Apart from the recognition that the sanitary dimension of the pandemic crisis is symmetric, the same does not hold for the social and economic effects expected for the near future. Countries start from different positions when their broad social conditions, macroeconomic performance and political and economic structures are considered. It is therefore reasonable to expect that the social and economic crisis will affect MS in variable degrees. The ensuing social and economic crisis might therefore encompass an asymmetric dimension (Campanella and Dookeran 2020). A similarity between the Eurozone crisis and the pandemic crisis is recognised when the two dimensions of the comparative exercise are weighed, with a changing pattern in different stages of the crisis. At the outset, the yet-to-be Eurozone crisis was exogenous, but it turned into an endogenous crisis from 2010 onwards. At the outset, the pandemic crisis triggered symmetric effects. Expected social and

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economic consequences of the crisis heighten the differences between MS, as far as its impact is considered, turning it into an asymmetric crisis. Overall, there is a sharp contrast between both crises. While the Eurozone crisis was (largely) endogenous and asymmetric, the pandemic crisis is an exogenous, symmetric (at least in the sanitary dimension) crisis.

4 The Cartography of Institutional Actors in the Pandemic Crisis As crises are an opportunity to foster paradigm change, the pandemic crisis might shed light on the institutional recalibration of the EU. We remind the reader that the analysis in this chapter is provisional, as the adjustment to the pandemic crisis is still ongoing. At the time of writing, the following is the assessment that we make of the inputs of the several institutions of the EU and national governments. We examine the actors’ positions in the early stage of the pandemic crisis, trying to understand how they fare on a scale that estimates how proactive or hesitant they were.

4.1 The European Central Bank: The Proactive Actor The European Central Bank (ECB) played a crucial role in the Eurozone crisis, as it is widely documented (De Grauwe and Ji 2015). The decision to “do whatever it is necessary” (quoting the famous speech of the former president of the ECB, Mario Draghi), and the subsequent Outright Monetary Programme (OMT) that pushed the monetary authority to buy MS public debt on the secondary market, was the turning point of the crisis. This changed the institutional balance in the Eurozone, as the ECB provided the main input to solve the crisis (Chang 2018), but additional effects reinforced its position (the indirect assistance to MS fiscal policy). It was no longer a low-profile institution, as the ECB became an institution with political influence (Verdun 2017). Yet, according to some sectors, the ECB’s decision to buy public debt came late (Breuss 2017). The ECB was challenged beforehand to play the role of lender of last resort. During Jean Claude Trichet’s tenure, the central bank was unwilling to act accordingly. The price to pay was an enduring crisis that (perhaps) could have been solved at an early stage. The centripetal role of the ECB during the Eurozone crisis is the benchmark to assess the monetary authority’s position when the Covid-19 outbreak started to hurt MS (and the Eurozone). The ECB was not assaulted by existential doubts or ideological inertia when the first signs of economic turmoil emerged. Differently from the Eurozone crisis, the ECB was swift to provide an input that anticipates expected negative effects of the economic crisis (Giavazzi and Tabellini 2020). The precedent of the OMT programme eased the decision of the Governing Council of the ECB. The

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decision was to create a new tool, the Pandemic Emergency Purchase Programme (PEPP), that enabled the ECB to buy up to e750bn of MS public debt on the secondary market on 18 March 2020 (Lucchese and Pianta 2020). The rationale was to give additional room for manoeuvre to MS fiscal policy now that they were challenged by the strenuous economic impact of the pandemic crisis. Costs connected with the sanitary dimension of the crisis (increasing spending with the national health system) are the first source of deterioration of the fiscal deficit. In addition, the anticipation of a deep recession paves the way to a second negative input: the likelihood that countries’ fiscal deficit will substantially worsen, as it is also expected that public debt unsustainability will affect some MS. Lessons were learned from the Eurozone crisis. The ECB reacted quickly, acknowledging the destructive potential of economies tied to the pandemic crisis. The proactive stance of the ECB is palpable. Instead of delaying decisions and waiting for the thorny effects of the crisis (as happened with the Eurozone crisis), the central bank went ahead at the first macroeconomic symptoms of the crisis, providing tools that are expected to efficiently address future challenges. The behaviour of the ECB was reinforced on 4 June 2020 when the Governing Council decided to almost double the PEEP capacity up to e1,350 trillion (European Central Bank 2020). The ECB reviewed estimations on the economic impact of the crisis, in line with other international organisations, national governments’ statistical offices and European Commission forecasts, recognising that the security belt must be reinforced to cushion national economies against the potential destructive effects of the pandemic crisis. When looking at the challenges of the pandemic crisis, the ECB acted before other actors, setting the example. The central bank plays a prominent role as it delivers a discreet but relevant input of political leadership. In addition, the central bank was in the spotlight because its officials’ statements place the institution at the chessboard of inter-institutional interactions, pushing its political visibility further. The monetary authority is asking national governments to engage in fiscal activism,1 which represents a paradigm shift in the governance of the Eurozone. In the past, for several times the ECB constrained national governments’ leeway on fiscal policy, pushing governments to maintain fiscal discipline. The current position of the ECB is different. The central bank recognises that the input to an efficient economic policy mix requires cooperation between different branches of economic policymaking. Monetary policy is still a very important area for shaping overall Eurozone economic policy, but the central bank itself is aware that fiscal policy must play an important role. Such is the case when deteriorating economic growth sets the stage. Prior to the outbreak of the pandemic crisis, the ECB had already stressed how important an expansion of countries’ public spending was to reinvigorate economic activity

1 Politico. “Lagarde pushes coronavirus emergency to governments”. 12 March 2020. https://www. politico.eu/article/christine-lagarde-european-central-bank-dumps-coronavirus-emergency-in-lea ders-laps/. Accessed 23 June 2020.

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and to boost economic growth.2 Now that the prospects for the short-term are so frightening, the plea of the ECB makes additional sense. The paradigm shift has a twofold rationale. First, through OMT and PEEP the ECB helps national governments’ handling of fiscal policy. It is understandable, therefore, that the ECB asks for national governments’ co-responsibility. MS cannot always rely on the initiative of the ECB when a negative business cycle hits the ground and national governments rely on the intervention of the monetary authority on public debt’s secondary market. Second, the central bank wants national governments to show a degree of commitment to economic recovery that lowers the threat of moral hazard which currently puts the “frugal four” (the Netherlands, Denmark, Austria and Finland) and the so-called “cohesion countries” against each other. By resorting to fiscal activism as purported by the ECB, national governments must comply with increased patterns of responsibility. Unsound fiscal policy is ruled out if national governments meet the ECB’s plea. The ECB therefore leads the way, as it fundamentally, but discreetly, happened with the Eurozone crisis.

4.2 The European Council: From Hesitation to a Path-Breaking Input? The Eurozone crisis highlighted the central role of the European Council in the EU institutional architecture. The numerous meetings of the Heads of State or Government attracted media attention, leading to a generalised perception that (some) national leaders controlled political decisions (Camisão 2015, 269). As a result of this “summitization” of crisis management (Martin Schulz cited in Dinan 2013, 89), the European Council ended up disputing (and, according to several studies, gaining) some of the Commission’s traditional powers, namely agenda-setting and policy initiative. Some authors go even further, arguing that, to a certain degree, the role played by the European Council in crisis management resulted in a fundamental shift from “economic governance”, i.e. a rules-based system, to “economic government”, which involves discretionary executive decisions (De Schoutheete and Micossi 2013, 5). In the current crisis, the European Council hasn’t taken centre stage, at least for the time being. The institution did not react as swiftly as the ECB (or the European Commission—see Sect. 4.3). As an institution where national authorities have a seat, it is reasonable that decision-making faces inertia. Frequently, qualified majority voting is used, which makes it easy to overcome obstacles to decisions tabled for discussion. For more sensitive decisions, unanimous decisions (or consensus, a euphemism for unanimity) are required. When divergent national interests clash, decision-making becomes cumbersome and prone to veto points. Decisions are often 2 Financial

Times. “ECB’s Lagarde urges governments to boost public investment”. 22 November 2019. https://www.ft.com/content/c3483866-0d07-11ea-b2d6-9bf4d1957a67. Accessed 23 June 2020.

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postponed until veto players are convinced and give their agreement (Frieden and Walter 2019). Some important decisions came from national governments. Nevertheless, they were focused on immediate challenges stemming from the sanitary dimension of the pandemic crisis, as the assignment of competences between the EU and MS puts these issues in the hands of national authorities. However, when the consequences of the pandemic crisis began to thrive, MS finally realised it was time to interact with EU institutions. Early discussions focused on how to economically support national economies in the event of the expected unprecedented economic crisis. A debate re-emerged about the reinforcement of EMU in order to prepare it for the likely event of an economic disruption with asymmetric effects. Since macroeconomic forecasts were overwhelming, old arguments about risk-sharing, Eurobonds (here renamed as Coronabonds) resurfaced (Herzog 2020). These discussions did not take place at the institutional level, but within the academia and the press. Nonetheless, the discussion spilled over to the political level. The European Council could not evade the discussion when a political-economic reaction to the economic effects of the pandemic crisis was at stake. At some point, discussions were fierce and unkind, as different viewpoints were expressed with vehemence and acrimony. The Dutch finance minister, Wopke Hoekstra, voiced his opposition to risk-sharing or to public debt mutualisation, adding unpleasant words on how Spain reacted to the outbreak of the virus.3 The Portuguese prime minister, António Costa, acted on behalf of snubbed Spaniards, saying that the words of the Dutch minister were “repugnant” and revealed a biased approach to European integration.4 In its 23 April 2020 meeting, the European Council asked the European Commission to submit a proposal on how to provide the Eurozone with an efficient answer to the expected economic effects of the crisis (European Council/Council of the European Union 2020b). Although a decision was expected for that meeting, hesitation prevailed, perhaps due to the impossibility of reaching a unanimous agreement among heads of state or government. The European Council bought some time, entrusting the European Commission with the task of preparing a detailed proposal for the near future. Thus, while hesitation hampered the European Council, the political profile of the European Commission was enhanced (see Sect. 4.3). A few days before the European Commission submitted a European Recovery Plan (on 27 May 2020, with the approval of the “Next Generation EU”)5 important events marked the timeline of the pandemic crisis in the EU. On 5 May 2020, the 3 Financial Times. “Straining the ties that bind

the Eurozone”. 26 March 2020. https://www.ft.com/ content/f54d21cf-0701-492e-8516-8f60d000d68f. Accessed 24 June 2020. 4 Euractiv. “Portugal slams Dutch finance minister for ‘repugnant’ comments”. 30 March 2020. https://www.euractiv.com/section/politics/news/portugal-slams-dutch-finance-minister-forrepugnant-comments/. Accessed 24 June 2020. 5 Politico. “European Commission Proposes e750B EU recovery package”. 27 May 2020. https:// www.politico.eu/article/commission-to-propose-recovery-instrument-of-e750-billion/. Accessed 24 June 2020.

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German Constitutional Court announced they were not convinced by the European Court of Justice (ECJ) ruling that confirmed the legal congruence of the ECB’s OMT programme (BVerfG 2020). The German Constitutional Court asked the ECB to provide convincing legal arguments within three months. Maybe the timing of the German Constitutional Court’s ruling is not innocent. The ECB had just announced a new PEPP as the central bank’s input to the accommodation to the expected economic crisis. Amidst criticisms (Maduro 2020) and praise to the German Constitutional Court (Buras and Dalhuisen 2020), a legal battle with unexpected political consequences was open. Some days afterwards (on 18 May 2020), the German chancellor, Angela Merkel, and the French president, Emmanuel Macron, presented a joint plan for the recovery of Europe in the face of the pandemic crisis.6 Both countries were eager to put aside the usual lens of hesitant political reaction and expressed their political willingness to a massive recovery plan made partially of grants and partially of loans. Business as usual: a Franco-German initiative leads the way. This time Germany was not opposed to accept a more ambitious solution that, one way or the other, will involve higher disbursements and a burden to German taxpayers. It remains to be seen whether this initiative, which France openly embraced, was the political reaction to the unexpected drama triggered by the constitutional doubts of the German Constitutional Court. The Merkel-Macron plan paved the way for the European Commission’s proposal, the “Next Generation EU” plan, submitted on 27 May 2020. From a political point of view, this joint action gave moral authority to the European Commission’s soon-tobe recovery plan (see below, Sect. 4.3, for the characteristics of the plan). The plan was first presented on the 19 June European Council meeting, where disagreements were noticed. The European Council approved the Recovery Plan on the 17–21 July meeting, following dramatic, lengthy negotiations. The final version kept the total amount of funds unchanged (e750bn). Nevertheless, the distribution between grants and loans was changed, with less funds available through grants (e390bn, against e500bn planned by the European Commission’s proposal) and an increased package for loans (e360bn, instead of e250bn as planned at the outset) (European Council/Council of the European Union 2020c).

4.3 The European Commission: Muddling Through? The role of the European Commission (henceforth Commission) in the Eurozone crisis is a disputed topic in the literature. Whereas some studies concluded for its active role, even in intergovernmental forums of negotiation (Camisão 2015), others portrayed the Commission as a marginal player at best (Hodson 2013). Authors 6 The

Guardian. “Franco-German plan for European recovery will face compromises”. 26 May 2020. https://www.theguardian.com/world/2020/may/26/franco-german-plan-for-europeanrecovery-will-face-compromises. Accessed 24 June 2020.

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were less divided regarding the importance of the new competences the Commission gained out of the reform of the EMU, which gave the institution room to play a much more salient role in a mostly intergovernmental area, though dependent on its ability to transform technical competences into political influence (Vila Maior and Camisão 2018, 112). Indeed, the bulk of the analyses pointed to the Commission as a winner of the crisis (Bauer and Becker 2014; Camisão 2015; Savage and Verdun 2016), considering that the institution “not only kept but has reinforced its powers of monitoring and surveillance (including budgetary surveillance)” (Vila Maior and Camisão 2018, 110). An assessment of the role played by the Commission in the ongoing pandemic crisis has to take into account many layers, since, as discussed in Sect. 3, this is a multifaceted crisis that encompasses several policy dimensions. Considering the scope of the book, our assessment of the Commission’s role is focused mostly on the economic tier of the crisis. Following the opening of an alert notification on the Early Warning and Response System (EWRS) by the Directorate General for Health and Safety (DG Sante), the first actions of the Commission were related to the sanitary dimension of the crisis, namely mobilising funds for research (including research for treatment, diagnosis and vaccines), launching joint procurements of personal protective equipment together with MS, coordinating EU support to China and the repatriation of EU citizens through the EU Civil Protection Mechanism. The first European case was reported on 24 January, but the seriousness of the problem in Europe was not fully grasped until late February, early March. At that time, domestically, MS response was based on an “every man for himself”7 approach. Some critics blame the Commission’s indecisiveness for this initial cacophony.8 In the institution’s defence, a strong Commission’s response would have been difficult as the EU only has support competences in public health (article 168.º TFEU) and has no autonomous competences regarding crisis management. Also, a closer look at the timeline of the EU response does not confirm the accusations of inaction.9 That being said, the first initiatives that came from “Brussels” were completely dwarfed by the uncoordinated actions of national leaders (Faiia 2020). Eventually, as the crisis unfolded, its multiple ramifications were disclosed, pervading areas of EU shared (or even exclusive) competence (including competition and the market), and therefore giving the Commission enough room to be proactive (rather than reactive). Steadily the Commission’s action extended to interrelated matters such as travel and transportation, disinformation and, of course, the 7 The

expression was used several times to describe MS actions, including by Internal Market Commissioner, Thierry Breton, during an interview to the French television channel LCI (April 2020). 8 The President of the Commission recognized the EU’s initial unpreparedness: “Yes, it is true that no one was really ready for this. It is also true that too many were not there on time when Italy needed a helping hand at the very beginning. And yes, for that, it is right that Europe as a whole offers a heartfelt apology” (Von der Leyen 2020b). 9 For a full list of the Commission’s response to the pandemic, see, for example, European Commission, Timeline of EU Action. https://ec.europa.eu/info/live-work-travel-eu/health/coronavirus-res ponse/timeline-eu-action_en. Accessed 26 June 2020.

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economy. The more the severity and the multidimensionality of the crisis became clear, the more the idea of a coordinated answer became appealing. The Commission not only advocated the idea, but took upon itself the task of carrying it out: When Europe really needed an ‘all for one’ spirit, too many initially gave an ‘only for me’ response (…) But it was not long before some felt the consequences of their own uncoordinated action. This is why over the last few weeks we took exceptional and extraordinary measures to coordinate and enable the action that is needed. (von der Leyen 2020a)

The institution’s narrative consistently repeated the need for urgent action based on solidarity and a coordinated strategy (European Commission 2020a, b; Von der Leyen 2020a). As a first immediate move to assume the lead, in the beginning of March, the President of the Commission, Ursula von der Leyen, set up a coronavirus response team10 to bring together the different strands of action around three main pillars: medical field, mobility (including Schengen) and economy. By then, it was clear that the Commission was invested in playing its full part. The Commission’s centrality was soon confirmed by EU national leaders. On 10 March, the Heads of State or Government of the EU countries held a videoconference on the response to the Covid-19 outbreak, mandating the Commission to further step up its response to the coronavirus pandemic and to coordinate MS actions. Following the meeting, the Commission President announced a “Corona Response Investment Initiative” (CRII) allowing for e37bn under the cohesion policy to be redirected to the fight against Covid-19. On the same day, the Commission proposed measures to ease the negative impact of the Covid-19 outbreak on the aviation industry and the environment. The CRII and several other measures aiming at ease the socio-economic impact of the pandemic were putted forward only three days later (13 March), in the Communication on a coordinated economic response to the Covid-19 outbreak. The Commission’s proposals included deploying existing EU budget instruments in order to facilitate immediate relief to firms, sectors of activity and regions, state aid to citizens and national companies (foreseeing the possibility of a temporary framework to enable MS to use the full flexibility foreseen under state aid rules to support the economy in the context of the Covid-19 outbreak),11 enhancing the liquidity of the banking sector, broadening the scope of the Solidarity Fund to include major public health crises, and the flexibility of the European fiscal framework, namely through the activation of the general escape clause of the Stability and Growth Pact to accommodate a more general fiscal policy support (European Commission 2020a). The Commission’s proposals were welcomed and endorsed by the Eurogroup and the European Council (Eurogroup 2020; European Council 2020a). The Commission was then at

10 The Coronavirus response team includes five commissioners: Janez Lenarˇ ciˇc (crisis management); Stella Kyriakides (health issues); Ylva Johansson (border-related issues); Adina V˘alean (mobility), and Paolo Gentiloni (macroeconomic aspects). See, European Commission Coronavirus response team. https://ec.europa.eu/info/live-work-travel-eu/health/coronavirus-response/european-commis sions-action-coronavirus_en. Accessed 26 June 2020. 11 The Temporary Framework was adopted on 19 March.

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full steam, issuing proposals and adopting measures on a regular basis (for all dimensions of the crisis), of which the SURE initiative (2 April),12 a solidarity instrument supporting MS to protect employment in the difficult emergency circumstances of the COVID-19 pandemic, is just an example. The endorsement and the swift adoption of the majority of the Commission’s proposals appear to confirm that in crisis management other central EU institutions not only accepted, but actually expected the Commission’s entrepreneurship. As the economic dimension of the crisis gained ground to its health dimension, due simultaneously to a decrease in the numbers of the disease and to devastating economic forecasts, the challenge was to come up with a recovery plan robust enough to rival with the one that lifted Europe’s economy after the Second World War. The call for a second Marshal Plan echoed from various fronts. Acting on a request from the European Council members (26 March 2020),13 the presidents of the Commission and of the European Council presented a Joint European Roadmap towards lifting COVID-19 containment measures (15 April 2020), aiming at getting Europe’s societies and economies back to a normal functioning and to prepare the ground for a comprehensive recovery plan. Unable to reach an agreement on the details of a common solution (see Sect. 4.2), the European Council (23 April 2020) mandated the Commission to design the Plan. Despite the urgency of the request, it took the Commission more than one month to present the proposal (27 May 2020). One obvious explanation is the magnitude of the task ascribed to the Commission. Indeed, to come up with a plan both ambitious enough to lift EU’s economy from the deep crisis, and consensual enough to overcome MS substantial differences on the size and type of instruments to channel the funds (e.g. grants or loans), was a particularly difficult endeavour. The Plan foresees a e750bn European Recovery Instrument, dubbed Next Generation EU. The Commission, on behalf of the EU, will borrow for the recovery fund on the financial markets. Loans are to be repaid through future EU budgets (from 2028 to 2058).14 Adding to this, the Commission presented a revamped proposal for the next Multiannual Financial Framework (amounting to some e1.100bn between 2021 and 2027) and an updated Commission work programme for 2020 (European Commission 2020b, 4). The money raised through Next Generation EU and the new EU budget will be channelled through EU programmes and invested across three pillars (European Commission 2020b, 4–6): (i) support to MS for investment and reforms, which include a new “Recovery and Resilience Facility” totalling e560bn (of which e310bn in grants and e250bn in loans) to help MS in funding their recovery and resilience plans, and a new initiative REACT-EU for crisis repair measures; (ii) 12 The

proposal was adopted by the Council on 19 May 2020. European Council/Council of The European Union. (2020). Joint statement of the Members of the European Council. https://www.consilium.europa.eu/media/43076/26-vc-euco-statement-en. pdf. Accessed 30 June 2020. 14 Under the repayment topic, the proposal (re)introduces the debate about possible new sources of the EU’s own resources, including the extension of the Emission Trading System, a carbon border tax, a digital tax or own resources based on operations of large enterprises (European Commission 2020b, 4). 13 See

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kick-starting the EU economy by incentivising private investment, which includes upgrading InvestEU and creating a Strategic Investment Facility and a new Solvency Support Instrument; (iii) lessons from the crisis, which entails creating a new standalone EU4Health Programme for prevention and crisis preparedness and boosting the support to EU global partners through the enhancement of the existing external cooperation and aid instruments. The Commission’s proposal was received on a fairly positive note by the majority of the MS, with the exception of the so-called “frugal four”,15 who were opposed to a mutualisation of debt and to an increase of the EU budget.16 Regardless of the generalised idea of a good “starting point” for the negotiations, no one doubted the toughness of the process ahead. A note of cautiousness was captured by Merkel’s words following von der Leyen’s speech: “Negotiations will be difficult” (Potor and Boucart 2020). In a nutshell, a look at the Commission’s actions in the last six months confirms that the institution took substantial measures in the areas where its competences allow it to do so. However, it remains to be seen whether the Commission’s activism will be sufficient to countervail the initial negative image of a Union that failed to assist its MS when they most needed it.17

5 Conclusions The significant differences between the current pandemic crisis and the previous Eurozone crisis had an impact on the role of EU institutional actors throughout the events. The Eurozone crisis was an endogenous, asymmetric crisis that affected MS unevenly, triggering a “you’re to blame” narrative that woke up old divisions between rich and poor, north and south, creditors and net recipients. The current crisis is an exogenous, symmetric crisis that began as a public health issue, with no immediate scapegoats, except a generalised perception that the problem was initially underestimated regarding its potential impact by international and national authorities. In the Eurozone crisis, EU institutions hesitated to respond, in part due to the lack of adequate instruments within the EMU framework, but also to the unwillingness of some MS to address a problem they consider someone else’s problem. In this crisis, EU institutions such as the Commission had their hands tied up, considering that the EU has no clear public health or, for this matter, crisis management competences. 15 See European Commission unveils 750-billion recovery plan, DW.com. https://www.dw.com/en/ european-commission-unveils-750-billion-recovery-plan/a-53584998. Accessed 30 June 2020. 16 The chorus of criticism was bigger when it came to the Commission’s methodology for channelling the funds to MS, which has been contested by several countries (including the Netherlands, Denmark, Austria, Belgium, Ireland, Lithuania and Hungry) for having no direct connection with the pandemic. 17 See, for example, Herszenhorn et al. (2020). Ursula von der Leyen’s Disaster Management. Politico, 27 April 2020. https://www.politico.eu/article/european-commission-president-ursulavon-der-leyens-coronavirus-covid19-disaster-management/. Accessed 29 June 2020.

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When the disease reached pandemic status, MS reacted in panic, adopting disarticulated measures, even in areas that eventually encroached on EU competences such as borders or the single market. This cacophony contributed to the initial generalised perception that the EU failed to respond when its MS most needed it. As in many other difficult times, the obituary of the EU was written. As the crisis unfolded, it became clear that we are facing a multi-layered crisis that extends well beyond its sanitary dimension. One of the dimensions of the crisis that stood out was its impact on the EU economy, as the lockdown measures adopted by MS to halt the spread of the disease temporarily paralysed a large part of MS economic activity. This opened up room for the Commission and other institutional actors such as the ECB to play a proactive role, since the EU has clear instruments and opportunities to intervene in this area. Confirming the prominence gained during the Eurozone crisis, in the current crisis the ECB jumped to the limelight by boldly announcing its intention to step up its purchases of government debt (through its new PEPP) and to lend freely. Invested in playing a coordinating role, the Commission experienced some difficulty in overcoming the resistance of some MS, but soon picked up the pace, making bold proposals and pushing for the possible coordination of MS decisions regarding crisis management. The European Council, unable to reach consensus on a common solution, adopted a passive position, mandating the Commission to present a large-scale recovery plan. To be fair, that is exactly how things normally work in the EU. The Commission makes the proposal and the other institutions (the Council, the European Parliament or the European Council, depending on the subject) build on that. But we are not in normal times. Perhaps the “politics of events” are more “business as usual” than anticipated. Will this be enough?

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Paulo Vila Maior Ph.D. in Contemporary European Studies (University of Sussex, Brighton, UK), Associate Professor at University Fernando Pessoa (Faculty of Social and Human Sciences) and full member of CEPESE (Research Centre for the Study of Population, Economy and Society, University of Porto). He was the Coordinator do the Jean Monnet Action “European Union Politics” at University Fernando Pessoa (2007–2012). His main areas of research are European economic governance, with a focus on the political economy of Economic and Monetary Union, Eurozone crisis and reform, federalism and the European Union, and the constitutionalization of the European Union. Isabel Camisão Ph.D. in Political Science and International Relations, Assistant Professor at the Faculty of Arts and Humanities of the University of Coimbra. Currently, she is also Deputy Dean of the same Faculty and Director of the B.A. in European Studies. She is full member of the Research Center in Political Science, coordinator of the APCP’s Section of European Studies, the Portuguese coordinator of the UACES RN Communicating Europe, and member of the Jean Monnet Centre of Excellence PRONE, University of Coimbra. Her main areas of research are EU governance and institutions, with a focus on leadership and entrepreneurship.

The Post-pandemic Euro: Macroeconomic Lessons Learned from Crises and Economic Orthodoxies Luis A. Hierro, Pedro Atienza-Montero, Helena Domínguez-Torres, and Antonio J. Garzón

Abstract In 1999, the euro was launched on the basis of treaties structured around the new economic orthodoxy that replaced Keynesianism. The Great Recession, the Euro Crisis and now the Pandemic Crisis, all of them deflationary demand crises which are incompatible with such an orthodoxy, have had a similar effect and have blown away the economic orthodoxy of the last 40 years. The European Union (EU) entrusted all of its economic regulation to this orthodoxy and has been the main victim of its failures since 2008. The Great Recession brought about public deficit and, due to the requirement of the treaties, procyclical fiscal policies were applied, causing a W-shaped crisis that no other economies in the world suffered, while the European Central Bank (ECB), tied to its objective of controlling inflation, was unable to react suitably. The result was growing citizen detachment from the EU project. We review how economic crises have been exposing the mistake of creating the EU in the image and likeness of the economic orthodoxy of the moment and how Europe has had to overcome, one by one, the rules established in the treaties in order to implement effective policies and so combat economic crises. Keywords Euro · Economic crises · Economic orthodoxies · Treaties · Pandemic

1 Introduction In February 1999, Alan Greenspan, the main bulwark of the economic orthodoxy of the moment and chair of the Federal Reserve (FED), in his speech before the Senate and Congress, used the term “virtuous cycle” to define an ideal economic situation of stability with low inflation and low unemployment, based on a new economic orthodoxy that he described as follows: “Americans can justifiably feel proud of their recent economic achievements. Competitive markets, with open trade both domestically and internationally, have kept our production efficient and on the expanding frontier of technological innovation. The determination of Americans to L. A. Hierro (B) · P. Atienza-Montero · H. Domínguez-Torres · A. J. Garzón Department of Economics and Economic History, University of Seville, Seville, Spain e-mail: [email protected] © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 J. Caetano et al. (eds.), New Challenges for the Eurozone Governance, https://doi.org/10.1007/978-3-030-62372-2_16

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improve their skills and knowledge has allowed workers to be even more productive, elevating their real earnings. Macroeconomic policies have provided a favourable setting for the public to take greatest advantage of opportunities to improve its economic well being. The restrained fiscal policy of the Administration and the Congress has engendered the welcome advent of a unified budget surplus, freeing up funds for capital investment. A continuation of responsible fiscal and, we trust, monetary policies should afford Americans the opportunity to make considerable further economic progress over time” (Greenspan 1999). In the midst of this wave of optimism, that same year the EU had launched its new currency, the euro, approving some treaties in doing so: The Treaty on the European Union (TEU) and the Treaty on the Functioning of the European Union (TFEU), which regulated an economic system in line with such an ideal. In the grip of economic euphoria, Robert Lucas, in his presidential address delivered at the 155th meeting of the American Economic Association on 4 January, 2003, declared that depressive crises were over: “My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades” (Lucas 2003, p. 1). Five years later, the second most important depression the world had known up to that moment unleashed itself and the EU found itself tied to an economic policy framework that was totally ill-equipped to fight it. This chapter is devoted to reviewing the transition the EU has undergone in its attempt to adapt its economic policy to the needs triggered by the Great Recession and the current pandemic and to circumvent the self-imposed restrictions caused by its rigorous adherence to this economic orthodoxy—a transmutation process that sheds light on the radical changes that must be incorporated into the treaties so as to give rise to a new Europe in the economic domain.

2 Economic Crises Although some economic schools play down their existence, economic crises do exist and do recur. They take place when production decreases, rather than increasing, as is the norm, and their direct effect is to spark a rise in unemployment, while one very important indirect effect is that they destabilise the financial balance sheets of economic agents, which amplifies their effect on the economy over time. Regardless of whether the consequences on production and employment are similar, economic crises differ significantly from one other. If we consider the event which triggers them, economic crises differ depending on whether they originate from circumstances outside the economy or are caused by the economic system itself. The former are called exogenous shocks and are usually caused by international political crises, natural disasters, wars, pandemics… In contrast, the system’s

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own crises occur when economic malfunctioning leads to an accumulation of imbalances that eventually become unsustainable. These imbalances can also be generated by misapplying economic policy. Economic crises may stem from the real sphere of the economy, directly affecting aggregate demand and/or aggregate supply, or may originate in the financial sphere of the economy (financial markets, exchange markets and financial intermediaries…) and then affect supply or demand. Crises that affect supply are fundamentally associated with changes in production costs and their structure, while demand crises are caused by a fall in private spending (consumption/investment) or public spending, or by the deterioration of the current account balance. Geographically speaking, crises can affect a country, a group of countries or an economic region, or indeed the whole world. When they spread beyond a country’s borders, they are transmitted through international financial flows and the trade of goods and services between countries. Recurrence and persistence over time is another fundamental characteristic to be taken into account. Crises may be cyclical, when they are recurrent and are preceded by expansionary periods, or may be structural when they involve changing the path of long-term economic growth. One key feature of economic crises is their effect on price levels. Some crises increase price levels; in other words, inflationary crises, whereas others put downward pressure on prices, and are known as depressive or deflationary crises. This effect is essential vis-à-vis identifying the transmission mechanism of the crisis, whether it be through supply or demand, as well as with regard to selecting the appropriate economic policy response. The most important economic crises to have occurred over the last 50 years are shown in Table 1, where we describe their main characteristics. Most notable was the crisis resulting from the oil shocks and the Great Recession, given the impact they had on the orthodox economic concept of the moment. In the EU, the first crisis after the euro was launched was an asymmetric shock, which did not affect all the economies of the Eurozone, and which was caused by the German recession of 2002–2003. The German economy had been struggling from economic woes related to its unification in 1989–1990 (Bank for International Settlements, BIS 2003), and these difficulties were aggravated by the burst of the dotcom bubble (International Monetary Fund, IMF 2003). As of 2008, the EU was hit by the Great Recession, as were all other countries. In an effort to counter the decline in economic activity, the Group of Twenty (G20) agreed in Washington to deliver a coordinated expansionary policy that was quantified at five billion dollars worldwide at the London summit in April 2009 (G20 2009), in addition to the reaction of the automatic stabilizers. The result was an increase in public deficits, which caused a liquidity crisis and the deterioration of peripheral countries’ sovereign debt risk premium in 2010. In an attempt to improve access to markets, the EU imposed austerity policies, which merely worsened existing macroeconomic conditions and triggered a new crisis that lasted until 2014, and which came to be known as the European sovereign debt crisis or the Euro Crisis. The next crisis is the one that has just started, caused by the Covid-19 pandemic.

Endogenous-Economy

Latin American debt crisis

2000/2001

2008/2009

2011/2014

Dot-com crisis

Great Recession

Euro crisis

Source Authors’ own compilation

Endogenous-Economy

1997/1998

Southeast Asian financial crisis

Endogenous-Economic Policy

Endogenous-Economy

Endogenous-Economy

Endogenous-Mixed

Recession of the 1990/1993 early 90s

1981/1983

Exogenous

Exogenous

First oil shock

Endogenous-Economic Policy

1973/1975

1970/1971

End of dollar convertibility (Nixon Shock)

Source

Second oil shock 1978/1981

Year

Name

Contractionary fiscal policy against the deterioration of risk premiums

Housing and stock market bubbles

Stock market bubble

Foreign private over-indebtedness

Housing and stock market bubbles and anti-deflationary monetary policy

Foreign public over-indebtedness

Oil prices rise

Oil prices rise

USA trade rebalancing policy

Source

Table 1 50 years of economic crises: 1970–2020. Main characteristics

Monetary/real

Monetary

Monetary

Monetary

Monetary

Monetary

Real

Real

Monetary

Sector

Regional

Global

Global

Regional

International

Regional

Global

Global

Global

Geography

Demand

Demand

Demand

Supply

Demand

Supply

Supply

Supply

Demand

Mechanism of transmission

Deflationary

Deflationary

Deflationary

Inflationary

Deflationary

Inflationary

Inflationary

Inflationary

Inflationary

Effect on prices

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3 Economic Orthodoxies and Crises Economic crises and their solutions are not indifferent to the predominant economic orthodoxy of the moment. The prevailing economic paradigm defines the analytical framework for interpreting the crisis and, as a consequence, also defines the economic policy to be applied. Major economic crises are often associated with incorrect interpretations of the type of economic crisis or inadequate definitions of the economic policies to be applied. When misinterpretation of the crisis occurs because the current economic orthodoxy lacks the instruments to understand it or is conceptually incompatible and cannot generate sound economic policies, scientific change starts and leads to a substantial shift in economic orthodoxy (Kuhn 1962). Over the last 100 years, we have experienced three crises that can be classified within the group of crises which alter economic orthodoxy and trigger crises in economic thought (“scientific revolutions” according to Kuhn [1962] or “new research programs” according to Lakatos [1980]). The Great Depression that followed the burst of the US financial bubble, known as the Crash of 1929, is one example of this situation. Classical orthodox economists of the time explained the economy as a process where the production of a good activated its demand and the system, by aggregation of microeconomic equilibria, produced a general equilibrium, based on a gold standard monetary policy. In that system, depressions were temporary imbalances in this equilibrium and were usually the result of bad harvests that slowed down production and caused unemployment and famines. Prior to that, there was no division between macroeconomics and microeconomics; demand was irrelevant and the best economic policy was the one that did not exist. The main particularity of the Great Depression is that it was global and that it was caused by an unprecedented financial crisis which destroyed much of the banking system. In addition, following the prescriptions of classical liberal orthodoxy (CO), governments failed to intervene and the economic crisis grew worse by the day due to ever-growing unemployment, the fall in consumption and the paralysis associated with any deflationary process. It is the greatest depression capitalism has ever known. The way out of the crisis was first articulated by political initiative: the Swedish Social Democrat (1932) and the American “New Deal” (1933) are its main examples. The building of an alternative orthodoxy began on the basis of the Keynesian Revolution (Keynes 1936) and created a new theoretical body, macroeconomics, which was consolidated and which prevailed until the 1980s. The basis of the new Keynesian orthodoxy (KO) was to adjust aggregate demand in constant pursuit of full employment, based on a fixed exchange rate system. Implicitly, KO was a system that worked permanently with a flat Aggregate Supply (AS) curve, so that by offsetting falls in private spending with public spending, it managed to maintain full employment. Price stability was achieved by keeping a fixed exchange rate against a convertible dollar, as agreed at Bretton Woods. As did the Great Depression, the crises that took place during the 1970s also unleashed similar effects. KO was twice hit below the waterline. In 1970, the end of the convertibility of the dollar destroyed the Bretton Woods international payment

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system and with it world monetary stability. Immediately after this event, two oil shocks triggered what was a hitherto unknown situation, and one which did not square with KO, and which came to be known as stagflation (unemployment + inflation). If governments were to apply an expansionary demand policy, inflation would not stop increasing and economies might suffer from hyperinflation, whereas if they were to restrict demand, they would only generate further unemployment. Demand-based Keynesianism was unable to properly identify the type of crisis and so deliver an effective economic policy. The result was that the economic crisis persisted over time and the academy built a new classical type orthodoxy, based on market flexibility, using flexible exchange rate systems and restrictive monetary policies. We will call this the “Second Classical Orthodoxy” (SCO). The SCO was based on the hypothesis that there is a tendency towards full employment, which is called long-term equilibrium, and that when shocks disrupt this equilibrium a selfadjusting process of returning to long-term equilibrium is triggered through price and wage adjustment. The main aim is to maintain a very strict monetary policy that prevents the growth of inflation while market regulation allows for fast adjustment. Under the umbrella of this orthodoxy, the last great crisis of this kind took place. This commenced in 2008 and is referred to as the Great Recession. This was a crisis in the monetary sphere of the economy, the culmination of a continuous process of recurring financial crises that ended up affecting the world’s largest economies. In the USA, a financial bubble was generated and was transmitted through international financial flows which, on bursting, crippled the banking system in many countries. The SCO was unable to comprehend this crisis, given its deflationary nature, and its advocates defended an economic policy based solely on monetary policy, entrusting the adjustment of the real economy to the system itself, through the self-tuning adjustment of prices and wages (wage deflation) that should be accelerated through so-called “structural reforms”.1 Again, the crisis extended over time due to the lack of action proposed by the SCO, and the famous “lost decades”2 affected many countries. This failure triggered a fresh orthodoxy, which has undoubtedly been accelerated as a result of the pandemic.

4 The SCO and European Union Treaties One singularity of the EU is that its constitutional configuration was intended to build a regulated economic model which is fully consistent with the SCO. This economic system is embedded in the TEU (article 3) and in the TFEU (Title VIII. “Economic and Monetary Policy”). Its most generic definition appears in art. 119 of 1 Structural

reforms usually refer to those which contribute towards market flexibility, in particular the labour market, so as to foster price adjustment and control structural or permanent public spending (pensions, public sector pay…). 2 The term “lost decade” was coined to describe the depression which Japan suffered after the 1991 banking crisis (Hayashi and Prescott 2002).

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the TFEU when it affirms that “Member States economic policies will be conducted in accordance with the principle of an open market economy with free competition”. This generic definition is split into a series of pieces which, as in a puzzle, fit together until they define an economic system that is fully consistent with the SCO: the absolute freedom of capital flows established in art. 63 of the TFEU; price stability as the main objective of the euro defined in art 119.2 of the TFEU; total independence of the ECB in art. 130 of the TFEU; and the separation of fiscal policy and monetary policy by prohibiting direct and indirect deficit monetization, art. 123 and 124 TFEU, respectively.3 The outcome of this economic framework was a single economic policy based on controlling inflation and public deficit. To explain how the SCO works, we use Fig. 1, which is common in SCO-era macroeconomics manuals (Dornbusch and Fischer 1978 in the first stage and Blanchard 1996, in the most recent stage). The economy’s self-adjusting tendency towards full employment is represented by the ASLP curve, and movements of the economy occur along the ASSR curves or with a shift in these curves. A supply shock, i.e. an oil shock (Fig. 1A) cannot be dealt with by expanding demand, since this would push prices and wages up, causing an inflationary spiral (adjustment 1). The solution is tight control over monetary policy so that inflation expectations are anchored lower and wages are adjusted downward, such that the ASSR cushions the shock and returns to the initial equilibrium (adjustment 2). Likewise, inflation also proves problematic if demand expands when the system is in equilibrium, since the temporary increase in production is offset by increases in prices and wages that shift the ASSR curve (adjustment 3). The way to avoid expansions in demand is to apply a restrictive monetary policy in the face of an excessive rise in private spending (adjustment 4) and a fiscal policy aimed at balancing the budget, which prevents expansionary public spending policies. The main consequence of the

Fig. 1 Representation of the basic problems of economic policy according to the SCO. Source Authors’ own compilation 3 Hierro

et al. (2019) describe this design as a process of adapting the Union’s economic policy to the principles proposed by Williamson (1990, 1993), which became popular under the name of the “Washington Consensus”.

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SCO is that the economic policy objectives are always the same: to control inflation and public deficits. In the EU, the objective of inflation control was set above any other in art. 127 of the TFEU (“The primary objective of the European System of Central Banks (hereinafter referred to as ‘the ESCB’) shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union”). For fiscal policy, art. 126 of the TFEU limited deficit and public debt, imposing strict supervision of budgetary discipline on member states. The resulting economic policy of the SCO was thus regulated at the constitutional level in the EU. The global expansion of the SCO was systematic and many countries adapted their regulatory frameworks to the new economic policy, imposing rules and limits. However, there were substantial differences. Whereas the EU’s anti-inflationary objective was set at the constitutional level, other countries not affected by constitutional processes adapted their laws, yet without embracing the new economic policy into the constitution. However, some countries did not modify their specific legislation. For example, the USA maintained its regulation with a multi-objective scheme where full employment precedes price stability: Section 2A of the Federal Reserve Act: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.4 Australia maintained its own vision of KO, leaving inflation out of any legal targets: Section 10(2) of the Reserve Bank Act (1959) “It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank under this Act and any other Act, … are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to: (a) the stability of the currency of Australia; (b) the maintenance of full employment in Australia; and (c) the economic prosperity and welfare of the people of Australia”.5 As regards public deficit, the EU also incorporated the strict version of the SCO at the constitutional level, and the limits referred to in art. 125 of the TFEU were set at 3% of GDP for deficit and at 60% of GDP for public debt in Protocol 12 of the TFEU. The hyper-reaction of the EU during the Euro Crisis led to the Treaty on the Stability, Coordination and Governance (TSCG) in 2012, establishing in its art. 3.2 the obligation of member states to incorporate the budget balance rule into national law, “preferably of constitutional rank”. Prior to the ratification of the TSCG, Germany, voluntarily, and Spain at the request of the EU, had already incorporated the rule into their respective constitutions (art. 109.3 of the Basic Law of Bonn and art. 135 of the Spanish Constitution). 4 https://www.federalreserve.gov/aboutthefed/fract.htm

(accessed 23 June 2020). (accessed 23 June 2020).

5 https://www.legislation.gov.au/Details/C2015C00201/Html/Text

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With regard to this issue, the USA was again less incisive, creating partial specific regulations, which were never of constitutional rank, such as: The Budget Enforcement Act, which imposed an annual limit on discretionary spending; or the Pay As You Go rule, which establishes deficit control by demanding budget neutrality in long-term structural spending (Health, Social Security, etc.) (Auerbach 2008). In any case, these regulations have been modified so as to adapt them to reality when compliance therewith has not proven feasible for some reason. In short, both in the monetary and fiscal spheres, the SCO had far greater relevance and legal status in EU countries than it did in other countries and, when the Great Recession hit, the EU found itself tied to a veritable straitjacket in matters of monetary and fiscal policy which, as shall be seen below, pushed the EU to the limit, putting its future and its very existence at risk.

5 The Effects of the Great Recession and the Eurocrisis in the Eurozone The problem of having set up the fight against inflation and public deficit as key economic policy objectives emerged when the first economic depression of the euro era unfolded in 2008. Monetary policy, whose sole objective was to pursue price stability, had been defined so that inflation would not exceed 2% per year, which meant that if a deflationary crisis appeared, such an objective would be reached without having to act monetarily. Since any financing of states was also prohibited, even indirectly, large-scale quantitative expansions were excluded. As a result, the ECB had no macroeconomic commitment to fight the crisis and merely confined itself to supporting bank liquidity. What is more, the ECB raised the interest rate twice in 2011 (April and July), in the midst of a recession, in an incomprehensible move (Hierro et al. 2019). The ECB played it by the book in terms of its monetary policy manual: “In the long run, the central bank cannot influence economic growth by changing the money supply” (ECB 2011, p. 55), and failed to apply any quantitative easing expansion in the strict sense until 2015, six years after the FED had done so. If Eurozone monetary policy had proved ineffective in macroeconomic terms until 2015 (Borrallo and Hierro 2019; Domínguez and Hierro 2020), in the case of fiscal policy it proved to be even worse. In the autumn of 2009, a problem in Greece’s public accounts came to light, which led to a serious problem in the price of its public debt. The architecture of the EU prevented the ECB from acting as a lender of last resort, either directly or indirectly, a situation which was exploited to cast doubt on the solvency, first of Greece, later of Portugal and Ireland, and finally of Spain and Italy. The Eurogroup, whose members were outspoken advocates of the SCO, reacted by invoking deficit and debt limits, attributing deficits to peripheral country mismanagement and ignoring the deflationary nature of the global crisis and the effect of automatic stabilizers. This invocation shattered the consensus that had existed within the G20 up to that point.

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Real GDP annual growth (%)

6 4 2 0 -2 -4

Euro Area real GDP growth

2018

2019

2016

2017

2015

2013

2014

2012

2010

2011

2008

2009

2007

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2006

2004

2002

2003

2000

2001

1999

1998

1997

1996

-6

US real GDP growth

Fig. 2 Evolution of the GDP growth rate in the Eurozone and in the USA. 1996–2019. Source Authors’ compilation based on Eurostat data and the US Bureau of Economic Analysis

By activating protocols for non-compliance with debt and deficit limits, the EU prevented automatic stabilizers from being triggered and imposed spending cuts and tax increases that led to deflationary fiscal policies at a time when the economy was already suffering from a global depression. This procyclical policy sparked a second crisis in the EU. The result was a resounding failure of the extreme version of the SCO implemented in the EU, which caused a W-shaped crisis like the one seen in Fig. 2, which shows GDP growth rates in the USA and the Eurozone.6 The first glimpse of the separation of EU economic policy from the SCO occurred in 2012. Indeed, in 2010, when the EU created the first financial assistance mechanism, in other words, the European Financial Stability Facility, the ECB implemented the Securities Market Program (SMP) which was aimed at purchasing public debt in the secondary market. However, its conditions and size made it irrelevant, since in reality the ECB was reluctant to apply a monetary solution to the sovereign debt problem and refused to assume the role of indirect lender of last resort. ECB inaction pushed the euro to the brink of self-destruction and on 26 July, 2012, faced with the possible collapse of public debt markets in Spain and Italy, President Draghi ended the Euro Crisis with his famous phrase: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro and believe me, it will be enough” (ECB 2012a). The result of this declaration was the birth of the Outright Monetary Transactions Program (OMT), through which the ECB could acquire sovereign bonds from countries affected by bailouts for an amount that was in principle unlimited (ECB 2012b, 2012c). 6 Despite

the stubbornness of the data, it was not until January 2015 with the appearance of the unorthodox Greek Minister of Finance, Yannis Varoufakis, that a voice would emerge within the Eurogroup evidencing the error of applying the policy based on the SCO. His voice was to last a mere six months.

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The survival of the euro was seen by the ECB as paramount to any other monetary policy objective, since without the euro there could be no monetary policy. The ECB thus assumed de facto the role of indirect lender of last resort if necessary. In fact, this did not prove to be necessary, since the OMT constitutes a paradigmatic example of a monetary policy measure that had an announcement effect, since it ended the Euro Crisis without ever actually being applied. The OMT was contested before Germany’s constitutional court for having violated the TFEU. Said court, however, confirmed the legality of the OMT on 21 June 2016 (BverfG 2016). Despite the success of the OMT, the ECB still did not consider itself to be an active anti-crisis actor until January 2015 when it announced the Expanded Asset Purchase Program (EAPP) for 60,000 million euros per month (ECB 2015). Over six years had passed since the start of the Great Recession. The EAPP was also contested in Germany, and in this case, the court ruled in favour of the appellants (BverfG 2020). The ECB’s response was that it was not subject to German jurisdiction. Such a response would have been inconceivable 10 years earlier. The shift in fiscal perspective in the EU began to take shape after the change in monetary policy. In February 2016, the European Council endorsed the “Commonly agreed position on Flexibility in the Stability and Growth Pact of November 30, 2015” (Council of the European Union 2015). This was a document that allowed the European Commission to modulate the required fiscal adjustment according to the business cycle. It also allowed member countries to request a limited and temporary relaxation of their adjustment paths in order to carry out structural reforms or investment projects. This document implied an acknowledgement of the mistake made by the EU. However, it was necessary to wait until January 2019 for the error to be verbally recognised by the President of the European Commission, Jean-Claude Juncker. He did so just before the end of his term, apologizing to Greece for the “lack of solidarity” during the crisis and eluding the responsibility of the Treaties, the European Commission and the Eurogroup while relating the problem to having attached “too much importance to the influence of the International Monetary Fund” (European Commission 2019). One by no means negligible effect to come out of the two successive economic crises concerned the changes that took place in the political scenarios and, in particular, in disaffection towards the EU. Figure 3 shows the evolution of the confidence shown by EU citizens in the various Eurobarometer surveys from 1999 to the latest one available. The figure shows how the Great Recession sparked a drop in confidence, while the Euro Crisis sent it spiralling to its lowest levels of support. Confidence only began to pick up as of 2015, coinciding with the quantitative expansion of the ECB. Confidence today has yet to return to the levels at which it stood when the euro first came out. Indeed, its current levels are around those of the Great Recession. This sudden loss of confidence and European citizen disaffection gave rise to a significant upheaval in EU countries’ political party systems as well as to the proliferation of political parties that may be termed “anti-system” and, consequently, Eurosceptic or even anti-European. In Britain, discontent was channelled into antiEuropeanism and has resulted in the country leaving the EU. Brexit is a key milestone for the EU since it makes the alternative of leaving the EU a reality and places a “sword

% of EU populaƟon who tend to trust the EU

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L. A. Hierro et al. 60 50 40 30 20 10 0

Fig. 3 Percentage of the EU population who tend to trust the EU. Source Authors’ compilation based on data from the Standard Eurobarometer no. 81 (Spring 2014) and no. 92 (autumn 2019)

of Damocles” over Europeanist rulers’ heads, making them less dogmatic and more inclined to find fast and effective solutions to crises.

6 Effects of the Covid-19 Demand Shock The economic crisis triggered by Covid-19 has come at a time when Great Britain is beginning to leave the European Union. This is an exogenous crisis and represents an external shock to the economic system stemming from a worldwide pandemic in which governments around the globe face restricted mobility in their attempts to contain the spread of the virus. We are facing a deflationary crisis of demand— consumption and investment—caused by confinement. Furthermore, since it is a global economic crisis, it has played havoc with international trade. The deflationary nature of the crisis is evident if we observe price behaviour. According to Eurostat, the annual inflation rate in the euro area fell to 0.7% in March, to 0.3% in April and to 0.1% in May. Recognising the crisis for what it is, namely a demand shock that causes a deflationary crisis, and with the lesson learned from the economic policy mistakes of the Great Recession, institutions have reacted swiftly. They have abandoned the SCO and, rather than promoting automatic adjustment through wage deflation, are now proposing expansive demand policies based on the KO. Countries have applied expansive public spending policies, and monetary policy has ceased to be the pillar of economic policy and has become the necessary crutch for fiscal policy. Inflation is not here, nor is it expected to appear, and the objective is to maintain aggregate

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demand and, thus, employment and workers’ incomes, which are what ultimately sustain consumption and economic growth. The IMF has moved to defend expansive demand policies. With regard to fiscal policy, the IMF advocates large-scale fiscal stimulus in order to avoid an even greater fall in output by increasing aggregate demand and boosting confidence. As regards monetary policy, the IMF supports the monetary stimulus and liquidity service measures implemented by central banks to reduce systemic tension, maintain confidence and curb the scale of the shock. Finally, in terms of financial policy, the IMF believes that supervisors should encourage banks to renegotiate loans with families and companies in difficulty rather than pay off loans as it has advised in the past (IMF 2020a). Adopting this same approach, and at the same time as confinement was decreed, countries have launched stimulus packages. In the USA, a fiscal stimulus plan amounting to 4.74% of GDP has been approved as have programmes for recapitalization, asset purchases, loans, debts assumptions and extra-budgetary funds valued at 5.74% of GDP (IMF 2020b). The EU has followed a similar path, although previously, and for the first time, it had to trigger the so-called general escape clause which has formed part of EU rules since 2011 (the 2011 “Six Pack Reform” of the Pact of Stability and Growth), to temporarily release EU countries from their deficit control obligations (European Commission 2020a). In addition, the European Commission has created its own policy to fight the crisis, which includes two packages of fiscal measures, one approved and the other pending approval. The first package, which has already been approved, amounts to 540,000 million euros to be spent within the normal scope of its competences—3.87% of EU-27/2019 GDP (IMF 2020b). The second package is “The EU budget powering the recovery plan for Europe” (“Next Generation EU”). It was presented on 27 May 2020 in the European Parliament but has not yet been approved by the Council. Worth 750,000 million euros—5.37% of EU-27/2019 GDP—it includes transfers to states to the tune of 500,000 million euros and loans amounting to 250,000 million euros (European Commission 2020b). The last group of countries to defend the SCO, the so-called frugal countries, led by the Netherlands and comprising Austria, Finland and Sweden, has come out against this second package. Mark Rutte, Dutch President since 2010, is an outspoken advocate of the SCO and has always been opposed to any form of directly funded financial aid policy. The position of the Netherlands was set out in no uncertain terms by former President of the Eurogroup and former Dutch Minister of Finance, Jeroen Dijsselbloem, in an interview published in the Frankfurter Allgemeine Zeitung (FAZ) on 20 March, 2017: “Being a social democrat I regard solidarity as something very important. However, who asks for it also has duties. I cannot spend all my money on booze and women and after that ask you for financial support. This principle applies to the personal, local, national and European level”.7

7 The hawks of the pro-cyclical fiscal policy which sparked the sovereign debt economic crisis were

Jeroen Dijsselbloem himself and German Finance Minister Wolfgang Schäuble, both of whom left office in 2017.

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This second package is an indirect financing scheme for the states that de facto exceeds art. 124 of the TFEU. If approved, it will finance the largest coordinated expansive fiscal policy package in European history since the Marshall Plan. Table 2 includes the anti-crisis programmes of the euro area countries. As regards monetary policy, the FED, for example, has decided to put in place unlimited quantitative easing (this implies unlimited indirect monetization of public deficit) and has established facilities to sustain the flow of credit (FED 2020). For its part, the Bank of England (BoE) has designed a 200,000 million pounds quantitative easing package to acquire government and non-financial corporation bonds and 330,000 million pounds in financial facilities. However, the main novelty is that it has approved temporary direct monetization of deficit through a direct short-term credit line to finance the needs of the United Kingdom Treasury. Although this type of measure is strictly prohibited in the TFEU, Great Britain can now apply it since it is no longer a member of the EU (BoE 2020). In contrast, the ECB, which is Table 2 Fiscal policies adopted by the States of the Eurozone due to the economic crisis associated with the pandemic. Quantification in % of 2019 GDP Country

Public spending and revenue measures (%)

Recapitalizations, asset purchases, loans, debs assumptions, extra-budgetary funds

Guarantees on loans

Austria

7.26

2.25%

Belgium

2.15

11%

Cyprus

4.10

Estonia

1.78

1.78%

3.56%

Finland

4.30

0.49%

0.70%

5.82%

22%

France

4.54

Germany

4.50

Greece

12.80a

Ireland

2.67

Italy

4.47

Luxembourg

13% n.a. 0.57%

0.57% 22%

12.12

5.66%

Malta

3.93

Netherlands

7.27

n.a.

Portugal

9.37

3.20%

Republic of Latvia Republic of Lithuania

2.74

1.52%

2.29%

20.22

2.31%

10.32%

Slovak Republic

1.80

6.37%

Slovenia

9.16

5.41%

Spain

2.77

8.38%

Source Authors’ compilation based on IMF data (IMF 2020b). a Including state guarantees for bank loans

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weighed down by its regulation, has remained hesitant, as usual. It first announced a very timorous and meagre policy, which created more problems than solutions. Later on, and also as usual, said policy was rectified, although this time it only took five days to do so as opposed to the previous occasion, when it took six years. On 12 March 2020, the ECB thus announced the strengthening of the quantitative expansion for an amount of only 120,000 million euros until the end of 2020 and the easing of the conditions of the different Long-term Refinancing Operations (ECB 2020a). At the same time, President Lagarde called for a strong fiscal response to address the COVID-19 crisis while stating that “we are not here to close [bonds] spreads” (ECB 2020b). The latter was interpreted by market agents as a break from the total commitment of her predecessor, Mario Draghi, to preserve the Eurozone “whatever it takes” and triggered the immediate rise in risk premiums on sovereign bonds in Italy, Greece, Spain, and Portugal. Faced with the risk of lapsing back into a Euro Crisis that would have been fatal not only for the euro but also for the EU itself, the ECB changed its mind in just five days. On 18 March 2020, at midnight and after an emergency meeting, the ECB announced the Pandemic Emergency Purchase Program (PEPP) aimed at purchasing public and private assets for a total of 750,000 million euros. The Governing Council will end the PEPP once it considers that the COVID-19 crisis is over, but in any event not before the end of 2020 (ECB 2020c). By way of a qualitative novelty, asset purchases in this programme need not strictly meet key capital; that is, the purchase quotas according to the percentage of participation in ECB capital (ECB 2020c), and also includes the purchase of greek bonds again. Obviously, pressures on risk premiums have disappeared. With the PEPP, the ECB has tied Eurozone member states’ financing costs to their interest rate and has set EU states free to fight the pandemic by any means. In addition, the ECB has stated that it is “fully prepared to increase the size of its asset purchase programmes and adjust their composition, by as much as necessary and for as long as needed” (ECB 2020d). In fact, on 4 June 2020, it announced a 600,000 million increase in PEPP and extended it until June 2021, with the possibility of extending it until the Governing Council deems the Covid-19 crisis to be over. The result is that for the first time the ECB has put in place quantitative expansion associated with a highly expansive fiscal policy, that is, a purely Keynesian economic policy. This has brought down the SCO’s last stronghold in monetary matters.

7 Conclusion: A New Economic Orthodoxy, a New Economic Policy, a New Treaty As pointed out at the beginning, when the economic orthodoxy of the moment is unable to adequately characterise a crisis and define the required policies, changes are initiated so that a new orthodoxy assumes the role of basic economic scientific knowledge. The Great Recession and the pandemic crisis, two deflationary demand

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crises, have blown away the economic orthodoxy of the past 40 years and which we have termed the second classical orthodoxy. The SCO is a theory of general equilibrium with a natural tendency towards full employment in which all the variables are self-adjusting in the long term, and which is precisely its Achilles heel. In no orthodox manual used in any university faculty of economics will we ever find such a period defined. It may be five, 10 or 20 years. Implicitly, the SCO defines it as the time it takes for the economy to return to equilibrium in the long term, such that we would find ourselves in a kind of circular fallacy: the economy adjusts to the equilibrium of full employment in the long term, which is the time it takes the economy to return to full employment. As Keynes already criticised in reference to the defenders of the CO and as Skidelsky (2009) reminds us: “but this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again” (Walsh 2008, p. 44). Regardless of any other theoretical error, this question of time is by no means a trivial one. During a deflationary crisis, as time goes by, aggregate demand selfdestructs, more workers become unemployed, more families fall into poverty, more companies disappear, public debt increases, financial and real assets lose more value, a greater number of private debts go unpaid, and the banking system is more likely to collapse … and it is even more likely that the political system will implode. In deflationary crises, every month we delay implementing an expansive demand policy only serves to deepen the crisis. SCO inaction in waiting for long-term adjustment is an economic and political mistake. This is even more so for an institution like the EU, which is always subject to centrifugal forces and which remains greatly distanced from citizens. The EU entrusted all of its economic regulation at the constitutional level to the SCO and has been the main victim of its mistakes since 2008. The Great Recession caused public deficits and, through the TFEU, spawned procyclical fiscal policies to correct them. It took six years for the ECB to apply quantitative easing while the European Commission failed to implement the necessary expansionary policy. The results were a W-shaped crisis that no other economic zone in the world suffered, coupled with growing citizen detachment from a project which, instead of solving the crisis, made it worse. However, reality has been stubborn and the consequences have been very serious. The EU has had to loosen the economic straitjacket of its TFEU while step by step it has gone beyond self-imposed limits. This situation confronts the EU with a new dilemma: to continue to go beyond its limits in order to maintain the SCO’s fictional economic ideal, with the economic and political costs of delays in reaction time to the crises that this entails, or to change the limits so as to define a flexible and adaptable economic policy system for all economic orthodoxies. The answer to this question will determine what the post-pandemic euro will be like.

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Luis A. Hierro is a Senior Lecturer in Economics and Public Economics at the University of Seville. He was the Head of the Department of Economics and Economic History and Member of the Board of Directors at the Pablo de Olavide University. He was Deputy, First Secretary of the Economic Committee and member of Foreign Affairs Committee of Congress of Deputies of Spain and President of the Economic and Social Council of Seville. His research focuses on monetary policy, fiscal federalism, regional economics, energy economics, housing economics, whose results have been published in more than 30 journals. Pedro Atienza-Montero is a Lecturer in Economics at the University of Seville. He holds a Ph.D. in economics from the University of Malaga. His research has focused on applied economics, especially public economics, resulting in 33 articles, 2 book chapters, 3 books and 40 conference papers. His fields of research are sub-central government financing systems, Autonomous Communities financing, redistributive effect of the public budget, economic growth, fiscal balances, oil economy, economic impact, housing market and cooperativism.

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Helena Domínguez-Torres is a Ph.D. candidate in Economics at the University of Seville. She holds a B.A. in Economics from the University of Seville, a Master in European Economic Studies from The College of Europe and a Master in Economic Consulting and Applied Analysis from the University of Seville. Her research focuses on the territorial effects of monetary policy. The results of such research have been published in the Journal of Economic Surveys and the Journal of Policy Modeling. Antonio J. Garzón is a Ph.D. Candidate in Economics at the University of Seville. He holds a B.A. in Economics from the University of Seville and a Master in Economic Consulting and Applied Analysis from the University of Seville. His research focuses on energy economics and the macroeconomic effects of the oil market evolution, whose results have been published in several journals. He has also investigated the economic functioning of the European Union and the Euro Area.