Euro Governments can run out of money

The euro zone  economy contracted by 3.8% in the first quarter which was much steeper than either the UK (-2%) or the US (-1.2%). Lockdowns are beginning to ease but the percentage fall in GDP could reach double digits in all three  economies in q2, given the collapse in activity seen in April. Budget deficits will automatically rise in such circumstances (tax receipts fall while transfers to the unemployed rise) but governments have also taken discretionary spending measures in order to support incomes, with the result that fiscal deficts are likely to be extremely large- the IMF forecasts an EA deficit of 7.5% of GDP, with the US at double that figure and the UK at 8.3%. The implication is that the discretionary fiscal effort in the EA  is much lower, in large part because the  EU as a body cannot provide much  budgetary support, leaving it up to individual governments to go it alone. Member states have varying degrees of fiscal space and all lack monetary sovereignty i.e. they cannot create money and so in theory could run out of funds to spend.

A ‘ €540bn stimulus package’ has been agreed by the EU but as is often the case with these initiatives the detail is less encouraging. A €100bn package of loans is on offer to support employment across the EU while €200bn of the package turns out to be EIB loans, with that figure deemed possible from €25bn in additional capital from member states. The final €240bn is again in the form of potential loans, this time from the ESM, although as yet no country has requested funds, with a perceived political stigma apparent given the Fund was set up to bail out countries unable to access the bond market.

The frustration of some EU States  with such ‘smoke and mirrors’ has been apparent, notably from Italy and some of its Southern neighbours, with a call for EU grants rather than loans, given the already high level of debt in many countries. The idea of ‘Corona bonds’ was floated , with the EU as a body guaranteeing repayment, but such debt mutualisation is seen as  anathema in some states, including Germany.

The EU does have a Budget of course but its annual spend is of the order of €160bn  which is just 1% of EU GDP. Moreover, Article 310 of the EU Treaty would seem to rule out running a Budget deficit and to date all spending is funded from current resources.

It was a surprise therefore when Chancellor Merkel and President Macron   unveiled a plan for a €500bn ‘Recovery Fund”, with debt issuance by the EU and the sums then distributed as grants. Some hailed this as a “Hamiltonian moment’ referencing the decision by  US Secretary of State Alexander Hamilton in 1790 to convert individual State debt into Federal Government liabilities. Opposition from other EU states has emerged , however, and it remains to be seen how events unfold.

The borrowing proposed under the Plan is modest enough (3% of EU GDP) and appears to be ‘one-off’, implying that bonds would be repaid from EU resources on maturity, rather than funded by fresh bond issuance, as is the norm for individual governments. In that case it is  bringing forward future EU budgetary spending, so other non-covid related  spending would have to  cut or additional resources raised from member states

The ECB has a role to play in that it could buy some of these EU bonds and is of course  already buying some of the debt of member states, although the German constitutional court challenge to the ‘proportionality’ of that policy has raised issues. Indeed some argue that the German willingness to accept some EU borrowing, however limited, is a realisation that  future ECB asset purchasing is problematical. Again it remains to be seen how the Court challenge will play out but ultimately the pandemic has exposed the fact that the EU, as currently set up, has very limited room to provide centralised fiscal support on the scale required in a crisis. That and the  ban on monetary financing leaves each member State dependent on their respective ability to borrow, so the fiscal support provided  is not unlimited as the money can run out.