The COVID pandemic is putting pressure on the sustainability of some European economies, prompting some to argue that economic growth and monetary support from the European Central Bank will not be sufficient and that public debt should be renegotiated.
The EU is struggling to overcome the deepest crisis in its seven-decade history, caused by the most fatal pandemic in a century, which depressed growth and sent public debt to record levels.
During the past financial crisis, EU public debt (excluding the UK) increased by 20 points to 86.6% of its GDP.
Still holding high debt levels from the previous downturn, the public debt across the EU is expected to grow by 15 points this year to reach 95% of its GDP, according to the European Commission’s latest forecast.
This burden will be especially painful for half a dozen countries (Greece, Italy, France, Portugal, Belgium and Spain), raising questions about the sustainability of their public accounts in the medium and long term, the Commission warned in early November.
Economists agree that public debt is sustainable as long as economies grow above the costs of debt-financing, a scenario possible thanks to the intervention of the ECB.
Its pandemic bond-buying program of €1.35 trillion euros, which came on top of its ongoing asset purchasing programme, and its near-zero rates have kept bond yields at record low levels.
“As long as the ECB buys 75% of the Spanish debt, we won’t have any problem,” said Maria Jesus Fernández, a senior economist at Funcas, a Spanish research centre.
But she added that if the ECB starts turning off the tap, “it will be very dangerous, a time-bomb for the Spanish economy”, given the enormous structural imbalances of the fourth largest EU economy. “We can be forced to adopt very abrupt adjustments,” she explained.
Nevertheless, countries on the tight rope can count on ECB support. Ángel Talavera from Oxford Economics points out that “the ECB is not expected to raise rates in the near future”, given the inflation trends. “High debt is a problem that we will eventually have to tackle, but not for now,” he said.
Although the Eurogroup and the European Commission have ruled out a new stimulus, ECB President Christine Lagarde promised to act again “with determination” in December in the face of the second wave of the virus.
“Growth is the only credible and healthy solution,” said Maria Demertzis, deputy director of Bruegel think tank.
To boost national economies hit by the virus, the EU agreed in July on a €750 billion recovery fund to finance investments in member states. The fund, still blocked by Hungary and Poland, will be financed with an unprecedented amount of EU debt (to be repaid eventually via new European taxes).
It will offset part of the cost of the recovery, especially for Italy and Spain, the hardest-hit member states.
Lorenzo Codogno of the London School of Economics and Cambridge University’s Giancarlo Corsetti argue that the massive European stimulus could fuel inflation, and the ECB could consider whether to start reducing its accommodative stance.
But given the evolution of inflation in recent years and the current paradigm, under which central banks including the Fed are willing to overshoot their inflation target to support fiscal policy, Codogno and Corsetti believe that the ECB will act with caution and not repeat the mistakes of the last crisis.
Even if the ECB maintains its monetary stimulus in the medium term, some voices argue that growth will not be sufficient to survive the huge amount of new debt.
With Italian debt expected to reach 160% of GDP, Riccardo Fraccaro, one of the closest advisers to Prime Minister Giuseppe Conte, has asked the ECB to cancel the sovereign debt it has purchased, or extend its maturity in perpetuity. Lagarde rejected the idea, explaining that there is no legal basis for the ECB to cancel the sovereign debt it owns.
IMF Managing Director Kristalina Georgieva said earlier this week that the proposals coming from Italy would require EU treaty change, highly unlikely to happen any time soon. Instead, she maintained that debt sustainability has to be dealt with in a “prudent manner and not by kicking the can down the road”.
“The best way is on the basis of growth”, she said, thanks to the ECB intervention and by using the EU recovery fund to improve the competitiveness of European economies.
“It is easy to say but much harder to do”, Georgieva admitted.
The impact of the pandemic has also pushed businesses near the cliff, especially tourism, restaurants and retail sectors. Companies have muddled through thanks to liquidity measures and special credits approved by governments.
“Government loan guarantees and bankruptcy moratoria have prevented a large-scale wave of non-financial companies defaults, but a sizeable number of firms could be forced to file for bankruptcy if these measures are lifted too early or bank lending conditions tighten,” the ECB said in a report in November.
Ángel Talavera of Oxford Economics is more concerned about private debt than public levels, especially in households and some sectors, due to the risk of defaults and the potential impact on the banking sector.
Bruegel’s Demertzis, meanwhile, believes that the lesson from the past crisis is that “the sooner private debt is restructured, the better for all sides”, including the banks.
She added that the EU has better instruments to cope with this than a decade ago, including improved frameworks for insolvency proceedings.
[Edited by Zoran Radosavljevic and Benjamin Fox]