COVID-19 threatens to fragment the EU further
The economic impact of COVID-19 poses the most immediate threat to EU cohesion
A serious divergence has emerged between northern and southern EU states over how to respond to the economic impact of COVID-19. At least nine mainly southern members want a consolidated euro-area fiscal response through the issuance of Eurobonds -- a shared debt instrument -- but they face strong opposition from Germany and the Netherlands in particular, who fear they may have to underwrite the debts of poorer countries. Failure to resolve this dispute could result in a euro-area crisis and undermine broader EU unity.
What next
Germany and the Netherlands will push for implementation of the European Stability Mechanism (ESM) -- a bailout fund -- to help those countries most affected by COVID-19. Italy and Spain oppose the ESM because it comes with conditionality that could force them to pursue austerity measures. The key question will be whether Germany and the Netherlands can accept a significant reduction in levels of conditionality to assuage Italian and Spanish concerns, and whether Italy and Spain are willing to accept any conditionality at all.
Subsidiary Impacts
- Eurobonds should lower the spread between Italian and German bonds as they would make Italy’s public finances more easily sustainable.
- A Eurobond issuance could slow the rise of populists in some poorer countries by giving governments greater capacity to deal with COVID-19.
- A deeper and longer-term economic crisis caused by COVID-19 could expose Europe further to influence from Russia and China.
Analysis
On March 25, the governments of Belgium, France, Greece, Ireland, Italy, Luxembourg, Portugal, Slovenia and Spain sent a letter to European Council President Charles Michel to call for the issue of a jointly underwritten bond to help member states finance the economic costs associated with COVID-19 (see EU: Euro-area COVID-19 recovery could be slow - March 26, 2020).
This proposal resembles previous proposals to create Eurobonds as common sovereign debt instruments for use by euro-area governments. It differs from its predecessors in three respects:
- the bond(s) would be used exclusively to cover the costs of responding to COVID-19;
- the bond(s) would be issued by a European institution such as the ESM or the European Investment Bank; and
- the expectation is that the bond(s) would be purchased by the ECB as part of its 750-billion-euro (820.8-billion-dollar) large-scale asset-purchasing programme to mitigate the impacts of COVID-19.
The implications of the bonds being issued and purchased centrally is that there would be a constant flow of demand and funding would be cheap. In turn, member states would be able to use the proceeds to increase COVID-19-related spending without increasing their national debt.
Preference for the ESM
When the Council held its teleconference on March 26, the Dutch government objected that national governments should have undertaken the budgetary reforms necessary after the 2009-12 euro-area crisis to ensure they had sufficient fiscal space to deal with the current crisis.
If those governments need additional assistance, Prime Minister Mark Rutte suggested, they should turn to the ESM, which is designed to provide financial bailouts and which is equipped to ensure that governments are able to manage the repayment of any debts incurred once the crisis is over.
German Chancellor Angela Merkel was less vocal in criticising governments that had requested assistance, but she too was clear that the facilities for providing aid already exist should they be required. She also argued that the ECB's new asset-purchasing measures would suffice to ensure all governments have access to financial markets during the crisis.
This response did not satisfy the governments of the original nine countries. They argue that the ESM was designed to aid countries in the event of a country-specific shock rather than assist a bloc of countries facing similar health and economic consequences.
Moreover, they fear that accepting the ESM would entail conditionality on government borrowing, such as raising taxes and reducing some public expenditure.
Italy and Spain fear the ESM would single them out as the only countries needing financial assistance
Any application of conditionality on those countries most in need -- Italy and Spain -- would have significant domestic political consequences that could result in the collapse of either, or both, coalition governments. By implication, the Italian and Spanish governments ruled out recourse to the ESM because that recourse would stigmatise them as uniquely in need of assistance.
Political challenges
Opposition to Eurobonds is political as well as economic and financial.
Germany's co-ruling Christian Democratic Union is in the middle of a leadership contest and faces opposition to any form of common borrowing instrument from both within the party and from the Alternative for Germany. Fiscal conservatives fear that Germany will have to pay extra in the scenario that a poorer member state defaults on its repayments.
In addition, the Social Democrat finance minister, Olaf Scholz, agrees with Merkel that it is too early in the COVID-19 timescale for the implementation of a consolidated euro-area fiscal response.
Domestic political pressures are making it hard for the Netherlands and Germany to compromise
The political calculus in the Netherlands is also complicated. The current government relies on a one-seat majority in the Dutch parliament, it faces staunch opposition from Eurosceptic populist groups to the right, and it has to look forward to a general election next year.
Room for compromise?
Nevertheless, there are voices that are more open to compromise. On March 27, the Dutch central bank governor, Klaus Knot, made it clear he did not believe the ECB's actions could respond effectively to the crisis without greater effort on the fiscal side.
He also expressed a willingness to explore arrangements such as a new debt facility that could help to underpin a shared fiscal response. Knot has a reputation as one of the more hawkish members of the ECB's Governing Council; his willingness to compromise, therefore, represents an important break with past Dutch attitudes toward common fiscal arrangements. Moreover, Knot's comments drew support from the left-liberal D66 political party in the Dutch coalition government.
The conversation over Eurobonds is expected to come to a head again in the run-up to a video conference meeting scheduled by EU finance ministers on April 7. The Italian press has reported that another five countries have joined the original nine in support of the Eurobond proposal.
Despite this, it is likely that the Dutch and German governments will continue to hold out, together with Austria and Finland.
Italy and Spain would likely only accept the ESM if there were zero conditions attached
Another key question is whether the Germans and the Dutch can agree to relax the conditions on ESM lending sufficiently to assuage the Italian and Spanish government's concerns about conditionality. Rome and Madrid would likely demand zero conditionality, which would be very difficult for Berlin and The Hague to accept.
Outlook
It is possible that neither scenario will take shape in coming weeks. Germany and the Netherlands are probably content to delay a decision until the COVID-19 crisis deteriorates further. If the crisis becomes acute, they will try to push Italy and Spain into the ESM by saying there is no time for an alternative arrangement to be put into place. Italy and Spain might still refuse, potentially triggering a euro-area crisis and undermining wider EU unity.
