The Corona Debt Conundrum in the Eurozone - Stiftung ...
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NO. 23 MARCH 2021 Introduction The Corona Debt Conundrum in the Eurozone Limits to Stabilisation by Monetary Policy and the Search for Alternatives Paweł Tokarski and Alexander Wiedmann One of the most serious economic and social consequences of the pandemic is the higher public debt of the Eurozone countries. The massive interventions of the Euro- system have lowered borrowing costs to record lows. For some time to come, the sustainability of the public finances of the most indebted Eurozone countries will depend on expansionary monetary policy. However, this approach raises questions. It is uncertain how long monetary policy can support the debt market of the EU-19, whether there are effective alternatives, and what impacts the high debt levels and the interventions of the European Central Bank (ECB) will have on the foundations of the Eurozone. The Corona pandemic has hit Europe hard. have increased even more and many com- In many states, public life was – and in panies would have had to fear insolvency. some places continues to be – almost com- All this would have had devastating social pletely shut down. Businesses have had consequences, especially for the poorest. to close and curfews have been imposed. At the same time, the states would face a Consequently, the Corona crisis has also financing problem because the number been a major shock to the European econo- of employees subject to social security con- my. The member states of the Eurozone had tributions, and thus tax revenues, would no choice but to massively counteract the fall and social spending would increase. In collapse of some economies. With liquidity addition, there would be higher expendi- assistance, they have been trying to support tures on health care. However, the states the population groups and economic sec- can, at best, try to mitigate the consequences tors most affected by the crisis. To make of the crisis, but they cannot prevent an these state interventions possible, the Euro- economic collapse as European economies pean Commission activated the general have experienced the largest recessions in escape clause of the Stability and Growth decades. Those euro area countries still Pact. These support measures were neces- struggling with the aftermath of the euro sary and continue to be so. Without them, crisis, including high public debt levels, are unemployment in the Eurozone would at the same time particularly affected by
the pandemic, as the vital tourism sector record levels. This raises questions about
in southern Europe has largely come to a debt sustainability and the stability of the
standstill. Falling economic growth, com- euro area. However, the view on govern-
bined with higher government spending ment debt is also changing. Unlike in the
levels, has caused government debt to rise. previous Eurozone crisis, no actors can be
According to European Commission fore- blamed today for the excessive debt due
casts, in 2021 the debt ratio in France will to their misconduct. Rather, the increased
rise to around 118 per cent of gross domes- public debt resulting from the Corona pan-
tic product (GDP) – compared to 98 per demic serves to mitigate its enormous nega-
cent in 2019 – and in Italy even to 160 per tive economic and social impacts and to en-
cent. For Spain, the Eurozone country most able a quicker return to economic growth.
affected by the Corona crisis, an increase of The question for the post-Corona period
26 percentage points to 122 per cent of GDP is whether the rapid growth of public debt
has been predicted. In Greece, the debt level will be a challenge for recovering econo-
will reach the 200 per cent mark. There, mies. Previously, it was said that with debt
public finances are also under pressure ratios above 90 per cent of GDP, rising
from military spending. Not even Germany government debt would have particularly
still meets the Maastricht criterion of 60 per negative consequences for future economic
cent of GDP, as its debt ratio is now 70.1 per growth, as private investment would be
cent (see Figure 1). crowded out and public finances burdened
The negative fiscal impacts of the pan- by debt-servicing costs. Many Eurozone
demic will be exacerbated in 2021 by the members, including Greece, Italy, France,
need to maintain restrictions on the econo- Spain, and Portugal, have far exceeded this
my, at least until the second quarter. On level. However, as debt-servicing costs are
the other hand, the cost of servicing public currently low, the problematic consequenc-
debt in euro area countries is still at near es of debt for public finances are also rather
record lows. The reasons for this are the in- limited at the moment, as the pressure to
terventions of the Eurosystem, which con- cut other investment-enhancing govern-
sists of the ECB and the 19 national central ment spending is weak.
banks of the Eurozone. For this purpose, a To assess the risk of excessive public
special purchase programme was launched, debt, it is not enough to calculate only the
mainly for government bonds (the pan- debt-to-GDP ratio. The main consideration
demic emergency purchase programme, should be whether the economy will be
PEPP). Can rising government debt never- able to service higher levels of debt in the
theless become a pressing problem for the future, for example thanks to higher growth
Eurozone? rates. What is important is whether its eco-
nomic model is flexible enough to adapt to
new challenges such as digitalisation and
Growing Public Debt and the green transformation. Future debt sustain-
Stability of the Eurozone ability also depends on the balance sheet of
the public sector. This includes assets such
Already since the 1970s, public debt has as shares in state-controlled enterprises and
been growing in the developed European financial assets, but also (especially long-
economies. The introduction of the euro term) liabilities. It should be noted that the
helped to lower interest rates on govern- negative consequences of the Corona crisis
ment bonds and put government debt on for public finances will only become appar-
a sustainable path. However, the global ent later. In many countries, they will mani-
financial crisis and the euro crisis caused fest themselves, for example, in poorer
the debt-to-GDP ratio to rise again signifi- demographic development, including sharp
cantly in most euro area countries. Now the declines in birth rates. This may cause
current pandemic has caused debt to reach implicit debt to rise, for example costs for
SWP Comment 23
March 2021
2Figure 1
Source: European Commission
health care, social care, and the pension ing the business cycle and debt sustainabil-
system. Unfavourable in this context are ity. Finally, if the government is no longer
the prospects of highly indebted euro area able to meet some or all of its debt obliga-
countries such as Italy, Portugal, and Greece. tions on time, it risks losing access to finan-
There, the old-age dependency ratio – that cial markets. Currently, the entire debt sus-
is, the ratio of the over-65s to the 20 to tainability of the over-indebted Eurozone
64-year-olds – is rising in a worrying way. countries is based solely on the expansion-
The higher the public debt levels, the ary monetary policy of the Eurosystem.
more sensitive public finances are to the in-
creased servicing of their costs. In the event
of a downturn, fiscal policy-makers would
be faced with a dilemma between stabilis-
SWP Comment 23
March 2021
3ECB to the Rescue: capital key, which it officially abandoned
Risks and Alternatives with the PEPP but has been trying to adhere
to (see Figure 2).
With the announcement of the €1,850
billion PEPP, the ECB has implicitly com- Risks of the ECB’s Involvement
mitted itself to keeping government bond
interest rates low. So far, the ECB’s strategy However, the strategy of basing Eurozone
has been successful, as member states can debt stabilisation on monetary policy could
currently finance their debt at record low also entail risks for the Eurozone. One
levels. Even the recent political crisis in major problem is the distribution of risk in
Italy has not led to an increased premium the Eurosystem. This is highly decentral-
on Italian government bonds. The crucial ised, and part of the risk is the responsi-
question is how long the ECB can continue bility of the participating central banks.
to stabilise the Eurozone debt market. The Similar to previous public-sector asset pur-
ECB’s Governing Council has announced chase programmes, the PEPP is character-
that the purchase of government bonds will ised by limited risk sharing. This covers
last until at least March 2022, when the only 20 per cent of the purchases of govern-
Covid-19 crisis phase is over and the capital ment bonds under the PEPP. The bulk of
payments due from government bonds will the risks are borne by the national central
be reinvested by the end of 2023. However, banks. The Italian central bank, for exam-
it is hard to imagine that the asset purchas- ple, has to buy mostly Italian securities on
es will be stopped in the final phase of the the secondary market, taking on the entire
presidential elections in France in 2022. risk. If a central bank holding a large quan-
Moreover, the economic consequences of tity of national sovereign debt had to accept
the pandemic, such as higher debt and un- losses, the continued participation of this
employment levels, will require monetary bank in the Eurosystem would be in ques-
and fiscal policy support for much longer. tion.
Inflation is the key factor in determining Another, more significant problem is the
whether the ECB can support the Eurozone danger that the ECB – if it owns a signifi-
debt market for a longer period. As long cant part of a state’s debt – intervenes as
as inflation remains well below the ECB’s an actor in national politics. This could
target (below but close to 2 per cent), it can encourage reckless behaviour by national
justify its accommodative monetary policy. actors due to economic disincentives (moral
Otherwise, it would have to choose between hazard). Even if market pressure was not
the monetary policy target and the stability a decisive factor for long-term structural
of the monetary union. Currently, inflation reforms, it was useful in keeping govern-
in the euro area is at a low level. It is true ments on the reform path. Once the ECB
that the five-year inflation swaps – an indi- owns a large part of a country’s public
cator of inflation expectations – have risen debt, the government there could not only
steadily in recent months. But whether reverse structural reforms. In an extreme
inflation will really grow significantly and case, it could loosen public fiscal policy,
come close to the ECB target is disputed knowing that the ECB will intervene in the
among economists. debt market to avoid a possible destabilisa-
Another kind of challenge is the situa- tion of the entire Eurozone. However, a
tion in the US market. The recent plans massive show of financial support for the
of the US government for a massive fiscal euro debt market would again raise legal
stimulus package caused the interest rates questions – for example about the limi-
of US bonds to skyrocket. As a result, Euro- tation of purchases per issuer or about the
pean bond rates also rose. This will force ECB’s capital key – as the ruling of the
the ECB to buy more expeditiously and per- German Federal Constitutional Court in
haps detach the purchases from the ECB’s May 2020 showed. A similar legal problem,
SWP Comment 23
March 2021
4Figure 2
Source: ECB
namely the need for the ECB to specify the such as banks would be forced to accept
concrete time horizon of its intervention, the losses. Another option would be to take
would arise if the bonds purchased under advantage of the fact that the government
the PEPP were extended indefinitely by the bonds were issued under national law. This
Eurosystem, thus constituting a kind of could be changed, for example, to extend
“perpetual debt”. the maturities of bonds (local law advan-
tage). However, such a move would trigger
Possible Alternatives very negative reactions in the financial
markets and drive up the financing costs of
The question is whether there could be an other highly indebted Eurozone countries.
alternative solution to stabilise the Euro- In recent months, the suggestion has
zone debt market. It is hardly likely that often been made, especially in France, that
the GDP of the most indebted states will the ECB should go further in supporting
grow fast enough to reduce their debt public finances, and that all Corona-related
levels. Even before the pandemic, growth public debt bought by the ECB should be
rates in the Eurozone were modest. An- cancelled. Even though Article 123 of the
other way to reduce government debt is Treaty on the Functioning of the European
through restructuring. Bonds of euro area Union does not directly prohibit monetary
members are issued under national law, financing, debt cancellation by the Euro-
and the recent reform of the collective system would be contrary to the spirit of
action clauses in bond covenants has made the Treaty. Such a precedent could make
restructuring easier. However, in the case investors who buy government bonds fear
of Italy, where domestic investors buy the that the bonds they hold will one day also
bulk of government bonds, this could desta- be cancelled. This would inevitably lead
bilise the financial system, as investors to higher interest rates on the debt. Such
SWP Comment 23
March 2021
5a solution is also likely to encourage the to the increase in debt. The banking sector
tendency towards moral hazard. Instead is likely to be hit hard by the pandemic
of initiating difficult structural reforms on because of problems in the real economy.
their own, the highly indebted countries The extent of such difficulties will be re-
could continue to expect the ECB to cancel vealed by the stress test coordinated by the
their debts. Therefore, this option should, European Banking Authority. The results
at best, be considered as a last resort for of the test are expected at the end of July
possible extreme cases, for instance if the 2021.
current pandemic proves to be permanent. Currently, there is no effective alterna-
This would require a profound restructur- tive to debt stabilisation through monetary
ing of the sectors affected by the pandemic policy, which allows member states to focus
and would cause debt to rise dramatically on fighting the pandemic. Under current
once again. conditions, it is crucial to continue active
Another proposal is to involve the Euro- fiscal policy at least until 2023 to support
pean Stability Mechanism (ESM) in debt the post-pandemic recovery. It is also im-
stabilisation. This instrument could take portant that Germany maintains an active
over the portion of the bonds bought by the fiscal policy for as long as possible. A quick
Eurosystem, and thus enable an exit from return of the largest economy in the Euro-
expansionary monetary policy. However, zone to normal growth rates could help
such a solution would contradict the cur- other member states.
rent model of ESM operations, which con- It is also essential to limit the use of
sists of granting financial aid to certain monetary policy in the debt market as
member states only under strict conditions. much as possible so as to encourage re-
If the ESM is to be involved in debt stabili- sponsible economic policy-making of the
sation, the ESM Treaty, which lies outside member states. It is important to use public
the EU legal system, would have to be resources effectively to combat the effects
amended. Such a solution would have to of the pandemic in order to maintain
be agreed by all members and ratified by labour force participation and create a
all national parliaments. In order for this broader basis for economic growth through
instrument to play a more important role productive investment. Above all, invest-
in stabilising the debt market, it would first ments should be made in human resources,
and foremost have to be removed from especially digital skills. Only faster eco-
the direct control of the member states and nomic growth offers the chance for stabili-
made into an EU institution. At present, sation, and possibly debt reduction. Spend-
this is difficult to imagine. ing efficiency is important, especially in the
case of the reconstruction fund. It is the net
contributors who assess it. If the countries
Monetary and Fiscal Policy As the most affected by the pandemic fail to use
Core of the Stabilisation Strategy EU funds effectively for growth-enhancing
stimulus and structural reforms, they will
The euro area will have to deal with high face the same problems after the pandemic,
levels of debt among its member states for but with much higher public debt levels.
a long time. Current projected levels are Particular attention should be paid to how
likely to rise further in many of the EU-19 Italy uses the reconstruction fund. The new
countries as the pandemic continues and government under former ECB chief Mario
vaccination progresses more slowly than Draghi offers a good chance that these
expected. It is not only higher levels of funds will be planned and used effectively.
spending and lower revenue streams that On the other hand, Italy’s medium-term
will put more pressure on public finances. political outlook is a cause for concern,
The need for public support for the banking especially as a right-wing populist coalition
sector, among others, may also contribute is expected in the next elections. All this
SWP Comment 23
March 2021
6is likely to have a negative impact on the forming the fiscal rules. In addition to the
country’s fiscal stability. It is also likely to long-proposed simplification, the rules
dampen the willingness of other euro area will have to be based less on specific bench-
countries to engage in further fiscal inte- marks and be tailored more to the situa-
gration. tions of specific economies, their business
In terms of debt management, govern- cycles, and their systemic importance for
ments of the most indebted euro area coun- the stability of the euro area. However, this
tries should make the most of the current “individualisation” of fiscal rules risks fur-
low interest rate environment to issue debt ther politicising them. The high level of
with the longest possible maturities. This debt and the need to relieve the Eurosystem
would help ensure the sustainability of of the task of stabilising it will necessitate a © Stiftung Wissenschaft
public finances in the face of short-term partial post-Corona debt mutualisation. The und Politik, 2021
fluctuations in financial markets. Eurozone – in its current form as a fiscally All rights reserved
decentralised monetary union – is vulner-
This Comment reflects
able to debt crises in its most indebted mem-
the authors’ views.
Prospects: Foundations of the ber countries. Such crises can quickly trig-
Eurozone under Pressure ger a domino effect throughout the Euro- The online version of
zone. Before any joint issuance, however, this publication contains
The stabilisation of public debt will be one plans for the post-Corona period must be functioning links to other
SWP texts and other relevant
of the most pressing issues on the euro area accompanied by discussions on how sustain-
sources.
agenda in the coming years. It will influ- able the economic models of the southern
ence two important debates on the founda- euro countries are, and what conditions SWP Comments are subject
tions of the monetary union: the design of should apply to reforms. to internal peer review, fact-
the current fiscal policy framework and Rising government debt will also largely checking and copy-editing.
the review of the ECB’s monetary policy determine the current debate on the ECB’s For further information on
our quality control pro-
strategy. monetary policy strategy. The main ele-
cedures, please visit the SWP
Rising debt levels challenge existing fis- ments of this strategy – such as the defini- website: https://www.swp-
cal rules. In most of the cases, public debt tion of the inflation target, the way infla- berlin.org/en/about-swp/
levels will be far higher than the Maastricht tion is measured, and the monetary policy quality-management-for-
reference value of 60 per cent of GDP. There- horizon – will also have a major impact swp-publications/
fore, it is in doubt whether this framework on the Eurosystem’s ability to stabilise debt.
SWP
is tenable. Examples are the rule adopted in It would be beneficial if monetary policy Stiftung Wissenschaft und
2011, which requires an annual reduction were given more flexibility in supporting Politik
of the debt ratio by one-twentieth of the dif- economic policy, as is the case worldwide German Institute for
ference between the actual debt ratio and today. Monetary policy alone, however, will International and
the 60 per cent threshold, or the limitation not be able to permanently stabilise the Security Affairs
of the budget deficit to 3 per cent. Although euro area as long as the most glaring struc-
Ludwigkirchplatz 3–4
there is undoubtedly a need to make the tural deficits persist in the largest euro area 10719 Berlin
fiscal rules in the Eurozone more realistic, countries. In the short term, the ECB faces Telephone +49 30 880 07-0
it does not seem to be a good idea to start the challenge of stabilising interest rates on Fax +49 30 880 07-100
this discussion now. Due to the unfavoura- the sovereign debt of Eurozone members. www.swp-berlin.org
swp@swp-berlin.org
ble political situation (elections will take Indeed, after the announcement of the US
place in Germany in 2021, in France in fiscal stimulus package, these interest rates ISSN (Print) 1861-1761
2022) and very different positions, it would were sharply increased due to rising US ISSN (Online) 2747-5107
hardly lead to a constructive solution. bond yields. In the longer term, the ECB doi: 10.18449/2021C23
It would be best to extend the currently will have to master an even more difficult
valid general escape clause of the Stability task. It is a matter of intervening in debt (English version
of SWP-Aktuell 24/2021)
and Growth Pact at least until the end of stabilisation while keeping national fiscal
2022. However, sooner or later, Germany policy from dominating supranational
will also have to face a discussion on re- monetary policy.
Dr Paweł Tokarski is a Senior Associate in the EU / Europe Research Division.
Alexander Wiedmann worked as an intern in the EU / Europe Research Division. SWP Comment 23
March 2021
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