Saving Eurozone After COVID-19: How to Tackle Europe’s Growing Economic Divergence

Written by | Monday, May 25th, 2020

COVID-19 is not a ‘symmetric’ shock to Europe’s economy. The economic costs of lockdowns, and the continued social distancing measures that follow them, will be different across countries and regions. And some governments are better able to offset the costs of these measures than others – and to stimulate their economies once the virus is under control. We can identify three ways in which COVID-19 will be a force for divergence. First, lockdowns in countries with larger outbreaks will last longer. France, Italy, Spain, and the UK have had the worst outbreaks in Europe. Most countries in Europe have imposed comparably stringent lockdowns – and for each month that they go on, around 3% of annual GDP is lost. But lockdowns will continue until the number of infections has fallen to a low level. Our simulations suggest that this will take many weeks longer for France, Italy, Spain and the UK than it will for Austria, Germany and Poland.

Second, through a new analysis of the impact of lockdowns on Europe’s regions, we can see that regions in Southern Europe are likely to suffer larger and more long-lasting recessions than those in the north and east. The manufacturing and tourism sectors are hardest hit by lockdown measures, and tourism will remain limited even when lockdowns are lifted. Finally, Southern European governments are less able to offset the costs of COVID-19, and their higher debt levels will weigh on the recovery. Available data show that consumer confidence has been hit hardest in countries that have enacted less stimulus and higher debt-to-GDP ratios will probably result in higher borrowing costs for governments. Consequently, with more tax and business revenues being used to finance debt, there will be less capacity for investment. Unless the EU’s fiscal rules are reformed, they will also require Southern Europe’s governments to rapidly cut debt, which will reduce growth over the medium term.

Further economic divergence is bad in and of itself. But it will also make European politics even more fractious. Slow growth in some regions provides fertile ground for the far right and left, and undermines the appeal of the EU as a ‘convergence machine’. During the initial months of the COVID-19 crisis, the EU’s richer countries balked at large outright transfers to the worst-affected countries. Now, the Franco-German proposal for a €500 billion ‘recovery fund’ has the potential to forestall further divergence, if sceptical countries in Northern and Central Europe can be persuaded to accept significant transfers to Southern Europe. Agreeing the details of the fund will be hard, and the sceptics may demand more money from the EU budget in order to sign up. The EU’s fiscal rules are too rigid, and mandate the reduction of debt even when economies are weak. Now is the time to reform them: the aim should be to stabilise debt levels once the pandemic is over, and to let growth reduce debt over time.

COVID-19 is likely to reinforce the decoupling of economic performance and living standards between Northern and Southern Europe, unless better-off countries provide substantial financial support to those that are hit hardest. Until Angela Merkel and Emmanuel Macron made their proposal for a €500 billion recovery fund, the richer, more frugal member states in the north had been unwilling to provide outright transfers to Southern Europe. The recovery fund, which will certainly have a difficult passage through the European Council, would entail more sizeable transfers than those offered through the European Stability Mechanism (ESM), by the European Commission (€100 billion in cheap loans to support national furlough schemes) and the European Investment Bank (EIB). There is a logic for transfers to take place at the level of the EU, not just within the eurozone, because the high degree of economic integration between member states means that they are dependent upon each other’s economic recovery. The money would be borrowed by the EU, and distributed to the most affected sectors and regions, which will mean that southern member states will be net recipients. The €500 billion would be repaid by member states according to their relative levels of prosperity, but the details are yet to be determined.

The fund should be distributed according to two principles. The first should be the size of the drop in output in each region and sector in 2020, compared to previous years. The second should be the likelihood that the region or sector will make a swift recovery without help from the fund, given that some sectors will benefit from pent-up demand (because consumers have postponed purchases) and others may not. In any case, a debt crisis in Italy may spread to other eurozone member states, and the eurozone needs a common fiscal stabilisation tool. Europe also needs to reconsider its fiscal framework, and embolden the ECB to support the recovery rather than restricting the bank’s room for manoeuvre. Even with a generous EU ‘recovery fund’, the national debt levels of all countries will be higher once the crisis is over. But this additional public debt does not need to be repaid. Countries rarely if ever repay their debt: instead, they roll it over, while fostering economic growth to make existing debt fall relative to income.

Europe’s deficit and debt reduction targets are too rigid after this crisis, and need to be loosened. Europe should aim to stabilise debt in countries with high debt levels, such as Italy (something that Rome had achieved, prior to the current crisis). At the same time, Europe should be relentlessly focused on fostering economic growth, and on inflation returning sustainably to its 2% target. This is the best way to bring down debt in the process. It is important that Europe does not repeat the mistakes it made during the euro crisis: to switch fiscal policy into premature austerity and end monetary stimulus too soon.

There will be severe consequences for the EU if it fails to agree on a bold recovery fund and a stronger focus on growth. The EU’s promise of economic convergence among its member states underpins its political appeal and needs to be reaffirmed. Since Italians’ living standards started to diverge from those in Northern Europe in the mid-1990s, euroscepticism has grown. A recent poll by Tecnè found that a majority of Italians think that EU membership has been a disadvantage for their country, and a sizeable share want to leave the EU. Spain has historically been one of the most pro-EU countries in Europe, but continued divergence may result in more anti-EU sentiment there too. Unless the EU has the support of public opinion in all of its big member states, it will continue to be dysfunctional, and in extremis its very existence may be threatened. If the EU fails to implement bold policies to support the worst hit and foster growth, the COVID-19 crisis is bound to lead to further divergence, and policy-makers will have no-one to blame but themselves.

‘Three Ways COVID-19 Will Cause Economic Divergence in Europe’ – Christian Odendahl and John Springford – Centre for European Reform / CER.

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