The Corona Debt Conundrum in the Eurozone

Growing Public Debt and the Stability of the Eurozone

Already since the 1970s, public debt has been growing in the developed European economies. The introduction of the euro helped to lower interest rates on government bonds and put government debt on a sustainable path. However, the global financial crisis and the euro crisis caused the debt-to-GDP ratio to rise again signifi­cantly in most euro area countries. Now the current pandemic has caused debt to reach record levels. This raises questions about debt sustainability and the stability of the euro area. However, the view on government debt is also changing. Unlike in the previous Eurozone crisis, no actors can be blamed today for the excessive debt due to their misconduct. Rather, the increased public debt resulting from the Corona pan­demic serves to mitigate its enormous nega­tive economic and social impacts and to en­able a quicker return to economic growth.

The question for the post-Corona period is whether the rapid growth of public debt will be a challenge for recovering economies. Previously, it was said that with debt ratios above 90 per cent of GDP, rising government debt would have particularly negative consequences for future economic growth, as private investment would be crowded out and public finances burdened by debt-servicing costs. Many Eurozone members, including Greece, Italy, France, Spain, and Portugal, have far exceeded this level. However, as debt-servicing costs are currently low, the problematic consequences of debt for public finances are also rather limited at the moment, as the pressure to cut other investment-enhancing govern­ment spending is weak.

To assess the risk of excessive public debt, it is not enough to calculate only the debt-to-GDP ratio. The main consideration should be whether the economy will be able to service higher levels of debt in the future, for example thanks to higher growth rates. What is important is whether its eco­nomic model is flexible enough to adapt to new challenges such as digitalisation and green transformation. Future debt sustain­ability also depends on the balance sheet of the public sector. This includes assets such as shares in state-controlled enterprises and financial assets, but also (especially long-term) liabilities. It should be noted that the negative consequences of the Corona crisis for public finances will only become appar­ent later. In many countries, they will mani­fest themselves, for example, in poorer demo­graphic development, including sharp declines in birth rates. This may cause implic­it debt to rise, for example costs for health care, social care, and the pension system. Unfavourable in this context are the prospects of highly indebted euro area countries such as Italy, Portugal, and Greece. There, the old-age dependency ratio – that is, the ratio of the over-65s to the 20 to 64‑year-olds – is rising in a worrying way.

The higher the public debt levels, the more sensitive public finances are to the in­creased servicing of their costs. In the event of a downturn, fiscal policy-makers would be faced with a dilemma between stabilising the business cycle and debt sustainabil­ity. Finally, if the government is no longer able to meet some or all of its debt obliga­tions on time, it risks losing access to finan­cial markets. Currently, the entire debt sus­tainability of the over-indebted Eurozone countries is based solely on the expansion­ary monetary policy of the Eurosystem.

ECB to the Rescue: Risks and Alternatives

With the announcement of the €1,850 billion PEPP, the ECB has implicitly com­mitted itself to keeping government bond interest rates low. So far, the ECB’s strategy has been successful, as member states can currently finance their debt at record low levels. Even the recent political crisis in Italy has not led to an increased premium on Italian government bonds. The crucial question is how long the ECB can continue to stabilise the Eurozone debt market. The ECB’s Governing Council has announced that the purchase of government bonds will last until at least March 2022, when the Covid-19 crisis phase is over and the capital payments due from government bonds will be reinvested by the end of 2023. However, it is hard to imagine that the asset purchases will be stopped in the final phase of the presidential elections in France in 2022. Moreover, the economic consequences of the pandemic, such as higher debt and un­employment levels, will require monetary and fiscal policy support for much longer.

Inflation is the key factor in determining whether the ECB can support the Eurozone debt market for a longer period. As long as inflation remains well below the ECB’s target (below but close to 2 per cent), it can justify its accommodative monetary policy. Otherwise, it would have to choose between the monetary policy target and the stability of the monetary union. Currently, inflation in the euro area is at a low level. It is true that the five-year inflation swaps – an indi­cator of inflation expectations – have risen steadily in recent months. But whether infla­tion will really grow significantly and come close to the ECB target is disputed among economists.

Another kind of challenge is the situa­tion in the US market. The recent plans of the US government for a massive fiscal stimulus package caused the interest rates of US bonds to skyrocket. As a result, Euro­pean bond rates also rose. This will force the ECB to buy more expeditiously and per­haps detach the purchases from the ECB’s capital key, which it officially abandoned with the PEPP but has been trying to adhere to (see Figure 2).

Monetary and Fiscal Policy As the Core of the Stabilisation Strategy

The euro area will have to deal with high levels of debt among its member states for a long time. Current projected levels are likely to rise further in many of the EU-19 countries as the pandemic continues and vaccination progresses more slowly than expected. It is not only higher levels of spend­ing and lower revenue streams that will put more pressure on public finances. The need for public support for the banking sector, among others, may also contribute to the increase in debt. The banking sector is likely to be hit hard by the pandemic because of problems in the real economy. The extent of such difficulties will be re­vealed by the stress test coordinated by the European Banking Authority. The results of the test are expected at the end of July 2021.

Currently, there is no effective alterna­tive to debt stabilisation through monetary policy, which allows member states to focus on fighting the pandemic. Under current conditions, it is crucial to continue active fiscal policy at least until 2023 to support the post-pandemic recovery. It is also im­portant that Germany maintains an active fiscal policy for as long as possible. A quick return of the largest economy in the Euro­zone to normal growth rates could help other member states.

It is also essential to limit the use of mone­tary policy in the debt market as much as possible so as to encourage re­sponsible economic policy-making of the member states. It is important to use public resources effectively to combat the effects of the pandemic in order to maintain labour force participation and create a broader basis for economic growth through productive investment. Above all, invest­ments should be made in human resources, especially digital skills. Only faster eco­nomic growth offers the chance for stabili­sation, and possibly debt reduction. Spend­ing efficiency is important, especially in the case of the reconstruction fund. It is the net contributors who assess it. If the countries most affected by the pandemic fail to use EU funds effectively for growth-enhancing stimulus and structural reforms, they will face the same problems after the pandemic, but with much higher public debt levels. Particular attention should be paid to how Italy uses the reconstruction fund. The new government under former ECB chief Mario Draghi offers a good chance that these funds will be planned and used effectively. On the other hand, Italy’s medium-term political outlook is a cause for concern, especially as a right-wing populist coalition is expected in the next elections. All this is likely to have a negative impact on the coun­try’s fiscal stability. It is also likely to dampen the willingness of other euro area countries to engage in further fiscal inte­gration.

In terms of debt management, govern­ments of the most indebted euro area coun­tries should make the most of the current low interest rate environment to issue debt with the longest possible maturities. This would help ensure the sustainability of public finances in the face of short-term fluc­tuations in financial markets.

Prospects: Foundations of the Eurozone under Pressure

The stabilisation of public debt will be one of the most pressing issues on the euro area agenda in the coming years. It will influ­ence two important debates on the founda­tions of the monetary union: the design of the current fiscal policy framework and the review of the ECB’s monetary policy strategy.

Rising debt levels challenge existing fis­cal rules. In most of the cases, public debt levels will be far higher than the Maastricht reference value of 60 per cent of GDP. There­fore, it is in doubt whether this frame­work is tenable. Examples are the rule adopted in 2011, which requires an annual reduction of the debt ratio by one-twentieth of the dif­ference between the actual debt ratio and the 60 per cent threshold, or the limi­tation of the budget deficit to 3 per cent. Although there is undoubtedly a need to make the fiscal rules in the Eurozone more realistic, it does not seem to be a good idea to start this discussion now. Due to the unfavourable political situation (elections will take place in Germany in 2021, in France in 2022) and very different positions, it would hardly lead to a constructive solution.

It would be best to extend the currently valid general escape clause of the Stability and Growth Pact at least until the end of 2022. However, sooner or later, Germany will also have to face a discussion on re­form­ing the fiscal rules. In addition to the long-proposed simplification, the rules will have to be based less on specific bench­marks and be tailored more to the situations of specific economies, their business cycles, and their systemic importance for the stability of the euro area. However, this “individualisation” of fiscal rules risks fur­ther politicising them. The high level of debt and the need to relieve the Eurosystem of the task of stabilising it will necessitate a partial post-Corona debt mutualisation. The Eurozone – in its current form as a fiscally decentralised monetary union – is vulner­able to debt crises in its most indebted mem­ber countries. Such crises can quickly trig­ger a domino effect throughout the Euro­zone. Before any joint issuance, however, plans for the post-Corona period must be accompanied by discussions on how sustain­able the economic models of the southern euro countries are, and what conditions should apply to reforms.

Rising government debt will also largely determine the current debate on the ECB’s monetary policy strategy. The main ele­­ments of this strategy – such as the defini­tion of the inflation target, the way infla­tion is measured, and the monetary policy horizon – will also have a major impact on the Eurosystem’s ability to stabilise debt. It would be beneficial if monetary policy were given more flexibility in supporting eco­nomic policy, as is the case worldwide today. Monetary policy alone, however, will not be able to permanently stabilise the euro area as long as the most glaring struc­tural deficits persist in the largest euro area countries. In the short term, the ECB faces the challenge of stabilising interest rates on the sovereign debt of Eurozone members. Indeed, after the announcement of the US fiscal stimulus package, these interest rates were sharply increased due to rising US bond yields. In the longer term, the ECB will have to master an even more difficult task. It is a matter of intervening in debt stabilisation while keeping national fiscal policy from dominating supranational mone­tary policy.