March 27, 2020
Watch out for the coalition of the south
The most interesting aspect about last night’s European Council is that Italy and Spain, for the first time, have formed a de facto coalition. This time, Portugal is also on board. António Costa criticised Dutch pettiness as threatening the future of the EU. During the eurozone crisis, the periphery never formed a political coalition. This is now different.
Last night’s European Council was a failure. The meeting ended with no agreement, only a perfunctory declaration. The leaders passed the buck back to the eurogroup, but without giving any direction.
Oddly, we think this is good. The absolute worst outcome would have been agreement to use a small ESM credit facility to deal with a large symmetric shock. Our estimate of the fiscal effects of this crisis has been in the range of 20-50pp, probably towards the upper end now. It could be higher. Not only does this go beyond the capacity of the ESM, but it requires a much different instrument than a credit facility or country programme.
There is no movement from Germany and the Netherlands. Angela Merkel yesterday categorically ruled out what is known as a coronabond, a one-time-only mutualised asset. Mark Rutte said eurobonds were inconsistent with the design of the eurozone.
We noted a revealing comment in FAZ, which said that Germany achieved a partial victory yesterday: it succeeded to frustrate a permanent anti-crisis group at EU level. This tells us that we are at a point where the frustration of crisis resolution is celebrated in the media as a political victory. We note that even the left in Germany is not interested in a European solution anymore. They are celebrating their Keynesian moment. But it is a national celebration.
What is clear is that the new south-western alliance will not get their eurobond, at least not in the form of a mutualised security underwritten by all 19 members. It would, however, make sense for them to do it among themselves. But, even without a eurobond, they are in a much stronger position now compared to 2012, because of the ECB’s de facto unlimited support. There is nothing much an ESM credit line would do for Italy. Right now, Italy can raise as much cash through the bond market as it requires. The pandemic emergency purchase programme is better than OMT. It is unconditional and, while not officially unlimited, it is de facto unlimited. Even the capital key is ultimately irrelevant, not only because the increase in German debt issuance provides some headroom. None of the limits have ever constituted a real-world constraint to prevent the ECB from doing what it needed to do. They were legal smokescreens, to be broken when expedient.
The only instrument that would make a difference for Italy and Spain right now is one that would reduce the countries’ sovereign debt load. There are various ways in which this could be done.
On a technical level, a mutualised eurobond would constitute the plain-vanilla tool. It could be technically replicated in other, less transparent ways. But, however you construct a new instrument and no matter what you call it, it has to involve an element of mutualisation. The point is to even out what would otherwise be an asymmetric fiscal effect from the pandemic.
We should recall that the ESM was created because a monetary union transforms balance-of-payments risk into credit risk. That transformation was not foreseen by the monetary union’s founders. The Covid-19 crisis is of a different nature. It is a huge symmetric macro shock for all. But, like the virus itself, it affects some more than others.
A report by the Italian news agency Ansa suggests to us that Giuseppe Conte sees the issues relatively clearly. He is clear in his rejection of an ESM programme. He demands a response that is massive, fast and co-ordinated at eurozone level, and globally. Ansa also pointed out that Italian diplomats had gotten almost everything they were seeking ahead of the summit, yet Conte said no. One suggestion we heard is that the sudden re-emergence of Mario Draghi could have played a role in stiffening Conte’s spine.