Europe’s response to the crisis

Blog post by Christine Lagarde, President of the ECB

Robert Schuman famously argued that “Europe will not be made all at once, or according to a single plan. It will be built through concrete achievements which first create a de facto solidarity”. This was as much a prediction as it was a challenge. One of the most important characteristics of any effective polity is its ability to adapt to unexpected circumstances and redefine what solidarity means. In its response to the coronavirus (COVID-19) pandemic, Europe has passed the test.

COVID-19 has delivered the largest shock to the European economy since the Second World War. Key macroeconomic indicators have plunged on a scale and at a speed previously unseen. Industrial production fell by 18% month-on-month in April. Durable goods production was down by almost 15% in the same period and new car registrations dropped by around 50%. If the ECB’s baseline macroeconomic scenario for 2020 is borne out, the euro area will lose as much output in two quarters as it had gained over the previous 15 years – and growth will not recover in full until the end of 2022.

Faced with an economic collapse of this magnitude, macroeconomic policies had to respond with commensurate alacrity and force. The overriding imperative was to prevent a wave of bankruptcies and job losses that would have caused untold harm to the lives of Europeans and left deep scars on our economy. The priority for national authorities was to “freeze” the economy in order to suppress the epidemic and temporarily absorb the loss of private income triggered by the lockdown measures. In parallel, monetary policy was called on to prevent financial markets from falling into a downward spiral and amplifying the shock.

This twin policy response was – at the outset – naturally conditioned by the design of our institutional framework, where monetary policy is a European competence and fiscal stabilisation takes place through national budgets. This differs from the United States, where the federal budget is responsible for a large share of fiscal stabilisation. In fact, it is estimated that around 50% of an unemployment shock in the euro area is absorbed through national budgets, significantly more than is absorbed by the federal budget in the United States.^[1]

So it was no surprise that national governments and the ECB were the first responders in Europe. But this did not make our reaction any less powerful. With the EU’s fiscal rules suspended due to the extraordinary situation, European governments have pushed through unprecedented fiscal expansions, with the aggregate fiscal balance expected to widen to around -8.5% of GDP in 2020. Monetary policy has launched new measures of extraordinary size and innovation. And, when the limits of national responses became visible, Europe adapted again: national measures have been complemented by a targeted and forceful European fiscal response.

Crucially, monetary and fiscal policies have reinforced each other. Two key features of the euro area economy – our reliance on bank-based financing and our preference to protect jobs – have become the cornerstones of our crisis response.

First, national fiscal authorities have offered massive loan guarantees and other liquidity support measures – equalling around 20% of euro area GDP – to mobilise banks and deliver liquidity to firms as fast as possible. Monetary policy has provided €1.5 trillion to fund this credit expansion at the most favourable terms we have ever offered through our new series of targeted longer-term refinancing operations. In order to ensure that lending reaches even the smallest borrowers, the ECB has started to accept loans to micro firms and sole traders as collateral in our operations. And our supervisory measures, acting in tandem, have freed up €120 billion in bank capital for new lending.

From March to May, the increase in bank lending to euro area firms was almost €250 billion, the largest rise on record in a three-month period. Across countries, loan growth and guarantee take-up are very strongly correlated. This emergency lending has been critical in keeping viable firms liquid and encouraging employers to stem layoffs.

Second, national governments have provided unheard-of fiscal support to firms that retain jobs, helping make the surge in bank loans and corporate debt serviceable ex post. More than 25 million workers in the euro area – 15% of employment – have been enrolled in short-time work schemes during the second quarter. As a result, jobs and incomes have been protected and the connections between employers and employees have been preserved.

Monetary policy has enhanced and empowered these actions by countering the serious risks posed by the outbreak to monetary policy transmission and the outlook for the euro area. In particular, our €1.35 trillion pandemic emergency purchase programme has prevented an undue tightening of financial conditions for both public and private sectors.

In parallel, the ECB has acted to facilitate access to euro liquidity outside the euro area by setting up a series of bilateral swap and repo lines with other central banks and launching our new Eurosystem repo facility, which can be accessed by a broader set of central banks. This has helped in stabilising financial markets, especially in countries where the euro is often used extensively, and in fostering the euro’s international role.

Towards a European response

The scale of fiscal support in Europe has created huge financing needs for national governments, who are expected to issue €1 trillion to €1.5 trillion in additional debt this year. At the same time, the euro area entered the crisis with debt ratios among member countries ranging from 8% to 175% of GDP, threatening an asymmetric and uneven fiscal response. Faced with a common shock, it was appropriate for Europe to deploy its collective weight through its common institutions to ensure that all members could react to the crisis adequately. The next phase of Europe’s response to the crisis was about putting this into action.

The first element was to support and complement national fiscal responses mainly by strengthening existing European facilities. The European Stability Mechanism, the European Commission via its Support to mitigate Unemployment Risks in an Emergency (SURE) scheme, and the European Investment Bank made available a €540 billion safety net to help finance sovereign expenditures related to the pandemic, fund national short-time work schemes and provide credit guarantees to firms. Support largely consisted of access to very cheap loans.

As the full scale of the crisis became clearer, Europe went a step further by recognising that loans would not be sufficient for the worst-afflicted countries, since they would only increase public debt levels further. But European funds had previously been used for long-term convergence and not for recovery and stabilisation purposes. This is why the Next Generation EU (NGEU) fund – agreed in the early hours of Tuesday morning by the European Council – is such an important step forward. For the first time ever, Europe has – temporarily – put in place a European budget that complements the fiscal stabilisers at the national level.

From 2021 onwards, €750 billion in new European spending will come on line, with two unique new features: outlays will be financed by European debt issuance and €390 billion of the spending will take the form of grants. This represents a good balance between grants and loans and will offer significant support to the countries most in need. There are two key benefits to this approach.

First, so far little fiscal support has been legislated at the national level beyond the end of this year, which could create a risk of premature fiscal tightening in Europe. Under the European Council agreement, 90% of the total NGEU envelope will be disbursed to sovereigns through the Recovery and Resilience Facility, and 70% of all funding from that facility will be committed by the end of 2022, with the remaining 30% following in 2023. This means that additional European stimulus will come on line at the right moment to complement and bolster national fiscal responses.

Second, it is already clear that the recovery phase of the crisis will be less about preserving the status quo – which was the initial priority – and more about transforming the economy to reflect the new realities of the post-COVID-19 world. But reallocation from “sunset” industries towards new sectors and technologies usually takes time.^[2] Government actions will therefore be key in smoothing the transition and promoting change – and the NGEU fund can help anchor that transition.

Most importantly, 30% of spending in both the NGEU fund and the EU budget will have to be linked to the climate transition and all spending should be consistent with the Paris climate goals. This means that more than €500 billion will be spent on greening the European economy over the coming years – the biggest green stimulus of all time. Countries will only be able to receive money if they submit recovery and resilience plans that contribute to the green and digital transitions. These must be our priority areas if we are to exit this crisis modernised, reformed and strengthened. And in order to reach this goal, NGEU will need to be firmly rooted in sound structural policies conceived and implemented at the national level. 

Learning the lessons of the past

Measured against realistic expectations, Europe’s response to the crisis has been impressive. It has substantially exceeded the most recent benchmark – its response to the sovereign debt crisis – and broadened the boundaries of what is possible should we be struck by such dramatic shocks again. Indeed, even though NGEU is temporary, the potential to activate such tools in future crises is already a powerful change to the structure of the Union.

But this raises a final question: why has the response been better than before? Learning the lessons of the past, Europe has moved towards a new model for dealing with crises: one based around strategic autonomy, policy coordination and the Union method.

First, Europeans have realised, more than ever before, that their prospects for growth depend on each other. During the sovereign debt crisis, several countries compensated for the weakness of the monetary union by turning to the rest of the world to sell their exports. But the global nature of the COVID-19 crisis and the slow and uneven recovery have curtailed that possibility. At the same time, the euro area has only become more interconnected over time, with trade and supply chain linkages amplifying common shocks by around 20%. The upshot is that no country can recover and thrive fully unless its European partners do, too.

Second, we have seen the value of policies complementing each other rather than working against each other. A key shortcoming of the euro area during the sovereign debt crisis was its failure to consider the aggregate policy mix – that is, the negative spillovers created by uncoordinated fiscal policy tightening at a time when monetary policy was aiming to stimulate the economy. From 2013-18, fiscal policy in the euro area tightened by around 2.5 percentage points of GDP, compared with a loosening of around 0.8 percentage points in the United States.^[3] This was one factor behind the euro area’s weak growth and inflation dynamics during that period. Now, policies are fully aligned in securing the fastest possible recovery, which also underpins medium-term price stability.

Third, Europeans have concluded that a coordinated response works best with the EU leading the way. The response to the sovereign debt crisis mainly took place outside of the EU’s institutional framework, which helped facilitate agreement but also brought a “last resort” logic to collective decisions. The decision to place NGEU within the EU budget, however, broke with these constraints and sent a different signal about solidarity. The very positive market reaction to the Franco-German and European Commission proposals in May illustrates how this shift was perceived from the outside.^[4]

This new model for action did not emerge overnight. It took some haggling and internal disagreements. But Europe has adapted. We have shown that we can act quickly and adapt our institutions in the face of even the most severe challenges. Europe is a community built on interdependence, and working together is by far the best medicine to treat the economic symptoms of COVID-19. Now we must carry forward the positive momentum we have built and shape the recovery further. In doing so, we can rise to Schuman’s challenge and forge a new Europe out of this crisis.

Read more about the ECB’s response to the coronavirus pandemic