At the time of writing (3 April 2020), more than one million people have been infected and more than 53 thousand have lost their lives in the Covid-19 pandemic. The euro area (EA) is one of the epicentres of this global crisis and faces huge human and economic costs.

Introduction

CMMP analysis can add little value to the debate over the human costs and the appropriate medical and social responses to the pandemic. It can add value to the economic and political debate, however, by applying its three core analytical frameworks – global debt dynamics; money credit and business cycles; and financial sector balances.

I begin by challenging three myths from the past two decades that: (1) painful structural reforms post-2000 were the main driver of Germany’s recovery and resurgent competitiveness; (2) existing fiscal frameworks (including the Stability and Growth Pact) are still relevant in 2020; and (3) “this crisis is primarily the hour of national economic policy” (Issing 2020).

Instead, I argue that: (1) the main reason why Germany’s fiscal deficits did not widen substantially after the collapse of the 2000 IT bubble was that ECB policy led to other countries experiencing asset bubbles, lost competitiveness (and a build-up of unsustainable debt); (2) asymmetric fiscal rules that are tough on deficits but weak on surpluses are inappropriate in the current situation; and (3) this is the time to re-establish coordinated, counter-cyclical fiscal policy across the EA.

EA governments have the opportunity to show that it’s not just the ECB that “will do whatever is needed”. More importantly, failure to acknowledge and debunk the myths of the past and to respond to this opportunity appropriately, risks immeasurable harm to the future of the European project.

Myth #1: The role of structural reforms

Twenty years ago, the euro area (EA) experienced a sharp economic slowdown following the collapse of the IT bubble. The Germany economy was hit hard in the process, experiencing three consecutive quarters of negative growth (3Q01-1Q02). The domestic fiscal response was insufficient to counter the massive increase in savings by both the NFC and HH sectors.

In short, Germany had become the second developed economy (after Japan) to experience a balance sheet recession in the post-war period (Koo, 2015). In response, important “Agenda 2010” structural reforms (pensions, labour market) were introduced between 1999 and 2005. This (painful) experience has shaped the enduring narrative about the requirement for similar reforms across Southern Europe.

Unfortunately this narrative is incomplete and underplays the role of ECB policy at the time. In the face of German economic weakness, the ECB cut ST interest rates to 2% in 2003 – lower that they had ever been under the Bundesbank.

This had little impact on Germany where money supply, prices and wages continued to stagnate, as balance sheet recessions theorists predict.

The story was very different elsewhere in Europe. Other countries in the EA lost competitiveness against Germany, experienced unsustainable asset bubbles, and built up unsustainable levels of debt.

This brief historical summary is important because it falsifies the idea that recessions and the lack of competitiveness in Europe’s periphery are the results of “national idleness”. Instead, they occurred because Germany was unable to use fiscal stimulus to address its own severe balance sheet recession and ECB monetary policy was forced to pick up the slack, leading to asset bubbles across the EA and, when these bubbles burst in 2007, balance sheet recessions in periphery countries and ultimately the euro crisis.

Myth #2: Fiscal frameworks are still relevant

In February, before the full impact of the pandemic was becoming understood, I was arguing that the EA was still dealing with the legacy of these debt overhangs. Private sector debt levels were still high too high, money, credit and business cycles were significantly weaker than in past cycles and inflation remained well below target.

In spite of this, the nations of the EA were collectively running a fiscal policy that was about as tight as at any period in the past twenty years. They were doing this at a time when the private sector was running persistent net financial surpluses. This policy mix failed a basic “common sense test” even before the wider impacts of the pandemic were emerging.

A key lesson from the German (and Japanese) experience is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. Balance sheet recession theorists argue that these “unborrowed savings (at a time of zero interest rates) are responsible for the weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary” (Koo, 2015).

Relating the same argument to inflation targets, when inflation and inflation expectations are below target and rates are zero or negative, fiscal policy should lead with an expansionary stance and monetary policy should cooperate by focusing on guaranteeing low interest rates for as long as needed.

Since, I wrote these comments, EA governments have responded with a series of emergency fiscal measures including immediate stimulus via spending and foregone revenues, deferrals of some revenue sources, and other liquidity provisions and guarantees. However, the scale of the responses varies widely and, most importantly, there has been a lack of common fiscal responses, even in the EA.

Before, turning to this issue in myth #3, I will highlight an important argument from my preferred sector balances approach and Wynne Godley’s core identity that states:

Domestic private balance + domestic government balance + foreign balance = zero

Governments in low-debt countries often overlook that they have benefitted massively from membership of the single market and the ability to run large current account surpluses. Germany was able to emerge from its earlier recession by boosting exports to the rest of the EA where economies were responding (too quickly) to ECB rate cuts. Today, Dutch private and public sector deficits are offset by financial deficits run by the RoW.

Put simply, “asymmetric fiscal rules – tough on deficits, weak on surpluses – are quite inappropriate to the [current] macroeconomic situation” (Gentiloni, 2020).

Myth #3: This is the hour of national economic policy

The EA is one of the epicentres of the Covid-19 pandemic and faces huge human and economic costs. Non-essential services in major economies that account for one third of total output have been closed and the IMF estimates that each month’s closure equates to a 3% drop in annual GDP. The IMF concludes that, “a deep European recession this year is a foregone conclusion” and today’s PMI releases support that conclusion.

Policy makers have responded quickly with large monetary and fiscal expansions (including suspensions of previous fiscal rules and limits). Through its Pandemic Emergency Purchase Programme (PEPP) the ECB plans to buy €750 billion in addition bonds (on top of the previously announced €120bn purchases) and has removed country limits.

Debate now centres on whether a further common and significant response is needed. Options under consideration include ESM credit lines (combined with OMT); so-called “corona bonds”, a EA Treasury, and one-off joint expenditures.

Once again, this debate has exposed divisions between “defensive hawks” and more “ambitious integrators”. The French, Italian and six other EA governments are proposing combining using the ESM with the issuance of corona bonds. The German government has a preference for exhausting other options first, while the Dutch government has not only stated that use of the ESM should be considered only as a last resort, it has also ruled out the option of issuing corona bonds.

The IMF argues that, “the determination of EA leaders to do what it takes to stabilise the Euro should not be understated.” The EU’s economic chief, Paolo Gentiloni, believes that “consensus is growing day by day that we need to face an extraordinary crisis with extraordinary tools.” Nonetheless the corona bond debate threatens to deepen the rift between EA capitals over how far and how fast the EA should harness common fiscal solutions to tackle the pending economic damage.

The future of the European project may rest on how this debate is resolved.

Please note that the summary comments above are extracts from more detailed analysis that is available separately.