June 4 brought two important pieces of good news. The first was an agreement within the German grand coalition government to add €130 billion to its fiscal response to the economic consequences of the coronavirus pandemic. The second was the decision by the European Central Bank’s (ECB) governing council to add €600 billion to its pandemic emergency purchase program, to extend that program to June 2021, and to maintain or rollover any holding in that program through 2022. The question is whether this is going to be enough to hold disaster at bay. Given the nature of this crisis, the answer is always going to be uncertain. The same doubts apply to the European Commission’s proposal for a ‘next generation EU’ (European Union) recovery program.
Europeans can still afford to be optimistic. Even if they turn out to be inadequate, this collection of policies shows that Europe’s leaders have mastered the lessons from the last crisis and are determined to respond to the current crisis in an effectively coordinated fashion. So long as Europe’s leaders continue along this path, they should be able to rise to the occasion.
Lesson 1: German fiscal stimulus is good for European macroeconomic performance.
The German stimulus package is the kind of leadership that was missing in early European responses to the last crisis. The German economy is Europe’s largest both in absolute terms and in terms of manufacturing. Moreover, the German economy is open. Germany exports more than it imports, but it imports a lot. In 2019, for example, Germany imported just over €1.4 trillion in goods and services. That is almost twice as much as France imported, over two and a half times as much as Italy, and over three times as much as Spain. In fact, Germany imported just €300 billion less than the next three largest economies in the euro area put together. This year the European Commission expects German imports to fall by just over €150 billion. That will pull a significant amount of demand for exports from across the euro area – for automotive parts and electronics, as well as for clothing, food, wine, and holidays.
When the German government gives €300 per child, that may not buy a lot of Benetton clothing, but it will buy some. It will also buy Lego produced in Hungary. Subsidies for German car purchases will draw parts from across Central and Eastern Europe. Investment in medical technology will draw testing equipment from Northern Italy. And efforts to bail out the small business that make up the German hospitality sector will ensure that German consumer confidence remains stable. Germans may even go on holiday. Whatever they do, confidence in Germany can spread to other countries.
Lesson 2: The European Central Bank is here to close the spreads.
It will take time for fiscal stimulus in Germany to have an impact. The same is true for other countries, where according to researchers at Bruegel the level of new spending is considerably lower as a percentage of national income. Such fiscal efforts can blunt the terrible impact of the crisis, but they remain mostly at the level of stopgap measures. This means that the bulk of the policy response falls to the European Central Bank as it tries to ensure that firms across the euro area have enough access to credit to survive. For that to work, however, the ECB has to keep the monetary plumbing connected and working efficiently. Otherwise credit will not flow across the European financial system; some parts of the euro area will find themselves flooded with money and other parts will have shortages.
This was a bitter lesson from the last crisis and it only struck home with Mario Draghi gave his famous ‘whatever-it-takes’ speech in July 2012. Most people think of that speech as Draghi’s defence of the euro as some kind of talisman for political commitment to Europe. In fact, Draghi was pledging to defend Europe’s financial plumbing – called the ‘monetary transmission mechanism’ – because if that plumbing does not work, then the euro effectively ceases to exist as a single currency.
The ECB has now internalized that lesson and as a result, it does ‘whatever it takes’ more quickly and decisively. You can see that commitment in the opening statement that ECB President Christine Lagarde read at the start of her press conference last Thursday:
[T]he Governing Council remains fully committed to doing everything necessary within its mandate to support all citizens of the euro area through this extremely challenging time. This applies first and foremost to our role in ensuring that our monetary policy is transmitted to all parts of the economy and to all jurisdictions in the pursuit of our price stability mandate.
That commitment explains why the ECB created its pandemic emergency purchase program once it saw the first signs of market volatility last March, it explains why the ECB has expanded that program more recently, and it explains why it would be unwise to bet against the ECB expanding that program again if necessary. ‘Whatever-it-takes’ is no longer something markets have to wait for from the ECB’s Governing Council; it is part of the standard toolkit.
Lesson 3: There is no substitute for effect policy coordination.
Importantly, however, this huge monetary policy effort cannot solve the economic problems of the euro area on its own – any more than firms and households can borrow their way into solvency. Europe needs demand, and the demand it needs is far greater than the rest of Europe can count on from Germany. Unfortunately, not all parts of Europe are equally equipped to contribute to a more ambitious stimulus package. Some countries will struggle because they have been so hard hit by the crisis; some will struggle because they are so dependent upon what happens in other countries for their income; and some will struggle because they had high debts and weak credit ratings even before the crisis. Again, the issue is timing. Europeans can debate the diagnosis of the problem and the side effects of any remedies. While they do so, however, Germany’s fiscal effort will bleed out through imports and the ECB will become ever more overextended in the expansion of its balance sheet.
This is where the European Commission’s proposal for a ‘next generation EU’ recovery fund becomes important. That proposal does not have to be perfect in all dimensions; what it needs to do is bring focus to the conversation. The goal of that conversation is to make sure that all European member states work together to construct a common fiscal response that can in turn be used to complement those efforts taken at the national level (i.e. in Germany and elsewhere), and within the European Central Bank. What is impressive about the proposal is not the specific policy innovations that it encompasses, but the fact that we are only three months into the crisis and the European Commission already has a comprehensive package to serve as a focal point. This is a huge improvement over Europe’s response to the last crisis (or crises depending on how you count the various shockwaves that hit the European economy from 2007 through 2015). The challenge now is for Europe’s heads of state and government to capitalize on the opportunity this represents in order to lock down a meaningful agreement for coordinated action.
Conclusion: Affordable and unaffordable optimism
When you look at the combined European response to the crisis, there is good reason to be optimistic. Germany is exercising leadership in terms of fiscal policy that will offer clear benefits to the economies of other countries. Together with the fiscal efforts underway in other countries, this German package can help blunt the impact of the crisis and lay foundations for recovery. Meanwhile, the European Central Bank is acting decisively to ensure the whole of Europe has access to the credit necessary to buy time. And the European Commission has put forward a proposal that will make it possible for every part of the European Union to participate in a coordinated response to the economic challenges that we are only just beginning to understand and that we can be sure will intensify over the coming months.
This combination of measures shows that European leaders have learned the most important lessons from the last crisis. So long as they continue down this path, Europe’s leaders give Europeans cause to be optimistic and to begin planning on the basis of an effectively coordinated macroeconomic policy response.
That kind of optimism is affordable even if this situation takes a turn for the worse. If a powerful second wave of contagion hits Europe’s economies, if one or more of Europe’s major trading partners has to go into another lockdown, if the crisis starts to hit European banks and so sends tremors through the financial system, and if the hunt for an effective treatment and cure turns out to be more timely and complicated that current economic forecasts build into their assumptions, Europe’s leaders are showing that they can rise to the challenge.
The kind of optimism Europeans cannot afford is to believe in some sort of magical realism where this horrible pandemic disappears and takes its devasting economic consequences along with it. Emerging from the lockdown is not the end of the economic crisis; Europe is still only at the beginning. The recovery will be difficult, time-consuming, expensive, and conflictive. Europeans should be proud of how well their policymakers have responded. But Europeans cannot afford to allow false optimism to cause their commitment to effective coordination to falter.Follow @Erik_Jones_SAIS