The economic challenge arising from the coronavirus crisis has multiple facets, including a supply-side shock, huge drops in demand and liquidity issues. Debt is a major challenge. Many European Union countries will soon face big increases in their nominal sovereign debt burdens, exacerbated by the sudden collapse of economic growth. What can the European Union do to address these debt problems?
‘Corona bonds’ have been suggested by Italy’s prime minister as a possible policy solution. This has been supported by seven German economists writing in Germany’s mainstream conservative newspaper. Missing from these discussions is an understanding of the politics that could block their implementation, and how to overcome any objections. We discuss the design of such bonds and also a related proposal for a European Stability Mechanism (ESM) line of credit, in order to address some of the understandable objections of those with the power to make decisions, especially in the European North.
A useful, though imperfect analogy, comes from the United States. A bit of history is in order on the ‘no-bailout’ norm developed in the US, and what it really meant. In the 1840s, some American states become insolvent because of excessive investment in railroads. They appealed for a central government bailout, but Congress, which was composed of legislators from states with debt problems and states with no debt problems, refused. However, there have been US government bailouts of state governments. First in the 1970s, then in 2003, and again in 2009, the federal government gave money to the states that prevented meltdowns at state level. In those cases, there was the perception that every state was hit by recession/global financial crises, not by individual bad decisions as in the 1840s. The shock was external and hit everybody.
How the mechanism worked when the federal government did act was politically important. Each state received transfers on a per-capita basis. Even Wyoming, which because of its size and because of what it produces had a budget surplus in 2003, received money under the Jobs and Growth Tax Relief Reconciliation Act of 2003.
All EU countries are suffering from an exogenous shock. One can debate the policies put in place and the preparedness of healthcare systems, but the reality is that this virus hits everyone. Moreover, the economic recovery at home will not proceed without recovery across the EU. The economic recovery can only start after the end of the pandemic and will be quick and V-shaped if the medical emergency is short-lived. But it could be U-shaped and prolonged if the pandemic goes into the summer and beyond.
To get through the deep trough, and eventually aid recovery, monetary and fiscal measures are both needed. The European Central Bank has announced a gargantuan €750 billion Pandemic Emergency Purchase Programme, and all EU countries have announced government programmes.
What is still missing is fiscal support at the EU level. A reasonable approach would be to create a debt instrument called the ‘corona bond’ that would fund only COVID-19-related expenses. Such a bond is in the spirit of the Treaties (Article 103), which envision mutual financial guarantees for the joint execution of specific projects, so the principle of corona bonds is in line with what member states have already agreed. A related, compatible proposal would be an extended line of credit through the European Stability Mechanism (ESM).
The key consideration is not the form of the financing (bond or extended credit), but the responsible institution within the EU framework to oversee the process: the ESM. The ESM already issues bonds, and has the technical capacity to expand its operations. Its rules create a clear baseline that set procedures and responsibilities for deciding allocations. This is important in a crisis when time haggling over details can lead to delay. The capital key of the ESM would determine liability and voting rights. For day-to-day operations this means a qualified majority. To start a programme requires unanimity. For emergency situations, however, when the European Commission and the ECB judge that failure to act “would threaten the economic and financial sustainability of the euro area,” a qualified majority representing 85% of the capital shares is needed for approval. This means France, Germany, and Italy alone could block such a programme. Changes to the programme then require an 80% share. In this case, France and Germany alone could veto changes. (See ESM Treaty, Article 4.)
For this to work politically, and analogous to the US in 2003 and 2009, it is important that all EU countries can participate. The financing and distribution details would be important. The ECB uses its capital key to decide on the distribution of bond purchases; one could set the same limit here. Like other ESM programmes, there would be conditionality. But to avoid the stigma of the conditionality when lending to crisis countries, let us call this ‘COVID conditionality’, meaning that money goes to additional expenses related to the economic impact of the virus. A narrow view of this would be for expenses directly related to the care of patients. But a more expansive view would make sense. One could take the debt burdens at the end of 2019 and use member states’ own stability programmes as a baseline for where debt would have been without the crisis.
The ESM is well-positioned for this task. It is mandated by its Treaty (Article 13 1.b) to analyse the debt sustainability of member states, and it has the methodological framework to assess the difference created by the pandemic. Key to this setup is that there would be a European institution that manages the process, so that the sum is greater than the parts for the markets. COVID conditionality is equally important. It ensures that the issuance of corona bonds does not become a blanket common assumption of debt, but is restricted to the current extraordinary circumstance.
What are the potential objections to this set-up?
Isn’t a corona bond or a line of credit through the ESM just a dressed up Euro bond? No. This is not a common debt instrument to fund debts of member states. Instead, it is the common assumption of debt for a specific task. It would go only to virus-related expenses and there would be COVID conditionality, monitored by the ESM.
Why would Germany participate? Leaving aside the important issues of reinforcing the euro and EU solidarity, the taxpayers of the stronger member states would need to maintain control of any debt-issuance process. France and Germany alone can veto changes to an ESM package after it is originally instituted with unanimity. So they can block a change in a given programme if they get nervous about its intended use.
But isn’t it anti-democratic if France and Germany have a veto? One would anticipate that the start of a programme would pass with unanimity, and the formal rules require that Italy should also approve. There should be one big package that all approve, so every state votes on it and every state gets something.
There could be mission creep, so the money is used to pay for old debt anyway. Again, the ESM might prevent some of this. But yes, this could happen and we do not see why it should not. If some countries can come out with a stronger balance sheet after the pandemic, thanks to corona bonds, this would be a collateral benefit. Some states in the US banked the money in 2003. At the same time, this package is not free money. EU countries would pay it back. If the debt is more expensive for some northern countries than what they can rise by themselves, they won’t want this additional debt.
So why not remain with the status quo, in which national governments can borrow at low rates and the ECB buys sovereign bonds through quantitative easing? Investors  can lose confidence quickly in the sustainability of one country’s debt. With a corona bond or an ESM line of credit the backing of member states like Germany and the Netherlands would be clear, and the transparent conditions attached to the debt would reassure the markets. Moreover, the fact that member states could draw on such funds would reduce pressure on national sovereign bonds because they would be judged less likely to default.
One can return to the US analogy, and the limits to it. An advantage of the US system is that no one knows which states (or which taxpayers) are liable if the federal government defaults. The reason is that no one needs to figure this out – it is not credible that the US government would default. The Fed can always print money and buy treasuries, and the US dollar is privileged. The euro does not enjoy such privileges and there is no fiscal backstop. But one could still take steps to make corona bonds as credible as US Treasuries. The ECB could even buy them as part of the Pandemic Emergency Purchase Programme (PEPP). And while member-state taxpayers might worry about the solvency of their national governments, few worry about the solvency of the ESM. A well-designed programme focused on the corona crisis would not change this situation.
Wouldn’t the same taxpayers pay back the loan if the national government or the ESM issued the debt? Governments in trouble should be able to raise more aggregate funding from all sources at a given interest rate with ESM support than without it. The Marshall Plan extended only loans and no grants to Germany after the second world war, yet the loans were crucial for the rebuilding of the country.
Why use the ESM at all? Every member state faces some trouble, but if there is no immediate action, one of the biggest, Italy, might be unable to service its debt. With projections of a drop in euro-area GDP of up to 20%, we do not know if or which other countries will reach their debt limits and be unable to service their debts by the time the pandemic is over. The ECB’s measures can deal with liquidity issues, but Italy potentially has a debt problem, as, most likely, will other countries. The debt burden is bound to jump from an already high level because of the pandemic shock, and some form of shared-debt financing is needed. France, Spain, Portugal, Greece and Cyprus have debt-to-GDP ratios hovering around or exceeding 100%, and a -20% growth shock would likely push them all into unsustainable territory. In particular, the current system cannot deal with the default of a big member state like Italy. The corona bonds would address directly the debt issue without creating moral hazard. Because the moral hazard issue would be addressed, voters in EU countries with lower initial debt levels should object less.
The current pandemic could potentially have profound social and political implications. Protecting the euro area by strengthening the weaker links will be good for the weaker links, good for the system and, by implication, good for the stronger economies which are also part of the system. Given the interdependence of euro-area countries and spillover effects, this is, in our opinion, the predominant justification for corona financing. This proposal relies on existing institutions and on the ESM in particular, while creating a new debt instrument only for virus-related expenses, in line with the EU Treaty.
One remaining question looms big over any proposal for a common fiscal instrument. Corona financing might not be a common assumption of debt by stealth, but could it develop into common assumption of debt? Yes it could. But only if there is unanimous political agreement, and it will be restricted to the debt created in fighting a common enemy and will not be open-ended. (Re)opening the door for this debate in the aftermath of an unprecedented crisis would be a good thing.
 Mme Lagarde quickly walked back her ill-fated remark that “we are not here to close the spreads”, but there was a second part to her statement that was spot on: “there are other actors to actually deal with those issues”. With corona bonds and the ESM credit line, these other agents take up an important role in closing spreads.