This is not a forecast. But I think it is a plausible scenario. After initial relief at the emergency deal struck last week by EU finance ministers, investors will study the small print and conclude the rescue package will have no macroeconomic impact.
The main elements of the deal were a credit line from the European Stability Mechanism, credit support from the European Investment Bank, and reinsurance for national unemployment schemes.
The dispute about whether a loan from the ESM bailout fund should come with strings attached will be forgotten. Italy does not want one anyway. Giuseppe Conte, the prime minister, has concluded that his government would not survive the humiliation. In any case, the European Central Bank has done enough to forestall a sovereign liquidity crisis this year. The ECB’s pandemic emergency purchase programme trumps all else.
The only programme under discussion that could have made an economic impact is the post-crisis recovery fund. After EU leaders kicked the ball across to the finance ministers, they have kicked it back. The European Council’s agreed text mentions a recovery fund, together with a reference to innovative financial instruments. (This means different things to different people.) But nothing was agreed. The momentum for “coronabonds” as an instrument to raise finance for the fund may be fading.
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My expectation now is that the European Council will, instead, end up agreeing on a small recovery fund from within the EU’s 2021-2027 budget, with the usual exaggerated claims of how much this amount can be leveraged. The main function of a recovery fund will be to serve as an attention-seeking device for idle European institutions making no macroeconomic impact whatsoever in a €12tn economy.
So we are left with national fiscal policies and ECB support. My baseline assumption is that the economic impact of the crisis will be larger than estimated by some forecasters. The German economic institutes have produced their joint forecast of an improbably precise 4.2 per cent decline in national gross domestic product this year, followed by a 5.8 per cent increase in 2021 — the perfect V-shaped recovery. If they are right, and if it translates to the eurozone as a whole, then we are done. There will be no crisis and no need for extraordinary measures beyond those that have already been taken.
But I believe they are wrong. These forecasts are not factoring in the global network effects of the lockdowns, the lasting impact on sectors, such as transport and tourism, and a possible second wave of infections in the winter.
My scenario assumes a fall in eurozone GDP closer to 10 per cent this year, with Germany performing a little better than the average and Italy and Spain worse. My scenario also assumes that the German economy will recover moderately in 2021, while the south will recover less.
The combination of rising debt and falling GDP will raise Italy’s debt-to-GDP ratio from the current 135 per cent to between 160 and 180 per cent.
The majority of members in the ECB’s governing council will always support the eurozone economy in a moment of crisis. But I would not bet on the ECB bankrolling highly-indebted countries indefinitely. The ECB’s emergency programmes will end. People may start remembering Christine Lagarde’s slip of the tongue last month. The president of the ECB may actually have meant it when she said the bank’s job is not to close spreads. There are quite a few people in the ECB governing council who believe exactly that.
At some point, rating agencies or investors could start to question Italy’s solvency. The issue is not only the total amount of outstanding debt but also the country’s low economic growth rate. This is the third recession in Italy since 2008. Each time the economy has emerged weaker. So, what if the rating agencies conclude that Italy cannot service its outstanding debt, and attach sequential credit downgrades?
Imagine if this happens in 2021 or 2022, just before Italy’s next general election. Mr Conte and his government are popular right now. Will that continue to be so once the full depth of the recession becomes apparent? Matteo Salvini, a more marginalised political figure in Italian politics since last year, may bounce back. If he were to win an election in 2022 or 2023, his government might be tempted to default on Italy’s debt. And then what?
Like any scenario, this one, too, depends on uncertain events unfolding in a particular sequence. I hate to attach numerical probabilities to any future outcomes. But I think this scenario is not any less likely than the optimistic one of a V-shaped economic recovery, on which actual policy is based.
So I am left wondering: why does the EU not wish to hedge against it?
