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NEW YORK – After arduous negotiations between member states’ governments last month, European Union leaders are celebrating their agreement on a €750 billion ($886 billion) rescue package for EU countries hit hard by the COVID-19 crisis. But it is too soon to pop open the champagne. The plan for the “Next Generation EU” recovery fund has two major weaknesses that will make it not only ineffective but also a threat to the eurozone’s very existence.
In addition to being too small, Next Generation EU lacks essential conditionalities for fiscal sustainability, including an orderly sovereign-debt restructuring mechanism (SDRM). The recovery fund’s €390 billion grant component is a mere 2.8% of the EU27’s 2019 GDP. And even if one counts the €360 billion loan component and the €100 billion in lending through the Support to mitigate Unemployment Risks in an Emergency (SURE) program, the total still reaches a mere 6.1% of GDP.
Worse, even though fiscally challenged national governments need financial support immediately, the recovery fund will not make funds available to member states until 2021, at which point the €750 billion allotment will be expected to last for three years. (The relatively insignificant SURE program is already operational.) Nor can European governments expect much help from the 2021-2027 EU budget, which amounts to no more than 1.1% of annual EU GDP, and is not meant to provide additional funding for the COVID-19 crisis.
To be sure, Next Generation EU could be significant from a longer-run perspective if it were to establish a precedent for either regular intergovernmental fiscal redistribution programs or (preferably) a supranational fiscal facility within the EU. A new joint facility that could borrow, spend, and tax according to clear rules and with proper accountability to the European Council and the European Parliament would represent a significant step forward. But that outcome is extremely unlikely. After all, the EU has made loans to member states outside the eurozone since 2002 under the balance of payments assistance facility, and even that did not spur the development of the EU’s fiscal capacity.
When it comes to cross-border fiscal and financial assistance, there is significant distance between the positions held by the “frugal four” (Austria, Denmark, the Netherlands, and Sweden) and the governments of southern EU countries like Italy, Portugal, and Spain. As such, it is extremely unlikely that Next Generation EU will lead to a meaningful fiscal union. Moreover, the European Council has made clear that the fund is “an exceptional response” to “temporary but extreme circumstances,” and that the European Commission’s borrowing power remains “clearly limited in size, duration, and scope.”
The absence of a meaningful EU or even eurozone-wide fiscal facility will leave both groupings (especially the eurozone) at constant risk of national sovereign-debt defaults, owing to the lack of national monetary-policy instruments. In fact, in the eurozone’s case, the logic of Modern Monetary Theory applies.
When a country’s debt is denominated in its own currency, and when there is a national central bank that is ultimately subservient to the national fiscal authority, sovereign default is a choice, not a necessity. But eurozone member states cannot rely on a national central bank stepping in to monetize national public debts. Because their public debt is effectively denominated in a foreign currency, sovereign defaults can occur as a matter of necessity.
With the debt burdens of fiscally challenged member states rising steadily, this is not some distant or marginal concern. It is absolutely crucial that the grants and loans allocated by Next Generation EU be made conditional on fiscal sustainability; apparently, however, they won’t be.
On a more positive note, the fiscal rules of the Stability and Growth Pact (which did not offer any loans or grants) have been suspended. They should now be scrapped permanently, and replaced with fiscal sustainability conditions for any financing offered by a central EU fiscal authority.
But even the most ambitious European fiscal support mechanism that is politically feasible is unlikely to be sufficient to prevent further sovereign defaults, especially in the eurozone. To avoid another Greek-style debt crisis, the EU needs an orderly SDRM. The best way to achieve that is to turn the European Stability Mechanism into a European Monetary Fund (EMF), which should then be empowered to provide conditional financial support to distressed eurozone member states, consistent with a debt-sustainability analysis conducted by the EMF.
An EMF structured in this way should be able to manage any necessary sovereign-debt restructurings in an orderly manner. It could impose a standstill on debt service, and it could force minority creditors to accept a deal approved by a qualified majority. (Of course, collective-action clauses that cover only individual debt contracts would need to be transformed through comprehensive aggregation clauses.)
Any new debt issued by the EMF or EMF-sanctioned parties should be made senior to outstanding debt. To ensure that the EMF does not run out of liquid resources, it should have a credit line with the European Central Bank (guaranteed by eurozone member states). The size of the credit line could be decided by a qualified majority of eurozone governments, most likely through the Eurogroup of finance ministers.
With a much larger countercyclical recovery fund, proper conditionality to ensure fiscal sustainability, and an effective SDRM, there would be hope yet for the eurozone and the EU. Without these reforms, the threat of a breakup will always be present.
Willem H. Buiter, a former chief economist at Citigroup, is a visiting professor at Columbia University.
© Project Syndicate 2020
