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How Should Europe Respond to the Pandemic?

How Should Europe Respond to the Pandemic?
 Eric Chaney
Senior Fellow - Economy

Hearing before the European Affairs Committee
of the French National Assembly
April 16, 2020

Madam President, ladies and gentlemen, thank you for inviting me to discuss the European response to the pandemic. I would like to make clear that I am speaking today in my own name.

The economic impact of the fight against the epidemic is colossal. Depending on the effectiveness of the lockdown exit and of the economic policies being taken, we can either expect a relatively rapid recovery (the V-scenario), with a return to the initial situation within two years, or a prolonged depression (the L-scenario).

In the first scenario, the spike in unemployment, although high, would only be temporary, and the increase of public debt in the eurozone by 15 to 25 GDP points over the next three years would be manageable. In the second one, we face mass unemployment, a fall in living standards, and an increase in public debt reaching wartime levels, especially in the Southern countries, but also in France. I will not attempt to describe the social and political consequences of that.

The second scenario must therefore be avoided at all costs, and it is from this angle that I will first examine the crisis responses at the European level, before moving on to what would be desirable to complement this response.

1. The ECB has provided the most coherent and powerful response to the crisis

The ECB has risen to the occasion by implementing two critical measures. First, putting €1,100 billion on the table will support the eurozone economies. Second, lifting self-imposed limits in the ECB’s previous procurement programs will alleviate the crisis of confidence currently affecting Italy. The message to member states is clear: don’t be afraid to go into debt, we will finance you.

The message [from the ECB] to member states is clear: don’t be afraid of going into debt, we will finance you.

The ECB will be able to sustain its action, but let us bear in mind that it does not have the same leeway as the Bank of Japan or the Bank of England. That is to say, is not the extension of a state, but a co-ownership that is therefore subject to co-ownership regulations, and the divergent views of its co-owners.

2. The Eurogroup's agreement is good, but only suitable for the most urgent cases

Even in the event of a very serious crisis, the eurozone rule of compromise prevails. The compromise of April 9 is coherent: eurobonds, which could have been introduced in the form of coronabonds, were ruled out, as countries less reliant on credit have good reason to be wary of them. Moreover, Italy finally accepted the option of the European Solidarity Mechanism (ESM), thanks to lighter conditionality clauses. In doing so, it potentially placed itself under the nuclear umbrella of the "direct monetary transactions" (DMCs) invented by the ECB in 2011.

The idea of a partial mutualisation of unemployment insurance in eurozone countries, (including in the form of reinsurance as was proposed by Belgian economist Daniel Gros), led to the creation of the SURE programme. The EIB, usually extremely cautious, has fully engaged. A total of €540 billion has been mobilised, representing 4.5% of GDP. Albeit considerable, this amount is only a fraction of the cumulative budget deficits for 2020 and 2021, estimated by the IMF at 11 GDP points, or €1 300 billion. An estimate that I, personally, find conservative.

This plan and the support of the ECB will allow the eurozone countries to weather the crisis in a best-case scenario. Should the darkest scenario unfold, this plan will be insufficient.

In reality, there is strong endogeneity in this dynamic. The very design of the lockdown exit strategies and the adequacy of the national and European support plans will tip the balance one way or the other.

As I am not qualified to talk about health plans, I shall focus on the national economic response, which also applies at the European level.

Protecting supply, above all SMEs, and safeguarding employment have been the guiding thread of government provisions in France and in all EU countries, demonstrating that governments have understood that initially this was a supply shock. As such it must be prevented from tearing at the economic fabric before the epidemic subsides. However, now is the time to reflect upon the next phase, recovery.

A general principle: support demand, but don't forget supply

Economic actors, such as companies and households, will become overly cautious with their spending, due to the uncertainty of the crisis and the lack of previous experience.

Companies may reconsider their investments, while households could cut on consuming sustainable goods. Being clear and transparent about the exit modalities will help reduce uncertainty, though it may not cancel it out entirely. After all, the virus has chosen no to disclose its plans. Demand support may therefore be justified, in due course, and should aim to encourage business investment.

Countries who will help businesses have the best chance of recovery will fare better.

Action must also be taken on the supply side as well. For many companies, the priority will be to meet orders accumulated while production was halted. The stakes are high, as those too slow to resume production will be squeezed out by their more agile rivals. Labour mobilisation through flexibility in the management of working hours and holidays, could make the difference between recovery and bankruptcy. Countries who will help businesses have the best chance of recovery will fare better.

What should European efforts focus on? I have four proposals.

1. Consider the Italian case as systemic

Italy is the most affected country in the eurozone. It is also the one with the weakest economy, the most fragile banking system, and the highest public debt (apart from Greece).

The Italian risk is systemic, meaning that Italy sinking puts the whole of Europe at risk. It is why the coordination of European aid will need to focus on Italy. The ECB has been flexible about allowing the Italian state to go into debt without difficulty, but that will not be enough. In the arsenal mobilized by the Eurogroup, transfers and recovery aid in the form of loans will have to go primarily to Italy, Greece and Portugal. The EIB should follow the same line of thought. In response to this solidarity, Italy's partners should ask the country to apply for ESM credit. That would serve to keep Italy from making any self-fulfilling speculation under the protection of the ECB. Ex-post, the ESM should have the ability to verify that the money  lent has been allocated to fighting the epidemic and its consequences.

In the longer term, the sustainability of Italy's debt will have to be addressed. That will be an extraordinarily difficult endeavour, and is outside the scope of this hearing. It would be safe to say, however, that his crisis has brought that discussion to the forefront.

2. Contribute directly to business investment

Before deciding on funding, the recovery plan proposed by France and adopted by the Eurogroup must be specified. The following is an attempt to quantify a plan of 1,000 billion (7% of EU GDP in 2019) over a period of 2 years (until mid 2022).

A first phase should aim at maximising the strength of  recovery and to tilt the balance in the right direction. It should respect the rule of economic neutrality and stimulate overall investment, rather than targeting specific sectors. One way of doing this could be through direct aid to finance a given fraction of investment. In 2019, investment in the EU amounted to 3 200 billion, a sum that will be lower in 2020 and 2021. A 10% contribution, for example, would cost around 300 billion on a full year basis. The fewer conditions attached to aid, the more effective it will be. But only companies eligible should be those that would use their profits exclusively for investment, and do so in the EU.

3. Increase research efforts massively by capitalizing on the ERC

The second component should be aimed at basic and applied research. Research has the immense advantage of offering a very high and long-term social return, often estimated at 10% to 15%, without depreciation. The Pythagorean theorem or Louis de Broglie's wave function is still profitable. Research funding requires checks, which national bodies such as the CNRS or INSERM in France are able to exercise. So can this be applied at the European level?

The second component should be aimed at basic and applied research. Research has the immense advantage of offering a very high and long-term social return, often estimated at between 10% and 15%, without depreciation.

We have an exemplary body, both in terms of governance and results: the European Research Council (ERC), which dedicates around €2 billion each year, or 0.012% of the EU's GDP, to cutting-edge research. The ERC has become a global reference and has financed the majority of future European Nobel Prize winners since it was established. Its meagre funding is in danger of falling victim to budgetary negotiations. The idea would be to capitalise on the ERC and turn it into a European Research Fund. With a capital of 400 billion and living off its own income, the ERF would quadruple its annual output and no longer depend on the EU budget.

By way of comparison, the endowments of the 10 richest US research universities amount to approximately  $200 billion.

For both components, pooled debt financing would be fully justified because of their multiplier effects for the EU as a whole. As the plan does not favour any country or sector, mutualised financing would be more easily accepted, provided that the debt raised is "super senior", meaning that it has a higher seniority level than national debts.

4. Implement a carbon price policy as early as 2021

The sharp fall in oil prices is likely to last, for structural reasons. The impact on European economies is very small, since consumption is constrained. Ultimately, it will have a positive effect on wealth, but it will also lead to an acceleration of carbon emissions per unit of GDP, reversing the trend of these last 40 years. This is an opportunity to introduce a single carbon price for all goods and services consumed in the EU, including imported goods, through border adjustment. By fully redistributing the proceeds of the carbon price (the carbon dividend), the EU would not increase the tax burden, which would benefit the recovery process. Provided that each country is free to decide how to redistribute, this could be akin to an income policy, with uniform redistribution favouring, by definition, the lowest income households.

To summarise, my proposals for a European response are to:

  1. Favour the rescue of Italy;
  2. Contribute directly to the financing of businesses;
  3. Capitalise the ERC to multiply cutting-edge research efforts; and
  4. Introduce a carbon price policy in the face of declining oil prices.

Thank you for your attention.




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