Franco-German Recovery Fund will not Fix Eurozone
By Pepijn Bergsen, Research Fellow, Europe Programme, Chatham House, 20 May 2020
The proposed fund to aid recovery from the coronavirus is a welcome sign of EU solidarity. But it does not do nearly enough to address the bloc’s underlying weaknesses, and is not a game changer for fiscal integration.
We don’t know yet exactly what Angela Merkel and Emmanuel Macron's proposed temporary fund of €500 billion will be spent on, but it will likely include investment in green infrastructure, research and support for the hardest-hit sectors.
Although the money will flow through the EU budget, it is likely to be spent early in the next budget period from 2021 to 2027. There are different options for dealing with the debt load created by the fund - it could be paid back over a long period, or continuously rolled over. The latter option is preferable given the likely high demand for these safe assets in financial markets.
As described by Merkel, the Franco-German proposal would mean that the debt servicing (the repayment of interest and principal) would be done through funds allocated to the EU through contributions from the member states, based on their share in the regular EU budget.
This would mean Italy would need to contribute around 15 per cent of these new liabilities. As a result, this technically increases the Italian state’s liabilities by around €75 billion, although accounting rules mean this will probably remain off the state’s balance sheet and thus not increase its headline debt to GDP ratio.
For those more in need?
To be net beneficiaries, countries must receive more from the fund than their share of liabilities. Therefore, if the EU spends more than €75 billion of the recovery fund in Italy, the country will be coming out ahead and it would constitute a transfer from those less in need to those more in need.
Given the relative severity of the coronavirus-related disruption, this is likely to be the case. However, given that other large countries, most notably Spain, have also been hit hard, there will be a limit to the upside for Italy. All member states, not just eurozone countries, will need to receive some of this money, with the political bargaining meaning it likely can’t be too far off from their share of the liability.
Assuming that spending from the fund in Italy is just over 50 per cent more than its share of the liabilities, at €115 billion or 6 per cent of Italy’s 2019 GDP it would constitute an increase in spending in Italy of around 2-3 per cent of GDP for the next couple of years. Some of this spending could have happened without the fund. But this would have come with higher debt servicing costs and it is thus safe to call this plan a significant fiscal boost for Italy, and other fiscally weaker economies.
A fiscal boost should not be confused with a revolution. Some have referred to this as a 'Hamiltonian' moment for the eurozone, referring to the American treasury secretary who bartered the compromise that led to the US federal government assuming the debts incurred by the states during the war of independence.
However, the recovery fund would, for now, remain a one-off and European countries will remain liable for their current debt loads, and for the increase in their debt stocks that will result from the coronacrisis anyway. The European Commission forecasts that the Italian debt stock will increase from 135 per cent of GDP last year to 153 per cent at the end of next year.
The size of the fiscal stimulus provided by the fund means it is likely to boost the growth potential for the Italian economy, particularly if accompanied by other reforms, as the plan suggests it should. However, it would require an unrealistically large boost to significantly improve Italian debt dynamics, especially given the disruption from the coronavirus crisis is going to be felt for a long time anyway.
The Italian state will continue to have to aim for large primary surpluses to finance interest expenditures significantly higher than that of its eurozone peers. If you believed that the Italian situation was economically and politically unsustainable over the long term before the crisis, even a larger version of this fund should not change your mind.
The recovery fund could turn out to be a template for future crisis responses and thereby represent a move towards a proper Hamiltonian moment. But as the fund is an EU instrument, instead of a eurozone instrument, this is harder. Furthermore, the next crisis is unlikely to be as symmetrical as the current one, meaning it will be even more difficult to get those member states already opposed to this plan to agree to a repetition or an expansion into something more like a fiscal union.
This does not mean the recovery fund is a bad idea. On the contrary, it should be welcomed as part of the EU’s response to the COVID-19 crisis. Ensuring the southern economies can recover is also in the interest of the fiscally stronger EU member states, who rely on their neighbours to buy many of their exports.
Furthermore, it would be something of a bargain for them, as it should only cost them their share of the interest costs and some of the fund will be spent in their economies. If that is too much to ask in solidarity, the EU has much bigger problems.