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Corona transfers instead of Coronabonds

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Via VOX EU

There can be little question that the economic fallout from the COVID-19 epidemic is hitting different EU member states with very different intensity levels. In this exceptional situation, solidarity is warranted. The weakest members, which are unfortunately often hit hardest, deserve help. Those member states which are able to help, mostly in the North, are likely to themselves experience a sharp recession. However, they have the financial means to overcome the crisis by providing generous assistance to their enterprises and provide a safety net to their unemployed citizens. They would also be able to provide some assistance to the member states most in need.

The first question to ask is whether the coronavirus crisis calls for solidarity within the EU or the euro area. During the financial crisis, one could argue that membership of the euro area was, itself, a source of some of the difficulties for Italy and Spain (because in the face of pressures on their financial markets, they could not turn to their national central banks for liquidity).

The origin of this crisis is very different. Being hit by an unforeseen epidemic has nothing to do with euro area membership. There is therefore a strong argument to consider the present situation as a case which requires solidarity at the EU level.

Nonetheless, what kind of assistance should be provided – loans or grants?  This is the second key question. 

It is possible to argue that the additional state expenditure required to mitigate the impacts of the coronavirus shock should be financed by issuing common bonds. The shock is symmetric in nature and all governments will now have large deficits. One could therefore consider allowing all member states to issue ‘Coronabonds’, to the value of, say, 5-10% of GDP (€500-1000 billion). These bonds would have a low interest rate if they were supported by a ‘joint and several’ guarantee from all member states. That being said, this would not solve the key problem for the fiscally and structurally weaker countries, whose situation is further complicated by the fact that are already heavily in debt (Martin 2020, Gros 2011). The Italian government would pay a lower interest rate on the part of its debt financed by Coronabonds, but the overall public debt in Italy would still increase. Moreover,  the relatively small gain in terms of interest savings through Coronabonds would probably be offset by a higher cost of the remaining debt (still 135% of GDP), since that ‘old’ debt would effectively be subordinated to the Coronabonds (Gros 2011).

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Increasing the total public debt of Italy would be dangerous because a higher debt level usually requires a higher risk premium, which can lead to a doom loop. In this case, the higher debt leads to a higher risk premium, which in turn leads to higher deficits, and even higher debt (Alcidi and Gros 2019).

This is why the countries in the South (which are, for now, hit hardest by COVID-19) need grants, not credit. The simplest way would be for the EU to issue ‘eurobonds’ and then make a large transfer to Italy and any other countries in need. However, under present conditions this may not be possible because the Treaty stipulates that the EU budget has to be in balance (Article 310.1). This is why a number of proposals have been made to find a way around this prohibition of a deficit via guarantee schemes, sometimes involving the European Stability Mechanism (ESM).

Fortunately, there is no need for financial ‘acrobatics’, as there may be a simple way through. Italy, and some other countries, could be exempted from contributing to the next EU budget for a number of years. Normally, all countries contribute about 1% of their GDP to the common budget. Exempting the ‘Corona South’ from its obligations to contribute would be worth 1% of GDP per year. This could be framed as a sliding scale over the seven-year cycle of the Multiannual Financial Framework (MMF), under which the contribution for the ‘Corona South’ would increase, starting from zero in 2021, to 100% in 2027. The new MFF (which has to be agreed later this year anyway) could incorporate such a provision. The lower contributions to the budget would of course have to made-up by the other countries. The burden would therefore fall on those hit less hard by this crisis, or those simply better able to withstand the impact of the pandemic. These stronger countries in the North and East would have to abandon the principle of ‘juste retour’, at least for this MFF. For domestic political purposes they could label the ‘extra-contribution’ as ‘Corona solidarity’ in their national budgets.

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In principle, the amount transferred implicitly could be quite high. For example, if Italy were exempted from contributions to the EU budget for seven years (and the expenditure structure of the Budget were to remain essentially the same), the transfer would amount to 7% of GDP (over €100 billion). If the exemption from contributions were to be scaled down linearly to zero over the life of the next MFF, it would still be worth approximately 3.5% of Italian GDP (or close to €60 billion over the entire MFF).  For Greece, the figures would be smaller, at around a tenth of this (pro-rata).

The burden on the ‘strong’ North appears to be manageable: if about a third of the EU needs financial help worth about 1% of GDP, the remainder would have to shoulder about 0.5% of GDP (for a number of years). This approach would of course transform the nature of the negotiations for the new MFF which will take place later this year. Presumably, the budget would be refocussed along the priorities of the North, but even the proposals from the ‘frugal five’ foresee a budget of around 1% of GDP.  

It would of course be possible to use also the expenditure side of the EU budget, which could foresee substantial sums for public health infrastructures and other investments (which might be needed more in the South). However, the sums involved here would probably remain much below the 1% of GDP contribution rate.

Of course, the transfers envisaged here would not come all at once. This means that in the short run the debt of the Southern countries would increase. Nonetheless, given that this is transitory (and that, on average, even Italy only pays less than 1% on its public debt), this should not be a problem.  Moreover, financial markets are very likely to react to the announcement of such a scheme with more confidence within the country.

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Therefore, there exists a plausible and simple way to organise a real expression of EU solidarity, without engaging in any large-scale financial transactions.

References

Acidi, C and D Gros (2019), “Public debt and the risk premium: A dangerous doom loop”, VoxEU.org, 23 May.

Baldwin, R (2020), “COVID-19 testing for testing times: Fostering economic recovery and preparing for the second wave”, VoxEU.org, 26 March.

Baldwin, R and B Weder di Mauro (eds) (2020a), Economics in the Time of COVID-19, a VoxEU.org eBook, London: CEPR Press.

Baldwin, R and B Weder di Mauro (eds) (2020b), Mitigating the COVID economic crisis: Act fast and do whatever it takes, a VoxEU.org eBook, London: CEPR Press.

Gourinchas, P O (2020), “Flattening the Pandemic and Recession Curves”, University of California, Berkeley.

Gros, D (2010), “The seniority conundrum: Bail out countries but bail in private, short-term creditors?”, VoxEU.org, 5 December.

Gros, D (2011), “Eurobonds: Wrong solution for legal, political, and economic reasons”, VoxEU.org, 24 August.

Martin, S (2020), “How Europe should design a ‘coronabond’”, Financial Times.


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