Lessons from the financial crisis to prevent the Great Fragmentation
A tale of two crises: Lessons from the financial crisis to prevent the Great Fragmentation
The recent forecasts by official institutions and market analysts confirm that the Covid-19 crisis is set to lead to a downturn of historic proportions, much deeper than that witnessed during the financial crisis which followed the bankruptcy of Lehman Brothers in 2008. Figure 1a shows that the current recession is more than twice the size of the one that followed the financial crash and it envisages a partial and much slower return to the pre-crisis growth levels. In Q2 2020, EU real GDP will be almost 14% lower than that registered in Q2 2019, while for 2020 as a whole, the Commission estimates a deep recession with EU and euro area GDP declining by 8¼% and 8¾%, respectively (European Commission 2020b).
Figure 1 Growth and financing needs
a) GDP downfall and recovery during the Covid-19 crisis and the financial crisis
b) Financing needs
Source: European Commission
The crisis has created huge financing needs in terms of equity repair, investment gap and social distress. Figure 1b shows that the additional financing needs of the EU for 2020-21 amount to almost €2 trillion for a baseline scenario and they exceed €2.5 trillion if a stress scenario were to materialise.1 In Buti and Messori (2020), my co-author and I attempt to apportion such financing needs to the three phases of the crisis developments: emergency, transition, and recovery. We argue that social needs will be particularly present in the initial emergency phase, but partly also during the transition phase. The need to fill the investment gap (public and private) will happen in the transition phase, but only become a key priority in the final phase, whereas the need for recapitalization will characterise both the transition and the recovery phase. Approximately, the financing needs in the emergency phase will amount to around €800 billion, the transition phase will need €500 billion while the phase envisaging the recovery will involve financing needs amounting to some €1.2 trillion.
There has been much debate on the dynamics of the crisis and the potentially uneven impact on different countries. Early hopes of a V-shaped recession have faded in spite of recent positive sentiment indicators. In a U-shaped scenario, the recession would last longer and the rebound would be much slower. A W-shaped recession could be possible in case there will be a second wave of infections. The scenario of a ‘Victorian bathtub’ cannot be excluded – here, a period of stagnation would be followed by only a timid recovery due to an increase of private and public debt as well as persistent uncertainty leading to high saving, less investment and constrained consumption. Hysteresis effects would take a toll denting the exit from the crisis and negatively impact potential growth.
According to the European Commission’s and most other forecasts, both the severity of the recession in 2020 and the following bounce back of the economies differ markedly among member states. As shown in Figure 1a, Germany will suffer a much smaller downturn than Italy and Spain in 2020. In a similar vein, the rebound and the level of GDP that these countries will reach in 2021 differ markedly. While Germany will also not return to its 2019 GDP level by 2021, its situation is much less severe than that of Spain and Italy.
Several factors underpin such asymmetric behaviour affecting not only the severity of the recession but also the speed of the recovery. Exogenous reasons pertain essentially to the structure and resilience of the economies, whilst endogenous reasons are related to the interactions between the national policy space and the relaxation of rules at EU level.
Countries relying on services will not recover fully the lost demand given the low consumer confidence and stricter safety protocols. These activities are unlikely to recover fully until an effective medical treatment of the virus is found. The typical case is tourism and leisure that have a sizeable weight in Greece, Spain, Italy, Portugal and Croatia. Moreover, these countries’ industrial structure is characterised by a much larger number of SMEs which will suffer more as they have less of a capital buffer to absorb losses and therefore are likely to experience more bankruptcies (McKinsey 2020). In contrast, countries with larger industrial sectors, like Germany and its central European suppliers, are likely to recover more quickly as pent-up industrial demand and order backlogs will restart soon after restrictions are eased.
Besides these exogenous reasons, the asymmetric reaction to the crisis is due to endogenous factors. Given the high public debt levels, countries such as Greece, Italy and Spain do not have as much fiscal space to withstand the shock as Germany and other northern European countries. This means that countries could profit differently from the leeway provided by the Commission’s triggering of the General Escape Clause of the SGP and the loosening of the state aid framework.
Taking a long-term perspective, comparing the GDP level in 2021 with that in 2008, the German and the French economies will be 13% and 7% larger, respectively. Spain shows a mere 1½% increase compared to 2008, while Italy would still see a reduction of almost 9%. The variation of real GDP in the last 12 years shows the weight that the financial and Covid-19 crisis had on the economies, especially in Southern Europe. Therefore, importantly, the asymmetric impact of the Covid-19 crisis adds to the very divergent behaviour of European economies in the financial crisis and its aftermath.2
In all, the present crisis will have a larger impact on the periphery, which had not fully recovered from the financial crisis. However, the shape of the recovery as well as its distributive impact will depend on the ambition and effectiveness of the policy response at national and EU level. An ambitious policy reaction would tame these centrifugal forces and safeguard the integrity of the single market and the economic and political viability of the EU project. A sustained intervention to support the worst-hit countries would avoid seeing the EU move from the Great Recession following the 2008 financial crisis to what may be called the Great Fragmentation where the global and European economies would fracture across countries, regions, sectors and generations.
Preventing the Great Fragmentation: Lessons from the financial crisis
Preventing the Great Fragmentation is a key goal of the European policy response. To what extent can the lessons learned during the financial crisis be of help in designing such a response? Figure 2 tries to capture in a comparative way the main features of the two crisis episodes.3
Figure 2 Financial crisis and Covid-19: A comparison
First, while the financial crisis was a policy-induced shock and there was no agreed narrative between Member States, today’s crisis shows a more consensual view regarding its narrative, origin, effects and hence the appropriate policy solutions. There is a much less focus on and traction of moral hazard considerations, which instead characterised the financial crisis. There is also a large consensus that the crisis, as discussed above, while common in the origin, will have an asymmetric impact. The fact that the pandemic hit some countries before others generated a moral duty in those countries less hit to help those where the pandemic hit with more intensity. In economic terms, it also generated a positive externality as the countries down the line could profit from the experience and measures taken by those hit first. However, the most compelling reason for a strong EU response is the need to correct the endogenous fragmentation following the suspension of the fiscal adjustment under the Stability and Growth Pact and the loosening of the state aid rules that gave a large advantage to countries with more fiscal space in helping consumers and enterprises. The ensuing fear of undermining the integrity of the single market and, ultimately, of the Union made redistributive policies politically acceptable.
Second, during the financial crisis the policy mix was very unbalanced: for most of the years, monetary policy was the only game in town. With insight, the fiscal stimulus of 2009 was withdrawn too soon, at the first signs of growth. The fact that the sudden stop of capital flows and market run were triggered by the discovery of massive cheating in the fiscal accounts of Greece led, in core countries, to a reading of the financial crisis through ‘fiscal lenses’. As a consequence, the surveillance framework was tightened with the adoption of the Fiscal Compact and the strengthening of the SGP. This went hand in hand with reluctance on the part of countries with fiscal space to use it, which implied a very unbalanced policy mix, with fiscal consolidation taking precedence over support to the economy. As a result, too much onus fell on the shoulders of the ECB. This led to a paradoxical overturn of Sargent and Wallace’s “unpleasant monetarist arithmetic” which postulated that, absent credible constraints on fiscal policy, fiscal dominance will ensue resulting in pressure to monetise public debt (Sargent and Wallace 1981). In the case at hand, excessive fiscal prudence proved also a form of fiscal dominance: when monetary policy is at the effective lower bound, fiscal inaction hampers the effort of the central bank to fulfil its price stability mandate. During the Covid-19 crisis, the need to react strongly via a decisive fiscal expansion was acknowledge since the start, with the ECB and the Commission being the strongest and most consistent advocates.
Third, experience during the financial crisis shows that achieving an appropriate euro area fiscal stance only via horizontal, bottom-up coordination of national policies is exceedingly difficult. When a broadly adequate overall stance was attained in the aftermath of the crisis, it took place via the wrong distribution between countries, in violation of their respective fiscal space. The proposals to set up a euro area fiscal capacity, as in the Four Presidents’ Report and the Five Presidents’ Report (Van Rompuy 2012, Juncker 2015), did not gain political support. Even the modest proposal by the Commission in 2017 to establish a European Investment Stabilisation Function (EISF) was rejected by a number of countries which saw stabilisation as belonging to the national level in EMU. Today, to help offset the asymmetric outturn of the crisis, a complementary central fiscal intervention is paramount. The strong role for the EU budget in the Commission proposals (see the following section) would complement horizontal surveillance with vertical coordination, as originally proposed by the Sapir Report (Sapir et al. 2003, Buti and Nava 2003).
Fourth, political acceptability of a central response has led also to the ‘resurrection’ of the Community method rather than pursuing the intergovernmental approach which dominated the decision making during the financial crisis (Buti and Krobath 2019). A more consensual view on the adequate policy response and the low political traction of moral hazard views, have helped overcome the ‘ultima ratio’ logic which led to delays in decisions, systematic compensations for any European help, and ultimately to the crystallisation of the divide between creditors and debtors. Given the nature of the shock and its potential ramifications, European policymakers operate today much more under Rawls’ ‘veil of ignorance’ as those suffering less today are not necessarily going to be spared tomorrow. For instance, the break-up of value chains and possible protectionist reactions in third countries make economies more reliant on external demand more vulnerable.
Finally, there has been a radically different role of international cooperation in shaping and implementing the policy response to the two crises. Whilst the financial crisis saw a strengthening of global governance with the rise of the G20, especially at the outset of the crisis (Buti and Tomasi 2018), international cooperation has taken a back seat in the present crisis. Increasing awareness in Europe that, in a more fragmented world where rules-based multilateralism is called into question, an export-led growth model would be increasingly vulnerable has paved the way to a stronger reliance on the EU single market as ‘indigenous’ growth engine.
In sum, this time it may well be different. Domestic and international conditions appear to be reunited for an effective response to the crisis with a decisive role of the EU level and a renewed boost to policy coordination.
The European response: Next Generation EU
The Commission has proposed a package of €750 billion – two-thirds grants and one-third loans – over the period 2021-24 to be financed via issuing common debt. Next Generation EU would complement the measures agreed by the Eurogroup for a total of €540 billion in support of healthcare spending, unemployment and short time work, and credit to the private sector. The centrepiece of the Commission package is the Recovery and Resilience Facility (RRF), which amounts to €560 billion between grants and loans to support investment and reforms, with an emphasis on favouring the green and digital transition.
Figure 3 The European Union response to the Covid-19 crisis
Source: European Commission
According to Commission estimates, the recovery package would raise real EU GDP by 1¾% in 2021 and 2022, increasing to 2¼% by 2024. Moreover, given the support of investments to countries productivity, even after ten years GDP levels are estimated to be 1% higher than the baseline scenario. The package is estimated to create two million jobs over the medium term (European Commission, 2020a, Verwey et al. 2020).
Based on the allocation key proposed by the Commission, member states with below-average GDP per capita levels are expected to see a sizeable boost in economic activity in the medium term, with GDP levels 4½% above baseline by 2024 for those belonging to the lower debt cluster and 4¼% for those belonging to the higher debt cluster. EU countries with above-average GDP per capita levels would experience smaller but still positive GDP effects of 1¼% compared to baseline by 2024.
Lastly, the Commission package is expected to be self-financing. Overall, the average government debt-to-GDP ratio in the EU27 falls by around three-quarters of a percentage point in the short run, and falls further below baseline levels over the medium to long term. By 2030, the average debt-to-GDP ratio in the EU is estimated to be almost 3% lower than in the baseline scenario. Specifically, for those member states with below-average GDP per capital level in the higher debt group, debt to GDP is expected to decline by 5%, and 3¼% for those in the lower-debt group by 2024. According to the simulations, over the long term, the debt ratio would decline further by 8½% for those in the higher debt group and by 7% for those in the lower debt group by 2030. For the higher income group, the public debt ratio would rise slightly in the medium term, but by 2030 would fall back to the same level as in the baseline scenario.
Stronger political integration ahead?
If adopted, the proposals by the Commission have a chance to strengthen the EU economically. Would that lead also to stronger political integration? Based on Rodrik’s globalisation trilemma (Rodrik 2000), Figure 4 illustrates the paths open to Europe in the response to the crisis: Europe cannot achieve at the same time deep political integration, strong democratic legitimacy, and decision making essentially based on national institutions. Options A to C indicate different ways to solve the trilemma.
In the 1980s and 1990s, in response to ‘Euro-sclerosis’, option A was chosen, by establishing the Single Market and EMU: sovereignty was shared at the supranational level by strengthening or creating new European institutions, most notably the ECB. Intergovernmental solutions under option B tended to prevail during the financial crisis: the setting up the EFSF, later transformed into the ESM, and, on the fiscal front, the adoption of the Fiscal Compact took place in an intergovernmental context where the leading role was played by the European Council rather than Community institutions. Whilst the Single Supervisory Mechanism of the Banking Union was established under Community law, the financial support of the Single Resolution Mechanism and the still-to-be-established common deposit guarantee (EDIS) have been negotiated essentially as intergovernmental tools. Lack of trust and the crystallisation of the division between ‘creditors’ and ‘debtors’ underpinned the intergovernmental approach. Finally, option C prevailed during the immigration crisis of the mid-2010s where, under the impulse of the Commission, some common actions were undertaken, but no common EU immigration policy emerged.
Figure 4 Trilemma of political integration
Source: adapted from Buti and Lacoue-Labarthe (2016)
As argued above, the handling of the Covid-19 crisis has so far been characterised by a largely consensual view on the nature and effects of the crisis implying lower worries of moral hazard, the need to complement the monetary policy response by a centralised fiscal action. The risk of fractured global governance also pushes the EU to devise a response to the crisis that relies more on its inner strengths. As a result, there has been a resurgence of the Community method compared to the mainly intergovernmental approach during the financial crisis. Hence, there is chance that option A is chosen with the EU adopting an ambitious response to the Covid-19 crisis, and also finalising long-lasting open institutional chantiers such as Banking Union and Capital Markets Union. This would be the best chance to devise an effective response to the crisis and boost European sovereignty domestically and abroad. It would also ensure that the present crisis will not be remembered as the Great Fragmentation.
Author’s note: The views expressed in this column belong to the author and should not be attributed to the European Commission. I would like to thank Simon O’Connor for the comments and Oscar Polli for excellent research assistance.
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1 The Commission estimates of financing needs are based on the Spring Forecast published in May 2020. Since then the growth outlook for 2020 has deteriorate by about 1 percentage point in both the EU and the Euro area.
2 The Covid-19 crisis risks leaving long lasting scars in the social fabric of hardest hit countries. This will concern also intergenerational equity – Cockx (2016) finds that it takes about ten years for young people entering the labour market during a recession to catch up with those that did not.
3 The analysis in this section draws on Buti (2020a and 202