Breaking taboos in the euroarea

The EU Budget and NGEU agreements this week matters for at least four reasons. 

First, for the first time the EU can borrow to support spending, raising the universe of “collective” liabilities instead of running a balanced budget. Second, transfers between members states have become an explicit policy (rather than hidden) tool. Third, loans at concessional rates (closer to France and Germany) have also been institutionalized. Fourth, while people might complain the aggregate number is not substantial (say 1.3% of GDP for 4 years) for individual countries the balance of payments support over the next few years could be many multiples of this. 

Moreover, this needs to be seen in the context of ECB actions. The Pandemic Emergency Purchase Program (PEPP) broke a number of additional taboos. For one, it smashed through the APP issue and issuer limits. In addition, the capital key has taken to the back seat—though expects to be driving again soon. And even the Greeks were allowed in on the game—credit rating be damned.

So, France and Germany have meaningfully (i.e., explicitly) used their privileged balance sheet position, both fiscally and as part of the Eurosystem, to offer support across the EU and euroarea for the first time. And as with Draghi’s “whatever it takes,” the Crisis has shown when meaningful balance sheet strength meets markets, the market will lose—in-so-doing improving welfare amongst the population as a whole, where it matters most.

In other words, numerous monetary-fiscal taboos have been broken in a matter of 4 months. And breaking such taboos matters. Unlocking PEPP from various constraints supports the financial account across the euroarea, making monetary policy comparable with selective yield curve control—or the capping of yields.

Grants and concessional lending via the EU Budget will help support incomes across the EU, counteracting negative balance of payments pressure from reduced tourism and the like—if Germans cant enjoy a holiday in the Mediterranean then the  German government will make a transfer to make up a decent part of the loss while German households can de facto hold claims on the EU Commission so their lack of spending will not go to waste.

Thus, while I lamented back in March the need for fiscal authorities to share some fiscal risk and/or for the ECB to ditch the capital key, there has been steady progress on both fronts.

Where does this leave us? There are two questions. Why not before? And what happens next?

Why not before? One crucial reason is Brexit. None of this week’s action in Brussels would have been possible with a Conservative Party round the negotiating table. Recall Osbourne’s resistance to supporting Greece and Portugal back in 2010. No chance. So, Brexit has strengthened the EU as a whole, and cemented Franco-German leadership. The concessions achieved by the Frugals made good copy, but from a macroeconomic perspective they weren’t material. And that matters.

But it also shows that the narrative matters. Merkel felt compelled to act given the damage that COVID-19 had the potential to inflict across the euroarea. It was seen as an exogenous shock and not the result of feckless Greeks or lazy Spaniards. Perhaps the euro crisis might have been tempered had the narrative been controlled in a more measured way.

What happens next? There are two horizons—short term and long term.

Short term, the actions by the EU on fiscal and ECB on monetary still contradict each other according to the purist reading by the German Constitutional Court on May 5th. Fiscal measures need to have Bundestag agreement per the German basic law. And now such fiscal support has been provided by Merkel, it’s time for monetary policy to be put back in its box. Moreover, while making a decent fist of meeting the GCC’s need for a review of “proportionality,” in truth the ECB has not really delimited between monetary actions and fiscal policy or ESM conditionality. Put another way, can blatant capital key deviations and other limits on asset purchases be justified? Not really.

This creates the possibility that while many in Europe are celebrating the breaking of various taboos, they fulcrum of the Eurosystem that is the Bundesbank is about to exempt itself from bond buying—pulling the rug from under an otherwise bullish constellation for euroarea assets.

In the long term, the problem for the euroarea remains the weak institutional framework and the reliance on personalities and not organic policy actions. It is perhaps the only good fortune from COVID-19 happened after Brexit and while on Merkel and Macron’s watch. When these policy innovations are unwound in 4-5 years, with PEPP redemptions and the roll off of EU Budget/RRF support, Mercron will unlikely be around to steady the ship. 

In any case, it might be a case of two steps forward and one step back—or, even, one step forward and two steps back. Let’s see what Weidmann offers us in 2 weeks time.

END.

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