Europe could emerge stronger than ever from the coronavirus crisis. That may seem strange to say at a time when the world’s second-largest economy is tanking and more than 100,000 Europeans have already been killed by the virus, but investors shouldn’t miss some bullish news amid the gloom.
On Monday, the governments of France and Germany unveiled a deal to have the European Commission borrow €500 billion, or about $550 billion, on behalf of the European Union’s 27 member states and spend on “the most affected sectors and regions.” The governments of Italy and Spain quickly signaled their support for the plan, which marks the first time in decades the big four euro area economies ever agreed on any significant economic policy.
As a financial innovation and as a demonstration of what Europe’s leaders are willing to consider, the Franco-German initiative marks a profound step. At only about 3.5% of Europe’s 2019 gross domestic product—and spread out over several years—the amount currently proposed is far too small to offset the economic impact of the virus. But it could be the beginning of the “Hamiltonian” transformation of the euro area into a functioning economic and monetary union.
The upshot for investors: a new floor for European assets during future downturns, and a new fixed-income market that could one day rival U.S. Treasury securities in size and liquidity.
While the Commission has issued bonds on behalf of the EU before, it has done so only to finance loans to member governments. The Commission was just a pass-through entity, not a true borrower in its own right. Similarly, spending on infrastructure and public services by the Commission is not new, but until now, that spending was always financed out of contributions raised from member states.
Ever since the euro launched in 1999, it has functioned as a straitjacket that prevents the bloc from responding effectively to downturns. The problem is that every country in the euro area denominates its debt in the same currency, so investors have no inherent reason to prefer their own government’s debt to that of a neighbor. This means that many governments’ borrowing costs often go up when the outlook deteriorates.
When a downturn hits in Europe, the rising cost of credit pushes governments to cut spending on essential services and infrastructure even as the tax base shrinks thanks to falling employment and to rising emigration. Instead of easing the pain, European governments amplify it. This is why many investors invariably bet on the euro’s collapse every time there is a whiff of bad news.
Things have improved somewhat recently thanks to the actions of the European Central Bank, but even now, with the ECB committing to buy trillions of euros of bonds, government borrowing is currently forecast to be far lower in the euro area than in the U.S. Robin Brooks and Jonathan Fortun, economists at the International Institute of Finance, recently concluded that Europe’s unwillingness to borrow and spend sufficiently will generate a “deeper recession and slower recovery” there compared to the U.S., which has been “far bolder.”
There is only one sustainable solution to this problem: Europe’s economy requires a common debt to match its common currency. Combining existing national governments’ debts isn’t possible without a treaty change, nor is it possible for governments to individually issue new debt guaranteed by Europe as a whole. That means the best realistic approach would be to have the European Commission borrow and spend on common priorities, as it is poised to do now, thereby relieving national governments of the need to borrow and spend on their own account. After all, as Jean Monnet, one of the European Union’s founding fathers, often used to say, “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.”
The upside scenario for investors is one where the euro area would finally have the common institutions it needs: common unemployment insurance, common deposit insurance, common retirement systems, common infrastructure investment, and common defense. That would mean shallower recessions, faster recoveries, and a new bond market eventually comparable in size to the one for U.S. Treasury debt.
It shouldn’t have taken the devastation of the coronavirus to move Europe in that direction, but at least some good may come out of the crisis.
Write to Matthew C. Klein at firstname.lastname@example.org