The coronavirus crisis and a euro area contained—in a prisoner’s dilemma

As the eurozone faces into a deep recession, a transparent prisoner’s dilemma is preventing it from stopping the slide.

One of the two best policy options that might be available in the eurozone to face the dreadful economic consequences of Covid-19 is that the European Central Bank (ECB) buy on the primary market bonds issued by national governments or by the European Investment Bank (EIB), the European Stability Mechanism (ESM) or any other special-purpose entity. The only difference would be the intermediate institution receiving the money to be redistributed to the citizens.

True, public debt monetisation is forbidden by the Maastricht treaty. But Paul De Grauwe, among others, is right to say we should be thinking ‘outside the box’ given the present unique circumstances.

An alternative option is what the US Federal Reserve is about to do and other central banks have done or are also considering doing—transfer money directly to the citizens, rather than to the states, without risking inflation. Either policy would allow euro-area countries to face the crisis without having to accept the burden of a heavy public debt potentially hampering their economic recovery.

The worst option is where each country is left on its own. Not only does each then have to carry by itself the weight of the public debt to be repaid in the future. Doubts may also emerge on financial markets as to its capacity to resolve the debt, thereby increasing the interest to be paid on it. Such a negative market prophecy might become self-fulfilling, as fear that the debt might not be repaid would create precisely the conditions for this to be so.

‘European renaissance bonds’

Two mid-way cases lie between those extremes. In one—the second best—debt would be issued by a risk-free supranational entity and would therefore be a ‘safe asset’: the negative effect of an unfair and unnecessary market sanctioning, at least, would be avoided. Still, the burden of the debt to be repaid would remain, although proportionally among member countries. This is why, to soften the cost of repayment, proposals for eurobonds refer to a very long maturity, namely 50-100 and even infinite years in the case of irredeemable bonds (the famous ‘consols’ of the British tradition).

Incidentally, rather than the gloomy ‘coronabonds’, the expression ‘European renaissance bonds’, would convey the positive idea that a cohesive European Union would be bound to a bright and successful future. A European-wide appeal signed by more than 1,800 economists is proposing such a name.

A second intermediate option is to use the pre-existing endowment of the ESM, allowing a guarantee of up to €410 billion—as the Eurogroup proposed to do at its last meeting on April 9th, albeit to a limited amount of €240 billion. Single countries would be indebted to the ESM, while benefiting from reliably low interest rates. Given the particular situation, it appears that strict conditionality will not be applied on the debt as under normal circumstances. But the debt will still be borne by the country and will be a burden it will have to bear alone. Can we really call this solidarity?

Fiscal stimulus

While we address these questions, though, in the US they are about to adopt a solution (included above among the best possible solutions for Europe as well) which promises to be as resolute as the one that allowed them to solve the global financial crisis more than 10 years ago, when they approved a $700 billion fiscal stimulus, while in Europe we started imposing fiscal austerity. The outcome of such different responses was self-evident—a prompt US economic recovery versus a European economy that was still stagnant when hit by the coronavirus.

The situation looks similar these days: the US is about to drop money in the bank accounts of Americans to a value of $2 trillion, while in Europe we are once more playing a selfish prisoner’s dilemma game, without even realising it, that prevents us from responding adequately to the crisis. This provides clear evidence of the benefits of a federal union, such as the US, as opposed to the heavy price in terms of ineffective policies that a mid-way intergovernmental association of countries, each of them looking to their own short-term interest—as with the EU—has to pay.

Not even under the present dramatic circumstances do northern countries appear ready to exhibit solidarity. Such an attitude gives southern sovereigntist movements the opportunity to prove that they are right in asking why southern countries should keep giving northern ones the advantage of their ‘national’ currencies not appreciating as a result of their current-account surpluses.

Removing that advantage would reduce automatically their trade surpluses, while also reducing the trade deficits of southern countries. Yes, ‘it takes two to tango’ and if one wants to calculate the cost of solidarity one has to consider the overall picture: its expression would pay back at least some of the permanent competitive advantage northern countries receive via the southern ones. Moreover, if the reasons for staying together do not even show up in a situation like this and if countries are left alone to face such a huge negative shock—for which no issue of moral hazard can be invoked—what is the EU for?

Symmetric shock

The optimum-currency-area literature predicted that problems in a monetary union would mostly arise in the presence of asymmetric shocks, while it should have been easy to agree a common policy if shocks were symmetric. It looks like we shall have to reformulate our theories and revise our beliefs—because Covid-19, although hitting symmetrically all euro-area countries, is not prompting them to propose and accept the same policies, given their different starting points.

In such a situation the euro area first and the EU soon after are seriously at risk of disintegration. Should that happen, the automatic exchange-rate market mechanism would be allowed to function again. The ‘rules of the game’, as they were called during the Gold Standard, would get back to work and the appreciation of northern currencies would reduce inevitably their trade surpluses.

The prisoner’s dilemma game which in Europe we are playing against each other would then suddenly appear in all its clarity—including to northern countries.