The eurozone lacks the scaffolding to withstand the symmetrical shock of the next recession, which could imperil the euro itself.

That the eurozone is incomplete is an assessment shared by almost all economists and economic policy-makers. The prevailing opinion is that the European banking union is the most important missing part, in connection with a capital-markets union. A recent book, Still Time to Save the Euro, published by Social Europe, addresses six key economic problems which are central to the survival of the euro system—otherwise the euro may not have a long life expectancy.

First, to be a complete ‘lender of last resort’, the European Central Bank (ECB) should ensure the value of sovereign bonds of all member countries and treat them as safe assets, as in all other OECD countries, to avoid high interest-rate spreads and government insolvencies.Secondly, the fiscal framework needs to be reworked, with a European treasury or expanded national fiscal space, or a mix of both. Thirdly, the banking union needs to be completed as soon as possible, notably the Single Resolution Mechanism with a financial backstop via the European Stability Mechanism (ESM), and the European Deposit Insurance Scheme (EDIS), so far on hold.

Fourthly, the imbalances in the current accounts of the 19 eurozone member states are a time bomb for the cohesion of their economies—a point ignored in most reform debates. Fifthly, the tasks of the ESM need to be reconsidered, because it is an ad hoc stopgap for functions which the ECB does not, but should, fulfil and for those of a European treasury which does not exist. Finally, institutional reforms are needed because the European treaties are very difficult to amend, although they lead to inefficient decision-making or the neglect of important changes—never mind the deficiency of democratic legitimacy of decisions on the euro area specifically.

All these problems are highly concentrated in two member states. Greece and Italy are in a stagnation trap. Both are once again posting the per capita gross domestic product of their entry into the monetary union. They have hardly any room for manoeuvre. Europe leaves them to themselves, on the assumption that their problems are homemade and require some ‘structural reforms’. It is only a matter of time before political trust in European institutions in these countries falls below critical: according to the Eurobarometer, in November 2018 trust in the EU in Greece and Italy ranked lower or only slightly better than in the UK, as was also true of France.

Symmetrical shock

The first two reform areas mentioned are decisive in the short term. They will put the monetary union to a crucial test as the union is badly prepared for a recession, despite many reforms after the great financial crisis. Suppose that the eurozone is faced with a ‘symmetrical shock’, a mild or severe recession. What stabilising forces are in place?

In the past, central banks usually reduced the interest rate, which used to drop by as much as 4-5 percentage points. This scope no longer exists—the key interest rate is zero. The unconventional new monetary policy, starting in 2015, focused on the public sector purchase programme (PSPP) to buy government bonds with medium-term maturity, which ceased in December 2018. In principle, the ECB could pick-up the PSPP again, but its president, Mario Draghi, has already declined this option. Another instrument could be the so-called targeted longer-term refinancing operations (TLTRO), to support long-term bank lending, This programme  could only slightly lower average long-term interest rates, being already very low outside of a few cases, in particular Italy and Greece. The ECB currently does not have many more instruments in its quiver.

On March 7th, facing a new growth forecast of only 1.1 per cent for 2019, instead of 1.6 per cent, the ECB made two announcements. First, the zero-interest rate policy would be continued at least until early 2020, rather than until summer 2019—there would no quick exit. Secondly, a new generation of so-called TLTRO III would be offered in autumn 2019, with two years maturity until 2021. This is a credit line used mainly by banks from southern-European member states but now it would be under slightly less comfortable conditions. In essence, the response of the ECB to lower growth is more of the same, and nothing new.

In fact, the ECB temporarily exercised its lender-of-last-resort function fairly well with the PSPP. Long-term interest rates fell in Italy, for instance, from 5.5 per cent in 2012 to 2.1 per cent in 2017, as a result. But this is over now and it is to be feared that, without new monetary-policy programmes, spreads will rise again (irrespective of the Italian government), especially with greater uncertainty in a recession. That would even be an unintendedly pro-cyclical monetary policy for several countries, presumably aggravated by more restrictive bank lending.

The key concern is not the size of public debt: it is, rather, rising risk premia on interest rates for sovereign and private debt in the course of a global recession, and the return of redenomination risks due to euro exit fears. This might hit in particular countries with a high volume of non-performing loans, such as Greece, Cyprus, Italy and Portugal.

The ECB’s untapped outright monetary transactions programme is available, in principle, but only for countries which succumb to the conditionality of the ESM, thus largely giving up their economic-policy autonomy. So there are strong incentives not to be ‘saved’ by the ESM. It is likely that the ‘Juncker plan’ supporting private-sector investment all over the EU will lose momentum in a recession, thus providing no substantial counter-cyclical stimulus.

Fiscal leeway

In contrast to monetary policy, the fiscal policy of member states would have in principle some leeway. Couldn’t we repeat what was possible in 2009—a co-ordinated counter-cyclical fiscal policy, then called A European Economic Recovery Plan, kicked off by the European Commission in November 2008? Since the beginning of the euro era, 2009 has been the only year in which an anti-cyclical, expansionary fiscal policy has been pursued for the eurozone as a whole.

Yet the Fiscal Compact prevents a repeat. The pact, agreed in 2012 and incorporated in the Stability and Growth Pact (SGP), requires national ‘debt brakes’, meaning balanced budgets allowing only limited temporary and strictly symmetrical upward and downward deviation. Countries with greater fiscal space, especially Germany and the small Baltic countries, could do more but no one can force them and their fiscal steam would not suffice for the entire euro area.

Higher-debt countries are allowed within the framework of the SGP to suspend fiscal adjustments, should their output gap (between actual and potential economic performance) exceed 4 per cent. This margin was not even reached in 2009. If the output gap is smaller, they are allowed to reduce their structural deficit at a slower pace than prescribed under normal conditions. So they are still subject to austerity during recessions, albeit at a slightly lower dosage.

If there were a symmetrical shock such as a recession, stimulus programmes  could only work if the four largest countries comprising 75 per cent of the euro area’s GDP—Germany, France, Italy and Spain—would operate in a co-ordinated initiative. The SGP does not allow this for France, Italy and Spain, which are supposed to give priority to reducing their debt towards 60 per cent of GDP. And even if they were allowed, the SGP demands that temporary expansionary deviations be compensated within a few years by more restrictive measures. This was the main cause of the ‘double dip’ crisis in the eurozone after the one-off Keynesian stimulus of 2009.

All this leaves only national ‘automatic stabilisers’—tolerating increased cyclical deficits due to lower tax revenues and/or higher obligatory spending. Stimulus programmes are not provided for in the SGP framework. Yet it is claimed that the present fiscal stance in the euro area is already above neutral, owing to the measurement method of potential output, which shows a small positive output gap. In other words, laissez faire.

Fatal consequences

Thus, the eurozone would slow down towards recession without appreciable stabilisation facilities. The political consequences of rising unemployment, especially in countries with still high unemployment—such as Greece, Italy, Spain, Portugal and France—would be fatal. More unemployment likely feeds populist sentiments. Trust in the European Union would drop further.

In short, Europe, and especially the eurozone, is not prepared for a recession. The macroeconomic framework is blocked. The biggest obstacle is the mental repression of the problems, apart from uncertainty about political majorities after the upcoming European Parliament elections and the formation of the new commission.

In 2012, standing on the brink, the ECB rescued the eurozone. But Draghi’s famous words then—announcing a monetary stance of ‘whatever it takes’—have died away. There will be no repetition, and not only because he is soon out of office. The European Council has not done its homework and, above all, there is a quasi-hegemonic country which loves the status quo as well as rejecting all reform proposals. We are left hoping there may be guardian angels—in China, the US or elsewhere—who will save us from recession.

Treaty changes would be necessary, in principle, to make progress on the six areas of reforms set out above. Yet much could be done even without them. Important ingredients of the SGP fiscal-policy framework are based on regulations made by the commission, the Eurogroup of eurozone finance ministers and the Council of the EU. Not everything is set in stone.