Will Europe Waste The Crisis?

Investors should be rooting for EU leaders as they attempt reforms that do more than just ease the immediate pain.

Throwing money at a problem, it turns out, works pretty well if you look at market action so far through this pandemic. What is harder, though, is thinking beyond the current crisis so the money does more than salve the immediate wounds and actually helps the patient emerge with stronger bones and muscles.

Europe, so often the dithering emblem of a world falling apart, seems to be doing just that while governments elsewhere focus almost entirely on immediate pain relief. 

The massive €750 billion recovery plan its leaders will discuss on a videoconference this week has been somewhat overshadowed by recent headlines of fresh infection rates, anti-racism protests and China’s grip on Hong Kong. There has also been a lot of inconclusive chin rubbing around whether the proposal represents Europe’s “Hamilton Moment,” comparable to the deal struck by America’s first Treasury Secretary to bind the budding young country’s suspicious states together with federal assumption of their Revolutionary War debts.

The European Union is still a far cry from a single federal state. More important is that the new mechanism under construction is designed so the continent emerges from this crisis stronger and more resilient for the next one. 

European leaders got a crash course in international finance 10 years ago this summer as their currency union suffered what economists call an “asymmetric shock” in the aftermath of the Lehman Brothers meltdown. A sudden stop in global capital flows revealed overextended Irish banks, poor Portuguese growth, a defunct Spanish banking system and vast holes in Greece’s public accounts.  

If these economies were still operating in punts, escudos and drachmas, weaker exchange rates could have helped them adjust their competitiveness and soften the extraordinary blow to income. But as they were locked into the same currency, their best choice was to accept large loans and tough reform conditions from resentful euro area counterparts. 

The Lisbon Treaty actually prohibits lending to member states short of an emergency, which made these conversations especially poisonous. But soon enough, worries that Spain and Italy might lose market access and trigger the collapse of the currency union itself forced the establishment of a permanent backstop. The setup of lending instruments with conditionality, financed through several joint guarantees at first, then a permanent fund later, allowed the European Central Bank to back Mario Draghi’s promise to do “whatever it takes” to protect the common currency.

The United States actually operates a similar mechanism of sorts within its own “currency union” since California, Iowa and Pennsylvania all share the same exchange rate with very different economic bases. In 2008, for example, states like Arizona and Florida that were especially hurt by collapsing home prices benefited as the federal government injected more in support for state budgets and unemployment benefits and withdrew less in income taxes.  

But most of these transfers operate invisibly against the backdrop of a vast federal budget. Only occasionally do they lead to political outbursts as they did in May when Senator Mitch McConnell objected to further federal aid to state budgets and Governor Andrew Cuomo reminded him that New York is traditionally a net contributor to the federal budget while Kentucky is a net recipient. (Thank goodness New York never occupied Kentucky. Or did they?)

The COVID-19 shock demonstrated that Europe’s institutions still need reinforcement. As the contagion spread, countries closed borders and hoarded medical equipment with little coordination, violating the spirit, if not the letter, of EU rules. Germany emerged relatively stronger than its neighbors; Italy weaker. The question arose again as to who should help whom.  

Germany itself has been the biggest surprise, abandoning its fervent commitment to balanced budgets with a combination of spending, deferrals and liquidity that amounts to half its GDP. At a moment when the United States appears to be retrenching its political and military commitments to Europe, Chancellor Angela Merkel realized that Europe’s structures needed further reinforcement. More urgently, a ruling from Germany’s constitutional court that raised questions about the ECB’s market interventions threatened to bring the hard-won gains of the previous crisis tumbling down.
 

HISTORICAL SPREADS VS. GERMAN 10Y

Source: Bloomberg. As of June 11, 2020.

YTD SPREADS VS. GERMAN 10Y

Source: Bloomberg. As of June 11, 2020.
 

This now has her standing with France’s Emmanuel Macron and all but a few dissident voices in Sweden, the Netherlands, Denmark and Austria (the “Frugal Four”) for a significant expansion of spending during the next five-year budget, funded initially by new debt and possibly backed by taxes on carbon emissions or digital trade.

The current formulation is temporary, disbursing solely during the next budget cycle through 2027, but the commitment to issue joint debt in large quantities would likely make Hamilton smile.

“The European Union is still a far cry from a single federal state. More important is that the new mechanism under construction is designed so the continent emerges from this crisis stronger and more resilient for the next one.”

The proposal’s real significance, however, is that it creates a mechanism to address a fundamental weakness of the currency union. The EU will have new resources amounting to an additional three-quarters of its current budget to support member states—or regions of member states—that are especially hard hit by an external shock. And as much as half of the money may be disbursed as grants that don’t add to the recipients’ debts.

There will be difficult discussions and hard compromises ahead, but even a diluted version of the current drafts would represent an important step forward. Politicians talk a lot these days about not letting this crisis go to waste, but most have trouble thinking beyond the next election. This year’s strange confluence of events now has European leaders focused on both the present crisis and future resilience. 

Investors should be rooting for them to succeed.