The COVID-19 crisis has caused a huge increase in the public debt levels of Member States. Governments have so far reduced the economic impact of the supply and demand shocks caused by the pandemic through emergency support measures. Through these measures, the income levels of a significant number of employees have been stabilised and businesses have been protected from bankruptcies.
However, as the roll out of vaccinations is starting to gain pace across the Union, the economy is slowly getting back on its feet and these measures will eventually come to an end. Together with discretionary fiscal policies and automatic stabilisers, these measures will undoubtedly have a huge impact on the public debt levels across Member States— many of which have already violated the EU’s budgetary rules before the pandemic.
Despite the prominence of austerity measures during the Eurozone crisis, the policies aimed at reducing the deficit are not the main highlight of the debate on how to get our economies back on track. Have debt levels become less important than a decade ago?
Unprecedented support for households and businesses
An obvious difference between the current COVID-19 crisis and the sovereign debt crisis is of course its origins. The 2008 financial crisis originated in the financial sector and brought national governments into difficulties with bailouts of domestic banks, rising bond yield spreads and increasing unsustainable debt levels. The current crisis is of a completely different nature: an exogenous shock, which gave national authorities no other choice than to impose containment measures, causing a large supply shock.
Given the great uncertainty on the developments of the pandemic, this was followed by a demand shock, with a significant decrease in consumer and business confidence. Member States across the EU responded with unprecedented emergency support schemes to keep businesses afloat and protect the income of workers. The Commission estimated the impact of COVID-related discretionary budgetary measures at 4.0% of EU GDP in 2020, on top of operation of automatic stabilisers. In addition, a number of support instruments have been created at the EU level, as outlined in my previous blog. At the same time, financial sector regulators and supervisors have taken measures to support the immediate ability of banks to continue lending and absorb losses.
These emergency support schemes by national governments, and supporting measures by banks regulators and supervisors are shielding the majority of households and businesses in Member States from the immediate impact of losses related to the pandemic. As a result, levels in bankruptcies and non-performing loans (NPLs) are historically low, also compared to pre-crisis levels.
As governments have started the vaccination process, support measures will eventually end and the accumulation of insolvencies, private debt levels and rising unemployment rates will become unavoidable. Together with the support measures, this will translate into a huge increase in sovereign debt levels of Member States, often from already elevated levels. Following the health crisis, fiscal deficits and sovereign debt in the euro area and the rest of the EU will deteriorate dramatically. The average public debt-to-GDP ratio in the euro area is estimated at 100% for 2021 – 40% above the EU’s budgetary rule for debt levels.
Flexibility in the EU fiscal rules
For the first time, the general escape clause of the Stability and Growth Pact (SGP), the EU fiscal rules framework, has been activated in March 2020. The clause was introduced as part of the ‘Six-Pack’ reform of the SGP and allows for a coordinated temporary deviation from the normal budgetary requirements in a situation of severe economic downturn across the euro area. Its activation provided the necessary flexibility for the public finances of Member States for the unprecedented measures linked to COVID-19 crisis.
After almost a year after its activation, European policymakers are deciding when and how to deactivate the clause. The academic debate entails the same rationale as is applied for the premature ending of emergency support measures: as long as aggregate supply is heavily affected by containment measures, budgetary flexibility is necessary to accommodate the normalisation of economic activities (See for example Gern, Kooths and Stolzenburg (2020)).
A paradigm shift?
Despite rising sovereign debt levels, there are multiple signs that there is a shift in thinking on the type of policies that should be used to address economic downturns compared to the previous crisis (albeit the different origins and context of the current crisis).
The discussion already started in 2015, when the IMF admitted it had failed to realise the damage austerity would do to Greece (Wyplosz and Sgherri, 2015). But the largest shift became visible in response to the COVID-19 crisis. On 4 April 2020, the Editorial Board of the Financial Times (not particularly known for its Keynesian thinking) published an opinion piece on a ‘more active role in the economy’ by governments, which ‘must see public services as investments rather than liabilities’. The editors even promoted redistributive measures, basic income and wealth taxes.
At the EU level, this line of thinking is also visible. Under Next Generation EU, there is a strong focus on the importance of public investment for a strong recovery of European economies, acknowledging the benefits of post-crisis fiscal stimulus. Moreover, academic discussions on the review of the SGP focus on a so-called ‘golden rule’ for net investment, to improve the quality of public finances, given that pre-crisis public investment levels in the EU were already very low (See for example Darvas and Anderson (2020)).
Conclusions
The COVID-19 pandemic has already led to a major economic shock in the EU. However, the true economic impact of the pandemic will become visible after containment measures have been lifted and emergency support measures have been ended.
The duration of the pandemic will not only have caused structural changes to our economies, but the enduring support measures taken by national authorities will heavily impact future generations. While we might observe a shift towards a stronger role of the government to support economic growth, the sustainability of public finance and debt remains an unquestionable requirement for economic and financial stability in the EU and across the global economy.
Public debt accumulated to fight the COVID-19 crisis might not be a concern as such, but there are a number of issues that will determine its consequences. The transition period after the national emergency support measures, the deactivation of the escape clause, the review of the EU fiscal rules and the impact of EU instruments such as Next Generation EU will determine the true economic impact of the pandemic, and to what extent policymakers have been able to absorb part of the shocks.
Disclaimer: The views and opinions expressed in this blog are personal to the author(s) and do not reflect the official policy or position of any other agency, organisation or employer.
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