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Europe’s Fiscal Waves—Timely, Substantive, and Coordinated; But the Crisis Magnifies Need for Structural Reforms

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Europe’s fiscal response to the coronavirus crisis has been in marked contrast to its handling of previous crises.  For a region with a reputation for policy inertia, fiscal austerity, and testy relations amongst member states—it’s significant that the response in this episode has been timely, substantive, and coordinated. The fiscal response so far in 2020 can be described in terms of three distinct, but complementary waves. But old habits die hard. The latest crisis only magnifies the need for fiscal prudence and structural reforms to be re-established and strengthened to underpin a meaningful and long-lasting sustainable growth path.

Fiscal Wave #1: Emergency Spending 

Europe’s first fiscal wave coalesced almost as quickly as the virus. With the crisis unfolding, the EU authorities suspended the region’s fiscal rules in March, allowing national governments to increase emergency spending. This action was all about avoiding collapse: with government mandated lockdowns across the region to contain the spread of the virus, there was an urgent need to provide support to households and firms whilst the authorities effectively hit the economic pause button. These additional fiscal measures came on top of an already sizable social safety net of unemployment insurance, sick pay, and healthcare across the region that kick in automatically. But the additional flexibility at the EU level gave national governments the fiscal space to supplement these existing measures, introducing for example short-time work schemes, to meet the unprecedented challenge. These early national measures were complemented by the passage of an EU emergency package of €540 billion in April, which included a €240 billion credit line from the European Stability Mechanism to cover health-care costs, financial support for employment compensation schemes and small- and medium-sized enterprises, as well as a commitment to work towards a European “recovery fund.” To date, these measures have kept euro-area unemployment remarkably stable and well below the highs seen in past downturns or recently on the other side of the Atlantic (Figure 1).

Figure 1: Euro Area Unemployment Rate Lower Than in Past Downturns

Source(s): Eurostat as of June 2020.

Fiscal Wave #2: Shoring Up Demand

Continued management of virus hotspots and a further extension of short-time work in a number of countries to year end should help restore consumer and business confidence and underpin a gradual recovery. Against that backdrop, several countries, including Germany, Austria, and Belgium, announced some form of temporary value-added-tax cut in June. These have either been across the board VAT reductions, or targeted towards particularly affected sectors, such as restaurants and hospitality. And fiscal measures to boost investment were also announced, such as Spain’s €40 billion loan guarantee for new investments. 

The end result of these first two fiscal waves has been substantive. Discretionary fiscal measures average nearly 5% of GDP across a number of European economies, reaching as high as just under 10% in Germany, according to the IMF. And government loan guarantees have been significant too (Figure 2). This is one reason our colleagues on the European leveraged finance desk see relatively low high-yield default rates (compared to our U.S. high-yield default estimates) of 1.3% in 2020 and 2.0% in 2021.

Figure 2: Euro Country Fiscal Measures in Response to the Pandemic

Source(s): National authorities and IMF staff estimates as of June 12, 2020. Country groups are weighted by GDP in purchasing power parity-adjusted current US dollars. Revenue and spending measures exclude deferred taxes and advance payments. For details, see the Fiscal Monitor Database of Country Fiscal Measures in Response to the COVID-19 Pandemic.

Fiscal Wave #3: Next Generation EU

The third fiscal wave looks ahead to Europe’s longer-term recovery from the pandemic, with a focus on sustainable growth. The recently agreed European recovery plan—called Next Generation EU– is remarkable in its display of unity amongst policymakers, with such an outcome difficult to imagine only a few months ago. Moreover, it is substantive at €750 billion, representing approximately 6% of euro area GDP. And whilst the headline split between grants and loans is a bit less favourable than initially conceived, the part of the package that really matters for countries hardest hit by the coronavirus—the Recovery and Resilience Facility—is actually larger than expected and includes a higher amount allocated towards grants. Moreover, given that projects started on February 1, 2020 or later are eligible for financing and that 70% of grants are set to be committed by 2021-22, the RRF should help the hardest hit countries in a timely way. And it means that certain countries, such as Spain and Italy, will be eligible for funds amounting to approximately 10% of their respective GDPs—big enough to help in the current crisis, although not big enough to deal with legacy debt problems. So, while this agreement marks an important step towards European integration, countries still need to get their own houses in order. Indeed, the euro area’s Q2 flash real GDP reading of -12% continued to indicate disparate outcomes with Germany’s GDP declining by 10% and Spain’s GDP contracting by more than 18%. Our base case for 2020 GDP of -8.0% will largely depend on the consistency of the recovery’s trajectory in Q3 and Q4.   

Old Habits Die Hard. Is There Political Will for Structural Reform?

Europe’s fiscal waves, coupled with the ECB’s powerful interventions, are supporting the region through the ongoing storm.  However, the scale of the challenge going forward should not be underestimated. The fiscal measures to date only represent the necessary first steps and are by no means sufficient to assure a sustainable path towards recovery. A key near-term challenge will be the gradual removal of short-time working schemes—possibly resulting in an unemployment rate of 10% by year end—and facilitating a sectoral reallocation of labour to where it is needed most. Pre-pandemic, Europe was weighed down by low—or indeed no—growth in some countries, with an urgent need for structural reforms at both the country and EU level. The euro area’s new economic realities have only magnified the need for deep structural reforms.

While the prospects for these reforms present a key long-term challenge, the cumulative effect of Europe’s fiscal waves should bolster the union’s solidarity, support the initial stages of an economic recovery, and keep credit spreads on course for further compression in the months ahead, notwithstanding the lingering uncertainty regarding the short-term path of the virus.

Katharine Neiss, PhD

Katharine Neiss, PhD

Katharine Neiss, PhD, is a Principal and Chief European Economist for PGIM Fixed Income, based in London. Ms. Neiss covers the macro-economic outlook in the UK and euro area, including Bank of England and ECB policy. Prior to joining the Firm in 2020, Ms. Neiss was Head of the International Surveillance Division at the Bank of England, responsible for briefing policymakers on the global macro-economic and financial stability outlook. Previous roles at the Bank of England include Head of the Policy, Strategy and Implementation Division, covering regulation of major UK banks, and senior manager roles in the Structural Economic Analysis Divisions, covering the UK economy. Ms. Neiss has published several articles in peer reviewed academic journals on topics ranging from real interest rates as a monetary policy tool and the impact of the global financial crisis on supply. She received a BA Honours in Economics from Queen’s University and holds a Masters and PhD in Economics from the University of British Columbia.

This material reflects the views of the author as of August 5, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.

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