Ten years ago, European leaders judged that the economic recovery from global financial crisis was secured, and shifted from stimulus to fiscal and monetary tightening. The result was a second downturn and, in the eurozone, a near-existential sovereign debt crisis.
We should keep this vivid memory in mind today so as not to become complacent as the Covid-19 pandemic recovery picks up. The risks are great that this could become another false dawn. Whether it does, depends on how policymakers act in the months ahead. It is natural to hope for the best, but they must also prepare for the worst.
The pandemic and the lockdowns it triggered cast the European economy into its steepest recession on record. The eurozone lost one-sixth of its output in the first half of the year; in Spain, the fall was 22 per cent. Germany did better, with a first-half contraction of “only” 12 per cent.
The hope has always been that because the collapse was due to enforced lockdowns, economies could rebound quickly once those restrictions were lifted. The most recent numbers give ground for optimism. In June, industrial output grew faster than expected in the eurozone’s four largest economies. Retail sales have already recovered to pre-pandemic levels.
Even so, there is much that can still go wrong. First, the pandemic is not yet under control. A rise in infections is delaying the lifting of restrictions. If contagion accelerates further, both fear and renewed lockdowns will send economic activity back down again.
Second, governments face difficult policy choices. Massive rescue operations have spared their economies from even worse collapses. So far these have enjoyed popular support. But at some point the sheer magnitude of public borrowing and spending will become politically controversial. In addition, it is not always obvious which policies produce the best outcomes. When and how fast to withdraw furlough schemes, for example, is a matter of hot debate.
The good news is that politicians are alert to the risk of withdrawing support too fast. In a reassuring sign of common sense that has too often eluded European policymakers, Brussels will not seek to reintroduce the fiscal rules for national budgets until 2022. EU leaders’ agreement on common borrowing to fund recovery spending has kindled optimism about Europe’s economic prospects and swept away the worst-case worries about another debt crisis — at least for now. Nevertheless, there are still unanswered questions about how supportive of economic activity public policy is going to be.
Third, we have not yet seen the full economic damage of the lockdowns. Even if Europe’s economies quickly restore their full pre-pandemic activities, the losses run up during the downturn will leave scars. Unlike 10 years ago, the biggest worry should not be solvency of governments, given the recovery package and the European Central Bank’s willingness to keep financing cheap. Instead, the collapse may have irretrievably damaged the balance sheets of many private companies.
The risk is that the recovery comes too late to save them from bankruptcy and job losses. Government support may have given such businesses a stay of execution, but the reckoning is yet to come. That could derail recovery, even if the pandemic itself is disarmed as an economic threat. The sacrificing of a proposal for equity support for smaller companies to achieve agreement on the recovery fund shows that EU governments are not prepared for this danger.
Fourth, the pandemic may have permanently lowered the potential output of many economies. That is particularly likely where downturns have been deeper and more protracted, causing greater financial damage to companies and severing workers from their jobs so past productivity cannot be restored. It is also more likely where the virus has not been effectively suppressed and social distancing continues to obstruct employment that depends on physical proximity.
Much like the physical toll of Covid-19 itself, the long-term debilitating effects of the economic crisis may be the most insidious of all. In time, governments will be forced to raise taxes or cut spending just to keep debt from rising indefinitely. The sooner that moment comes, the greater the risk will be that governments snuff out recovery as they did 10 years ago.
Suspending the fiscal rules is therefore essential but not sufficient. Tentative reforms need new momentum so they can be replaced by a framework fit for a post-pandemic, low interest rate world that does not put outdated notions of fiscal responsibility in the way of economic growth.
Better still would be to minimise permanent damage now. That means three things, whatever the restrictions required by public health. First, offer more equity support and smoother restructuring schemes to tackle the debt problem. Second, keep demand robust in order to expand hiring for those jobs that can be safely carried out. Third, remove obstacles to job shifting, especially by cutting payroll taxes and giving furloughed workers the incentive to take new jobs if they find them.
Europe’s economic policymakers have, so far, played a bad hand well. The stakes are rising. Just as after the last crisis, it is they who will make or break the recovery.