Are we heading towards another lost decade?

The Covid-19 pandemic, and the containment measures coming with it, have led to a sharp fall in GDP last year, with the ECB estimating a contraction of the Eurozone economy of 6.9%, much larger than the 4.4% contraction suffered in the immediate aftermath of the 2008 financial crisis. This had led several analysts to express fears regarding the pace and the strength of the European recovery. These are mostly due to the much smaller European fiscal stimulus, with respect to the American one, and to what has been a decade growth following the double whammy that were the 2008 crisis and the eurozone debt crisis. These fears, however legitimate, are, in my opinion, overblown due to three main factors: the nature of the crisis, the current stance of the ECB and the fiscal stimulus deployed.

The nature of the crisis

One of the main reasons many economists think that the losses in output caused by the previous recession were so persistent is that the Great Recession was sparked by what was, essentially, a banking crisis. The EU situation was slightly different than the US one, but the results were similar. Here, with the advent with the euro, massive inflows of funds coming from Northern Europe allowed an expansion of credit in Southern Europe, accompanied by an increase in government borrowing as Italian, Greek and Spanish treasuries were suddenly considered as safe as German ones. These newly issued bonds were largely gobbled up by the very institutions expanding credit, mainly national banks, in turn giving rise to the “doom loop” mechanism. Essentially, when it became clear that the Greek government credit-worthiness was dubious, contagion spread to other European nations, whose treasuries fell in value, worsening the balance sheets of banks and leading to a credit crunch that strangled the economy further. This, in turn, led to a rise in non-performing loans (NPLs), further weakening the already shaky position of European banks, increasing the implicit liabilities of the governments that were expected to bail them out and, in doing so, arising even more doubts about the ability of these countries of paying back their debts. The resulting fall in bond prices, then, just restarted the loop.

Once the eurozone crisis had been tamed by Draghi’s “Whatever it takes” speech, banks found themselves saddled with NPLs, thus becoming more cautious in extending credit especially when credit was needed. This massively delayed the recovery as families and businesses were forced to deleverage themselves and to increase savings, strangling aggregate demand. Indeed, this was entirely consistent with several studies have shown that economic crisis sparked or coupled with financial crisis lead to persistent output losses as economic actors cut back spending and investment in an effort to deleverage. This is part of the reason why the previous recession was so impactful and why some countries, notably Italy, were yet to fully recover from it when the pandemic hit.

Now, the pandemic is a much different story.

First of all, the guardrails put in place by Basel III regulations following the financial crisis had insured that banks had a capital buffer big enough to absorb relatively large losses caused by an economic shocks, thus preventing bankruptcies and a credit crunch. Indeed, quite the opposite happened. Governments all across Europe started providing hundreds of billions of euros in loan guarantees as soon as the first lockdowns were implemented. Thanks to these guarantees, banks all over Europe felt safe enough to keep extending credit to the struggling businesses forced to close because of the pandemic, thus allowing many to weather the storm (at least until now). This led to a comparatively limited reduction in credit expansion. In turn, this had the positive effect of limiting the rise in non-performing loans that would have otherwise saddled the financial system with an additional unsustainable burden and prolonged until after the crisis the full recovery of the credit system. For all these reasons, this time around we avoided the drying up of credit and prevented an even deeper scarring of the economy that would have left the financial system saddled with NPLs, thus ensuring that, when the restrictions are lifted and the vulnerable sections of the population are vaccinated, the economy will be ready to come back roaring.

Monetary policy

Monetary policy was the main instrument used in the last large crisis to bring us back to growth, with audacious moves like Quantitative Easing and negative rates being employed for the first time. However important, these innovations were implemented in Europe only with a substantial lag. Indeed, these ground-breaking policies not only came late, but were actually preceded by a phase of monetary tightening, as Trichet raised rates in 2011 after having initially lowered them. This premature tightening and the delayed deployment of QE and of more aggressive rate cuts are widely credited to have been policy mistakes that partly contributed to the eurozone double dip recession and substantially slowed down the recovery.

"ECB President Christine Lagarde" by "Martin Lamberts/ECB" is licensed under CC BY-NC-ND 2.0 After Mario Draghi’s transformative tenure at the helm of the ECB, Lagarde’s ECB is clearly not intentioned to commit these mistakes again. Not only she has expanded QE immediately after the crisis, unleashing the 1850 billions PEPP program, but it also has decreased the haircuts applied on the assets banks use to finance themselves and it has loosened capital requirements. Perhaps most importantly, it has signalled, as the FED has done, that it does not expect to raise rates in the near future, thus stimulating aggregate demand by letting economic agents expect a future boom (although this is more controversial as it might be regarded as relying on a non-credible promise).

Even though the ECB response to this crisis has been way more on point that in the last crisis, the actions available to it were pretty limited this time around, due to the rates being already very close to the ELB (Effective Lower Bound). On the other hand, this provides an opportunity for fiscal policy to step in, as the low borrowing costs will limit the future servicing costs of the new debt and will reduce the crowding out effects of government action. This brings me to the net important topic: fiscal policy.

Fiscal policy

It is common knowledge that the fiscal response to the 2008 crisis had been inadequate on both sides of the Atlantic, but especially so in Europe where governments were initially constrained by the Stability and Growth Pact (SGP) that limited deficit to 3%, but during a recession, thus disincentivising large fiscal stimulus packages as the suspension operated for a limited period of time. Furthermore, many countries were later forced to undergo a very painful operation of fiscal tightening, especially in Southern Europe, in order to reassure investors of the sustainability of their debt, thus contributing to a double dip recession for the Eurozone and to the very slow recovery.

Now, the story this time around is very different. Last year, the EU suspended pretty much indefinitely the binding fiscal rules, thus allowing governments to support businesses and employees throughout the pandemic. This has avoided (for now) a massive rise in unemployment and has limited bankruptcies, leading to relatively limited scarring of the economy. Indeed, government deficits for the Euro area jumped from 0.6% of GDP in 2019 to 8.8% in 2021, roughly evenly divided between discretionary fiscal spending and automatic stabilisers (according to the Commission).

Chart taken from “Public loan guarantees and bank lending in the COVID-19 period”, by Matteo Falagiarda, Algirdas Prapiestis and Elena Rancoita Indeed, according to a European Commission paper published on the 3rd of March 2021, the furlough schemes put in place by national governments, protected around 20% of the employment in the EU. Instead, the ECB says that the lending support programs put in place all over Europe were instrumental in supporting businesses and preventing a rise in bankruptcies, especially so in France and Spain where take up was higher. Just in these two countries business have drawn, respectively, 120 and 100 billions in guaranteed loans, representing, in turn, 5% of gross indebtedness in France and 11% in Spain. It is clear that these schemes were fundamental in preventing a drying up of credit in a moment when credit needs had actually risen. This was especially true for small and medium enterprises, that were the main beneficiaries.

However large, these interventions are only the tip of the iceberg. The EU itself has stepped in and have provided several sources of additional funding and stimulus. Early last year EU leaders agreed to add a new, and unconditional, credit line to ESM for those countries that needed additional funds for their healthcare systems, as mentioned they created the 100bn SURE program to help finance the vast furlough schemes implemented all over Europe to prevent long-term unemployment and, finally, agreed to the creation of the 750 bn Next Generation EU program, of which a staggering amount are grants to member states. This latter element is important for two main reasons. The first is, quite simply, that it provides additional fiscal stimulus, aimed in particular at projects that will not only boost aggregate demand in the short term, but also raise potential output over a longer horizon. According to the Commission report cited above, this will increase European GDP by 2% in the medium term and 1% in the long term. The second is that it at least signals a step towards a fiscal union and debt mutualisation. This is important because it will reassure investors about the debt sustainability of more fragile members of the EU, avoiding a repeat of the 2011 debt crisis and allowing for continued fiscal supports till the crisis will be over. Continued support is crucial, as we have seen in 2008, to ensure that recovery does not peters away.

Lastly, it must be noted that the EU and the eurozone are net exporters and, hence, they will probably benefit from the strong expansion predicted in the US for this year, as it is predicted to grow by 6.5% this year, and China, that has survived largely unscathed by the pandemic.

In conclusion, I believe that the Eurozone (and the EU at large) will get out of the recession very fast as member states will gradually lift lockdown restrictions. This will be largely thanks to having learned the lessons of 2008 and 2011 and the speedy deployment of massive fiscal stimulus packages, together with the different nature of the crisis and the probable accommodating monetary policy. Indeed, this is confirmed by the Commission’s February 2021 growth forecasts, that see the eurozone grow by 3.8% both in 2021 and 2022.