Political Economy Journal: Is Europe ready to face this new financial crisis?

BY: Elena Lazzaro* , Luca Carelli*

PEJOURNAL – The Covid-19 crisis has shaken the global economy putting many countries on their knees. Although this is
not the first pandemic in human history, Covid-19 presents a number of characteristics that make it a unique
First of all, much like with natural disasters, this virus comes from exogenous factors uncorrelated to countries’
economies; however unlike these, it does not remain circumscribed to a specific area.
Additionally, when comparing the current economic recession to that of 2007, it appears clear that the former
does not present a sheer financial nature; however, as in the case of the subprime mortgage bubble, Covid-19
has shed light on weaknesses and pitfalls in the soundness of countries’ finances and is expected to disrupt their
economies in a manner that will most likely change their production process forever.
As the president of European Central Bank, Christine Lagarde, states: “The euro area is facing an economic
contraction of a magnitude and speed that are unprecedented in peacetime”. In fact, European countries were
expected to growth, on average, by 1.2% in 2020, while now it is foreseen that their economies will shrink by
about 8% to 12%. To get an idea of the magnitude of this contraction, during the financial crisis of 2008 the
GDP of European countries fell by 4.5%. For this reason, the Covid-19 pandemic is expected to be the worst
economic recession in the history of the eurozone since the Second World War. In addition, the European
Commission estimates that the unemployment rate will rise up to 9%, with an average increase of 2.3% when
compared to 2019.
There are multiple reasons that can explain why the 2020 crisis is having such a negative impact on the eurozone. Firstly, over the last decade both the European Central Bank and the Federal Reserve have cut the
long-term interest rates: this policy, together with the quantitative easing, have led to a situation of oversupply
of liquidity. Secondly, the manufacturing industry has been working in a situation of overcapacity, especially
in the automotive sector, and for this reason companies have failed to accumulate enough capital to cope with
an economic slump. Thirdly, and perhaps most importantly, Europe has never completely recovered from the
financial crisis of 2007, as it can be observed in southern European countries where the the GDP is still lower
than during the first years of the 21th century.
One further point to keep in mind relates to how the current recession shows effects on the economy. While
in 2007 the mortgage bubble spread across the globe through financial markets to then indirectly dampen the
real economy, the current emergency required lock-down measures to be enforced by sovereign States, and this
has brought several industries like catering, tourism, and public transports to a standstill situation from which
many businesses are expected not to recover. Furthermore, since in the recent years the globalization process
has seen an all time peak, the destructive impact of this pandemic is fed by the strong linkages among countries.
In this context, the breakdown of the above-mentioned sectors hit the rest of the economy, which therefore
streamed into a financial meltdown, where bond and stock markets lost considerable value and the higher
occurrence of credit defaults jeopardized the still healing European banking and financial system.
Although the virus has spread across every nation, the consequences of the disease have not been uniform across
all countries. Specifically, in Europe Italy and Spain are facing the harshest consequences of the pandemic crisis
and their respective governments estimate that they need at least e1.5 trillion to fully recover. On the other
hand, countries like Germany have been hit in a milder way: albeit this is the worst recession since the Second
World War, the economy is expected to dwindle only by 6.5% and to recover rather quickly, as opposed to other
countries that forecast negative leaps exceeding 10% of GDP. Therefore, this gap in the destructive impact of
Covid-19 has clustered Europe in two major groups according to the level of damage inflicted, and in some
cases more resilient economies have argued that their southern European counterparts should finance their own
recovery without asking for help. However, if Italy had to recover on its own, it would have to borrow more
than 150% of its GDP and this heavy burden could lead investors to lose faith in Italy’s ability to repay its debt
load and to consequently dump Italian bonds. Moreover, should this unfortunate scenario occur, Germany too
would have to face hard consequences, considering that Italy is the main supplier of the German automotive
In light of this, Paolo Gentiloni, European commissioner for the economy stated: “Europe is experiencing an
economic shock without precedent in modern times. This is why we need a recovery plan that is sufficiently
large, targeted at the hardest-hit economies and sectors, and deployable in the coming months. (. . . ) If not
now, when?”.
Since the European Economic and Monetary Union (EMU) is still undergoing a recovery process from the crisis
of 2007, Covid-19 puts into serious threat the stability of the already vulnerable European system. Despite the
fact that current account imbalances have decreased thanks to the austerity policy implemented by the EU,
southern European countries had not completed their catching-up process at the time of the current pandemic:
more precisely, France, Italy, Portugal, and Spain have not yet reached their pre-crisis level of GDP, whereas
Greece managed to replicate its 2002 GDP only in 2019. In addition, the unemployment rate was still high,
particularly among young people. Moreover, public debt as well as social inequality have increased in Italy and
Spain despite the stagnating average real wage.
Unfortunately, there are two further weaknesses in the EMU. First and foremost, the EMU itself was built on
already weak foundations, which have not been addressed despite eight years of discussion over the best way
to improve the system. Furthermore, another problem concerns the fact that the pandemic is not targeting a
relatively small country like Greece, but rather a big economy like the Italian one.
To summarize, Europe has never overcome the financial crisis of 2007, whose effects were just mitigated by
the European Central Bank. For example, when in 2012 the former ECB president Mario Draghi promised
to save the Euro by doing “whatever it takes”, the risk premiums of bonds of southern European countries
went down thanks to the massive purchase implemented by the ECB. This manoeuvre allowed the eurozone to
survive the acute phase of the financial crisis without ultimately solving internal disparities and other economic
issues. However, since then the risk premium of the above-mentioned countries has gone through a period of
fluctuations and with the outbreak of Covid-19 it fell again, therefore raising serious concerns on the stability
of financial markets.
With regard to endemic problems of the eurozone, a first concern relates to the lack of an effective balancing
and risk-sharing mechanism that could support the supranational monetary policy of the ECB. In other words,
there is no possibility to offset the formation of imbalances between different countries. Furthermore, due to
the monetary financing prohibition the ECB cannot fulfil its role of lender of last resort, or in other words, in
the event of a crisis the European Central Bank cannot buy up government bonds to mitigate the damages;
thus, Member States are vulnerable to debt crises as they theoretically risk to become insolvent.
After acknowledging the flaws in the EMU structure, European heads of state and government and European
institutions have gathered together to discuss on potential mitigating actions. The focal point of their confrontation has been the absence of a risk sharing mechanism between euro countries. This has led to the so-called
Eurobonds, which are common government bonds issued by Member States. In addition, euro countries created
a European finance minister, as well as an eurozone budget with the aim to offset asymmetric shocks and to
foster convergence. Finally, in 2015 the eurozone established the European deposit guarantee.
While these proposals fail to address the endemic flaws of the capitalistic system, they do ensure that in the
future, the structural problems of the EMU will not cause a snowball effect on the damages brought by future
These solutions have been put forward mainly by France and southern European countries, albeit Netherlands,
Austria and Finland have fought fiercely against the proposals. As for the reasons behind this division, it is
commonly argued that rich countries do not want to establish redistribution mechanisms from rich to poor
nations. However, one of the main supporter of the above-mentioned reforms is France, which also happens to
be one of the main contributors to the EU budget.
These solutions have been put forward mainly by France and southern European countries, albeit Netherlands,
Austria and Finland have fought fiercely against the proposals. As for the reasons behind this division, it is
commonly argued that rich countries do not want to establish redistribution mechanisms from rich to poor
nations. However, one of the main supporter of the above-mentioned reforms is France, which also happens to
be one of the main contributors to the EU.
On the other hand, Germany has always stood up against these kinds of proposal. Due to its financial history,
Germany has always paid a high attention on the level of inflation and has always tried to impose austerity
policies on other European countries, as it considers the soundness of public finances a paramount value and
does not want to be affected by the weaknesses of other Member States. Therefore, it has endorsed a “stability
union” rather than a transfer or fiscal union. However, these kinds of interventions, which aim to reduce the
level of public debt, will create serious damages to the economy of southern European countries, harming both
the social infrastructure and the possibility of economic development.
The lack of cohesion on the purposes regarding the leading principles of the political economy comes together
with an incomplete union from the financial and fiscal point of view. In fact, at the European level, there
is no such thing as a tax on financial transactions, despite the harmonization attempts put forward after the
past crisis aimed at implementing stricter rules on this subject. Another point to be mentioned is the still
uncompleted accomplishment of the European Banking Union. More precisely, the opposition of Germany
against the development of a regulation for the shadow banking system or for mechanisms such as a European
deposit guarantee scheme leaves the eurozone harmless against financial distress situations.
In particular, the lack of a common backstop mechanism for bank resolutions constitutes one of the major
issues nowadays. Even before the beginning of the Covid-19 crisis, Italian banks had in their balance sheets
e350 billion of toxic non-performing loans, which correspond to 7% of their liabilities. In this scenario, the fact
that many firms went bankrupt after the lockdown might have a trickle down effect on bank’s insolvency. In
fact, the absence of a strong European resolution fund will lead the Italian state to bail out banks which might
result in a doom loop between public debt crisis and banking crisis similar to the one of 2012; with the main
difference that instead of hitting Greece, this time it will involve the third largest country of the EU, thereby
risking to wreck the whole eurozone economy.
In light of the above reasoning, since early March the ECB has helped Italy by creating the Pandemic Emergency Purchase Program (PEPP), which consists in a purchase of bonds up to an amount of 750 billion. Although
this manoeuvre succeeded in reducing the risk premium associated to Italian bonds, its effects did not last
until May. More precisely, the difficult economic situation and the uncertainty related to the pandemic created
the need for more active intervention and financial aid. Although the possibility of leaving Italy and other
Southern European countries in bankruptcy was out of the table, some Northern states fought to treat the
Covid-19 crisis as an asymmetric shock which hit countries in different manners.
In conclusion, the recent financial crisis enhanced the loopholes and weakness already existing in the European
Union. The lack of a common intent has lead to months of meetings and compromises, which have undermined
the timing of Europe’s reaction. Furthermore, the ties of the ECB reduce its possibilities of success. As Mario
Draghi stated during his last speech as Chairman of the ECB: “For us Europeans, in a globalised world, a true
sovereignty that meets people’s needs for security and prosperity can be achieved only by working together”.

*Elena Lazzaro: incoming PhD student at European University Institute. Recently graduated in Economics at both Solvay University and LUISS Guido Carli.

*Luca Carelli: M.Sc. in Economics at LUISS University and at Solvay Brussels School of Economics and Management. I am interested in macroeconomics, particularly in International Real Business Cycle. I love surfing and mixed martial arts.

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