Italy Will Struggle to Sell the EU Rescue Deal at Home

(Bloomberg Opinion) -- The euro zone’s finance ministers finally reached a deal on a set of measures to combat the recession caused by the Covid-19 epidemic. The agreement offers some political backing to the European Central Bank, which is helping governments with their immediate needs. But it fails to solve the long-term problem that will haunt the monetary union: What to do about excessive public debt in its most fragile countries.

The package — which includes some innovative financing, but no progress on the mutualization of debt between member states — will cause significant political difficulties for Italy. For weeks, the country’s prime minister, Giuseppe Conte, raised domestic expectations that he could win support for some form of joint and several liabilities (“euro bonds”). He’ll find it hard to convince the Italian public, and some in the ruling Five Star-Democrat coalition, that he’s delivered much.

The deal has three substantive legs: First, and most important, the European Stability Mechanism, the euro zone rescue fund, will let all member nations borrow up to 2% of their gross domestic product to fund health-care expenses. These loans will have no further strings attached, unlike standard ESM financing which demands a package of austerity and structural reforms from the recipients. Second, the finance ministers agreed to a European Commission plan to give cheap loans to support labor markets, and, third, they promised more firepower for the European Investment Bank, the European Union’s lending arm, to help companies.

These changes show at least that finance ministers can agree on a package of measures, even though their voters pull them in opposite directions. For example, Italy is skeptical about using the ESM as it fears it would constrain national sovereignty. The Netherlands believed conditions on the loans were vital to ensure that a borrowing country can pay back its debts. It’s good that the Dutch ceded ground, even if in a very limited manner. A failure in the negotiations would have been a terrible signal at a time of deep humanitarian crisis.

The agreement also shows that Christine Lagarde’s ECB isn’t alone in fighting the economic impact of the epidemic on Europe. To be sure, the central bank will keep doing the heavy-lifting with its 750 billion-euro ($820 billion) program of bond purchases. But governments now have additional emergency instruments, if they need them. That will offer another line of defense against volatile financial markets.

Still, there’s bound to be disagreement on the details. The ESM credit line only relates to “direct and indirect” health-care expenses. Governments can simply rearrange their funding needs away from other big-spending departments to take advantage, so this limitation is in a sense irrelevant. But do expect some creative relabeling of expenses, should a government use this facility. There is a danger too that the ESM is offering up its firepower prematurely. Its main role, after all, is to rescue countries when they lose market access. That hasn’t happened yet, thanks to the ECB, but it may do so in the future.

The bigger problem is what’s not in the deal. The finance ministers did float the idea of a reconstruction fund, to make sure countries don’t emerge unevenly from the crisis. This danger is real: While Germany can afford to use its enormous fiscal clout to support its workers and businesses, Italy has to be ever mindful about what’s happening to its sovereign bonds, for fear of a spike in its borrowing costs.

France put forward a plan to issue some limited forms of euro bonds, for the sole purpose of dealing with the aftermath of the Covid-19 shock. Yet the finance ministers would commit only to more talks over “innovative instruments” of financing, which would have to be compatible with the European Treaties. If this is a step forward, it’s a tiny one.

This lack of progress on debt mutualization creates two issues. The most immediate relates to Italy’s domestic politics. Conte had originally backed an innovative use of the ESM as the right tool to fight off the crisis. He then changed course and said the ESM was “inadequate,” and he focused instead on euro bonds — or coronabonds, as they’ve been labeled recently. Matteo Salvini’s right-wing League described Thursday night’s deal as a fiasco for Italy. Most worrying, the co-governing Five Star Movement has joined the country’s crusade against the ESM. Italy’s government is in for a rocky ride; Conte has only himself to blame for raising unrealistic hopes.

The second danger is long-term debt sustainability. Whether they borrow from the ESM, the Commission’s labor market scheme or the financial markets, euro zone members will still accumulate debt on their own. For fragile countries, including Italy, Portugal and Spain, that will be a problem once the crisis abates, as their liabilities will be perilously high. Thursday’s agreement confirms that the stronger northern member states have no appetite to share this burden.

The euro zone might still surprise skeptics. Perhaps Germany and the Netherlands will agree eventually to the innovative instruments needed for a truly cooperative response. A group of German lawyers and economists has proposed a smart plan to use the EU budget to share the fiscal cost of the pandemic, although I fear this would face legal challenge. I’ve suggested an alternative interim idea for countries to commit to a specific joint debt-reduction fund, which would allow them the time to solve the legal and practical questions around euro bonds.

Unfortunately the likelihood of such changes remains remote. For all this week’s focus on the finance ministers, the euro zone will keep being held together by its central bank.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Ferdinando Giugliano writes columns on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.

©2020 Bloomberg L.P.

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