EU Destiny Meets ECB Policy in Pivotal Week for Crisis Recovery

(Bloomberg) -- The European Union’s economic policy makers face a defining moment next week that will either set the course out of the pandemic’s slump or risk delay in providing joined-up support for the region’s recovery.

The bloc’s leaders are set to convene for a summit on Dec. 10, seeking to end a row with non-euro members Poland and Hungary over the terms attached to an historic 1.8 trillion-euro ($2.2 trillion) rescue package, and multi-year budget.

Only if they succeed can the European Central Bank, meeting on the same day, have confidence that the monetary stimulus its officials are poised to unveil will have the potency they are aiming for.

2020 was the year in which the continent began to overcome its fear of common debt, evoking the “Hamiltonian moment” that made the U.S. an economic entity to be reckoned with. But the EU’s self image as a bloc united by shared values is now being undermined as the rift over rule of law abuses in Eastern Europe threatens to unravel its new-found budget solidarity.

“What gets the economists excited is the idea is that you are committing to the principle of some kind of fiscal confederation,” said Paul Donovan, global chief economist at UBS Global Wealth Management. “You’ve got to make the monetary union work, and the euro doesn’t work as a monetary union at the moment.”

In Europe, the first line of fiscal defense is still national budgets, and they are under stress. The jump in spending to protect jobs combined with a fall in revenue from a depressed economy this year has pushed most large economies in the bloc into double-digit budget deficits. Italy’s debt-to-output ratio is set to hit 160% this year.

That’s why the record multi-year budget and Next Generation EU stimulus package agreed by leaders earlier in 2020 is critical for the long-term spending and investment outlook for the bloc. Yet the passage of both -- which must be done this month -- is being blocked by the refusal of Poland and Hungary to countenance conditions that tie aid to adherence to the bloc’s democratic norms.

More than half of the headline value of the package is intended to boost modernization of the region’s economy, climate-change mitigation, digital transformation and health-care capacity.

This centralized fiscal firepower, backed by common debt, can make the difference between muddling through with the old spending constraints of the member states and pressing on to a more shared European economy.

“EU countries can borrow at very low rates and should continue to do so,” said Guntram Wolff, director of the Bruegel institute in Brussels. “The EU recovery fund, in turn, is extremely important to boost the growth potential.”

For the 19-member euro area alone, UniCredit Bank see the Next Generation package contributing 0.2 percentage point to expansion next year, rising to to about 0.5 percentage point in each of the following three years. The southern member states stand to benefit the most.

The role of the ECB in this long slog out of the pandemic trough is to make sure borrowing remains as cheap as possible and that markets don’t take fright at the scale of borrowing under way.

What Bloomberg Economics Says...

“Because the euro-area economy, battered by a second wave of infections and stricter containment measures, is likely to start 2021 on a weaker footing than previously anticipated, we expect the ECB to extend its PEPP program -- and its implicit pledge to support governments’ fiscal responses -- to the end of 2021.”

-Maeva Cousin, David Powell and Jamie Rush

To read the full report, click here.

On Thursday, the Governing Council is expected to boost the amount of its emergency pandemic bond-buying plan by 500 billion euros, and extend its life-span by as much as 12 months, as well as lengthen the period it will offer ultra-cheap loans to banks.

But last week Executive Board member Isabel Schnabel warned investors that the ECB would be acting to keep monetary settings at their current level of accommodation, rather than attempting to make conditions even easier. After more than a decade of being in the crisis-fighting vanguard, monetary policy has been relegated to second-rank in Europe’s response. That’s if the fiscal plan works out.

Investors don’t seem to doubt that it will for now, with bonds of indebted countries such as Italy and Spain still yielding almost nothing even after a selloff of their securities last week.

There are a number of Plan Bs in the pipeline for European leaders if the summit next week does not produce accord with the eastern-European holdouts. Rescue funds could be disbursed via an agreement that doesn’t include them, but allows Warsaw and Budapest to join later. The 19 euro-area members could move ahead alone. Or an intergovernmental agreement could be struck that just cuts them out.

None of those options amount to a convincing shift in Europe’s fiscal and monetary policy architecture, but rather a continuation of the political fudges of the past that could keep the ECB overburdened if left unaddressed. An opportunity exists now to build confidence in the bloc out of the ruins of 2020.

“Fiscal policy has been giving a life preserver to the economy, but what we need is fiscal stimulus,” said Citigroup economist Pernille Bomholdt Henneberg. “With the fiscal support, there will be more certainty about the economic outlook.”

©2020 Bloomberg L.P.