Author(s): Lorenzo Codogno, Paul van den Noord
Date published: Mar 2021
SUERF Policy Brief, No 581
By Lorenzo Codogno (London School of Economics) and
Paul van den Noord (Amsterdam School of Economics)
Keywords: Fiscal policy, business fluctuations, safe sovereign assests, fiscal capacity.
Download: SUERF Policy Brief, No 58 (0.69 MB)
The unprecedented fiscal package adopted by the European Council in 2020 – known as Next Generation EU – is vital for the recovery of the euro area economy from the pandemic. Thus, it is very much welcome. However, our estimates indicate that creating a Eurobond and permanent fiscal capacity at the centre would be more powerful to mitigate the impact of the crisis. It would provide a more timely and effective response, would help the transmission of monetary policy and alleviate the burden of countercyclical policies from national authorities.
The magnitude of the COVID-19 shock to economic activity in the Eurozone and elsewhere is unprecedented in post-war history. The Eurozone economy shrank by almost 7.0% in 2020, much more than in 2009. Yet the macroeconomic policy responses have been unprecedented as well, both at the national and pan-European levels. Most significantly, the pandemic finally broke the taboo on a pan-European fiscal policy, dubbed ‘Next Generation EU’.
The bulk of the fiscal expansion is provided in the form of grants and loans to member states by the Recovery and Resiliency Facility (RRF) amounting to €312.5 and €360 billion (2018 prices), respectively, summing up to roughly 5% of EU GDP, spread over 2021-2027, with the benefit going by and large to those countries that have been hit the most by the crisis or are more vulnerable due to structural weakness. Alongside the RRF, member states receive €77.5 billion under a range of other programmes, such as ‘ReactEU’ and the Just Transition Fund (Figure 1).
Using conservative assumptions on the multiplier effects, we estimate the impact on Eurozone economic growth to be a cumulative 1.6% by 2023 and 2.7% by 2027 (Figure 2). Most of this will benefit the Eurozone periphery, where the cumulative effect could be as large as 2.8% by 2023 and 7.5% in 2027.2 While impressive enough, this comes on top of a range of other – national and supranational – policy initiatives that need to be taken into consideration as well.
Figure 1: Next Generation EU – estimated allocation by country
Figure 2: Next Generation EU – estimated cumulative impact on real GDP
Will Next Generation EU indeed be the game-changer it is intended to be? To get an impression we use a stylised macroeconomic model developed in Codogno and Van den Noord (2020) to capture the cumulative impact of policy change over the medium run. We proceed in two steps, broadly reflecting the chronology of events. First, we look at both the national and pan-European fiscal responses which were primarily shaped during the initial stages of the outbreak, as well as the ECB’s monetary policy response. Next, we add in the impact of Next Generation EU.
Finally, we compare these policy responses to a hypothetical case in which an alternative macroeconomic policy and governance framework is assumed along the lines of Codogno and Van den Noord (2020). Specifically, we assume (i) a single Eurobond to replace national bonds on banks’ balance sheets so as to break the link between banking and sovereign distress, (ii) Eurozone fiscal capacity, including automatic stabilisers and discretionary (but rules-based) policy, and (iii) a new quantitative easing (QE) scheme that mandates the ECB to purchase Eurobonds (while national sovereigns lose QE eligibility and those still on the ECB’s balance sheet are swapped for Eurobonds as well).
All simulations assume that the core and the periphery are hit by an adverse demand shock of respectively -10% and -15% of GDP and an adverse supply shock of respectively -5% and -7.5% of GDP. This is obviously a very crude gauge of the COVID-19 shock, and views are bound to evolve as information flows in. Also, we assume a favourable risk premium shock of -200 bps in the core – and hence an equivalent shock to the spread – due to a flight to safety (this is aside from the endogenous change in the spread in response to the changes in debt positions).
Table 1 reports the computed changes in main aggregates and policy variables in the core, periphery and euro area at large over a medium-term horizon. The first column, labelled ‘I’, shows the combined impact of:
Table 1: Shock-responses
Note: Scenarios refer to: I = National fiscal responses + SURE + ESM credit line + monetary policy, II = I + ‘Next Generation EU’, III = Safe asset + permanent fiscal capacity.
Column II of the table reports the computed outcomes of the actual policy, including the impact of Next Generation EU. Specifically, while keeping the assumptions underlying scenario I unchanged, it is assumed additionally that:
The main results of the simulation over the medium term can be summarised as follows:
Scenario III reported in Table 1 is based on the following assumptions:
The main results can be summarised as follows:
All in all, with a safe asset and a (partly rules-based) fiscal capacity, more of the pandemic shock would have been absorbed, with less quantitative easing needed. Moreover, the asset purchases would be directed to the safe asset rather than national sovereigns and hence avoid the political conflict this could entail and the need to keep the purchases in check with the capital key. The current policy response could be seen as a second-best, i.e. a less efficient way to respond to an economic shock, although still powerful, if not vital.
The recent massive fiscal stimulus in the US and in China will hit the ground much sooner than in the EU/Eurozone, which so far had to rely on domestic fiscal policies, it will be much more automatic, and it will facilitate the transmission of monetary policy through the economy. It will be less so in the EU/Eurozone.
The Next Generation EU package provides more resilience over the medium term to the EU/Eurozone economies than countercyclical support over the near-term. Our exercise shows that it would be worthwhile considering a more permanent macroeconomic stabilisation mechanisms in the future to allow the EU/Eurozone economies to respond more effectively to any future shock. They would include overpowered automatic stabilisers at national or EU/Eurozone level, but also a permanent central fiscal capacity and EU/Eurozone safe asset.
Bruegel (2020), The fiscal response to the economic fallout from the coronavirus, Bruegel Datasets. https://www.bruegel.org/publications/datasets/covid-national-dataset/
Codogno, L. and P.J. van den Noord (2020), “Assessing Next Generation EU”, LEQS paper No.166/ 2020, February 2021, https://www.lse.ac.uk/european-institute/Assets/Documents/LEQS-Discussion-Papers/LEQSPaper166.pdf
Codogno, L. and P.J. van den Noord (2020), “Going fiscal? A stylised model with fiscal capacity and a Eurobond in the Eurozone”, Amsterdam Centre for European Studies, SSRN Research Paper 2020/03. https://hdl.handle.net/11245.1/f56353ac-13af-44a8-97ff-b79d917d7ffd
OECD (2020), Building confidence amid an uncertain recovery, OECD Economic Outlook, Interim Report September 2020. http://www.oecd.org/economic-outlook/
Van den Noord, P.J. (2020), “Mimicking a Buffer Fund for the Eurozone”, World Economics Journal, 21(2), 249-281. https://www.world-economics-journal.com/Journal/Papers/Mimicking%20a%20Buffer%20Fund%20for%20the%20Eurozone%20.details?ID=795
Verwey, M., S. Langedijk and R. Kuenzel (2020), Next Generation EU: A recovery plan for Europe, VOX CEPR Policy Portal, June 9. https://voxeu.org/article/next-generation-eu-recovery-plan-europe
About the authors
Lorenzo Codogno is Visiting Professor in Practice at the LSE’s European Institute and founder and chief economist of his own consulting vehicle, LC Macro Advisors Ltd. Prior to joining LSE, Lorenzo Codogno was chief economist and director-general at the Treasury Department of the Italian Ministry of Economy and Finance (May 2006-February 2015). Throughout this period, he was head of the Italian delegation at the Economic Policy Committee of the European Union, which he chaired from Jan 2010 to Dec 2011. He joined the Ministry from Bank of America, London, where he was managing director, senior economist, and co-head of European Economics based in London over the previous eleven years.
Paul van den Noord began his career as a Research Fellow and Lecturer at the University of Amsterdam (1979-1989), where he holds a PhD. Subsequently he spent the bulk of his career at the OECD in Paris, first as a Senior Economist from 1989 to 2007 and next as a Counsellor in the Chief Economist’s Office from 2010 to 2013, while from 2007 to 2010 he was seconded as Economic Advisor to the European Commission in Brussels. More recently Paul worked at a global-macro hedge fund in London and Geneva (2013-2017) and has been an Associate Fellow at Chatham House in London (2013-2017) and a Visiting Professor at the College of Europe in Bruges (2014-2018). In 2018 Paul returned to his alma mater as a guest researcher. He has published extensively in the areas of fiscal policy, monetary policy, housing markets and the political economy of Monetary Union in Europe.
SUERF Policy Briefs (SPBs) serve to promote SUERF Members’ economic views and research findings as well as economic policy-oriented analyses. They address topical issues and propose solutions to current economic and financial challenges. SPBs serve to increase the international visibility of SUERF Members’ analyses and research. The views expressed are those of the author(s) and not necessarily those of the institution(s) the author(s).
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