OECD Economic Outlook, Volume 2020 Issue 1

Euro area

Lockdown measures to suppress the COVID‑19 pandemic have led to a major recession. If a second pandemic wave takes place later this year (the double-hit scenario), GDP is projected to contract sharply by 11.5% in 2020, and the unemployment rate will exceed 12% by end-2020, despite widespread use of short-time work schemes. If the virus remains contained after the end of lockdowns in spring 2020 (the single-hit scenario), GDP will fall by over 9% this year, the unemployment rate will reach double digits and average Maastricht public debt will exceed 100% of GDP by the end of the projection horizon. Substantial monetary and fiscal support will underpin the recovery once the lockdowns are lifted, but output and employment will still be much below pre-pandemic levels by end‑2021, especially in the double-hit scenario, heightening risks of persistent scarring effects, including larger divergence across the area.

Monetary and fiscal policies should remain supportive until at least end-2021, as any premature backtracking might derail the recovery. However, both national fiscal policies and the common monetary policy might become overburdened, especially in the case of a second outbreak. In this context, recent decisions to expand temporarily the role of the European Stability Mechanism or to help fund national short–term work schemes are positive initial steps. But more needs to be achieved. The recent proposal by the European Commission for a large European recovery plan, funded by common debt issuance and envisaging substantial grants to the most affected countries, is welcome. If swiftly adopted by member states in its current form, this recovery plan would provide a significant boost to European countries, notably to the most vulnerable ones. Eventually, these temporary supports should evolve into permanent common fiscal tools, such as a full‑fledged European unemployment reinsurance scheme.

Euro area: Two scenarios of real GDP and two scenarios of unemployment

Source: OECD Economic Outlook 107 database.

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Euro area: Demand, output and prices (double-hit scenario)

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Euro area: Sovereign debt markets and two scenarios of public debt

Source: OECD Economic Outlook 107 database; Refinitiv.

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Euro area: Demand, output and prices (single-hit scenario)

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Strong containment measures have limited contagion

The COVID-19 pandemic has deeply hit European countries. After a few isolated cases in the initial weeks of the year, mass contagion started in earnest in late February in northern Italy and shortly afterwards in many other euro area countries, notably Belgium, France, Germany and Spain. Some countries have been less affected so far, possibly because they imposed lockdowns at an earlier stage of contagion. Despite generally robust health systems, some countries and regions faced capacity constraints in hospitals at the peak of the outbreak, with patients in intensive care at an all‑time high. In most countries, the number of new cases has been trending down since early April.

Unprecedented measures to limit contagion have been taken at national and European levels. To help countries cope with the health emergency, the European Commission has launched joint public procurements of protective equipment and provided financial support for medical purposes. Furthermore, in a coordinated move, EU countries agreed in March to restrict non‑essential travel to the European Union, with some exceptions. However, most containment measures were taken at national level in March, including country‑wide quarantines, closure of borders between euro area countries for non‑essential travel and mandatory shutdown of large swathes of economic activity. From late April onwards, euro area countries have begun to roll back these measures gradually, but some restrictions will extend well into the third quarter.

Economic activity has contracted sharply

Containment measures have taken a huge toll on economic activity. In many of the largest euro area economies, direct output losses during periods of lockdown have been estimated at 25‑30% compared to normal periods of activity. Services have been most affected, especially when still relying on direct contact between providers and clients, with tourism, also hit by travel restrictions, being a prime example. To a smaller extent, activity in manufacturing has been also severely hampered, especially in sectors, like car making, heavily dependent on international supply chains that have undergone major disruption. This disruption has spread car production cuts across borders, particularly affecting central European countries strongly integrated with Germany. Construction activity was also much reduced in many countries. Under the first few weeks of confinement alone, GDP in the first quarter of 2020 fell by 3.6% quarter‑on‑quarter, the largest decline ever recorded. In anticipation of huge adverse impacts on public finances, discussed below, tensions have resurfaced in sovereign debt markets, with vulnerable countries experiencing a significant rise in borrowing costs.

Economic support has been provided at the European level and by national budgets

The ECB has committed to act forcefully to support the economy through this shock. Since March, to preserve bank lending and liquidity, the ECB has announced new non-targeted longer‑term refinancing operations, lowered twice the interest rate applied in targeted longer‑term refinancing operations (TLTRO III) and eased collateral standards. In addition, action by the European Commission, the ECB and national authorities has provided temporary capital relief to banks, inter alia as regards the treatment of non‑performing loans. Furthermore, the ECB has expanded its asset purchase programme by an overall EUR 1470 billion (12.3% of the euro area 2019 GDP). This mainly consists of the EUR 1350 billion Pandemic Emergency Purchase Programme, with net purchases set to continue until at least June 2021 and to which, in a welcome decision, some of the ECB self-imposed limits for asset purchases will not apply. Throughout the projection horizon, policy rates are set to remain unchanged, and asset purchases are assumed to keep long-term interest rates broadly stable for all euro area countries.

In the absence of a European fiscal capacity, the fiscal response to the crisis has been so far almost exclusively left to national budgets. Governments have been temporarily freed from the Stability and Growth Pact constraints and, as regards support to firms, allowed to use the full flexibility foreseen under state aid rules. Adopted measures have included short-time work schemes, increased healthcare spending, income support to households, tax deferrals, public loans and credit guarantees. Measures with a direct impact on the budget balance represent a discretionary stimulus in 2020 of about 3.5 percentage points of euro area GDP in the single-hit scenario, and marginally more in the double‑hit one. At the European level, access to cohesion policy funding has been made faster and more flexible, inter alia through the possibility of zero national co-financing, which will help to shore up investment in the main recipient countries. Furthermore, low-conditionality facilities for lending to member states on favourable terms have been developed, but involving modest amounts. These facilities include the European Stability Mechanism (with a benchmark 2% of national GDP for loans for healthcare spending under the Pandemic Crisis Support) and a new scheme, SURE (offering an aggregate 0.7% of EU GDP to fund loans for national short‑time work schemes). European Investment Bank guarantee schemes to mobilise funding for SMEs have also been expanded. More recently, the European Commission has proposed Next Generation EU, a far stronger response, envisaging EU borrowing of EUR 750 billion (5.4% of the EU 2019 GDP) to finance grants (almost 60% of the total), loans and guarantees, with a focus on those countries hit hardest by the recession. This plan, if swiftly adopted by member states, is expected to be operational from January 2021.

After a huge recession, the recovery faces important risks

The single-hit scenario assumes that the virus outbreak is contained by the summer, and so only one shutdown period of about two months that ended in May 2020, with restrictions gradually lifted afterwards. After an unprecedented GDP fall in the first half of 2020, affecting investment the most, a relatively swift recovery ensues, but output towards end-2021 is still 3% lower than in the last quarter of 2019. Dynamic job creation in 2021 progressively reduces the unemployment rate to below 9%. In the equally likely scenario of a second virus outbreak later in the year, output and employment losses in 2020 will be even heavier. GDP will fall by 11.5%, and the recovery will be delayed by approximately two quarters. Inflation will decline further, to close to zero. The joint effects of the recession, automatic stabilisers and discretionary fiscal stimulus make the area-wide Maastricht public debt rise to 112% of GDP. In both scenarios, southern countries tend to suffer the largest GDP falls in 2020, which poses risks of increased divergence within the euro area.

Deeper-than-expected scarring effects of the pandemic would weaken employment and investment for longer, threatening productive potential and social cohesion. The expected increase in non‑performing loans could hurt the availability of bank credits and lead to evergreening behaviour. Acute market concerns about public debt sustainability in some euro area countries would make sovereign spreads soar, pushing those countries into excessive fiscal consolidation that would likely prove self‑defeating. Similar pressure could stem from the reactivation of the current defective European fiscal rules and an excessively strict interpretation of them. On the upside, resolute joint action to tackle these risks would lead to a permanent improvement in the institutional architecture of the economic and monetary union.

A joint fiscal response is essential to support the recovery

To support the recovery and help stave off the above risks, the ECB should maintain a large degree of monetary accommodation over an extended horizon and keep departing from its self‑imposed rules, notably regarding the cross-country allocation of its sovereign bond purchases, if required to make its policy effective. Setting up an asset management company at European level would help speed up resolution of non-performing loans.

In addition, the European fiscal response needs to be substantially upgraded, particularly since the countries hit hardest tend to be those with less fiscal space. Grants financed by common debt issuance would relieve pressure on national budgets and contribute to a supportive fiscal stance across the euro area, and thus to a more dynamic recovery. Coupled with ECB purchases, long‑term loans at very low interest rates would strengthen debt sustainability. In this context, the swift adoption by member states of the proposed Next Generation EU recovery plan in its current version would be welcome.

The response to the pandemic crisis is also an opportunity to progress towards long‑term targets and a better functioning monetary union. Investments under the recovery plan should help meet Europe’s climate change mitigation targets. On the fiscal governance front, the temporary relaxation of the Stability and Growth Pact should be the opportunity for deeper reform, replacing the current multiplicity of numerical rules by an expenditure rule anchored to a debt‑ratio target. In addition, strengthened coordination of national fiscal policies and the creation of a permanent common unemployment reinsurance scheme would help cyclical stabilisation of the common currency area in case of adverse economic shocks.