The Global Economic Crisis

Since last December, a new coronavirus, Covid-19, has been putting our lives at risk. At the same time, it has paralyzed most of our productive systems, whose survival is now under threat. This unprecedented health emergency has triggered a very serious economic crisis, the depth of which will be determined by the duration of the pandemic.

A deep and rapid recession

Given the non-negotiable priority of human life, it is undeniable that defeating the pandemic comes first. The challenge we all share is to prevent the collapse of the healthcare system, but it is also true that we are suffering economic damage due to the epidemic, damage that continues to intensify. What started with the closure of the Chinese province of Wuhan in January has led to a recession unique in history, the most intense and rapid ever known. The dynamic that it triggered can push us back to levels similar to those recorded following the recession following the severe financial crisis on Wall Street in 2008. In the space of a few weeks we have plunged into an economic outlook no less bleak than the memorable one of the 1930s.

The upheaval unleashed by the Asian virus is new in every respect. The most resounding aspect of this economic shock, in fact, is its deleterious originality. It does not originate from a collapse of the financial system or from an overproduction not absorbed by the markets.  It comes from a natural phenomenon that is fortuitous, and that cannot be attributed to the bad management of the economic system. A virus has managed to disrupt the global production chain, one of whose first stages is found in China.

A modern economy is a complex network of interconnected parts: workers, businesses, manufacturers, suppliers, consumers, banks and financial intermediaries. All of them in turn are operators, customers, someone’s creditors, and so on. If one of these buyer-seller chains is broken by the pandemic or containment policies, it results in a series of cascading disruptions. The Covid-19 pandemic has exposed the vulnerability of the production system in many advanced economies, which are closely dependent on Asia for supplies of industrial products – both parts and finished products – and health products at this particular time.

This pandemic is a severe blow to the world and the European economy. To deal with it, most European countries have taken courageous measures to quarantine and suspend social activities. In addition, a coordinated and strong response from the authorities was necessary. Its details are obvious. From the outset ample public funds had to be assigned to health services. Specific measures were taken to support the people, businesses and local communities most affected. Central banks had to provide abundant liquidity. Mario Draghi’s well-known statement: “The European Central Bank (ECB) is ready to do whatever it takes to preserve the euro,” has become the paradigm for central banks in the face of the need to save lives and reduce the impact of the pandemic on the economy.

It is now clear that we can, if circumstances require it, stop a state’s economy to a bare minimum level of activity. Yet at the same time we have proof that the consequences are catastrophic. Never before has the global economy suffered a simultaneous shock of this magnitude. In the United States alone, at least 17 million people lost their jobs in the first three weeks of March.

The crucial question is how much of the world economy will survive this forced hibernation. It depends on the availability of credit. Economic activity functions on the basis of credit. Those parts of the economy that continue to function need it. Millions of households and businesses around the world depend on state subsidies and loans to survive the stoppage. But tax revenues have collapsed, so states also need credit. All over the world we are seeing the biggest increase in deficits and public debt since the Second World War.

Banking systems and markets provide the financial fuel for the world economy. Loans are given based on the expectation of the success of the activity financed. At the macroeconomic level, this means that growth is expected. If there is no growth, confidence collapses and credit contracts, causing a cloud of pessimism. It is no exaggeration to speak of “financial contagion.”

Thanks to the central banks and their energetic action, Europe and the United States have so far been able to maintain the flow of credit. Without this, most of their economies would have no life support. Maintaining the flow of credit was the precondition for a concerted public health response to the pandemic and, at the same time, preventing the collapse of the economy.

The inevitable reaction of the financial markets

In the third week of March, the world financial markets were close to collapse.[1] The share price of the world’s large companies plummeted. The value of the dollar – a currency that traditionally provides shelter in financial crises – rose against all the currencies of the world, putting debtors everywhere at risk.

The markets reacted to an unthinkable turn of events. After a fateful period of fluctuation, governments around the world, one after the other, ordered periods of economic hibernation to contain a lethal pandemic. Built for growth, the world economic machine came to a standstill. In 2020, for the first time since World War II, production worldwide will contract.

It is well known that financial markets scour the world in search of risks and opportunities. Investors were shocked by the news, on January 23, that the outbreak of an unknown virus was so serious that the Chinese authorities imposed an extensive quarantine. They sought immediate refuge in US Treasury Bonds, while still believing the virus was a problem limited only to China. They then realized that Covid-19 was turning into a global pandemic when the Italian government imposed a lockdown at the beginning of March. That was when panic broke out.

On the morning of Monday March 9, at the opening of the Wall Street stock exchange, the situation was so serious that circuit breakers – which suspend trading in securities when prices fall by a certain percentage – were triggered immediately. The aim was to stop or delay a massive sale. In any case, a message of fear was conveyed.

Since the dollar is the main currency of exchange in most of the world’s commercial transactions, the growing demand for US currency sent the currency markets into a frenzy, increasing financial tensions and forcing the US Federal Reserve (the Fed) and other major central banks to intervene through foreign exchange (swap) operations, which increased the supply of dollars.

The financial crisis and Italy

Italy was the first European country affected by the virus. Lombardy, the region most affected by Covid-19, is among the richest regions in the world. To fight the crisis, Italy needed to spend markedly on public health and to support the economy as the lockdown came into effect. But could the strength of the euro and the need to balance public finances have given it room for manoeuvre?

The problem was that spending to deal with the coronavirus crisis would drive up Italy’s public debt; the higher it went, the higher the interest rate to pay for loans. For a European government, the risk premium measures the difference, or spread, between its interest rate and that of German public debt, which is the strongest and most solid economy in the eurozone. With pre-crisis debt of around 135% of GDP, Italy was dangerously close to the point where its rising spread would raise its interest rate and deficit, and thus cause a vicious circle in which its debts would become increasingly unmanageable.

Since Italy is a member of the eurozone, its national central bank cannot buy back its debts and finance its deficits. Its monetary policy is laid down by the European Central Bank, which is prohibited by EU law from directly buying debt just incurred by a member state. As the coronavirus crisis intensified at the end of February and investors were worried about the prospect of increased public spending, the differential with the German interest rate widened. If it had increased too much, Italy would have faced not only a health catastrophe, but also a public debt crisis. What could Europe have done to help it? The very attitude adopted by the ECB would be decisive for the financial survival of the country.

Under the presidency of Mario Draghi during the previous crisis of 2012, the ECB had distinguished itself as the main institution involved in the  survival and stability of Europe. Draghi’s promise to do “whatever it takes” to keep the eurozone united, made in July of that year at the height of the crisis, has become a mantra of modern economic policy. The fiscal and monetary conservatives of northern Europe, always suspicious of Draghi’s interventions, saw in this promise a way to include Italy’s bonds in the ECB’s budget.

Christine Lagarde, former French Finance Minister and Director of the International Monetary Fund (IMF), took over the presidency of the ECB in October 2019. She faced a crucial test during a press conference on March 12, 2020. The critical moment came when she was asked about the ECB’s attitude toward sovereign debt. Her answer was significant: “We are not here to close spreads,” i.e. to buy the debt of states in financial difficulties. She was talking about Italy. But if the ECB had not helped Italy, who would have done so? Was Lagarde really hoping that other eurozone member states would set up a fiscal safety net for Italy?

Faced with the prospect that the ECB would refuse the increased Italian risk premium, the financial markets reacted, and as a result the price that Italy would have to pay for borrowing took off. On average, the differential increased by 0.65%. It may seem like a small increase, but when applied to an amount of debt such as Italy’s, the increase in debt interest is equivalent to around €14 billion a year, just the opposite of what Italy needed. Issuing a rare public reprimand, Paris, Rome and Madrid all distanced themselves from the ECB. The crisis was increasingly separating Europeans.

The reaction of the central banks

At the heart of the financial markets, driven by a quest for profit, resides a non-profit public institution, the central bank. When the financial markets function normally, they remain in the background, but when markets risk collapsing, they have the option – and the obligation – to come forward to act as lender of last resort. They can grant loans and can buy financial assets (public debt securities and bonds of private companies). Their purchasing power is unlimited. This means that they can decide who sinks and who stays afloat. We already saw this in 2008. In 2020 it became even more evident.

When the virus launched its attack, the leaders of the Fed, the ECB and Bank of England had in their hands the economic survival of hundreds of millions of people and the fate of many nations. The last few weeks have seen Western countries engage in an unprecedented reaction. The results were decisive. A gigantic public safety net has been put in place throughout the financial system.

After five terrible days of financial turbulence, March 14 and 15 were key for the coordination of the response by central banks around the world. As already mentioned, everyone wanted dollars so it was up to the Fed to take action. It did. It reduced interest rates to zero and in just 48 hours bought more securities than in the months following the 2008 crisis. Even the ECB decided to take action. It announced purchases of sovereign and private debt amounting to 750 billion euros. And it was also willing to go further. It said that, if necessary, it would reconsider some of its “self-imposed limits.”

This was a revolution for the ECB. The self-imposed limits on the purchase of public debt – rules on the evaluation of the public debt of the states it could have bought and in what quantity – are one of its foundations. It is well known that the conservative members of the ECB’s governing council opposed this operation. But in the end once again the financial turbulence of the moment and the threat to the survival of the euro area decided the matter. The ECB had to give a strong signal.

By the end of the third week of March, 39 central banks around the world had cut interest rates, relaxed financial regulations and established special lending services. The Fed strengthened its asset purchase program – both government debt securities and corporate and mortgage bonds – to an astonishing $375 billion in treasury bonds and $250 billion in corporate bonds in a single week. The S&P 500 and Dow Jones indices began to recover. Two days later, on March 25, the US Congress and Senate approved a huge 2 trillion dollar economic relief plan, more than twice the amount approved in 2009. This resulted in funds to expand unemployment benefits, to support businesses and the mainly private hospital system in the United States.

In Europe, the various governments in the eurozone also moved. Germany, putting aside its strict fiscal caution, committed itself to a massive program of government guarantees for commercial loans. Other countries also launched huge support programs to combat the health crisis and its serious economic and social consequences.

In the UK, the Treasury and the Bank of England worked hard to link the huge increase in public spending to efforts to stabilize financial markets. But in the eurozone this kind of coordination was lacking. The ECB managed to contain the immediate panic, but one question remained: whether the member states could devise a plan to support the finances of their most affected members, Italy and Spain. The obvious solution was to issue joint and solidarity-based debt to fight the crisis together, an idea repeatedly proposed during the eurozone crisis and against which the conservative coalition in northern Europe, led by Germany, had put up tenacious resistance. This choice would have allowed Italy to fight its crisis with greater strength with less pressure on its public finances.

For a coalition of nine states – led by France, Italy, Spain and Portugal – the course was obvious. On March 25, they called for a “common debt instrument” to finance an appropriate response to a symmetric crisis that was not caused by inappropriate financial behavior. The ECB supported this proposal. But once again the Netherlands and Germany refused to give in, arguing that the states requesting that measure had not taken advantage of several years of economic recovery to reduce their large public debt.

While the debate on the financing of a European action plan continues, three initiatives aimed at economic recovery have already been approved within the European Union. They involve the mobilization of loans, credits and guarantees to states for a total amount of EUR 540 billion, distributed as follows:

– credits of up to EUR 240 billion from the European Stability Mechanism (ESM) for states requesting it, without the usual strict “conditions” (requirements for strict structural reforms under the supervision of community institutions);

– loans of up to EUR 200 billion from the European Investment Bank to small and medium-sized enterprises;

– credit lines of up to EUR 100 billion from the European Commission to states as support measures for temporary reductions in working hours and unemployment benefits.

These measures were approved at the meeting of Heads of State and Government on April 23. Although they are a step in the right direction, in size and nature they are inadequate to deal with the very serious economic and social consequences that states, especially Italy and Spain, will face. In this regard, it should be stressed that receiving such aid, since they are repayable loans (albeit at favorable interest rates), implies an increase in debt, which is already very high in countries such as Italy (around 135% of GDP) and Spain (95% of GDP).[2]

Hence requests came from the Italian and Spanish governments, with the support of France and Portugal, for a Community recovery plan (a “Covid-19 Marshall Plan”), to be financed from European Community resources.[3] In response, the European Council agreed, in the words of its President Charles Michel and the President of the European Commission Ursula von der Leyen, that “work should be done on the creation of an urgently needed recovery fund. The fund must be of an appropriate size, targeted at the sectors and geographical areas of Europe most affected and designed to tackle this unprecedented crisis.” It is now up to the European Commission to make a proposal, setting out which parts of this fund will be repayable loans and which parts will be direct (non-repayable) aid.

Although the German Constitutional Court has confirmed that the ECB’s program for the purchase of government bonds complies with its own federal laws, it requires the ECB to demonstrate within three months that the purchases were proportionate, differentiating monetary and economic policy. Otherwise it will force the Bundesbank, with 26% capital, to stop participating in such operations.

Some think that this decision of the German court in the middle of the economic crisis could force one or more countries to abandon the monetary union. We will see what happens, but it is obvious that this ruling restricts Christine Lagarde’s room for maneuver and could prove disastrous for European integration.[4] This explains her immediate reaction, on Thursday May 7, when she said categorically: “We are a European institution with responsibility for the euro area and are under the jurisdiction of the European Court of Justice.”[5]

The EU faces a decisive challenge

This is the current situation. The Gordian knot that needs to be untied over the coming months involves establishing whether the Italian and Spanish governments have the margins to get into debt, while maintaining the solvency that institutional investors demand. This is especially the case when all European countries, for which the initial estimates predict an average fall of 8% of GDP in 2020, will resort massively and simultaneously to the sovereign debt market. The question is: Will the funds be enough for everyone? In this scenario, Italy and Spain are calling for Eurobonds, or so-called coronabonds, to improve the national capacity to issue debt and to mutualize part of the financing under the Europe brand. This instrument would reduce the risk of insolvency for the states issuing them, and thus lower their cost.

Is it possible to issue coronabonds without a common treasury? What about the argument of “moral hazard” that Germany and the Netherlands have repeatedly raised? Europe is at a crossroads. Parliament, the Commission and, above all, the European Central Bank have taken a decisive step toward solidarity and joint action. What is missing is the Council, the decision of the political leaders of the member states.

And yet, despite everything, credit aid may be inadequate. The debt burden could stifle the recovery of the Italian and Spanish economies. Never in the history of the EU has mutual action been more necessary. The reaction could come too late and the “bomb” of Italy and Spain could explode in the face of the European project. We are confronted with the decisive question of the EU’s effective solidarity with its members who need it. But this obvious call for solidarity does not only apply within the borders of the Old Continent.

In this regard, we can refer to a recent initiative proposed by the Spanish Government, along the lines supported by some financial experts,[6] aimed at strengthening the recovery of European economies, especially those most affected by the pandemic crisis. This is a perpetual public bond issue (which generates interest but has no expiry date), financed by the European Community budget managed by the European Commission. It would be an issue with the best possible rating, and would therefore have a very favorable interest rate. The funds obtained would not be lent to the member states (their level of indebtedness would thus not increase), but would be transferred to them (without repayment) to finance recovery-oriented investments.

It is not difficult to predict that this proposal, like others before it, will be rejected by the northern states (Germany and the Netherlands in the lead). It should be remembered, however, that more than ten times since the 1970s, the European Commission has issued on the financial markets securities guaranteed by the member states and distributed to states in crisis, and in all those cases there have been no outstanding repayments.[7]

Will developing countries collapse?

Recently, the Nobel Economics Prize winner Joseph Stiglitz,[8] along with many other experts,[9] stressed that this pandemic will devastate emerging economies far more than advanced economies, because their populations are more vulnerable to disease, and their health systems are less well prepared to deal with this emergency. Their exports will collapse as the world economy contracts. Investment flows and the prices of their key products will contract markedly. Therefore, many governments will find it extremely difficult to meet their debts on reasonable terms. In many areas, the loss of revenue could mean hunger.

According to Stiglitz, this means two operations are required. The first is to make full use of the Special Drawing Rights (SDRs) of the International Monetary Fund, a kind of “global money” that the institution has been authorized to create since its foundation. Special Drawing Rights (SDRs) are an essential ingredient in the international monetary order that John Maynard Keynes defended at the 1944 Bretton Woods Conference. They are based on the concept that, since all countries obviously want to protect their citizens and economies during crises, the international community should have an instrument to help the neediest countries without requiring their national budgets to be affected. A standard issue of SDR, with 40% going to developing and emerging economies, would make a huge difference. But it would be even better if advanced economies, such as the United States, donated or lent their SDRs to a trust fund designed to help the poorest countries.

The second necessary operation is for creditor countries to help by announcing a suspension of debt service – payment of interest and repayment of principal – of developing and emerging economies. In the current critical conditions, many countries simply cannot pay their debts, and this could lead to massive defaults if their debt service is not suspended. In many developing and emerging economies, paying the debt service would in practice mean consenting to the death of a large number of their citizens. This is, of course, unacceptable.

On Easter Day Pope Francis joined in this request. In this way he followed the path traced by his predecessor St John Paul II.

Previously, on March 26, G20 leaders issued a statement committing themselves “to do whatever it takes and to use all available policy tools to minimize the economic and social damage from the pandemic, restore global growth, maintain market stability, and strengthen resilience.”

In the famous words of John Donne, “no man is an island.” Nor is any country, as the Covid-19 crisis has highlighted. The need for solidarity is so obvious!

Is globalization sustainable?

The situation that has arisen raises the unavoidable question whether it is not now urgent to control the most problematic dynamics of globalization. It seemed irreversible, and it was believed that it would remain so. The various populisms have wanted to curb or neutralize it, and now it is a global health emergency that is managing to set limits. Borders have been closed, imports and exports have been frozen, populations have been locked up in their homes. Nation states have returned to the forefront, taking a leading role; they have regained their essential mission, to watch over their citizens.

We do not know when we will come out of this pandemic, nor how much we will recover of the previous situation, but perhaps an epochal change is taking shape. With the crisis that started in China, we are now dramatically aware of the limits and risks involved in the current configuration of the international economy, particularly in the globalization of production.

The fragmentation of production chains, as a result of the fatal logic of making profits at all costs, has made it necessary to relocate production, and this has seriously affected health and environmental controls due to the very high volume of trade that aggravates the pollution of our planet. Before the contagion reached Europe, in the early stages of the current health crisis, it became clear that the closure and quarantine of Chinese suppliers interrupted the flow of essential components to many Western factories, forcing them in turn to reduce or stop their activities. The consequence is obvious: companies must reconsider their relocation and dependence on long-distance supply centers. This adds an essential element to the debate on globalization.

The coronavirus is still the last link in a chain of epidemics that have ridden the extraordinary intensity of trade in the current world production system, the large globalized supply chain today. Some people speak of this epidemic as a by-product, an unwanted consequence of globalization. Perhaps they exaggerate, and we are once again making globalization the scapegoat for all our ills. There is no doubt, however, that it has shown its inherent weakness. The world cannot continue to depend on suppliers in such an extensive way. Let us remember in this regard that the European common agricultural policy was created in the 1960s precisely to ensure a vital supply of food without triggering very dangerous dependencies.

The economic impact of Covid-19 will be much more important than that of Sars in 2003, perhaps because that epidemic disappeared without anyone knowing why; or because the world was then less economically integrated than it is today. A virus, an invisible biological structure, brought this globalized world to its knees. Once we rise, we will have to decide how to organize ourselves and how to deal with a future that is seriously compromised. Major difficulties are expected.

Without the intervention of the states, we could neither have faced the pandemic nor prevented the collapse of the economy. This crisis will probably allow us to redefine the role of the state in Western economies. Is it not indispensable if we want to manage the current globalization? In the immediate future, as public health is restored, states will lead the process of reactivating their economies. This is a natural task for them as representatives of the relevant political communities. When we emerge from this crisis, the world will be different. The psychology of investors will change, as will the way we organize production and consumption. In addition, we will see that the state is once again active in the economy in order to remain there and guarantee the common good.[10]

DOI:

[1].    Cf. A. Tooze, “How coronavirus almost brought down the global financial system”, in The Guardian (www.theguardian.com/business/2020/apr/14/how-coronavirus-almost-brought-down-the-global-financial-system), April 14, 2020.

[2].    Cf. X. Vives, “Europe’s New Defining Moment”, in Project Syndicate (www.project-syndicate.org/commentary/europe-must-seize-covid19-opportunity-by-xavier-vives-2020-04), April 10, 2020.

[3].    Cf. P. Legrain, “A COVID-19 Marshall Plan for Europe”, ibid.
(www.project-syndicate.org/commentary/european-union-covid-marshall-plan-by-philippe-legrain-2020-04), April 10, 2020. See also G. Sale, “The Marshall Plan. One way to deal with the coronavirus crisis”, in Civ. Catt. En. May 2020, https://www.laciviltacattolica.com/the-marshall-plan-one-way-to-deal-with-the-coronavirus-crisis

[4].    Cf. W. H. Buiter, “Germany’s Judges Declare War on the ECB”, ibid. (www.project-syndicate.org/commentary/german-constitutin-court-ecb-pp-ruling-by-willem-h-buiter-2020-05), May 6, 2020.

[5].     www.corriere.it/economia/finanza/20_maggio_08

[6].    Cf. G. Soros, “The EU should issue perpetual bonds to fund the economic recovery from coronavirus”, ibid. (www.project-syndicate.org/commentary/finance-european-union-recovery-with-perpetual-bonds-by-george-soros-2020-04), April 20, 2020.

[7].    Cf. S. Horn – J Meyer – C. Trebesch, “Coronabonds: The forgotten history of European Community debt”, in VoxEU (voxeu.org/article/long-run-view-coronabonds-debate), April 15, 2020.

[8].    Cf. J. E. Stiglitz, “World must combat looming debt meltdown in developing countries”, in The Guardian (www.theguardian.com/business/2020/apr/07/world-must-combat-looming-debt-meltdown-in-developing-countries-covid-19), April 7, 2020.

[9].    Cf. P. Bolton et Al., “The Necessity of a Global Debt Standstill that Works”, in Project Syndicate (www.project-syndicate.org/commentary/covid19-debt-standstill-must-include-all-private-creditors-by-patrick-bolton-et-al-2020-04) April 23, 2020; G. Brown – L. A. Summers, “Debt relief is the most effective pandemic aid”, ibid., April 15, 2020.

[10].   The author is grateful to José Ramón Espinola who collaborated in the drafting of this article.