The new European Recovery Fund – Part 2

August 1, 2020

It is hard not to share the widespread enthusiasm for the € 750 billion agreement reached earlier this week. A brand-new facility that represents more than 5% of European GDP at a time when governments need to push for a powerful recovery seems exactly what is needed. It also innovates sharply from past practice and demonstrates an impressive level of solidarity. And yet, beyond the headlines, and the relief, there is less than meets the eye and reasons to be concerned. I describe these concerns in three parts. In the first part, I show that the effective amounts are likely to be much smaller and to come too late. In this second part, I argue that the moral hazard concerns, which complicated the negotiations, have been too widely set aside. In a third part, I share my fears about the way the 750 billion will be used.



Much has been said about Chancellor Merkel’s change of heart. For years, Germany rejected collective borrowing on moral hazard grounds. Issuing joint and several liabilities was anathema because it implied that Germany (and other fiscally disciplined countries) would be responsible for debts issued by countries that have not been fiscally disciplined for years running. By doing so, the former would encourage the latter to persist in their bad ways, thus creating a moral hazard.


When the pandemic broke out, I have argued elsewhere that moral hazard considerations should not stand in the way of a collective response, for two reasons. First, the Covid shock was unexpected, even though epidemiologists have long warned that the breakout of a pandemic was only a matter of time. Helping out adversely hit countries would not encourage them to seek more epidemics to receive more help, so there is no moral hazard. Second, the existence of the euro, and possibly of the EU, could come under threat if some countries are unable to borrow their way through the crisis because their governments are already highly indebted. Whatever moral hazard would be created did not match the perils of a EU breakup.


The new official line, in Germany and elsewhere, emphasizes the exceptional nature of the Covid shock. This argument, taken alone, is wanting, however. First, the dire impact of Covid differs across countries, partly reflecting readiness to promptly impose social distancing measures, partly past health policies. Second, the size of public debts at the outset of the pandemic are also the outcome of past policies. It can be argued that transfers that ‘reward’ years of policy errors and/or poor policy reactions create a moral hazard. It is right to override moral hazard considerations to build the recovery fund, but it does not imply that the issue should be ignored.


Dangerously high public debts, the main reason why the European Recovery Fund is needed, remains a source of moral hazard. A good agreement would have both set a recovery fund up and addressed the high debt problem, especially since the culprits are not just governments that did not really try to roll debts down. According to the Stability and Growth Pact, fiscal discipline is a collective responsibility. Had the pact been effective, all public debts would be low by now, two decades after the launch of the euro. All members of the Eurozone must accept a shared responsibility for a flawed construct and for never having adopted alternative mechanisms to control public debts. Instead, over the years, they have chosen to merely tinker with relatively minor technocratic issues, perpetuating the possibility for some countries to remain fiscally undisciplined year after year. Governments were loath to tackle a divisive issue and chose to declare it politically impossible.


Herein lies a severe limit of the historical agreement on the European Recovery Plan. This plan was as politically difficult as a deep reform of the Stability Pact – or its replacement by an alternative mechanism (various proposals have been mooted, including mine). The Recovery Plan could have opened a unique opportunity to undertake such a reform. Economic logic argues in favor of getting rid of this moral hazard, now enhanced by the plan. Political logic, maybe, suggests a that such a reform could have been offered to the “frugal countries” in exchange for their support for the plan, and required from the indebted countries in exchange for the transfers.


In fact, another occasion was missed. Living with high public debts is dangerous. They open up the risk of a run by the markets, as was the case in 2010. They also constrain fiscal policies when needed, as we now witness. After the Eurozone crisis, several proposals (including my own) have been advanced to collectively organize debt reductions before the next, unpredictable crisis. Policymakers have dutifully ignored these warnings and suggestions. The need to deal with even higher public debts after the pandemic is not mentioned in the agreement.