Finance in the times of coronavirus
Thorsten BeckA third challenge (though related to the previous two) would be the loss of confidence
in banks, be it by depositors (resulting in bank runs) or by markets. Loss of access
to funding markets can easily turn into systemic distress, and much earlier than non-
performing assets will show up on banks’ balance sheets. Swift intervention by central
banks as lenders and market-makers of last resort will be critical in such circumstances.
What will be the policy reaction of monetary and fiscal policy authorities? In the euro
area, the ECB has all but run out of munition, unlike the Federal Reserve and the Bank
of England – with the former having already taken action this week. While there might
be still be options to influence the yield curve, large aggregate demand effects cannot be
expected from such actions. Lowering already negative interest rates further might trade
off aggregate demand effects with putting further pressure on banks’ balance sheets.
Fiscal policy, on the other hand, has quite some space, especially in some of the ‘frugal
countries’ such as Germany. Italy has just announced temporary tax cuts and higher
health spending, with an obvious negative effect on its fiscal position. This seems
the most reasonable approach right now, though it certainly might lead to problems
further down the road in terms of Italian debt sustainability. The Italian government
has requested that the European Commission relax the fiscal policy targets for Italy
in light of both expected growth and a higher deficit resulting from COVID-19.
However, it seems to matter little if the Commission loosens fiscal criteria for the
Italian government, as it will ultimately be the market that will take a view on whether
or not Italian sovereign debt is sustainable. In a perfect storm, an increase in Italian
government bond yields together with rising loan losses could put Italian banks under
pressure. While this might seem like a tail risk at this stage, it certainly should not
be excluded. Policy responses to such an event would certainly fall outside regular
frameworks. They might require a new ‘whatever it takes’, a restart of the Outright
Monetary Transactions (OMT) programme (announced by Draghi in summer 2011, but
never used) and a coordinated effort at the euro area level.
Which brings me to a final point. COVID-19 is a typical example of a shock that is
hard for each country to handle separately. It is a challenge for which ‘Europe’ seems
an appropriate level to coordinate action (notwithstanding urgently needed global
coordination). Beyond handling the challenges for the health system, economic and
financial policy coordination is critical for the EU and the euro area in the case of an
adverse scenario. It might very well turn into another historic test for the EU and the euro
area, in terms of economic policy response but also in terms of political significance
and sending a signal of relevance and strength to its citizens.