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After the crisis: Economic lessons from the pandemic

Blog post by Fabio Panetta, Member of the Executive Board of the ECB

27 July 2021

With the complete reopening of the economy in sight, what Europe needs to emerge stronger from the pandemic will change. We will have to shift from offsetting lost income to adding new income, and from preserving productive capacity to reallocating capital and labour towards sectors with more favourable opportunities.

Whether we will succeed depends on how we reform the way in which the European economy is governed. 

When the pandemic hit, the European Union intervened to provide immediate support: Fiscal and state aid rules were suspended and powerful common instruments were introduced; the European Central Bank (ECB) adopted extraordinary actions to help the economy absorb the shock and loosened bank capital rules. 

As the acute phase of the pandemic draws to a close, we are faced with a fundamental choice: Do we go back to the pre-crisis model of economic policymaking or do we opt to transform it? 

During the financial crisis, the eurozone adopted a wrong policy mix, causing an economic gap to emerge with other major economies, one from which we have not yet recovered. Back then, the governance of Economic and Monetary Union (EMU) revolved around a dichotomy between a lack of coordination between fiscal and economic policies — outside of emergencies — and far-reaching policy conditionality when it came to financial assistance programs. These aid policies were conceived in partial equilibrium at the level of single countries; there was too little attempt to understand what they meant for the eurozone as a whole. 

This system experienced policy failures and political backlash. Limited coordination led to a premature withdrawal of fiscal support and sluggish structural reforms, which, in turn, contributed to the eurozone’s second recession. Far-reaching conditionality unnecessarily divided Europe into creditor and debtor countries, resulting in a deep economic and political divide. 

During the pandemic, however, Europe embraced a new model for managing crises. The virus and the restrictions put in place to contain it caused not only a huge negative demand shock but also a powerful and potentially long-lasting adverse supply shock. It accelerated digitalization and automation in ways that will radically transform production and the labor market. 

In the face of these shocks, three paradigm shifts have taken place. First, the new European common fiscal instruments, which were introduced to ensure broad-based and faster recoveries, were designed explicitly in recognition that the EU is more than the sum of its parts. 

Being funded collectively, the Next Generation EU (NGEU) package has created a critical fiscal policy space akin to federal budget support in other economies. ECB research suggests that if the entire NGEU loan envelope were taken up, the program could raise the public investment-to-GDP ratio in the eurozone by almost 40 percent by 2024. The ratio could even double in some countries. 

The second shift is the recognition that reforms are more likely to emerge in a growing economy, where resources can be redistributed more easily. That has also highlighted the need to align demand- and supply-side policies at the EU level. 

Europe’s sovereign debt crisis illustrated that austerity does not pay, and simply stimulating demand would not be sufficient to escape the low growth trap. The economy must adapt to the new economic environment created by the pandemic, with resources being reallocated across sectors and firms.  

The most productive companies need to expand, and the unprofitable ones need to exit. NGEU recognizes this by providing grants to accelerate the green and digital transitions, in exchange for growth-enhancing recovery plans that modernize legal and institutional frameworks, enabling this reallocation of resources.  

This points to the third paradigm shift, which is more institutional in nature: The explicit commitment by EU countries to transform their economies using European funding, so that the investment eventually repays itself through higher productivity growth and positive demand spillovers. 

This reflects the growing awareness of how interdependent European economies are. For example, the European Commission estimates that countries like Belgium, Luxembourg, Austria and even Germany will obtain most of the GDP stimulus from NGEU through the boost in foreign-induced demand, stemming from other corners of the EU. 

This autumn, as Europe reviews its economic governance, we have the possibility of taking decisions that will put the recovery and the post-crisis economy on stronger footing by building on these three paradigm shifts. But this will require a new approach. 

First, we need to make sure this new “European social contract” embodied by NGEU is adopted through recovery and resilience plans that are ambitious and well implemented. The recovery fund is based on a joint effort — through a balance of responsibilities — by European and national authorities. It puts European money on the table, while member countries put forward concrete plans, which are consistent with EU priorities, to tackle their economic and institutional weaknesses. If successfully implemented, NGEU will help legitimize this new model, and the use of EU bonds, should a future crisis again threaten to overwhelm national policies. 

Second, while NGEU grants will play a crucial role in managing the structural transformation created by the accelerated shift toward digitalization and automation, the EU liquidity toolbox remains insufficiently used or ill-suited to tackle this challenge head-on.  

Loans under NGEU can be used to modernize the economy, but the available envelope remains partly untapped. Meanwhile, liquidity support provided by programs such as the temporary Support to mitigate Unemployment Risks in an Emergency (SURE) and the European Stability Mechanism remains targeted at yesterday’s challenges — notably, substituting lost income and supporting health expenditure, which were more pressing during the immediate public health crisis that we are now starting to emerge from. 

These tools could be extended and adapted to support various policy objectives in the recovery phase, first and foremost boosting human capital through measures such as on-the-job training and active labor market policies. This would, in turn, stimulate employment growth as the recovery picks up speed. 

Third, it’s important to note that the bulk of Europe’s fiscal firepower remains nested in national policies. Therefore, reforms to the rules that govern them are essential. Fiscal rules aim to guide governments on which policy trajectories are consistent with the sustainability of public finances. But because they affect demand directly and through expectations, they can only be stabilizing if they are countercyclical. 

A targeted reform should therefore include both a conjunctural component (ensuring that fiscal policy is responsive to short-run market fluctuations and enables a strong recovery) and a structural component (strengthening the sustainability of debt over the economic cycle). 

Only by protecting public investment over the entire business cycle, while successfully implementing structural reforms, can we boost productivity and growth potential and, ultimately, rebuild tax bases and service debt in the long run. 

If we apply the lessons of the pandemic to our economic policy, we can emerge from this crisis with a stronger economy and greater social and political cohesion. Upgrading the rules by which the EMU is governed is unequivocally in the interest of all EU member countries, and the importance of NGEU cannot be overstated. Its success would recast the EU economic toolbox and shore up the European project for generations to come. 

This blog post first appeared as an opinion piece in on 27 July 2021.