Will COVID-19 be the Eurozone’s undoing?
High unemployment, rising poverty and the weakening of traditional safety nets will create an environment ripe for nationalist and populist rhetoric in the European Union.
COVID-19 will saddle the eurozone with financial and political risks for years to come, testing the economic and institutional resilience of the currency area. High debt and deficit levels will increase the probability of sovereign defaults, especially in Southern Europe, as high unemployment levels create fertile ground for social unrest and the resurgence of destabilizing nationalist and anti-establishment political parties across the Continent.
In most European countries, the recessions caused by COVID-19 will be worse than those caused by the financial crisis of the early 2010s. But the European Union is also more supportive of stimulus measures than it was a decade ago. The bloc now has a permanent bailout fund to help countries in distress due to the pandemic. The European Commission has also authorized governments to provide financing to companies in trouble, and has suspended the European Union’s deficit and debt targets. But perhaps most importantly, the European Central Bank (ECB) is now willing to purchase nearly unlimited amounts of debt from eurozone countries in secondary markets to keep their borrowing costs under control, including "junk" debt from countries such as Greece and potentially Italy if Rome’s creditworthiness is downgraded.
Compared with their predecessors, national governments in Europe are in a better position to soften the immediate economic and social impact of the COVID19 crisis. In recent weeks, EU countries have introduced cheap loans for companies affected by the outbreak, delayed tax payments for firms and individuals in trouble, helped businesses pay the salaries of their employees, and increased subsidies for low-income households. The goal of these policies is to curb the economic blow of lockdown measures, including the rise in unemployment, as much as possible.
Stimulus measures are mitigating the short-term impact of the pandemic in Europe, but they are also creating financial problems for the future. EU governments are paying for their stimulus programs through debt, which so far is cheap because of constant ECB intervention in secondary markets. The European Commission’s decision in March to suspend the bloc’s fiscal rules for an indeterminate period suggests that Brussels will not pressure national governments to reduce their debt and deficits in the short to medium term. But a more lenient European Union will not change the fact that most countries in the bloc will still emerge from the crisis with higher debt and deficit levels, a problem that they will eventually have to address. This situation will be particularly dangerous for Southern European countries, which were already saddled with high debt and slowing economic growth before the onset of COVID-19.
A second wave of COVID-19 infections could further constrain growth by forcing eurozone governments to reintroduce some lockdown measures. According to the International Monetary Fund, Europe’s probable economic recovery in 2021 will not compensate for the losses of 2020, and some forecasts estimate it could take between two and three years for eurozone countries to return to pre-crisis levels. In the meantime, new waves of infections in late 2020 or early 2021 could force governments to again impose economically disruptive lockdown measures. This means that economic growth in the coming years will probably not be enough for eurozone countries to reduce their debt burden. Southern governments will demand drastic measures that their northern counterparts will reject, such as changing ECB rules to allow the bank to directly purchase debt from them. Countries including Austria, the Netherlands, Sweden and Denmark have already expressed concern about proposals to increase fiscal transfers within the European Union.
Rising debt in a context of insufficient growth will increase the probability of sovereign debt defaults in the eurozone. In this, Italy presents the greatest danger due to the size of its economy (which is the third-largest in the European Union), as well as its debt (which, according to some projections, could reach 160 percent of the country’s GDP this year). But according to Eurostat, seven of the 19 members of the eurozone will end 2020 with debt-to-GDP ratios well above 100 percent, which means that financial crises and potential defaults are possible if financial markets believe they are no longer able to service their debt. On May 26, the ECB warned that the debt situation in several eurozone countries could enter an “unsustainable path” if the recessions turn out to be more severe than currently expected.
Rising unemployment will force thousands of households to delay, and potentially even default on, their debt repayments. A sudden increase in households and businesses defaulting on their debt would revert years of efforts by banks in countries such as Greece, Cyprus and Portugal to reduce their portfolio of non-performing loans. Banks in the eurozone also face a second source of risk, which is connected to the billions of euros they hold in sovereign debt from member states. Banks’ balance sheets will deteriorate significantly if those bonds lose value as investors get rid of them for fear of default.
Europe’s worsening economic outlook will create a fertile ground for social unrest and the emergence of anti-establishment political parties. The 2010 financial crisis led to the emergence of antiestablishment forces that threatened the political status quo in Europe. The immigration crisis of 2015 then boosted the popularity of nationalist parties that were critical of the European Union. With the Continent once again in recession due to COVID-19, a similar process is probable.
Most of the nationalist parties that have emerged in Europe over the past decade were electorally successful, but their threat to the eurozone has proved to be limited. The left-wing Syriza party governed Greece between 2015 and 2019, the anti-establishment Five Star Movement has been a member of Italy’s coalition government since 2018, and the left-wing Podemos entered the Spanish government in January. The antigrowth
Stimulus measures are mitigating the shortterm impact of the pandemic in Europe, but they are also creating financial problems for the future.
immigration League is currently the most popular party in Italy, while the rightwing Alternative for Germany is the main opposition group in the Bundestag. But despite their electoral success, the legacy of these parties has been mixed. They ended the supremacy of the traditional parties and were instrumental in fragmenting political systems across Europe. But they’ve also softened their anti-establishment and Eurosceptic positions over time, and many have since become part of the same establishment they used to criticize.
Because of the current stimulus measures, the correlation between economic recession and social discontent may not be as immediate as it was a decade ago. Most of the anti-establishment parties born of the 2010s financial crisis were the result of the tax hikes and spending cuts that governments introduced under pressure from EU institutions. The stimulus measures of the COVID-19 crisis could delay a repetition of this process. Opinion polls suggest that the health emergency has temporarily boosted the popularity of most European governments, while opposition parties are struggling to capitalize on the crisis. But the pandemic still makes it possible for social unrest and extremist politics to re-emerge, particularly in Southern Europe. Tourism, for example, was a constant source of revenue for southern countries throughout the last financial crisis, which will not be the case this time around, at least in the short term. Countries such as Greece, Croatia, Italy, Spain and Portugal are heavily reliant on tourism, and the COVID-19 crisis has significantly weakened this traditional safety net for their economies.
High unemployment, rising poverty and the weakening of traditional safety nets will create an environment ripe for nationalist and populist rhetoric in the European Union. The pandemic has strengthened deglobalization and selfsufficiency messages around the world, which is in line with the ideology of most populist and nationalist forces in Europe. These parties will demand greater autonomy for their countries and more isolationist positions, including a strengthening of the nation-state vis-a-vis the European Union. Country-first politics pose an existential threat to the European Union, which was built on the premise of a progressive pooling of sovereignty and resources.
In Southern Europe, social discontent will increase when governments start to withdraw the stimulus measures to reduce their deficits. The economic crisis that follows the pandemic will be severe and the subsequent recovery will be weaker in Mediterranean countries compared with the north. Under heavy debt burdens, governments in the south will eventually cut spending and raise taxes to reduce their fiscal deficits. This will create the conditions for social discontent that nationalist and populist political forces in the far-right and farleft will seek to capitalize on.
High debt and deficit levels will raise the risk of sovereign defaults, especially in Southern Europe, as high unemployment creates fertile ground for social unrest and political extremism across the eurozone.
In Northern European countries, nationalist parties will argue that sharing resources with Southern European countries is against their national interest. The debate between countries such as the Netherlands and Austria, which want EU financial assistance to take the shape of loans connected to conditions, and countries such as Italy and Spain, which want grants with no strings attached, underlines how the north of the eurozone is still suspicious of transferring taxpayers' money to the south. In addition, 'a recent ruling by Germanys constitutional court questioning the legitimacy of one of the ECB's bond-buying programs highlighted how a key institution at the very economic and political core of the European Union is still unconvinced that EU law is always superior to national law. Existing or new nationalist parties in the north will seek to capitalize on northsouth mistrust and promote Eurosceptic policies.
The combination of fiscal and political risks will test the economic and institutional resilience of the eurozone. The currency area was able to absorb the wave of anti-establishment sentiments that emerged during the 2010 financial crisis, but a second wave is possible in the likely case that the economic recovery is slow and uneven. Southern Europe, in particular, will be exposed to the risk of renewed social unrest and political volatility at a time of fiscal fragility due to high levels of debt and deficit. This could lead to renewed uncertainty for households and businesses in the euro area that may delay spending and investment decisions, prolonging the currency area's pandemic-induced financial woes.