May 19, 2020

EUROZONE: Merkron’s main risk is the interregnum (Italian politics in H2)

BY Antonio Barroso, Carsten Nickel, Wolfango Piccoli

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( 5 mins)
  • The Franco-German proposal for a budget-based recovery instrument is a promising first step, but significant political challenges still loom in H2/2020.
  • A unique constellation of factors has motivated Berlin to move, but among the many open questions are reform commitments and repayment modalities.
  • The main risk is that Italy’s potential need for immediate support sees the debate about the initiative get mixed up with more traditional fights over “conditionality.”

Although nobody in Berlin would want to call it like this, the Franco-German proposal effectively envisages the Commission raising EUR 500bn via the joint issuance of debt. The money would go into a recovery fund that forms part of the overall EU budget to be finalized in H2/2020. From there, it would be disbursed, via specific EU programs likely on health but also digital and green policies, to member states most affected by the Covid-19 crisis.

This ties the recovery debate to the negotiations about the new bloc’s MFF macro budget for 2021-27. The many questions yet to be agreed before the end of the year include:

  • The exact size of the instrument, with the Commission’s proposal on 27 May being the next signpost;
  • The specific utilization and distribution of the funds, beyond the overall focus on post-Covid-19 recovery and the green and digital sectors;
  • The specific form reform commitments would take, perhaps beyond the existing tools available under the European semester;
  • The precise mechanism for repaying the bonds, beyond the indication that the usual capital key would apply (with Germany thus responsible for 27% alone).

The open questions will have to be tackled in the context of the budget negotiations until the end of the year. The hope is that a classic Franco-German compromise is politically viable on all sides: Paris has abandoned “those Southerners calling for coronabonds,” while Berlin has rejected “those Northerners insisting on loans-based solutions.” The declaration’s specific focus on tax harmonization might be a bargaining chip with the extremely skeptical Netherlands.

As anticipated, Germany supports grants as long as joint decision-making in the context of the EU budget addresses the question of “liability and control,” with the Commission’s SURE scheme offering the blueprint. This allows Paris and Berlin to shift gears within the logic discussed for the 2018 Franco-German Meseberg declaration, which was short-term Merkel but longer-term Macron. The outlook for German political passage rests on a unique constellation of interrelated factors:

  • The magnitude of the (looming) economic crisis poses fresh questions about the cohesion of the euro and the European project while being a politically symmetric shock: it affects voters across the bloc, creating a shared window of opportunity;
  • The German constitutional court verdict may not directly have triggered Merkel’s move, but it has served as another powerful reminder of the democratic limits to monetary policy, thereby playing the ball back to politicians, as discussed;
  • The German presidency of the Council of the EU in H2: the need to agree an MFF macro budget for 2021-27 usually forces the presiding country to show some extra flexibility to get everyone to sign up to a deal;
  • Finally, Merkel is on her way out, which does not eradicate any structural red lines, but increases her ability to invest political capital on the last meters of her chancellorship.

The deal is also a political victory for Macron, who has long contended that the best way of stemming the rise of populist forces was to do reforms both at home and at the EU level. Berlin’s refusal to make significant concessions had thus become a source of frustration for the French president. The new proposal will allow him to claim that Germany has moved (such is indeed the framing French media has used in reaction to the deal). It will also help Macron to push for action in areas that are critical from a domestic political standpoint, from the financing of extra healthcare spending to the reshoring of supply chains.

Political outlook in Italy and the South

The proposal has been well-received by the Spanish and Italian governments. However, much of the actual impact of the deal on these countries will be determined by how it is implemented.

In this regard, the envisaged new levels of risk and burden sharing will come with strings attached going beyond traditional “conditionality,” instead further pooling sovereign decision-making. Merkel once again pointed to further work on “political union,” highlighting the planned conference on the bloc’s future. All this will also be intended to address concerns regarding individual member states’ institutional capacity to absorb the new EU funds (in a way that benefits local voters and economies). At a politically tricky moment, this might raise previously neglected questions about sovereignty in the south, once it becomes clear that money raised jointly will not be available for entirely independent spending decisions.

Especially in Italy’s tough domestic politics, that debate might come to a head in the second half of the year, thus posing the single most significant risk to the Franco-German initiative. Per definition, an MFF-based solution will provide funds only as of 1 January 2021. Still, the combination of economic challenges, the administration struggling with crisis management so far, and the complicated political backdrop mean that Italy might face the need for financial assistance already in H2/2020. The only tool available at that point would be politically toxic support from the ESM rescue fund (opening the door to OMT bond-buying). If in this “interregnum,” both debates get mixed up in Italian politics, this might create risks for the Franco-German plan – and perhaps for the immediate cohesion of the Eurozone.

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