Government support has helped European economies bounce back more strongly than expected – but at the cost of spiralling public debt.

The Bundesbank president has warned of a ‘debt illusion’ because this borrowing is spread across numerous schemes and policies, all of which must eventually be repaid. But if the pandemic continues to depress demand, even more deficit spending might be required and Europe should use its illusion.

However, if coronavirus causes lasting disruption to Europe’s supply capacity, there may be limits to the benefits of more borrowing. Indeed, too much deficit spending may be damaging in the long run.

Economies that locked down longest, like those reliant on tourism, fared worst and should see the largest rebounds even if that means slower future growth. But the bounce is already waning.

Europe’s exporters face Brexit in 2021 and the highly uncertain global outlook, plus spare capacity, will likely subdue business investment even if the EU’s 750bn euro recovery fund provides a boost further ahead.

So household spending is all-important. And while retail sales have rebounded, job insecurity and uncertainty means savings rates are unlikely to return to pre-pandemic levels. Higher unemployment will rise – though state support has delayed the increase – and loss of income means consumption growth will likely remain slow into 2021.

We expect Eurozone GDP to fall 7.6 per cent in 2020 and grow 5.7 per cent next year, then 2.5 per cent in 2022. But even at the end of 2022 we see GDP being more than 2 per cent below its pre-pandemic path.

COVID-19 seems to have reduced aggregate demand more than supply capacity in the near-term, so inflation is likely to remain well below both its pre-pandemic trajectory and the European Central Bank’s target. Monetary policy can thus be eased in December: we expect the Pandemic Emergency Purchase Programme to be increased by 250bn euro to 1,600bn euro and the purchase period extended to the end of 2021.

A fiscal stimulus of just over 4 per cent of GDP this year will mean record Eurozone debt-to-GDP ratios but the recovery should allow deficits to fall next year.

However, more and more deficit spending is not without risks. Borrowing to pay people to do nothing is not a sustainable strategy. And COVID-19 could prove a large supply shock as the long-term unemployed lose skills or as companies fail. By damaging aggregate supply, ever more stimulus could eventually stoke inflation.

There is also a risk that higher debt locks Europe’s economies into ever-slower growth in living standards. If the government borrows from the relatively wealthy – who tend to spend a smaller proportion of their income – growth could slow when it raises taxes or cuts spending to pay them back. Not only could this widen inequality, it could mean that deficit-spending now eventually results in slower growth and, in turn, lower interest rates and even higher debt.

The easier near-term path for Europe’s policymakers would be to use their illusion and let it take them where it may. But if debt continues to spiral and natural interest rates fall, it might eventually be best to fund spending via more active re-distribution.

First published 1 October 2020.

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