The Covid-19 pandemic, and the containment measures coming with it, have led to a sharp fall in GDP last year, with the ECB estimating a contraction of the Eurozone economy of 6.9%, much larger than the 4.4% contraction suffered in the immediate aftermath of the 2008 financial crisis. This had led several analysts to express fears regarding the pace and the strength of the European recovery. These are mostly due to the much smaller European fiscal stimulus, with respect to the American one, and to what has been a decade growth following the double whammy that were the 2008 crisis and the eurozone debt crisis. These fears, however legitimate, are, in my opinion, overblown due to three main factors: the nature of the crisis, the current stance of the ECB and the fiscal stimulus deployed.
The nature of the crisis
One of the main reasons many economists think that the losses in output caused by the previous recession were so persistent is that the Great Recession was sparked by what was, essentially, a banking crisis. The EU situation was slightly different than the US one, but the results were similar. Here, with the advent with the euro, massive inflows of funds coming from Northern Europe allowed an expansion of credit in Southern Europe, accompanied by an increase in government borrowing as Italian, Greek and Spanish treasuries were suddenly considered as safe as German ones. These newly issued bonds were largely gobbled up by the very institutions expanding credit, mainly national banks, in turn giving rise to the “doom loop” mechanism. Essentially, when it became clear that the Greek government credit-worthiness was dubious, contagion spread to other European nations, whose treasuries fell in value, worsening the balance sheets of banks and leading to a credit crunch that strangled the economy further. This, in turn, led to a rise in non-performing loans (NPLs), further weakening the already shaky position of European banks, increasing the implicit liabilities of the governments that were expected to bail them out and, in doing so, arising even more doubts about the ability of these countries of paying back their debts. The resulting fall in bond prices, then, just restarted the loop.
Once the eurozone crisis had been tamed by Draghi’s “Whatever it takes” speech, banks found themselves saddled with NPLs, thus becoming more cautious in extending credit especially when credit was needed. This massively delayed the recovery as families and businesses were forced to deleverage themselves and to increase savings, strangling aggregate demand. Indeed, this was entirely consistent with several studies have shown that economic crisis sparked or coupled with financial crisis lead to persistent output losses as economic actors cut back spending and investment in an effort to deleverage. This is part of the reason why the previous recession was so impactful and why some countries, notably Italy, were yet to fully recover from it when the pandemic hit.
Now, the pandemic is a much different story.
First of all, the guardrails put in place by Basel III regulations following the financial crisis had insured that banks had a capital buffer big enough to absorb relatively large losses caused by an economic shocks, thus preventing bankruptcies and a credit crunch. Indeed, quite the opposite happened. Governments all across Europe started providing hundreds of billions of euros in loan guarantees as soon as the first lockdowns were implemented. Thanks to these guarantees, banks all over Europe felt safe enough to keep extending credit to the struggling businesses forced to close because of the pandemic, thus allowing many to weather the storm (at least until now). This led to a comparatively limited reduction in credit expansion. In turn, this had the positive effect of limiting the rise in non-performing loans that would have otherwise saddled the financial system with an additional unsustainable burden and prolonged until after the crisis the full recovery of the credit system. For all these reasons, this time around we avoided the drying up of credit and prevented an even deeper scarring of the economy that would have left the financial system saddled with NPLs, thus ensuring that, when the restrictions are lifted and the vulnerable sections of the population are vaccinated, the economy will be ready