Two issues must be addressed: how the public finance gap should be funded ― in plain words, who is going to pay ― and how to prevent a confidence crisis about the integrity of the euro area.
Yet, whatever the shape of the recovery, a large hole in public finances is unavoidable. On our rough estimates, the increase of public debt in the euro area taken as a single entity is likely to lie between 10% and 35% of GDP by the end of 2023, i.e. between €1.2Tn and €4.2Tn, depending on the duration and depth of the recession and the recovery path. Most of the increase will come from automatic stabilisers such as lower tax receipts or higher expenditure on unemployment benefits, and discretionary spending to improve the efficiency and the resilience of healthcare systems. Not all euro area members will be equal since some of them will experience deeper or softer downturns. It will depend on the duration of lockdowns and their degree of restriction, and thus the overall intensity of the shock. It will also crucially hinge on their public finance starting positions, with gross public debts spanning from 49% of GDP for the Netherlands to 135% of GDP for Italy.
Therefore, two issues must be addressed: how the public finance gap should be funded ― in plain words, who is going to pay ― and how to prevent a confidence crisis about the integrity of the euro area. The latter issue had been addressed by the European Central Bank in the past, by means of the Outright Monetary Transactions (OMTs). It is a deterrent monetary policy tool designed during the euro crisis, which surrogates the missing lender-of-last-resort function of the central bank. It is an alive-and-well bazooka, which will be used if necessary. Markets have noticed.
Who is going to pay? Four solutions, in theory at least
Regarding who is going to pay, economics Nobel-prize winner Jean Tirole has well summarised the four options we have:
defaulting on debt, creditors being the payers;
asking taxpayers to foot the bill either by raising tax rates or by letting inflation do the job silently;
printing money, for instance, the European Central Bank warranting it will buy additional debt issuance in secondary markets;
mutualised borrowing, for which various mechanisms are possible.
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