Morgan Stanley
  • Thoughts on the Market
  • Aug 11, 2020

The EU Recovery Fund’s Next Phase

With Reza Moghadam


After intense negotiations, European leaders have reached a historic coronavirus recovery deal. However, the hardest challenge may lie ahead: How to spend the resources wisely.

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Current Episode Trancript

Welcome to Thoughts on the Market. I'm Reza Moghadam, chief economic adviser for Morgan Stanley. Along with my colleagues, we bring you a variety of market perspectives. Today, I'll be talking about the European recovery fund and how investors should view the road ahead. It's Tuesday, August 11th, at 4:00 p.m. in London.

After an epic four day summit last month, European Union leaders agreed on a 750 billion euro facility to aid member countries and regions hardest hit by the pandemic.

The negotiations were difficult. EU leaders fiercely debated issues such as the split between loans and grants, the allocation key for disbursing the funds among countries, and the governance process for approving and distributing the funds.

Lost in the fray, though, was a basic question: how should the money be best spent to promote long term recovery in Europe?

The EU agreement left this question largely open, except for stipulating that at least 30% of spending should go to green and digital investment. But is the EU emphasis on green investment justified given the time it takes to choose and implement green projects? And how should the rest of the money be spent?

One way to think about the problem is to recognize that the pandemic has affected various sectors differently. Contact intensive services such as tourism, transportation, restaurants, and sports have been harder hit than others. Until a reliable vaccine becomes reality, they may remain constrained due to workplace restrictions or consumer fear.

In the European Union, proximity-dependent activities account for about a quarter of EU output and a third of EU employment. In southern European countries, such as Greece, as much as 40% of GDP is affected.

During the initial lockdown phase of the pandemic, governments have had to provide life support to the constrained sectors of the economy. This is as it should be. But what about two, three, four years down the road?

The constrained versus unconstrained framework tells us that over the medium term, fiscal stimulus should increasingly target sectors where higher demand has a better chance of eliciting a supply response. Rather than across-the-board tax cuts or spending increases, it is better to target unconstrained sectors that have growth potential, such as public investment in renewables and digital infrastructure. So the EU's call for green spending by the recovery fund is macroeconomically sensible.

Of course, it would be essential to continue to provide unemployment benefits and income support for workers losing their jobs. But that is different from providing wage subsidies to constrained sectors. The problem here is safety, not price. Rather than binding workers to half-empty hotels and bars, it would be better to allocate resources to sectors with high employment potential, such as retrofitting buildings for energy efficiency; or subsidize sectors with network effects, such as battery technologies for transport.

Let me conclude by saying that the amounts being made available through the recovery fund to the southern European countries are large relative to their economies. Greece could get 25% of its GDP in the coming year; italy, Spain and Portugal-- 10 to 15%. Almost half will be in grants, the rest-- loans at rates below what the periphery pays in the market. Directing these funds to where they would have maximum growth and employment impact is a potential game changer for these economies, and so, for Europe's overall stability.

Many thought that the hardest part for the EU leaders would be to agree to the recovery fund. But that is only one step. The bigger challenge is to spend those resources wisely.

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