Is inflation coming back?

In 2021 the global economy is strongly rebounding after the dramatic recession caused by Covid 19. The upturn in economic activity brought attention back to a phenomenon in which there has been less interest in recent years: inflation.

Inflation is a general and sustained increase in prices, which reduces the purchasing power of a currency.[1] Recently, the US and Eurozone have experienced significant increases in their Consumer Price Indexes (CPI)[2], reaching their highest levels in more than 10 years. In October 2021, US CPI increased by 6.2%[3] year-over-year, marking the sixth consecutive month above 5%[4]. Core Inflation, a measure that excludes energy and food prices due to their greater volatility, showed an increase of 4.6% in October 2021, for the fifth consecutive month above 4%. Euro Area inflation reached +3.4% in September[5] (Core inflation +1.9%) and Eurostat preliminary estimates predict further growth in October to reach +4.1%[6].

inflation rates
Figure 1: US and Eurozone Inflation rates, 2008-2021. Source: ECB and St.Louis FED

The pandemic severely affected the global economy, World GDP fell by 3.2% in 2020[7]. Restrictions imposed to prevent the spread of Covid had a major impact on the demand for goods and services, forcing companies to reduce production. In addition, during the periods of greatest diffusion of the virus, some firms were forced to close, especially in non-essential sectors; this fact contributed to a reduction in production and, consequently, decreased their demand for raw materials and intermediate goods. In addition, the heavy drop in aggregate demand has led to lower prices in 2020 compared to 2019. Inflation is measured as the difference between the current year’s prices and the previous year’s ones: so today’s prices are higher than in the past, but they look especially elevated relative to 2020. This phenomenon is called the base effect, but only a small part of current inflation is due to it.

The extraordinary nature of pandemic crisis compared to previous economic crisis and the consequences for inflation

Normally, economic crises originate in a certain sector, for instance the financial crisis of 2008 was caused by the US housing market, and then they spread to other sectors, until they hit the whole economy. The contagion often passes through the credit market, because people affected by the crisis are unable  to repay their debts, then it reaches the financial markets and, finally, the real economy, reducing the wealth and purchasing power of families and purchasing power and pushing firms to decrease production. It takes time for these processes to occur and transform a sectoral crisis into a systemic crisis. Furthermore, in most cases, it also takes time for the economy to heal and recover. Typically, after an economic crisis people are poorer and have less money to consume, companies need time before they reach the pre-crisis production levels. For example, after the 2008 crisis it took 3 years for Germany and France to reach the pre-crisis GDP levels, 8 years for Spain and Italy has not yet been able to fully recover[8].

The economic crisis caused by Covid-19 was totally different. It was sudden and unexpected; demand fell sharply leading to the worst economic recession after WW2, but major Central Banks and governments reacted promptly with large and robust interventions, preserving favorable financing conditions even in the most difficult times. When the health situation improved, the reopening of manufacturing and the whole society, together with the availability of effective vaccines, allowed global demand to resume rapidly. At first, demand was driven by so-called “stay-at-home” goods such as technology, then advances in vaccination campaigns led to a general recovery in consumption also in the service sector and in businesses more closely linked to social life, such as restaurants and hotels. By September 2020, 6 months after the start of the pandemic, the US and the Eurozone were already in sharp recovery. Demand was already increasing for many types of goods. 1 year after the Covid spread, the US economy reached pre-crisis GDP levels  and, by the end of this year, the Euro Area is also expected to close the gap to 2019 GDP levels[9].

The rapid and sustained surge in global demand, which exceeded all expectations, has induced firms to increase their orders for raw materials and semi finished products, putting a strain on suppliers’ production capacity, which itself has been reduced by the pandemic. In addition, many manufacturing companies are importing raw materials, commodities and semi finished products from other geographical areas. The different timing of pandemic waves in different areas of the world has been another source of uncertainty and concern for global supply chains. Other factors that hampered global suppliers included port closures, container shortages during the reopening phases, and difficulties in handling such a fast restart of orders. At the beginning, companies tried to compensate for supply shortages by using inventories in their warehouses, once these were no longer sufficient to meet demand in many sectors they had to postpone orders,  an example is the automotive industry.  Reducing inventories, the firms had to still increase the demand for materials in order to restore them and this has put ulterior pressure on the supply-side and consequently on the prices, causing delays and problems in many industries.

How will we know if inflation is temporary?

For any economy to recover from a downturn, the demand and supply of goods and services need a period of adjustment. In this transitional phase, prices often rise. Economists are not concerned about temporary inflation; they are interested in whether inflation will remain high for long. The question is whether once suppliers are able to produce enough to meet all orders, prices will stabilize or, conversely, whether rising commodity and energy prices will be transmitted to the prices of all other goods. Experts monitor certain variables such as wages to see if there are signs of persistent inflation and transmission to other sectors. In fact, when workers expect prices to remain high for an extended period, they will try as soon as possible to renegotiate their contracts and increase their salaries to avoid losing purchasing power. Higher wages result in sustained increases in the cost of production of most goods and services and, obviously, to a higher inflation for a longer period. Other indicators of persistent inflation could be housing prices and rents.

Why is inflation a big concern?

Price stability is one of the main objectives of all major Central Banks[10]. The ECB and FED have the medium term goal of maintaining a level of inflation stable around 2%, on average. Persistent inflation significantly higher than the target would have negative effects on the economy. Savings in bank accounts would lose value in terms of purchasing power, debtors would have an unfair advantage over creditors in existing financing operations because the borrowed capital would be depreciated. Workers who do not have enough bargaining power to renegotiate their wages in line with inflation would be penalized by becoming poorer. Lastly, high inflation creates distorting mechanisms for household consumption and business investment, eroding the growth potential of the economy. In financial markets, rising inflation causes an increase in yields of debt securities, because any investor wishing to invest in bonds would require compensation for the risk of loss of value of the bond in real terms, expecting further growth in inflation. Indeed, rising yields reduce the market value of existing bonds and cause losses for individuals who invested their savings in the past.

Moreover, if inflation is persistently above the Central Banks’ target, they will consider raising policy rates. Policy rates set the minimum cost of credit, so the price that each bank has to pay to borrow money from Central Banks. Policy rates also determine market interest rates, because all banks will never lend money for a lower interest rate. Rather they will typically charge a premium on that, based on market risks and borrower creditworthiness. By increasing monetary policy rates, Central Banks make it more expensive for banks to borrow money and lend it to customers, generating a contraction in demand and leading to a realignment between aggregate demand and supply, at a lower level. A restrictive monetary policy that decreases demand reduces economic growth and leads to a normalization of prices. However, now we are in a situation of insufficient production and scarcity of commodities and raw materials after a recession, raising interest rates risks being an inefficient instrument that could take the economy back into recession to avoid an excessive increase in inflation. But this will not solve the shortage of productive inputs. On the other hand, inflation, by reducing the purchasing power of households and the production of companies, in any case has a negative impact on economic growth.

Currently, price increases are concentrated on raw materials, commodities and energy goods; some countries are already beginning to experience higher prices in other sectors as well, but there is no predominant view on whether current inflation is persistent or not. Governments and Central Banks will need to carefully monitor the situation, trying to take direct action to address supply chain bottlenecks that are limiting production and availability of resources. But, they will also need to be prepared to intervene more broadly and deeply as the inflation scenario clears up, working to avoid out-of-control price increases. It is crucial that Central Banks do not overreact to current inflation by raising policy rates too soon or too much. Economic recovery is closely tied to how inflation risk will be managed.

Michele Corio



[2] CPI measures the level of prices for a basket of goods and services representative of household consumption in a certain area.





[7] World Economic Outlook update July 2021




The twin transition challenges

Twin transition (green and digital) will affect the world as we know it. Will this change be beneficial for everyone? Are there risks?

An example from the recent past

Trade liberalisation over the last 30 years has impoverished some well-defined groups of the population in advanced countries. While most economists kept repeating how good it was to lower tariffs and customs barriers in order to open up to the whole world, they underestimated the impact this would have on those affected. Autorn, Dorn and Hanson – for example – analysed government aid programmes in the areas of the US most affected by trade with China. Their study indicates that even though people in the affected areas received subsidies, these were not sufficient to cover the loss of income. The authors estimate an annual loss per adult of $549, compared to government subsidies of just $58 [1], [2].  Moreover, it is clear that purely financial aid cannot really compensate for the human and psychological difficulties caused by a job loss, especially late in someone’s working life.

The situation is different in developing countries, many of which have benefited greatly from globalisation. Countries such as Mexico, China, Colombia, India and Argentina have become richer in the last 30 years. Although the proportion of the population in extreme poverty in these countries has decreased, inequality on the other hand  increased, indicating that this new wealth has not been distributed evenly. Some economists (including the two recent Nobel laureates Banerjee and Duflo) suspect a causal link between the growth of inequality in these countries and their trade liberalisation policies [3],[4]  .

However, tariffs cannot be the solution: most supply chains nowadays are international, introducing tariffs has repercussions on the cost of materials used by companies. Moreover, trying to impose an industrial strategy based on old standards has a negative effect on productivity and gross domestic product. Finally, new tariffs imply higher prices of imported goods, with a consequent negative impact on the purchasing power of citizens. [5]

International trade has helped global growth, contributing to an increase in the standard of living of many citizens in developing countries and increasing the purchasing power of those in advanced countries (especially small ones). However, one cannot overlook the suffering of those who have been personally affected by the transition from certain types of economic activity (such as steel or textile) to others (e.g. business and financial consulting). Ignoring the suffering of these people – often living in production clusters – could have been one of the causes behind the radicalisation of the electorate in the West, which led to phenomena such as Trump and Brexit.

Learning from your mistakes

Today it is important not to make the same mistake with the economic recovery packages in the advanced economies. It is vital to implement them, just as it was right to open up to trade thirty years ago. This time, however, we have to make sure that no one is left behind, or further discontent will rise. It is important to think in these terms of the twin transition – green and digital – promoted by the EU Commission. These changes are already underway and will be accelerated by the €750 billion from the Next Generation EU package. Like all revolutions, this one will bring about epochal changes that have winners and losers.

Everything below is an extract – with some additions – of page 6 of the European Policy Centre’s report “National Recovery and Resilience Plans: Empowering the green and digital transitions?”, written by Marta Pilati and available here.

While there is a common goal for these transformations – reaching a sustainable and inclusive society, economy and model of growth –, the scale of the required change is not the same for everyone involved. To be successful, the sustainable and digital transitions will require adaptations in production processes, public administration and services, education, the labour market, skill base, energy mix and infrastructure, and more. There is large heterogeneity across the EU regarding these policy fields, implying that the transformation towards the common objectives will require different, tailored efforts.

From a geographical perspective, EU regions that are less developed and/or underperform economically are also less equipped to successfully engage in the twin transitions. A

recent EPC study[6] puts forward the following conclusions:

  • The twin transitions may force some occupations to transform significantly or disappear completely. While they are expected to create new jobs, an issue arises if the jobs created and lost are not located in the same area and to the same workers. This is notably the case

for regions whose labour market is heavily reliant on energy-intensive industries (e.g. extraction and processing of fossil fuels). As large workforce mobility cannot be assumed, labour repurposing and retraining will be necessary to avoid higher localised unemployment. With this in mind the EU Commission launched the REACT-EU package[7].

  • All economic sectors will demand more (and new) skilled job profiles with more knowledge and technology intensity. Areas where the skill base is less advanced and/or there is less capacity to support in-work training will be less successful in engaging with the transitions quickly. This could result in negative effects on prosperity in the long term.
  • In order to reap the benefits of the digital transition and improved connectivity, digital infrastructure remains crucial. The ‘digital divide’ across EU regions is a cause for concern, as the lack of appropriate (digital) infrastructure can exclude entire areas from high-value

activities. It can also challenge existing activities, which might move elsewhere and therefore lead to economic decline. Similarly, it can prevent some areas from benefitting from digital public services. This is why the Commission has called for digital infrastructure to be put at the heart of recovery and resilience plans.

Copyright ©️ Bruegel 2015: European Union countries’ recovery and resilience plan
Copyright ©️ Bruegel 2015: European Union countries’ recovery and resilience plan

Social aspects must be a central focus when planning structural changes. Social cohesion will be the key determinant of the success or failure of the twin transitions. If these major transformations are perceived as leaving individuals, vulnerable groups or regions behind and/or forcing them to shoulder most of the burden, public support for these structural transitions will diminish. This would risk their overall success and thereby reduce the resilience of the EU economy. Some potential social effects of the twin transitions that are worth mentioning are listed below.

  • The impact of technological change on the labour market. For example, new forms of work linked directly to digitalisation, notably platform work, have recently emerged. Social protection systems have not always been able to adapt to these labour developments, resulting in protection gaps. [8]
  • The employment risk of automation. One in five low-income jobs is at risk of automation. This is one in six for middle-income jobs and only one in ten for high-income work[9]. Job disruption caused by automation represents a real concern of increased inequality and new instability.
  • The symbiotic relationship between social exclusion and digital exclusion. Vulnerable and socially excluded groups use the internet and technological tools less than the rest of the population, as they tend to have fewer digital skills and access. This digital exclusion also prevents them from reaping the benefits of new technologies, leading to poor educational attainment, for example. This exacerbates their social exclusion further[10].
  • Low-income groups’ vulnerability to price increases. If the ecological transition leads to higher energy or mobility prices, this will be problematic for low-income groups (at least in the short term) and affect the poor disproportionately[11].
  • The digital transition’s gender dimension. As STEM (i.e. science, technology, engineering, mathematics) skills and occupations become more important and requested in the labour market, there is a risk of women being left out of the gains and the gender gap increasing, as they tend to be less present in these areas.

Outlining these risks of inequality is by no means to undermine the need for the twin transitions. Rather, it is to ensure that the transitions are successful and just. The transitions can lead to a digital and sustainable economy and more cohesive society, as long as their benefits reach the more vulnerable. For example, digitalisation and teleworking can bring jobs and economic activities to areas where it is not physically feasible. Speeding through structural transformations without a strategy to prevent distortive effects and counterbalance costs dooms the effort to failure. There is increasing recognition that Europe’s social and territorial cohesion must be protected.

Marta Pilati

Giovanni Sgaravatti


[1] Abhijit V. Banerjee & Esther Duflo (2019), Chapter 3, “Good Economics for Hard Times”.

[2] Autorn, Dorn, Hanson, American Economic Review (2013) “The China Syndrome: Local Labor Market Effects of Import Competition in the United States”

[3] Ibid

[4] Goldberg, Pavcnik (2007), Distributional Effects of Globalization in Developing Countries, American Economic Association

[5] John K. Ferraro and Eva Van Leemput (2019) Long-Run Effects on Chinese GDP from U.S.-China Tariff Hikes, Federal Reserve

[6] Pilati, Marta and Alison Hunter (2020), EU lagging regions: state of play and future challenges“, Brussels: European Parliament.

[7] La quota del react eu dovrebbe essere diretta proprio a contenere squilibri territoriali e a supportare le aree più in difficoltà. REACT-EU – Regional Policy – European Commission

[8] Dhéret, Claire, Simona Guagliardo and Mihai Palimariciuc (2019), “The future of work: Towards a progressive agenda for all”, Brussels: European Policy Centre.

[9] OECD (2019), “Under Pressure: The Squeezed Middle Class”, Paris: OECD Publishing.

[10] Martin, Chris et al. (2016), “The role of digital exclusion in social exclusion”, CarnegieUK Trust.

[11] López Piqueres, Sofia and Sara Viitanen (2020), “On the road to sustainable mobility: How to ensure a just transition?”, Brussels: European Policy Centre.

The gender employment gap in Europe

The gender employment gap is not as hotly debated as the gender pay gap; nonetheless, it is a crucial issue for the economic recovery of the European Union (EU) and the continuation on the path of female rights embarked upon more than a century ago by the suffragettes[1].

Paid work is possibly the primary means of emancipation and plays a crucial role in defining a person, making them free to self-determine. Performing domestic and caring tasks should be a choice free of any restrictions, be they cultural, social or economic. Furthermore, the role and importance of caring for the weakest (the youth, the elderly and the disabled) should be formally recognised by society and not just informally by families.

Limiting women’s presence in the labour market means limiting talents, skills and capabilities available to the productive part of a country. A 2017 Eurofound report estimates that the economic loss due to the gender employment gap in the EU amounts to more than €370 billion [2]. The analysis also shows that there is significant heterogeneity between different European countries: for Malta, the percentage of gross domestic product (GDP) lost each year amounts to 8.2%, for Italy to 5.7% and for Greece to 5%, while at the other end of the spectrum we find Sweden and Lithuania with losses lower than 1.5% of GDP.

Eurofound (2016), The gender employment gap
Eurofound (2016), The gender employment gap: Challenges and solutions, Publications Office of the European Union, Luxembourg.

Using the latest available Eurostat data (2019), thus pre-coronavirus[2], the focus of this article is placed on the six most populous EU countries: Germany, France, Italy, Spain, Poland and Romania. The following graph highlights the problem within the EU and in these six countries. The employment rate for women is shown in green, the employment rate for men in blue. The difference in percentage points (pp) between male and female employment is shown in the dotted rectangle.

Employment gender data
Employment data by gender, age-cohort 20-64, year 2019, value % and percentage points (pp) - Source: Eurostat and author's computations

The gender employment gap is particularly evident in Poland, Romania and, above all, in Italy – where almost one in two women aged 20-64 is not employed.  The gap is also clearly visible in Spain, where the differential is nearly 12 percentage points, exceeding the EU average of 11.4 pp.

The importance of policies reducing gender employment gap

Unequal gender representation in the labour market is an expression of a long-standing patriarchal legacy. To change this it is needed a cultural shift, accompanied by reforms to tackle the gender employment gap. Let us then look at some of the policies introduced by France and Germany to boost female employment.

FR – Chèque emploi service universel: a voucher system introduced in 2006 through which domestic and childcare workers can be paid. The voucher simplifies the procedure of hiring, paying and contracting these figures, combining a tax incentive (expenses are deductible) and co-financing opportunities [3][3].

DE – Perspektive Wiedereinstieg: A support programme for women who have been out of the labour market for more than three years for family reasons. It offers professional assistance -both online and face to face- as well as training courses and tax incentives for employers [4].

FR – Complémente de libre choix du mode de garde: a financial compensation aimed at covering part of the costs of childcare for children up to six years old [5].

DE – Elterngeld: a parenting allowance to which parents are entitled if they reduce their number of working hours to less than 30 per week during the child’s first year. The funding is equivalent to the claimant’s corresponding salary if he or she had continued to work full-time. With different methodologies, also students and unemployed people can benefit as well [6].

DE – Pflegezeitgesetz und Familienpflegezeitgesetz: A legal provision allowing employees to take unpaid leave to care for immediate family members. The leave can be short – 10 days – or long – with a reduction of working hours up to a maximum of 15 per week for up to two years [7].

FR – La Charte de la Paternité en Enterprise: a charter of intents to be signed – on a voluntary basis – by companies that want to commit to the work-life balance of their employees. The aim is to guarantee more flexibility in working hours and to create an environment with an eye on employees with children, respecting the principle of non-discrimination in the career development of those with children [8].

I think it is important to highlight two recurrent elements in the policies listed above. The first is their flexibility: the burdens and benefits of companies and workers are modulated on a case-by-case basis and change as situations change. In fact, too rigid impositions may negatively influence employers, who may be inclined to prefer hiring a man rather than a woman. One example is the case of compulsory maternity leave: in France and Germany this is respectively 16 and 14 weeks, compared to 21 in Italy [9], [10]. The second element is that of inclusion: almost all the policies listed above are not aimed exclusively at women, but they rather try not to discriminate on the basis of gender. Returning to the example of maternity leave, a reduction in maternity leave in countries where it is very long should correspond to a lengthening of paternity leave. In this respect, Italy and Romania are adapting to the demands of the European Commission, reaching the European minimum standard of ten days of leave for neo fathers.

Finally, another important aspect of some of the policies listed above is that they lower the cost of childcare: this, in turn, reduces the incentive for the second earner (which often corresponds to the woman) to stay at home with the children not to incur the costs of kindergartens, summer camps and all childcare services. These policies also have a positive impact on the birth rate, an endemic problem in many European countries.

The level of education in the female employment rate

Education attainment is generally considered one of the strongest predictors of employability. This is confirmed in all six countries under review, for which a higher level of education corresponds to higher employment rates across the populations.

Below are the employment rates for women aged 20-34 by level of education, where Low indicates that the highest education attainment was that of compulsory education or less, Medium refers to a high-school diploma, and High to University or postgraduate education.

Female employment rate by education level
Female employment rate by education level, age cohort 20-34, year 2019, value % - Source: Eurostat

It is evident from the graph that a high level of education on average corresponds to a higher employment rate. This is particularly evident in Poland, where the employment rate between women with a low education level and those with a high-level changes by 60 percentage points. In Germany, on the other hand, the employment rate among those with a secondary school education (Medium) is very close to that of those with a university degree (High). This peculiarity could be attributed to the strong presence of vocational schools that prepare for the labour market already during the upper secondary education.

Promoting learning is therefore also a useful tool for closing the gender gap in the employment rate. Countries such as Romania and Italy -with a gap of more than 19 percentage points- could thus benefit from positive effects in the labour market by providing more incentives for female higher education.

It is interesting to note that, with the exception of Germany, girls tend to be more likely to complete tertiary education than boys[4].

tertiary education by gender
Share of population with tertiary education by gender, age cohort 15-64, year 2019, value % - Source: Eurostat and author's computations

Gender employment gap and the role of women in the future of the EU

The relaunch of the European Union should also pass through women and a renewed recognition of their role in society. To do so would be not only fair, but also necessary. For this reason, the European institutions have decided to tie all the funds of the multiannual budget and of the Next Generation EU destined to climate change mitigation and adaptation (a slice of 30% of the total, corresponding to about €547 billion) to projects with an eye on the gender employment gap. Thus setting the direction for the future: a transition towards environmental sustainability free from gender discriminations [12].

Despite the EU’s clear stance, some expected more: Alexandra Geese, MEP for the Greens/EFA, launched a petition asking that the funds allocated to digitalisation should also focus on women and their rights in the labour market. This would bring half of the Next Generation EU package’s total expenditure to projects attentive to the gender employment gap. The proposal may seem disproportionate, but given the extent of gender inequality in the labour market perhaps it is not so disproportionate after all.

 Giovanni Sgaravatti


[1]  Women’s emancipation movements and demands for the right to vote appeared all over the world in the late 1800s and early 1900s, although immediately after the French Revolution (in 1791) Olympe de Gouges wrote the Declaration of the Rights of Women and Citizens, in which she declared political and social equality between men and women. [1]

[2] Recent studies indicate that the employment gap in some developed countries will widen after the crisis. This is because the woman is more often the partner with the lowest income, who therefore decides to give up work to look after children during school closures. Moreover, in some countries women’s employment is higher in the most affected sectors, such as retail and catering [4], [5].

[3]  A similar instrument also exists in Italy, but unfortunately it does not seem to be bearing the desired results [3b].

[4] The phenomenon is also present in Germany in the younger population: those between 20 and 34 years of age.


[1] Dai primitivi al post-moderno: tre percorsi di saggi storico-antropologici, di Vittorio Lanternari, Liguori Editore, 351

[2] Eurofound: The gender employment gap: Challenges and solutions, Luxembourg 2016, Publications Office of the European Union.

[3] Le Cesu, qu’est-ce que c’est

[3b] Prestazioni di lavoro occasionale: libretto famiglia

[4] Perspektive Wiedereinstieg: Startseite


[6]Elterngeld und ElterngeldPlus



[9] COVID-19 and the gender gap in advanced economies | VOX, CEPR Policy Portal

[10] Il 98% di chi ha perso il lavoro è donna, il Covid è anche una questione di genere 

[10b]  (Occupati e disoccupati (dati provvisori)

[11] File:Total fertility rate, 1960–2018 (live births per woman).png – Statistics Explained

[12] The 2021-2027 EU budget – What’s new? | European Commission

The ESM Treaty Reform

In December 2018, the European Council launched a project for the ESM reform. The ESM (European Stability Mechanism) reform aims to increase its functions. The ESM will have an important role in pursuing a greater economic convergence among Member States to increase their competitiveness. Moreover, it will be involved in the framework of the European banking union.
The debate between the governments of EU countries on the reform lasted for years, mainly because of Italy’s veto from December 2019. Finally, an agreement was found and the Italian parliament gave the green light to the reform on 9 December 2020.

A lot of misleading news has circulated about the ESM reform. Some said that it would allow German banks to recapitalise with money from other European countries, or that it would force Italy and other countries to restructure their debt.  None of these statements is true. Moreover, this reform does not change anything about the ESM pandemic crisis support for health care spending during the pandemic.

ESM memes
ESM memes

Actually, the ESM reform concerns:[1]

  • A new role for the ESM as lender of last resort (Backstop mechanism) to the European banking Single Resolution Fund (SRF) in case of a banking crisis. The SRF is still under construction, it should be completed within 2024 and should have an endowment of about 55 billion: 1% of credit institutions’ protected deposits in the banking union. The fund will be directly financed by the banking sector and will intervene in the resolution of failing banks, if there are still creditors left to pay, after all other options have been exhausted (bail-in). (See the article Banking Union: A Step For More Stability for more information)

In the future, if the Single Resolution Fund is called to intervene in a banking crisis and its capital endowment is not sufficient to cover the needs, the SRF will be able to borrow money from the ESM.

The ESM will have up to 68 billion euro available to finance the SRF and these loans to the SRF will have to be repaid at most within 5 years.

The interventions of EU institutions through the SRF and, when necessary, the ESM in a banking crisis seek to avoid that the failure of a bank endangers the entire European banking system. They represent a European risk management tool, created with the objective of protecting all the EU countries from financial crises. They do not favour one state at the expense of another.

  • Changes to the monitoring roles of the EU institutions in case of ESM intervention in support of a state. The European Commission will be mainly responsible for monitoring the consistency of the economic policy measures implemented by the State and for assessing the sustainability of the debt and the macroeconomic framework in general.

The ESM, on the other hand, will monitor the capacity of member countries to finance themselves on the market and potential risks. It will also assess, during the intervention period, the risk that the assisted country will not be able to repay the loans received.[2]

  • Simplification of the requirements to access the Precautionary Credit Lines (PCCL). A State applying for support from the ESM through the Precautionary Credit Lines and fulfilling all the requirements will no longer need to sign a Memorandum of Understanding with the EU Commission and the European Council. It will suffice a letter of intent from the state, expressing its commitment to maintain the economic conditions that allowed it to access the credit line without enhanced conditionality during the ESM intervention period and in the future.
  • Changes to the Collective Action Clauses (CACs). CACs are clauses that allow a decision on a debt restructuring to be approved by a qualified majority of creditors. The debt restructuring is a modification of the initial conditions of a loan (interest rate, maturity, principal, etc.) that softens the debtor’s condition, increasing the probability that the loan is at least partially reimbursed. The reform establishes single limb CACs, clauses with single majority approval. So, it will be possible to approve a decision on debt restructuring with a single resolution of debt holders for all series of a given security, without the need to vote for each individual series issued.

However, this does not mean that the ESM reform imposes debt restructuring on member states as a condition for financial assistance. Debt restructuring is a rare and extreme event, usually carried out by countries close to bankruptcy. A decision to restructure even a portion of a country’s public debt would have dramatic effects on all public debt issues of the country. It would greatly increase the riskiness of the debt and, thus, the interest charged by investors (cost of debt), causing the market value of the securities to plummet.

The ECB holds a large share of Italian government debt, a large share is also held by banks, insurance companies and other financial institutions. Dramatically devaluing these government bonds would generate a crisis for the entire European Union, exactly the opposite of the objective for which the ESM was established. [3]

This amendment was introduced to improve the decision-making process in the case of restructuring by reducing uncertainty about the modalities and timing, not to make it more likely. In case restructuring becomes unavoidable, the absence of a clear and defined procedure may further increase the costs for all parties involved.

Michele Corio


[2] especially section “What will be the ESM’s new tasks in future financial assistance programmes?”


The ESM Programmes

Nowadays, the European Stability Mechanism (ESM) can lend up to 410 billion[1] to the Eurozone countries in financial difficulty via different case-specific ESM programmes. These resources are borrowed, issuing debt on the market, using as a guarantee of the ESM solidity its own capital (704 billion). The ESM can support the countries in different manners:

  • ESM programmes with loans in support of macroeconomic adjustment:

The Euro Area countries that need support to finance their public spending , because they are in financial distress or they can’t finance themselves directly on the market, can request financial assistance to the ESM. As a condition for the intervention, the ESM requires the state to implement certain reforms, established considering its specific situation. For example, these may concern reducing the public spending, strengthening the banking sector, adopting measures that improve the competitiveness of the country, increase its economic solidity and allow the state to return to economic growth in the following years. The reforms are established jointly with the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF), if the latter is also involved in the support programme. All the measures are reported in the so-called Memorandum of Understanding (MoU). The main objective is to restore the financial situation of the state to allow it to repay the previous debts and to be able to finance autonomously on the markets again.

The contribution of external and supranational institutions to the economic planning of the country in difficulty is often perceived negatively  by the public opinion. It is seen as a commissioner or, even worse, as an expropriation by foreign countries. Moreover, these reforms have been frequently criticized, because austerity and reduction of public spending in phases of economic contraction could exacerbate the recession, instead of solving it. However, past interventions of ESM programmes had always a positive impact on the country that has requested assistance. Even though they required numerous sacrifices, the reforms established with the European institutions contributed to a reduction of the inefficiencies in the public spending, relaunching the competitiveness of the national economy and its growth and impacted positively also on the labour market.

graph of GDP per capita trend

Figure 1: GDP per capita time series of countries whose  economies have suffered more during the sovereign debt crisis. Spain, Cyprus and Portugal requested the ESM assistance and realized a programme of reforms agreed with the European institutions. After some years of recession, their economy has returned to sustained growth. Italy did not join ESM programmes, but its recovery from the recession was slow and weak. Greece suffered a dramatic economic crisis. The country joined several support programmes of the IMF and the EU. Greek GDP diminished by around 30 percent between 2008 and 2016. However, recently, positive signs have emerged. The economy has started to recover and the country has been able to finance autonomously on the market again after a long time.[2]

unemployment rate trend europe

Figure 2: Unemployment rate of Greece, Spain, Italy, Cyprus and  Portugal from 2010 and 2019.[3]

Participating in the reform planning, the ESM and the other European institutions assure the other Euro Area countries that the resources lent are actually used to solve the vulnerabilities. Furthermore, the presence of conditionalities guarantees also to the ESM creditors that the institution employs the capital safely and will not have problems, in the future, to pay back its debts. Thanks to this mechanism, the ESM can finance itself at very low rates and lend to the countries in difficulty for lower rates than any other investor would offer them in the markets.     


savings ESM

Figure 3: Savings generated accessing the ESM programmes instead of financing directly on the markets. Source:

In addition, the repayment period for the capital of the loans starts only after many years. For example, Cyprus will start to pay back the capital of the ESM loans received in 2012 only in 2025. So far the country paid only a yearly amount of interest.[4]

The ESM can intervene providing loans to the States in crisis to finance their reforms and improve their economic situation, providing resources to recapitalize banks and other financial institutions or, even, purchasing government debt securities on the markets. Generally, the ESM loans have a higher seniority than the normal issuances of public debt. This means that the borrowing state will be responsible for repaying the ESM first and then the other creditors. This can contribute to increasing the cost for the state in difficulty to finance itself in the market. Indeed, the other investors will be more exposed to the risk of not receiving back the money lent, especially if the ESM loans are very large. However, countries that require substantial resources from ESM programmes have probably already lost the possibility to finance themselves on the market, because they are no longer able to find investors willing to purchase such risky debt or because the state is unable to pay the price these investors require to bear that risk. The negative impact of seniority may be softened by the fact that ESM loans have very long maturities.

For countries that can still finance themselves on the market, it is important to remember that the European Central Bank (ECB) can purchase debt securities of a Eurozone country, but only up to a maximum amount.[5] ECB purchases contribute to reduce the cost of debt for the recipient country. Moreover, in situation of extreme financial instability, a state that has requested assistance from the ESM through a macroeconomic adjustment program or a precautionary credit line with reinforced conditionality (see below), and has already signed the Memorandum of Understanding, can benefit from the Outright monetary transactions of the ECB (better known as OMT). [6]OMT allows the ECB to buy short term government bonds (1-3 years) of the state in the secondary market to prevent an excessive rise in yield rates, due to market tensions. By intervening with the OMT, the ECB has no constraints on the amount of securities that can be purchased. The ECB will also waive its right to a higher seniority than other creditors in order to avoid the negative consequences explained above.

Financing part of the needs with ESM programmes can really help a State in difficulty, because it can issue a smaller quantity of debt on the market, benefiting from the low rates and long maturities of the ESM and also from the effect on the cost of debt given by the intervention of the ECB, for the portion issued on the markets.[7]

Polandball comic on the news that the German Constitutional Court will rule on whether the European Stability Mechanism breaches the German constitution (2012)
  • Precautionary credit lines:[8]

Among other ESM programmes, there is the precautionary financial assistance.

A Eurozone state which has an overall sound economic situation, but finds itself temporarily in financial difficulty, or feels it must intervene preventively in order to be able to continue to finance itself on the markets, can apply for access to the precautionary credit lines of the ESM. Precautionary credit lines are shorter duration programmes which last at most two years. Their objective is to protect the States during a period of higher market tension, allowing them to finance their spending for low rates, without the need for deeper interventions. If the State that requested the ESM financing has a sustainable public debt – that is a deficit-GDP ratio below 3% in the last two years and a debt-GDP ratio below 60% (or it is already following a plan agreed with the EU institutions to restore its public finances)[9]– and its banking system does not have problems of solidity that could affect the Euro Area banking system stability then the country is entitled to access the Precautionary Conditional Credit Line (PCCL). The ESM will provide financial support and the state will undertake to plan the necessary measures together with the European institutions, signing a Memorandum of Understanding, to overcome the phase of difficulty.

On the other hand, if the global macroeconomic framework of the state is substantially good, but there are significant imbalances in at least one of the aspects being assessed (public debt, stability of the banking and credit system, etc.), then the country can only access the precautionary credit line with enhanced conditionalities (ECCL). In this scenario, the European Council, the Commission and the ECB, together with the country, establish a detailed corrective plan to overcome the critical points. In addition, the EU institutions initiate periodic surveillance to monitor the risks related to the country’s public debt and financial sector, considering also the possible impacts on other eurozone countries.

The ESM has often been criticised. Many people consider it as a symbol of poor European solidarity. Mainly because its aid programmes to countries in difficulty are loans subject to numerous conditionalities and not subsidies. Unfortunately, conditionalities are difficult to avoid in the absence of greater European integration and major steps forward in the unitary project. The intervention of EU institutions for national economic planning and reforms is seen as a loss of sovereignty, but in the past it has had a positive impact on the economies of the assisted countries. It should not be forgotten that the situations in which the ESM was activated were often particularly critical and could not be overcome by ordinary interventions. In order to have a stronger and more lasting union, it is essential to avoid mechanisms that incentivise some countries to get into debt and use resources that they could not afford in fruitless expenditure, only because they are convinced that, in the end, other European countries will settle the bill for them. Solidarity between EU member States is essential, especially in times of difficulty, but it must be remembered that other States also finance themselves on the markets or through taxes. It is not easy to determine to what extent it is fair to ask a citizen of another country to go into debt or pay more taxes to support another indebted country.

On 15 May 2020, after intense negotiations in the various European institutions, the ESM board of governors established a special temporary credit line to support the healthcare spending of Euro Area States during the covid-19 crisis.

  • ESM Pandemic crisis support:[10]

The pandemic crisis support is a credit line available for all the countries participating in the ESM. Each state can borrow up to 2% of its 2019 GDP for a cost lower than the ordinary precautionary credit lines.

resources for pandemic crisis ESM

Figure 4: Amount of resources that each country could borrow activating the ESM Pandemic crisis support.

These resources will be available until 2022, with the unique conditionality that the credit line must be used to finance the spending related to the sanitary crisis. The ESM disburses the health financing within 12 months of the request and the loan will have a maximum duration of 10 years. Moreover, this assistance is not only available in the form of a loan, the resources of the pandemic credit line can also simply be used as collateral to raise finance on the market at lower costs[11]. Once the ESM intervention has been requested, the state and the European Commission will have to draw up a pandemic response plan, setting out the measures and expenditure that will be financed with the allocated resources. The commission will also monitor the state’s intervention and its economic situation during the life of the loan. Due to the specific conditions of access, the pandemic credit line will only be beneficial for an applicant state if it has a strategic plan to address the weaknesses of its health system or to better address the health emergency. [12] This is especially true since the use and management of the funds is supervised by the European Commission. Convenience will also depend, as usual, on the cost for the state to finance itself on the market. If the market offers similar or lower rates, there will be little point in asking the help of ESM programmes to get resources.

ESM lending rate comparison

Figure 5: 10 years Euro Area government bond yields compared with the ESM lending rate.

Michele Corio

[1] The overall amount that the ESM can lend is equal to 500 billion considering also the resources already deployed. These resources are borrowed by the ESM on the markets to finance its programmes. As explained in the article “ESM for dummies” (link), the 410 billion (or 500) are not part of the capital contributed by the States (700 billion).




[5]  ECB can purchase government bonds of the Eurozone countries in proportion to each national central bank’s share of the ECB’s capital (Capital key). However, the Pandemic Emergency Purchase Programme (PEPP) allows the ECB to have more flexibility in the purchases concerning the capital key.

[6] The OMT is an extraordinary instrument that gives the ECB the right to intervene to preserve the financial and economic stability of a country – and the whole Euro Area –  purchasing its debt securities on the secondary market without any limitation on the amount. This tool was introduced after the famous speech of Mario Draghi (“whatever it takes”) in London in July 2012. Luckily, so far it has never been necessary to use the OMT.



[9] These rules have been suspended during the pandemic and they might be modified after the sanitary crisis.




what is the ESM?

The European Stability Mechanism (ESM) is a financial institution founded by the Euro area countries in 2012, during the sovereign debts crisis. Its objective is to support the member States, ensuring them financial assistance in hardships, when they can’t finance themselves on the markets or the cost of issuing debt is unsustainable[1]. Nowadays, 19 countries contribute to the ESM.

To provide assistance to the Eurozone States in case of need, the ESM does not draw financial resources from the taxpayers. It raises funds directly from the markets, issuing debt securities. Its creditworthiness is proven by its own capital endowment, which is jointly guaranteed by the 19 States. Establishing the ESM, the member States have decided to commit a capital of 704 billion for it, a share of approximately 80 billion euro was paid directly and the remaining of 624 billion was subscribed by each State and it is callable by the ESM, if needed[2]. Normally, the callable part of the capital serves only as an additional guarantee for the lenders and testifies both the solidity of the ESM and the commitment of the countries. The actual contribution of these resources could be requested only in extremely serious situations. At this point, it is crucial to have clear in mind that the ESM finances the countries with resources borrowed from the markets and not using the capital contributed by the States.

graph contribution mes per country

Every country contributes to a share of the capital, determined considering its population and its GDP. Figure 1 shows the percentage of the capital provided by each country. The fact that its capital is financed and guaranteed by all the Eurozone countries makes it extremely safe to lend money to the ESM. For this reason, it currently issues securities with a triple A rating, the highest in the rating scale (for more information see the article What Is The Role Of Credit Rating Agencies In The Economy?).

 Moreover, its financial strength allows the ESM to borrow at a lower price than any State in financial difficulties. [3]The cost of debt does not depend only on the borrower’s creditworthiness, but it is linked also to the duration of the loan. A three-year fixed-rate loan costs less than a 10-year loan with the same counterparties and conditions. Indeed, in a longer period of time, one or more fundamental variables of the financing, such as the market conditions or the stability of the debtor, are more likely to change and this could negatively affect the lender. Therefore, the lender requires a higher remuneration to bear the additional amount of risk given by the higher uncertainty.

To minimize the cost of funding, the ESM finances with short term loans, exploiting its large liquidity. This facilitates cheap lending to the Euro area countries in hardship. In addition, to make sure that the supported State has the time to recover, the loans distributed by the ESM have longer maturities than any other financing that the State could obtain directly on the markets[4].

The decisions on conceding financial support and on eventual additional contribution to the capital are taken by the Council of Governor of the ESM. The Council is a decision-making body composed of the ministers of finance of every member state. The individual ministers do not have the same voting power. The weight of every vote depends on the share of the capital owned by each state. This system allows the States that bear more risk to have a bigger impact on decisions too.[5]


The European Union is incomplete. Its member States have a large exchange of resources, goods and capitals, and they share a part of their economic and financial risks too. Some of them have a deeper cooperation and use the same currency, however it does not exist any sort of fiscal union yet. Decisions on the taxation systems, economic policies of any individual country  and other economic interventions are taken at national level. Even if there is coordination at European level on these issues and a set of common rules, there is nothing like a European Ministry of Finance. This absence is even more significant in times of crisis, when rapid and joint reactions can avoid major problems. Thus, the ESM was created as a defensive instrument to increase the power of intervention of the EU. However, this instrument is still far from being perfect. Long and hard negotiations have been necessary before reaching an agreement on its foundation. The main concern was preventing some countries from increasing their debt more than they could actually sustain only with their own public finances, just because they felt safe relying on the financial commitment of the other European partners. To avoid this misbehaviour, the ESM adopted precautionary and strict rules of intervention. The rules of intervention and the conditionalities attached to ESM programmes varies according to the type of support needed by the State in every specific case. We will deepen the analysis on the conditionalities directly analyzing the programmes of intervention of the ESM in a specific article (The ESM Programmes).

Therefore, the ESM has been created for sure to support the Euro Area countries during a financial crisis, but its role is also to defend the other Member States that are not directly affected  from a possible contagion effect.
Hopefully the severe rules and conditionalities will be reduced in the future, increasing the solidarity among the States. However, this will be possible only proceeding on the path of European integration, because the unique way to reduce conditionalities is increasing the trust among Eurozone countries and to achieve it a major coordination is needed.




[4] Maturity transformation.

[5] (Chapter 2 article 4)

An alternative fiscal model

In many OECD[1] countries the fiscal system is founded on the criterium of progressiveness. For example, the Italian Constitution introduces such concern in the 53rd article. Instead, in the U.S. progressiveness is established in the 1st article of Section 9. Progressive taxation is a system in which the tax rate increases along the tax base. This principle has been discussed and criticized by the most liberal political parties all over the world. However, criticizing progressiveness is not the objective of this article. Fiscal imposition is, undoubtedly, a fundamental instrument to reach a more equal distribution of wealth. It is even more important its role in guaranteeing crucial resources to provide some essential public goods, such as education. I just want to point out that the majority of taxes, proportional or progressive, create distortions in individuals’ behaviours. To apply the principle of progressiveness, income tax is the most suitable instrument. In other types of taxes it is more difficult to implement such a criterion. Imagine how difficult could be the application of different rates per person in the consumption taxes. How could you levy different rates on the same product, let’s say milk, to people belonging to different income classes? There, the progressiveness criterion is pursued by differentiating products by individuals’ needs, levying different rates for commodities and so on.

The main drawbacks which could arise with taxes are :

  1. Labor supply disincentives: i.e., people prefer to work less to avoid paying additional taxes.
  2. Tax evasion, often related to the underground economy’s problems.


To understand if a fiscal system is progressive there are several methods. The easiest one is probably the evaluation of the average fiscal rate, which should increase as the taxable amount increases. How does it work? For each additional unit of income,  the amount of taxes paid on that unit increases more than proportionally. For example, consider two individuals A and B. A has an income of €1,000 taxed with a rate of 25%. If B earns €2,000, he should be taxed with a larger rate, let’s say the 30%.
 In Italy the average fiscal pressure reaches 45% by the highest income classes. Also, many other countries have similar problems. As claimed before, in these cases people are discouraged to work and increase their income. Alternatively, they are incentivized to evade, in order to avoid the higher rates and ensure that the additional hours of work produce also an increase in their net income. The average rate is, then, a necessary measure of progressiveness of a fiscal system. It is possible to calculate it as the ratio of the total sum of taxes paid over the taxable income earned.


Here, I want to introduce a fiscal model that could reduce the negative consequences pointed out so far, respecting also progressiveness. The major contribution to this model was given by the economist and Nobel prize James Mirrlees:  the optimal taxation model with decreasing rates.[2] I want to explain it with a heuristic procedure, directly giving a practical example. This model is presented in a basic form and it is not directly applicable to any actual fiscal system.

There are three individuals, Bobby Charlie and Denny, who earn different incomes. In particular, Bobby earns €500 monthly, Charlie €5,000 and Denny €10,000. In this simple society the minimum income to conduct an adequate and sustainable lifestyle is assumed to be equal to €1,200. Bobby clearly does not reach the minimum standard, so instead of paying taxes he needs some help. The support could consist of a total exemption for taxes or negative taxes, i.e. subsidies, in order to allow him to reach the minimum income level. Such policies are currently used in several countries. For the other individuals decreasing marginal rates are applied every €2,000 exceeding the minimum income. The starting marginal rate could be equal to 23% and it should not be lower than a certain threshold, let’s say 19%. In order to be strictly progressive, the marginal rates[3] cannot decrease to infinity.  The choice of the minimum income level as well as the different income classes subjected to each rate are completely arbitrary. It is crucial to define a minimum standard of living and some welfare policies. Therefore, even if the marginal rates are decreasing, the average fiscal rates for each class of individuals is still strictly increasing. The criterium of progressiveness still holds. Who earns more pays, proportionally to his/her income, more taxes.

Don’t you believe it? Get a calculator and I’ll show you some number:

  • Bobby earns €500 per month. He will be completely exempted and he will receive €700 to reach the minimum standard.
  • Charlie earns €5,000 per month. On the first €1,200 he will not pay anything. The taxable income is reduced then to €3,800. So, he will pay an amount equal to 23% of the first €2,000 (€460) plus an amount equal to 22% of the remaining €1,800 (€396). The total amount of taxes paid by Charlie is  equal to €856. Then, the average rate is equal to 17.12% (€856/€5,000).
  • The same scheme will be applied for Denny. He will be exempted for the first €1,200 and a decreasing rate will be applied every €2,000 above the minimum standard. In particular, he will be taxed with a rate equal to 23% on his first €2,000 (€460), on the following €2,000 with a rate of 22% (440) and so on. The remaining taxable €800 will be taxed with a rate equal to 19% (€152). The total amount of taxes paid by Denny will be equal to €1,872 . Compared to his taxable income, it results in an average fiscal rate equal to 18.72%.

Therefore, it is easy to notice how this system, even if it is built with decreasing marginal rates, follows a criterium of progressiveness. Denny pays more taxes on average than Charlie. This system has many advantages. In my opinion, the most important is that taxpayers are not discouraged to increase their income, or at least they are not discouraged to file for taxes. On the contrary, they are motivated to produce more, to earn more and to contribute more to the economic growth, with the extension of the fiscal base. Indeed, the marginal cost for each euro earned is gradually decreasing. One could point out that the poorest individuals are not incentivized to work, preferring to rely on subsidies. However, before any practical implementation, this fiscal system should also include a mechanism that balances the substitution between subsidies and minimal wages, such that the poorest are motivated to supply labor. A big parenthesis could be opened on this issue, but this is not the purpose of this article. I just remind you that the choice of the minimum threshold is purely casual. For some countries it could be too high, for others too low. To sum up, subsidies are conceived for needy individuals, not for those who want to settle only with them. This model was studied for those individuals who could be discouraged to earn more money, afraid of facing increasing marginal costs, compared to leisure, ceteris paribus.

written by Giovanni La Rosa

[1] OECD is an intergovernmental economic organization with 37 member countries that share the democratic system and the market economy.

[2] Mirrlees, James A., (1971).  “An Exploration in the Theory of Optimal Income Taxation”, Review of Economic Studies 38, 175-208.,

[3] The term marginal rate refers to the percentage of the latest euro of income ( or class of income) that must be paid as taxes.

What is the role of credit rating agencies in the economy?

Gianlorenzo Zeccolella

Gianlorenzo Zeccolella

The current financial situation reserves an exceptional role for credit rating agencies, which may actively influence and, eventually, undermine the financial market stability. 

Both in the European Union and in the United States, the number of credit rating agencies is very circumscribed. There are just a few companies that operate in this business with no competition. Moody’s, Standard & Poor’s and Fitch Group, the so-called “Big Three”, hold around 92% of market share[1]. Their role is to assign a credit rating, an essential indicator to gauge both countries’ and companies’ soundness. Ratings contribute to determining the possibility to access new national and international capital resources. 

Ratings as measures of creditworthiness

Several international companies, before issuing a bond, ask the rating agencies to assess the financial instruments and assign a rating (often obliged by legislation), which consequently authorizes the allocation on the market. Moreover, not all the investors assess on their own the credit quality of companies and countries, before investing. Many of them directly rely on the evaluation provided by credit rating agencies.

The higher is the credit quality, the higher will be the rating. Together with the lower cost of capital, a high rating guarantees more accessibility to external debt[2]. The scale goes from AAA the best grade, to D, meaning Default (the scale is slightly different for Moody’s. See the table below). Companies rated at BBB- or higher are in the investment-grade area, while the ones with ratings below the BBB- threshold are in the speculative-grade zone (also defined “junk” or non-investment).

Moody’sStandard & Poor’sFitchDescription
AaaAAAAAAInvestment Grade
Ba1BB+BB+Speculative Grade

Ratings as risk indicators

The other side that can be captured using ratings is the risk involved in an investment. It is straightforward to understand that a debt issuer – generally a State or a company – with a high credit quality and a high rating will be a safer investment than another with a speculative grade rating. 

Institutional investors, such as pension funds, mutual funds and banks have different restrictions on the amount of risk they can (and they are willing to) bear.

This is partially due to regulation. Savers are investing their money in a pension fund to ensure the possibility to live respectably after retirement, without any interest in being exposed to speculative assets. Also, the investment strategy matters. Indeed, every portfolio is built pursuing certain objectives. In finance, expressed in terms of expected returns and risk. Investors, choosing to use their money to buy financial instruments instead of consuming, should receive an appropriate remuneration, proportional to the level of risk they are bearing. However, most of them would not accept the risk of losing a big portion of their capital chasing unrealistic high returns. For this reason, most of the investors will not be willing to invest a great share of their money in low rating government or corporate bonds. 

The importance of credit ratings for States

When a State is downgraded the impact on its cost of borrowing can be very significant, especially if its previous ratings were already low. Going from the lowest scores of investment grade to speculative grades can cause the exclusion from the main government bond indexes and, thus, from the portfolios of many institutional investors. This generates not only a dramatic increase of the cost of borrowing money on the markets but it can seriously reduce the capacity for that issuer to finance additional spending with debt. Today, according to Moody’s and Fitch, Italy is just one notch above the junk area and the covid crisis risks to compromising its creditworthiness.

CountryS&P’sMoody’sFitch10 years government bond yield
United StatesAA+AaaAAA1.12%
United KingdomAAAa3AA-0.29%
New ZealandAAAaaAA1.07%
South KoreaAAAa2AA-1.72%
ArgentinaCCC+CaCCC51.23% (7 years maturity )

Looking at the ratings and the yields on government bonds reported in the table above, it is noticeable that also other factors affect the bond yield. Indeed Italy has similar ratings to Russia, but a much lower cost of debt.

The intervention of the European Central Bank (ECB) has certainly played a crucial role in maintaining low the yield on European countries’ bonds, especially for Italy. ECB implements its monetary policies through different channels. Among them it is worthwhile to mention the Open Market Operations and the Asset Purchase Programmes (APP)[3]. These allow the ECB to provide liquidity at a very low cost to financial institutions and banks of the Eurosystem, in exchange for this liquidity the banks provide a collateral, which can be for example a government bond. Through these instruments, the ECB receives government bonds of the EU countries, relieving the pressure on the countries yield rate. However, government bonds have to meet certain requirements to be eligible to be used as collaterals[4]. One of them is being at least in the investment grade area. Otherwise, in the worst scenario, the ECB would not be anymore allowed to hold and  buy such government bonds. On 7 April 2020, to reduce the possible damages of a downgrade during the covid crisis, the ECB decided to adopt temporary collateral easing measures. Nowadays, all the marketable assets and issuers, which had at least the lower investment grade until 7 April 2020, remain eligible even in case of further downgrades (up to two notches lower)[5]. However, the fact that collateral eligibility for central banks’ purchasing programmes are tied to ratings show the relevance and the weight of these institutions in the financial markets.


Credit rating determinants and the main concerns

CRAs assign ratings considering various determinants of the debtor: 

  1. Ability to pay–back the borrowed amount. It includes the principal plus the accrued interests; 
  2. Ability to do it on time; 
  3. Likelihood that the obligor may not pay because of default.

Once analyzed these three broad categories, analysts can attribute a rating that determines the company’s creditworthiness.

Recently, the most important credit rating agencies have acquired greater importance on the capital and financial markets, becoming a target for several critiques. The biggest and most prominent credit rating agencies, namely Standard and Poor’s, Moody’s, and Fitch currently have a massive impact on the capital and financial market. Their assessment of a company’s financial quality represents a fundamental component in determining the pricing of credit risk, which in turn denotes the cost of both internal and external resources. 

However, the debated topic is whether those agencies may have some incentives to assign inflated ratings. The problem springs since agencies are not paid by investors but by the same companies that ask for the credit quality assessment (obligors). The borrower, who pays the agency, is interested in high ratings, which would guarantee stability (to keep the cost of external debt low). It is not complicated to understand that in this scenario, some interests are conflicting. The company that needs the assessments pays the agency that would probably be more motivated to give a high rating.

Structured products, such as Mortgage Backed Securities (MBS)[6], have always been more frequently placed on the market for several years, especially in the United States. Default rates were much more significant than what their intrinsic value was suggesting. Decomposing these structured products would have given assets with awful shapes but with an overall high rating. For this purpose, agencies have been blamed for assigning inflated credit ratings. All these inefficiencies played a critical role in the subprime crisis in 2008.

Furthermore, the insurmountable entry barriers are another crucial issue. The market of credit rating agencies is wholly dominated by three companies, characterizing it as an oligopolistic system. The leading firms may decide to cooperate and create a cartel that would increase the prices and discourage new entrants. Besides, CRAs may offer inflated ratings. In this case, it would be tough for regulators and supervisors to detect whether common shocks or collusive strategies drive extreme assessments.

What can be done to improve the situation?

It is fundamental to create a scheme of incentives where firms are motivated to deviate from such collusive synergies. An idea could be to establish a public rating department in the main global institutions – such as the International Monetary Fund or the Central Banks –  that can assess the companies’ credit quality. Their outcome must be compared with the agencies’ results to notice possible differences. If there are large differences (unfair assessments) not driven by fundamental motivations, the regulators may refuse to grant the license to operate in the credit rating sector in the future period. This action may sound unrealistic. Indeed, even in case of weird and unfair behaviors, rejecting the permission to Moody’s, Standard & Poor’s or Fitch seems improbable due to their market power[7].

Notwithstanding, the conclusions drawn on some undesired qualities and drawbacks of ratings do not have to distract us from the importance of them. Indeed, credit ratings offer a great informational substance that, if not subjected to bias, might be very useful for investor’s decisions. 

Michele Corio and Gianlorenzo Zeccolella

Sources and references


[2] debt held by foreign banks




[6]Financial instrument secured by a mortgage or collection of mortgages.

[7] Stolper, A., 2009. Regulation of credit rating agencies. Journal of Banking & Finance 33, 1266–1273.

EU needs a joint reaction against the covid crisis

The covid-19 pandemic hit Europe violently. The new coronavirus, which infected the first human in the Chinese region of Hubei, is changing our lives, subverting the political and economic framework. In the initial phase, the response of the European countries was scarcely coordinated and, often, late. The impact of the virus has been particularly severe in the economically most developed regions: Lombardy, Emilia-Romagna and Veneto in Italy; the Community of Madrid and Catalonia in Spain; the region of Paris, Ile de France; Bavaria, North Rhine Westphalia and Baden Württemberg in Germany; the Stockholm’s county in Sweden; Flanders in Belgium. Inevitably, the deep integration among the economies of the various EU countries was also an efficient vehicle of transmission for the virus. In absence of a joint strategy for the reopening, at European level, the risk of new spreading of the infections through these paths will be even higher in the next weeks.


Here you can see the diffusion of the virus on the interactive map


The most affected countries, Italy and Spain, have adopted very strict measures. They allowed to continue to carry out the production only to the companies producing essential goods and services or involved in strategic activities for the management of the crisis. On the other hand, the majority of EU countries chose a softer lockdown, closing commercial business in contact with the public, leaving most of the production companies open[1]. However, these restrictions, necessary to reduce the sanitary emergency, risk to undermine the European economy. The dimension of the crisis will diverge country by country. Indeed, the strictness of the measures, the direct and indirect damages of the epidemic and the financial capacity of each country to support its economy will make the difference. A precise and punctual intervention from the State is needed, providing the required liquidity to make it through the crisis.


The necessity to finance the spending with debt and its critical issues.


The main sources of financing for a State are taxation and the issuance of bonds on the markets. In the midst of a pandemic, a short-term increase in taxation is not a sustainable tool. The objective is to safeguard firms and to keep the productive and economic system alive. Instead, it is inevitable to increase the public debt to reduce the impact that an announced economic recession will have on every citizen’s life. As they demand loans on the markets to finance their spending, the States issue debt securities. Like any other loan, also government bonds embed the market risk – a reduction in the market value of the bond may cause losses to the holder – and, in extreme cases, the risk that the capital lent will not be completely reimbursed.
Generally, the more investors – banks, financial institutions, pension funds and households – will find it likely that the loan will not pay off, the more they will demand a high yield for the risk they are bearing. At the same time, the cost of the debt for the State will increase as the risk perception of the investors increases. Political and economic events together with the amount of debt outstanding affect the finances of the States. Moreover, they influence also the investors’ expectations and bond yields. A typical unit to measure the risk on public debt is the spread between a safe asset – usually in EU the reference is the German bund – and another government bond. Besides, to evaluate the dimension of a public debt it is common to use the Debt/GDP ratio (this topic was also discussed here).

The current situation of Public debt in the main EU countries;jsessionid=3EE7A0FCAD10FF1B716097B51DEA188E

It seems clear that the European States are not all in the same condition. Spain and Italy currently are facing the hardest consequences from the pandemic, but they are also the States with the highest debt. In the last years Italian GDP grew slowly[2], and its debt reached 134% of GDP in 2018[3]. Similarly, Spain had a Debt/GDP ratio equal to 97.6%[4] in the same year. However, recently Spanish GDP had a consistent growth, 2% in 2019 and an average growth of 2.8% per year since 2015[5]. Nonetheless, before the financial crisis in 2007 Spain had a debt/GDP ratio equal to 35%[6]. The huge increase in debt due to the crisis forced the Spanish government to reduce the public spending and to enforce several additional reforms to increase its competitiveness and maintain the possibility to raise funds issuing debt on the markets.


Therefore, Spain and Italy are caught in the crossfire. On one side they are facing an unprecedented sanitary crisis, on the other they have to spend massive amount of money for the reconstruction of their economies. In addition, they may not be able to benefit of cheap borrowing on the markets.


Already as 21st April, the yield on 10 years Italian government bond (BTP) was 2.02%[7]. The equivalent yield on Spanish bonds was 0.97%[8]. As a comparison, it is interesting to see that the yield on 10-years German bonds is negative, equal to -0.481%[9]. Germany had a Debt/GDP ratio of 61.9%[10] in 2018. While, Netherlands has a yield of -0,177%[11] and France has 0.06%[12]. Following the increase of these debts, also the related yields will grow. The cost of financing will increase for all the EU countries, but this effect will be much bigger for the States that already have a high debt.;jsessionid=3EE7A0FCAD10FF1B716097B51DEA188E


The debate about the EU measures against the crisis


The sanitary crisis is a global emergency. In front of covid-19, there is no virtuous country, nor vicious. It makes no sense to blame the most affected countries with moral judgements. This crisis is symmetric, differently from the financial crisis of 2008. Notwithstanding, its impact and the timing will be different country by country. Since the beginning of the emergency, there has been a hard debate in the EU. The two factions were the supporters of a joint issuance of debt as common response to the crisis – among them Italy, Spain, France – and the opponents – among them Germany and Netherlands. At least in the initial phase, the opponents, confident on their ability to face the economic crisis on their own, were available to help the other countries only under strict conditions. Their proposal involved rigid rules on the repayment of the public debt and on the duration of the loans – European Stability Mechanism (ESM) with enhanced conditions credit lines.
Meanwhile, the European institutions gave their support to the most damaged countries with the specific Pandemic Emergency Purchasing Programme (PEPP) of the European Central Bank (ECB). So far, this intervention allowed to all the countries to maintain a low yield rates on their bonds. This is especially true for Italian BTP. Additionally, EU allocated other 540 billion euro to support the economy (more info here). Unfortunately, the dimension of the crisis requires further interventions. Issuing common debt – Eurobond or European recovery bonds – to finance the economic reconstruction can be the correct solution. Eurobonds would allow to the countries in difficulty to borrowing low cost from the market, making a step further in the European integration process.


Why a joint intervention is in the interest of the whole EU?


It’s not only a matter of European solidarity. Facing a recession of Eurozone GDP estimated as 7.5% by the IMF[14], no one is stable. There are not solid countries and individualism is not a feasible option. Furthermore, the European Union is a supranational organization that has shared for many years the benefit of being an open economic area. Freedom of movement for workers, goods and capital generated an interdependence among the member States. This is also confirmed looking at the destination countries for the export of Netherlands, Spain, France, Germany and Italy in the figures below.;jsessionid=3EE7A0FCAD10FF1B716097B51DEA188E

The export is a fundamental component of the GDP for all the countries above. Especially for Netherlands that accrued an export/GDP ratio of 82.5% in 2019. Instead, Germany had a export/GDP of 46,9%[15]. Analysing the destination of this export it is extremely evident that the biggest share is directed to other EU countries. Italy is the fifth country for the percentage of goods and services received by the Netherlands and the sixth for Germany. While, Spain is the seventh destination country by dimension of export for Netherlands and the eleventh for Germany. Moreover, Germany and Netherlands are also destination of a significant share of Italian and Spanish export[16].

The European economies are deeply connected. Now it’s time for the European leaders to find an agreement for common and strong measures against the crisis. It will take time. It may require changes in the treaties and the EU budget has to be increased with additional contribution from every single country. This is in the interest of all the member States. Otherwise, the economic crisis will follow the same paths as the epidemic. The risks are an economic depression and the rise to the power of Eurosceptic parties, which may lead to the end of the European project.


Michele Corio



































Are financial markets discounting the coronavirus effects?

In the current environment of protracted uncertainty, the global economic growth outlook has significantly changed due to the COVID-19 effects. The whole economy is facing a series of fundamental macroeconomic and structural challenges which are leading to an impressive slowdown: the health crisis has quickly become an economic crisis and it is gradually turning into a financial crisis.

The recent stock market crash is probably just the beginning of a series of unfortunate events. The partial recovery experienced by the markets in the last weeks is only a small detour from the negative path undertaken since the beginning of the crisis. Intraday volatility, up-and-down price oscillation within the trading session, can be a proxy for the uncertainty of the investors about the future financial performances of an asset or the whole financial market. Recently this indicator has reached extreme levels. An additional proof of the investors’ concerns is given by the volatility index (VIX), typical measure for the market sentiment. The VIX touched the incredible bound of 82 on the 16th of March[1]. In the last 5 years the highest value of VIX has been 30, with an average of 15. Observing its time series, we notice that the value was even higher than the severe crisis in 2008.


VIX trend since 2007

Undeniably, the first quarter in 2020 was one of the worst in the history and, for severity, can be only compared with the one of the financial crisis in 1929. Nonetheless, we do have elements to believe that the coronavirus effects are still not fully embedded in the stock prices. There are two crucial factors to consider.

Firstly, before the coronavirus, analysts were expecting a market correction. It was estimated that financial markets were deeply overvalued (market value was extremely higher than the fundamental value). For example, the S&P500 intrinsic value was evaluated to be around 20% lower than its market price and, as of the 7th of April, the American index has left around 18% on the floor from the beginning of the crisis.

s&P500 trend since January 2020

The second factor concerns the oil price war between the UAE and Russia which has dramatically contributed to a further decrease in the stock market. To face the drastic reduction in oil consumption (demand) due to the global lockdown, oil producers should have cut their production (offer) to support the price. Unfortunately, because of political issues, the two countries did the opposite, started to produce more barrels per day, generating turbulence while uncertainty mounted. The inevitable consequence was a critical drop in the oil price, which has more than halved in just a few weeks. Last Thursday (2nd of April), Trump’s tweet concerning the agreement between the UAE and Russia drove the oil price rally and future[2] prices gained around 30% in just a few days. In any case, the crucial meeting was the OPEC+ where, exceptionally, were invited Texas and Canada and it was signed an agreement to cut the oil production of 10 million barrel per day. Despite that, according to Rystad Energy[3] (a valuable independent energy research company), the global Capital Expenditures (CapEx) – measure of the amount invested by a firm in renovating or maintaining its properties, buildings, industrial plants, technologies or equipment – for exploration and production firms is expected to drop by up to $100 billion this year, around 17% versus 2019 levels. In 2021 the drop could be subjected to a further intensification since many companies (i.e. Eni) have already announced that the CapEx reduction will increase to 30-35%[4]. The oil crisis has already characterized some troubles: McDermott, one of the main firms in the industry, announced that it had filed for Chapter 11 bankruptcy, canceling all shares of common stock.After these considerations, we should wonder whether the market value is currently offering a discounted price. Nowadays the answer is very uncertain, but as we have explained, it is very likely that the coronavirus effects have not been discounted in the stock prices. In addition, the results of the first quarter of 2020 have not been released yet. Together with the probable negative outcomes, the outlook for most of the companies and the recent downgrades given by the rating agencies, make reasonable to believe that the market is still expensive, probably more than before the outbreak of the coronavirus.

The equity market is not the only one that is suffering the crisis. The shock provoked by the coronavirus generated what the Financial Times has defined as “the seeds of the next debt crisis”. According to the Institute of International Finance[5], the ratio of total debt over Global Domestic Product reached 322% in the third quarter of 2019. During the last ten years, companies have gorged on cheap borrowings, but rating agencies’ estimations demonstrate how a global health crisis may push to an immediate reassessment of the credit risk, arising doubts about companies’ quality: stability and ability to generate cash flow in the short and medium-term. Also, in the debt market, the oil price war has led most of the oil and energy companies’ bonds to the distressed area[6].

Notwithstanding, financially speaking, every cloud has a silver lining. Indeed, this period will open the window to many M&A – Mergers and Acquisitions – opportunities. Discounted equity prices and a worsened debt structure may create occasions for companies with strong fundamentals. Solid companies with strong cash generation capacity may exploit the favorable environment to target businesses with a long-term positive outlook but with current solvency and liquidity problems.

Finally, the comprehension of gold price movements during the tumultuous period is of great importance. Gold is defined as a safe haven asset or defensive asset since it should outperform during recession periods and limit the downward pressure. Despite that, at the first glance, it seems that the metal has disappointed expectations. The recent sell-off has negatively characterized the gold performance which has undergone a contradictory result. However, the gold price changes are coherent with the history in periods of extreme volatility. It is very common that fund managers look for liquidity when markets are very volatile in order to fulfill margin calls of the riskiest assets. During the financial crisis in 2008, the gold price has decreased by almost 20% before climbing back to a value of 170% higher in 2011[7]. The gold price declined at the beginning because of liquidity restrictions, but, after the liquidity injection from central banks in the financial systems, it moved up in the traditional way. We can expect similar behavior in the forthcoming months.

Gold price path since 2007

Beyond any doubts, the coronavirus has highlighted how our lives are interconnected. The pandemic has caused a global lockdown and half of the world population is in quarantine. People are changing their lifestyle, changing how they work, socialize, play, talk and learn. The health crisis will inevitably influence economically and financially entire industries, affecting the world permanently. Some sectors, such as tourism, automotive, airlines, will suffer the most from the global instability, facing the hardest challenge. Despite that, nowadays, we are still not fully aware of the effects that the coronavirus will bring to the market but a substantial effect on both demand and supply are expected in the upcoming months. Thus, it is reasonable to forecast an additional discount on the market in the future.

written by Gianlorenzo Zeccolella


[2] Futures are contracts which allow two counterparties to agree on exchanging a certain stock – or other financial asset – on a certain future date for a price fixed at the agreement date. The value of a future can be determined from the comparison between the strike price, fixed at the agreement, and the actual value on the market of the underlying asset at the settlement date. Future contracts are the main instruments traded for the oil




[6] Financial distress is a situation in which a firm is not able to meet its financial obligations. In these conditions, it might unable to payback its debt or just a portion of it.



Never Miss A Story

Get our Weekly recap with the latest news, articles and resources.
Cookie policy
We use our own and third party cookies to allow us to understand how the site is used and to support our marketing campaigns.

Hot daily news right into your inbox.