Widespread lockdowns have resulted in record output declines and soaring debt across the euro area. But the political response to the COVID-19 crisis may be positive for the European integration project—and for euro-area bond markets.

Last year, governments across Europe locked down their economies in order to control the spread of COVID-19. Not surprisingly, this resulted in record output declines. This year, as vaccination programs finally gain traction, governments are starting to reopen their economies, a process that will inevitably yield unprecedented output gains. For the most part, these increases will be predictable and artificial, telling us very little about the euro-area economy’s longer-term prospects.

COVID-19 Shock Brings Important Changes

So, which recent changes will have a significant and lasting impact? In economic terms, both the mammoth increase in government debt and the widespread acceptance of money-financed fiscal activism will affect the longer-term outlook for growth and inflation. But COVID-19 is also likely to cause significant political disruption—positive and negative.

In fact, political change has already started. Last year, for example, COVID-19 provided the impetus for EU leaders to agree on a €750 billion recovery fund. While this was not quite Europe’s “Hamilton” moment, it did represent an important step towards joint borrowing and, perhaps one day, debt mutualization. It’s hard to believe this would have happened in the absence of a significant common shock.

COVID-19 and the recovery fund have also triggered important domestic political changes. In Italy, former president of the European Central Bank (ECB) Mario Draghi is now prime minister and parliament is united behind a €230 billion, multi-year investment and reform package. Seasoned observers might question how long this unity will last, but it stands in stark contrast with the situation shortly after the 2018 election—when two overtly populist parties were setting the agenda.