EU expansion

After appearing to drag its feet on the issuance of joint bonds, the German government last week endorsed a French proposal to set up a fund capable of delivering €500bn of grants to EU member states suffering from the economic impact of Covid-19. This week the European Commission went further by setting out a plan to borrow €750bn by directly issuing bonds and distributing the proceeds to member states. After a decade of wrangling, this is a very important step and is vital if the EU is to hold together as a cohesive body. At last, the Commission has decided to lend its weight to a plan to issue pan-European fiscal instruments and will thus back up the ECB which has done all the heavy lifting on policy up to now. There are many who see this as a game changing event. And if implemented, it will be. But there are a number of hurdles to be crossed before the plan can be realised.

What does the plan entail?

Ursula von der Leyen, the Commission President, outlined a programme dubbed Next Generation EU. This is very apt because if it can be made to stick the EU could be about to take the first steps on the way to a fiscal union. Who knows, but this plan may be to the formation of a common fiscal policy what the snake in the tunnel was to the single currency. If nothing else it would break the taboo on fiscal cooperation which has long been one of the structural issues which has prevented the euro zone/EU from becoming the economic entity that the 1990s generation of leaders envisaged. That said, this measure is viewed as a one-off plan, nor will the Commission take any responsibility for debt already incurred by member states.

The idea is that the Commission will use its strong credit rating to borrow €750bn on international capital markets and recoup the funds though future EU budgets “not before 2028 and not after 2058”(i.e. not within the current budgetary period). Of this total, €500bn will be distributed in the form of grants whilst the remainder will take the form of loans. But the Commission is not simply proposing to write blank cheques: The funds will be distributed via EU programmes designed to achieve specific goals such as boosting competitiveness, supporting a broader green agenda and building the digital economy.

In order to facilitate repayment, the Commission suggested that a number of additional revenue raising items could be agreed at the pan-European level with each country paying the revenues from these streams into a centralised budget. “These could include a new own resource based on the Emissions Trading Scheme, a Carbon Border Adjustment Mechanism and an own resource based on the operation of large companies. It could also include a new digital tax … These will be in addition to the Commission’s proposals for own resources based on a simplified Value Added Tax and non-recycled plastics.”

In terms of the entitlement of individual states, the Commission has set out a formula based on three main economic factors: (i) population; (ii) the inverse of GDP per capita and (iii) the average unemployment rate over the past 5 years compared to the EU average. Based on this formula, Italy would be entitled to the largest share of the grants (20.5%) followed by Spain (19.9%), whereas France would only be able to secure a maximum of 10% and Germany 7% (chart).

What are the obstacles?

The first obstacle, and the most difficult, will be to convince the ‘frugal four’ (Austria, Denmark, Netherlands and Sweden) to sign up. The plan requires unanimous approval from governments, primarily because it entails structural changes in the EU budget that demand ratification by national parliaments. The frugal four have consistently opposed the creation of a debt union and have led the opposition which the German government is not willing to explicitly lead but which its electorate supports. But although Germany may have come somewhat reluctantly to the table, the government realises that failure to take action will ultimately weaken the ties that bind the union. After all, rising euroscepticism in Italy risks taking the EU in a direction it would rather not go and Germany certainly does not want to be the trigger for a breakup of the union. Arguably, however, the frugal four have less to lose and since they do not have the clout to bring down the union on their own, they act as a useful sounding board for the fears of all the northern countries.

A second concern is whether the establishment of an EU-wide fund will prompt individual governments to reduce their own efforts to put in place measures to combat the economic crisis. There has long been a concern amongst northern European members that an EU-wide safety net would result in moral hazard issues.

There are also some concerns with regard to fiscal legitimacy. One of the biggest problems is that only national governments have the power to levy taxes on their citizens since the government derives its tax-raising power from its electorate. Although there is a European Parliament which derives its legitimacy from citizens of the EU, it looks after pan-EU interests rather than the local interests which are generally more important to electorates. The levying of specific taxes for pan-European purposes might thus be seen as problematic.

But a brave attempt for all that

A decade ago it was clear that the euro zone is not a proper economic union – it was effectively a fixed exchange rate system in which debtor nations had to bear the brunt of the necessary economic adjustment. Greece and Ireland learned this lesson in a very painful way as the global debt crisis unfolded. It was also equally clear that some form of fiscal transfer mechanism would be necessary if the euro zone were to survive in the longer term, but efforts by Emmanuel Macron to make headway over the last three years largely fell on deaf ears. Now the tide has turned. That said, the Commission’s proposals are unlikely to be accepted in their current form and a compromise will emerge instead. Nor do the proposals outlined this week constitute a fiscal union. But they do mean that some form of countercyclical transfer mechanism could be in place sooner rather than later. In my view it is a very heartening move – at least from an economic standpoint although we can argue about the politics. The only disappointment is that it took so long to get here.