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The EU’s trillion-euro question

Economic governance / OP-ED
Georg Riekeles , Philipp Lausberg

Date: 24/11/2022
Faced with a wartime economy, the energy transition, and major investments to keep up with China’s and the US’s bids for technological and industrial leadership, the EU needs a permanent fiscal capacity in the range of 1 trillion euros. This move will not come easily, but history teaches us that Europe must now take this leap towards economic federalism.

From the financial crisis to the war and energy shock of today, Europe has been more or less continuously in exigency since 2008. In this period, the EU has demonstrated resilience and the ability to overcome even existential challenges. However, it has also been slower than the US to resolve its crises, which have a tendency to last longer and be more severe than those in other regions.

In an age of permacrisis, a war in Europe, and ruthless geo-economic competition, a reflection on the EU’s agility and capacity to deal with shocks is needed. The current energy and supply chain crisis has put this into sharper focus. Europeans have acted quickly to substitute away from Russian gas, from a 45% overall dependence in 2021 to just  5-6% pipeline gas today. What cannot be replaced must be saved, with the full trauma on consumers and industry of rationing and spiralling prices likely still to come. That will not work without solidarity mechanisms, not only within but also between member states.

Yet so far, solidarity has been fainthearted. Germany’s much-criticised 200 billion euro energy shield package is the prime exponent of go-it-alone strategies. Instead of developing synergies between countries, the German subsidy package comes off as a bid for a competitive advantage over its neighbours, setting off a subsidy race which could further push up energy prices. Considering the interdependence of member state economies within the single market and the euro, this fragmentation is economically and politically toxic.

Thoughts go back to the sovereign debt crisis of 2010-2012, when Europe’s cohesion, stability, and prosperity were at stake in similar ways. As then, most member states' finances are severely constrained today. France, Italy, and Greece all have debt-to-GDP ratios higher than 110%, 190%, and 70%, respectively, compared to Germany's 70%, with yields and the all-important spread to Germany, already rising.

In the summer of 2012, then-ECB President Mario Draghi famously saved the euro by pledging to do “whatever it takes”, including “unlimited” government-bond purchases. But rising inflation has severely limited the ECB’s ability to respond to the current crisis in a similarly aggressive manner.

In the coming months, EU leaders will debate the European Commission’s proposals for a review of Europe’s economic governance. Although the debate appears technical, it is a defining political test. Governments face the daunting task of ensuring national fiscal sustainability through tax increases and spending cuts while allowing for wartime economic measures and facilitating future investment. A reckoning is in order: there is no way to achieve these goals simultaneously other than at the EU level.

Since the 1990s, Europe has seen a productivity slowdown, coinciding – quite remarkably – with the development of the EU’s single market and ‘Stability and Growth Pact’ budget rules. There is no single explanation, but comparisons with the US suggest much of the falloff is due to smaller growth contributions from investment in technology and innovation.

At the end of the Cold War, markets deregulated, and the focus was on harmonising standards and economic policies to create a European-level playing field. Though often breached, the debt and expenditure rules restricted spending, leaving little national space and willingness to finance ambitious long-term projects. This strategic vacuum was not filled by the EU, which acted more like an arbiter of the markets rather than assuming a vision of investment and industrial policy.

Now the emerging wartime economy and escalating rivalry between the US and China have compounded the EU’s industrial weakness. Europe was already hampered by investment gaps impeding its clean-energy transition and adoption of artificial intelligence and other foundational technologies. As the Americans and Chinese vie for control of critical technologies and value chains, through aggressive domestic support and discriminatory trade measures, Europe’s manufacturing base is dramatically at risk.

At the government level, neither the inflexible long-term EU budget with its €160-180 billion available annually nor initiatives like InvestEU, leveraging a small €16 billion EU guarantee into lending, can deliver the scale of change needed. The 2021 Recovery and Resilience Facility, painstakingly agreed upon under the pandemic, has more firepower with its €338 billion in grants and €385.8 billion in loans. But it is a one-off instrument, with most of the spending already tied up in detailed post-pandemic national plans.

To tackle today’s triple challenge of solidarity, investment, and economic security, a new financing infrastructure based on a permanent EU fiscal capacity is needed. Financed through common EU borrowing, it could be structured as a rolling balance sheet of up to 1 trillion euros with three main compartments. The first would be a facility providing quick financial firepower during emergencies. In the current situation, it would provide a mix of grants and loans to member states hardest hit by the energy crisis, but also back critical investments, such as in North Sea wind power, hydrogen and carbon capture and storage technologies, to speed up the energy transition.

The second compartment would take the form of a Sovereignty Fund aimed at boosting technological and industrial development in Europe. The money would be directed in support of public-private partnerships and industrial alliances, including by taking high-risk, high-reward equity positions in European start-up ecosystems in need of scaling up, such as biotech and quantum computing.

The third would help the EU pursue its geopolitical interests by providing critical resources to reconstruct Ukraine and advance its integration into the European Union. But it would also direct funds to initiatives like the Global Gateway – Europe’s answer to China’s Belt and Road initiative – which aims to invest up to €300 billion in sustainable technologies, climate-change mitigation and adaptation, and critical infrastructure in the Balkans, the Caucasus, Africa, and elsewhere.

Admittedly, the EU is not the United States, but a brief history of American fiscal federalism is instructive in how quickly central capacities must develop when the force of outside events requires them.  After the creative burst of early US federalism, the US state build-up was slow, with outlays as a percentage of GDP hovering around 2-3% until World War I.

Upon entering the war in April 1917, President Wilson developed a wartime economy and created special agencies to oversee food, fuel, and critical technologies. This federal capacity was partially reversed when the war ended, but then got a definitive dimension in response to the economic crisis in the 1930s and 1940s, with Hoover’s public works and relief projects and Roosevelt’s New Deal programmes, and then the outbreak of World War II.

Today, European nations can no longer afford to go it alone. If historical analogies are anything to go by, this is Europe’s moment for a leap towards economic federalism.

A shorter version of this op-ed was first published by Project Syndicate.

Photo credits:
European Union (2022)

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