A large proportion of the financing needs for Europe’s digital, energy, and demographic transitions, as well as defence, will have to be covered by public funding. This column argues that these can all be seen as European public goods, and that a first step towards achieving them should to maximise the capacity of existing instruments, without the use of additional taxpayers’ money ab initio.
The Draghi Report (Draghi 2024) and Letta Report (Letta 2024) offer a number of useful proposals for the EU’s economic and broader strategy to confront current geopolitical developments. However, these ambitions may easily get stuck in the discussion how to finance them and how to share the bill. In this contribution we argue that a first step would be to use existing resources to finance European public goods (EPGs) that benefit all member states.
Large investment needs and key priorities
The EU will be confronted with large financing needs for the digital transition, the energy transition, the demographic transition, and defence (e.g. Dorrucci et al., 2024). A substantial fraction will have to be covered by public funding. These expenditures can to a large extent be provided as EPGs, because they feature strong economies of scale or cross-border spillover effects (e.g. Strauch 2024). 1 However, the question is how to finance those EPGs. In view of the usual divide between the profligate and frugal countries, with the latter unenthusiastic about further expansion of collectively financed arrangements, it may be best to initially go for a more modest solution, namely, using existing funds to finance spending purposes that benefit all countries or leverage on the European Stability Mechanism (ESM) when financial instability risks arise. 2
One of the key priorities of the EU Commission 2024-2029 is “a strong and secure Europe”, and within this “strengthening EU security and defence…”. Defence and security may be the type of EPG on which all member states could find agreement. 3 A concrete example is European air defence (Wolff 2024): the air defence of one country will help to protect neighbouring countries, and jointly setting up such a system is cheaper and more effective than each country doing it for itself. Bolstering the EU defence industry through commonly financed R&D and joint procurement (Nicoli and Beetsma 2024, Beetsma et al. 2024) would be another example benefitting all member states. External border control concerns all countries because people coming from outside can travel without almost any hindrance through the EU. 4
How to pay for the EU’s ambitions?
The revised EU fiscal rules centre around net primary expenditure. The Commission will take into account a number of relevant factors when assessing the existence of an excessive deficit. An increase of government investment in defence would be explicitly recognised as one such relevant factor. In his report on the Single Market, Letta (2024) argues the need to boost European safe assets – debt issued by the EU, European Investment Bank (EIB) and the ESM/ European Financial Stability Facility) – which crossed €1 trillion in March 2024 (Anev Janse 2024), and suggests using the firepower of the ESM for defence. Available resources are increasing. Project funding by the EIB has fallen from its peak since the euro area debt crisis, while the EU has used just 30-40% of its NextGenerationEU (NGEU) lending capacity. The ESM lending capacity, currently €422 billion, will grow rapidly due to scheduled repayments by Spain and Cyprus. According to a recent ESM blog (Rey and Susec 2024), only 36% of the lending capacities available to the EU and euro area countries had been used by end of 2022. In funding EPGs, the competence of each institution should be exploited: project finance by the EIB, grants by the EU, and lending to preserve financial stability by the ESM. In general, financing the build-up of defence and security with debt would be justified by the fact that not only current but also future generations would benefit from these expenditures. 5 The usual short-term orientation of political leaders might actually help here.
For many years, there have been calls to develop European safe assets to mitigate country risk. In the last 15 years, the three safe assets have grown, developed, and have been appreciated by the market (Anev Janse 2023). In spite of identical repayment risk, yields on these assets exceed those of a number of EU sovereigns at the moment. They are anchored at a higher level that does not reflect the high rating, often AAA, of the European safe assets versus lower-rated sovereigns. There may be several (related) reasons for this, including the temporariness of these instruments, their absence from indices, the absence of a dedicated EU tax base and the prospect of potential ECB sovereign debt purchases. Another reason is the lower depth of the market for European safe assets compared with, for example, Bunds. Liquidity can be increased by having the international institutions issue more, but we have seen the EU widen spreads and yields increase when announcements are made about additional debt issuances without clarity of the future beyond 2026, which marks the end of NGEU as designed today. The market also distinguishes between capital-based institutions (the EIB and ESM), which are rated AAA across the board and based on balance sheets, and the EU and EFSF, which follow ratings of the member states and are still rated highly, but slightly lower. The EIB and ESM are more resilient when discussions around sovereigns take place, such as the downgrade of euro area sovereigns. The market price matters: borrowing from European safe assets is not taken up by countries when this borrowing takes place at higher rates, which in turn would put the overall idea of investing in common security and defence in jeopardy. The advantage of using the European safe assets is that they exist; no additional taxpayer money is needed ab initio. 6
How can the European safe assets be used to maximise their capacity?
Let’s start with the ESM, which has a lending capacity of €500 billion, of which €422 billion is available. First, Letta (2024) proposes to mimic the Pandemic Crisis Support €240 billion credit line for a credit line to spend on defence. Second, with a Treaty adjustment (adding lending to ‘third countries’ next to euro area member states), the ESM could lend directly to third countries like Ukraine. However, the financial stability criteria would continue to be applicable. While this is legally possible to adjust, it is politically more controversial. To help Europe’s competitiveness, a clause could be included that the funds be used for buying European defence products, which would simultaneously require further developing the EU defence industry. A third option could be to use the ESM Precautionary Lines and Primary Purchase Programmes to help sovereigns facing financial stability risks. At the start of the invasion of Ukraine, we saw a spread widening towards the Baltic states; such defence lines can ensure defence spending, reduce risk, and ensure financial stability for those countries. Obviously, it should be kept in mind that any commitment of funds in this way reduces the room for crisis funding and, hence, a trade-off is to be made in this regard.
The EIB had restrictions on defence financing (‘dual use’, for military and civil purposes), which have been gradually lifted from May 2024 onward. Unlike the ESM, the EIB can offer direct financing to the private sector, from project finance and acquisition support of European produced defence material, to limited equity financing. Like during the pandemic, when the EIB focused on financing businesses and ESM sovereigns, the EIB could finance European defence projects and sovereigns, while sovereign support when financial stability is at risk could be covered by ESM loans.
The NGEU grants and especially the loans have been underutilised. On 1 October 2024, €173 billion in grants and just €95 billion in loans were disbursed from the full €648 billion available, 7 representing around 41% of the available capacity. The other 59%, or €381 billion, are still available for disbursement and may not all be requested or absorbed. This was also concluded in the European Court of Auditors Special Report of September 2024 (ECA 2024). The EU could try to reallocate those funds, as the initial purpose of the NGEU was the Covid response. The grants have been more successful than the loans; the European Commission has decennia of experience in giving grants through structural and cohesion funds. The grants can therefore be channelled through structural and cohesion funds focused on defence. The loan component can be reverted towards non-euro area countries and countries outside the EU.
Finally, combining the best of all three institutions would help. From a market point of view, this would be seen as positive as more safe assets would come to the market and investors would price them in a similar way (as they do today). This would deepen the pool of European safe assets with an EU ISIN prefix, with a blended European risk, which is appreciated by market participants. Politically, an advantage would be that no new institutions or new paid in capital (EIB and ESM) via taxpayers’ money would be needed. This can be seen as a political compromise between the more proactive and more sceptical member states.
Conclusion
The first reaction of member states to the ideas in the Draghi Report (Draghi 2024) was that no new funds should be created. Hence, a first step in fulfilling the ambitions is to maximise the capacity of the existing instruments, without the usage of additional taxpayers’ money ab initio.
Only one third of the available European funds have been used. With the €422 billion of the ESM, €300-400 billion of the European Commission and a possible extension of the EIB balance sheet, an additional €1 trillion can be made available for defence, security, and migration border financing.
This can be seen as a win-win-win: more spending on defence and other strategic priorities, in particular boosting European competitiveness, by maximally leveraging funds already available.
Source : VOXeu
