Europe's big fiscal deal leaves some tough decisions ahead
It took five days of sometimes ugly negotiations for leaders of the European Union (EU) to agree in July to €750 billion in new debt to counter the economic shock resulting from the COVID-19 crisis and in particular to distribute the aid to countries less well-off and most in need. What they accomplished was a major step toward European fiscal integration. But until they decide how the new debt will be repaid, the long-term impact of the EU’s pathbreaking response remains uncertain.
The innovative €750 billion plan was part of a three-year supplemental budget to the regular new seven-year EU budget. But it embodies some messy but important compromises and constructive ambiguity to win unanimous approval from EU members.
How the deal was reached
Small frugal countries like the Netherlands, which favor saving money for themselves rather than spending EU funds on R&D and climate change, goals they claim to support, had to be bribed with larger national rebates on their EU budget contributions. In addition, the link between budget payments and member states’ rule of law had to be left vague, permitting Hungary’s autocratic prime minister, Viktor Orban, to claim that no link exists. (In fact, the deal stipulated that the European Commission can withhold funds for a while at least if a qualified majority of member states decide to do so.)
In addition, a cumbersome bureaucratic procedure was installed to allow individual members to delay disbursements they do not like but not to block them. For example, member states are required to submit national recovery and resilience plans setting out their reform and investment agenda for 2021–23 to enable the Commission to certify that their use of EU money is in accordance with the commonly agreed long-term macroeconomic goals. This provision again requires a qualified majority among members. If an individual member is unhappy about the recipient member’s reform record, it cannot block disbursement of funds to that member. But individual members like the Netherlands might delay disbursement by forcing an additional exhaustive discussion of a recipient country’s record.
In another compromise, the grant-based component of the €750 billion shrank from €500 billion to €390 billion. But that sum represented a twenty-fold increase over the €17 billion that European leaders had previously discussed earmarking for a euro area budget instrument.
Some argue that €390 billion, or about 1 percent of EU GDP annually for 2021–23, is macroeconomically almost irrelevant, given the decline in economic activity during the pandemic. This claim is misguided. The EU, in contrast to the US federal system, is fiscally dominated by member states, the only level of government able to raise tax-based revenues. The main macroeconomic stimulant from the agreement is, therefore, the political space it opens for the European Central Bank (ECB) to continue—if required—its asset purchases beyond the currently announced €1.35 trillion in 2021 and beyond. Accordingly, even highly indebted member states like Italy will not face financial market pressures, even if they have to issue bonds to sustain stimulus programs. Member states may also use the breathing space furnished by the supplementary budget and ECB asset purchases to undertake overdue pro-growth domestic reforms.
How the debt could be repaid
Two main obstacles remain for EU leaders to overcome, however. First, the regular seven-year budget needs to be agreed with the European Parliament. Parliament members are unlikely to look kindly at the tradeoff in which the €750 billion supplemental budget (over which the parliament has no say) necessitates a cut in the regular seven-year budget, over which the parliament has a veto. The parliament is not likely to block the new budget ultimately but may compel member states to add additional funds to the regular budget. In general, it is an advantage for the European Parliament that the 27 EU member states have accepted the supplementary budget agreement, as it avoids having to establish particular parliamentary oversight of euro area–only fiscal integration.
A more important issue is the lack of agreement over how or even when the new borrowed money is to be repaid. The agreement says only that the debt should be fully repaid by 2058 and that individual years’ principal repayment cannot exceed 7.5 percent of the total €390 billion in grants. In addition, the accord says that repayment should be steady and predictable and in accordance with sound financial management and that cash unused from the €12.914 billion allocated to interest payments from 2021 to 2027 can be devoted to early principal repayment. Of course, the Commission could repay 7.5 percent of the total €390 billion each year in a “steady and predictable way,” ensuring it would repay the total principal in less than 14 years, in principle meaning that it is not obliged to start repaying the debt until 2044. Member states wishing to repay principal early might be satisfied with only using the unspent interest payments, rather than finding additional financial resources themselves. Given that the EU can borrow at negative interest rates, most of the allocated interest payments is expected to repay debt principal.
On the other hand, the low current interest rates assume that the EU can retain its current AAA credit rating. Despite the Commission’s ability to cash manage and call upon additional resources from member states, credit rating agencies may be skeptical about the top-notch quality of the €750 billion borrowing, which is on top of an earlier agreed €100 billion to fund members’ labor market adjustment, and the fact that the €390 billion in the form of grants will have to be repaid directly by the EU, rather than by member states. The ECB is likely to purchase up to half of the new EU-issued bonds, thus providing a degree of market support to the EU’s credit rating.
Only five EU member states—Denmark, Germany, Luxembourg, the Netherlands, and Sweden—retain their AAA rating, meaning that simply calling upon other member states to step in if one or more defaults may not be straightforward in order to retain the top rating.
But EU leaders sequenced their decisions to help secure a high credit rating by reforming and expanding the way the European Commission can raise revenue directly into the EU budget, creating new revenues earmarked toward debt repayment.
From 2021 on, the Commission will get a share of revenues from a new “green levy” on the weight of nonrecycled plastic packaging waste with a call rate of €0.80 per kilogram. And by 2021, the Commission is to propose ways to raise additional new revenues earmarked for debt repayment from a carbon border adjustment mechanism, a digital levy, a revised proposal on the EU Emissions Trading System, possibly extending it to aviation and maritime, and even a financial transaction tax.
Member states have always resisted granting the Commission any rights to directly raise revenues, fearing that such a step will limit their control over these resources. But these steps grant the EU a potentially greater ability to levy modern sin (environmental and financial sector) taxes and 21st century trade tariffs from carbon border adjustment and a digital levy, approaching US federal revenue sources in the 19th century.
The €390 billion debt commitment to be repaid directly by the EU requires member states to agree to such new direct revenues to the Commission, or increase their own regular national contributions to the EU budget once repayment commences, or alternatively agree to cut other expenses in the budget.
In sum, the EU still faces some unenviable political choices, raising the probability that EU leaders will in the end agree to grant the European Commission the new direct sources of revenue with which to repay their new debt.
Only if this repayment scheme happens will the recent big step toward EU fiscal integration turn into a real quantum leap toward a far more fiscally integrated Europe.
1. Qualified majority voting means that it takes 13 out of 27 member states (15 for a qualified majority), or member states representing more than 35 percent of the EU’s total population (65 percent for a qualified majority), to reject a Commission proposal. This means that an action could be adopted even if Hungary and Poland object.