Balancing the books: Why the EU needs a European debt agency

The European Union is facing multiple expensive geopolitical crises. To support Ukraine’s war effort, alleviate the humanitarian crisis in the Middle East, and at the same time finance the EU’s climate transition and digitalisation agenda, it needs not only the widespread political support of its member states, but arguably also their money. But the strained economies that emerged from the covid-19 pandemic and are now finding their way out of the energy crisis might find it hard to raise the necessary funds.

This issue is further complicated by the need to comply with the EU’s fiscal rules contained in the Stability and Growth Pact (SGP), which among other points require government deficits to remain below 3 per cent of GDP and public debt levels below 60 per cent of GDP. In 2020, the EU temporarily suspended these rules to allow member states to raise public expenditure – thus inflating their debt – with the aim of alleviating the economic fallout of the covid-19 pandemic. The rules will kick back in at the beginning of 2024, unless member states can strike an agreement on the reform proposals brought forward by the commission in April this year. These proposals envisage EU countries issuing “national medium-term fiscal-structural plans” that set out their saving, investment, and reform plans for the next four years at least – with the aim of strengthening national ownership over fiscal plans – and, at the same time, a stricter enforcement regime of the countries’ commitments to the SGP.

EU heads of state and government will try to work out an agreement at the European Council meeting in December. But the matter is highly divisive, with European countries seemingly split into two groups with opposing views. In June, France and Germany clashed over the commission’s reform proposals, with Paris favouring an individualised approach, whereby member states would negotiate individual debt cuts with the commission, and Berlin advocating tighter fiscal rules that guide annual debt reduction for all member states. Both capitals stated that many EU governments supported their respective positions.

While markets might be indifferent to why debt is issued, they sure are interested in who is issuing it

German finance minister Christian Lindner and ten European ministers clarified their more frugal take on the commission’s reform proposals, stating that: “As far as the capital markets are concerned, debt is debt. Capital markets are not interested in the motives for taking on debt, however worthy they may be.” However, while markets might be indifferent to why debt is issued, they sure are interested in who is issuing it.

To reconcile these positions and solve the conundrum between stability and growth, a geopolitical Europe should tap into the largely unexplored potential of a joint eurozone safe asset and issue debt on behalf of member states. The EU already issued bonds to fund its response to the covid-19 crisis, borrowing over €800 billion in current prices on international markets to support the Next Generation EU initiative. In this context, the EU borrowed on a temporary basis to tackle a well-defined emergency. But the positive experience with the instrument so far and the necessity to cope with multiple crises speaks in favour of the instutionalisation of an avenue for debt management at the EU level – the establishment of a European debt agency.

Investors are willing to pay high prices and receive low interest rates for risk-free assets. A European debt agency could therefore benefit from its low cost of borrowing to roll over loans permanently without the need for member states to raise taxes to pay interest on them. The agency would stop issuing debt before it reached a point of affecting the agency’s risk profile – and thus raising the interest rate. An IMF simulation published this year showed that in this way a European debt agency would be able to issue an amount of debt equivalent to 15 per cent of the GDP of the eurozone by simply rolling it over and without losing its risk-free reputation on the market. The model assumes that no fiscal resource is transferred from the national to the European level and that the agency’s operations would be cost-free provided that the interest rate remains lower than the eurozone’s growth rate. Over time, both debt and GDP would grow, albeit at different speeds – but as long as the debt-to-GDP ratio shrinks, the debt would become less economically significant.

This process of debt mutualisation, in which sovereign debt is transferred to a joint eurozone agency, would give some breathing room to countries that breach the SGP’s 60 per cent debt threshold to carry out proactive fiscal policy by swapping national higher interest rate debt with the agency’s lower interest rate debt. Belgium, Finland, France, and Spain would still need to implement additional fiscal consolidation to put their debt on a sustainable path. These countries have high forecasted primary deficits, so a debt reduction via the mutualisation of either pandemic legacy debt or in proportion to GDP would not ensure the reduction of the debt-to-GDP ratio with sufficient probability after three years.

However, the window for issuing self-funded European debt is becoming narrower. The European Central Bank’s recent tightening of monetary policy and bleak growth forecasts suggest that the difference between interest rates and growth rates is shrinking. Moreover, more frugal countries might worry that debt mutualisation would just leverage their hard-earned credit rating and write a blank cheque to over spenders. On the other hand, sluggish growth and growing interest rates might in themselves jeopardise the stability of high-debt countries. In this case, a European debt management facility could avoid compromising the eurozone – especially as the debt levels were driven up by an external shock in 2020, which could not be included in the countries’ fiscal planning. Supporters of EU debt mutualisation often mention Alexander Hamilton’s decision in 1790 to have the Treasury pay off state debt to alleviate the burden of the debt accrued during the American civil war. But they seem to forget that the US Congress let some states default in the first of half of the 19^th century. They had massively financed public investment through debt and Congress deemed that bailing them out would have unjustly disregarded their fiscal profligacy – an argument that mirrors the concern over moral hazard.

But a European debt agency could serve its purpose even without debt mutualisation. The agency would initially be endowed with capital from member states, just like the European Stability Mechanism. It would then raise funds on the market in place of the member states – which would stop issuing bonds – and provide them with liquidity through perpetual loans, meaning that their debt would have no maturity date. The interest rates on these loans would vary between member states, according to their credit risk, generating a fiscal accountability framework that would address the concerns over moral hazard. Even in this scenario, the favourable borrowing conditions enjoyed by the agency would overall minimise borrowing costs and reduce market volatility for member states, lowering the cost of their debt refinancing. The recent surge in EU borrowing costs driven in part by the inclusion of non-repayable support in the Next Generation EU initiative and by the illiquidity of the EU bond market due to the temporary nature of the initiative further underline the value of this proposal in particular, as the agency would in time become responsible for issuing all eurozone debt.

The creation of a European debt agency could be highly beneficial to the European economy and help member states to finance the investments required by today’s geopolitical reality. But it would not erase the need for fiscal discipline. On the contrary, it would require a tighter fiscal surveillance framework and the finalisation of the banking union – the eurozone’s regulatory and surveillance architecture aimed at ensuring the robustness of the financial sector, minimising the economic fallout of bank bailouts, and reducing market fragmentation. The creation of such an agency could therefore reconcile two often contradictory demands – higher public expenditure and harsher fiscal discipline – and at the same time provide Europe with the resources to proactively engage with today’s geopolitical challenges. EU policymakers should take advantage of the current space for fiscal reform prompted by the covid-19 crisis to lay the foundations to make Europe’s foreign policy efforts economically sustainable – and a European debt agency can help them to do so.