May 21st 2020

Europe’s Hamiltonian Moment 

 

LONDON – The new Franco-German proposal for a €500 billion ($547 billion) European recovery fund could turn out to be the most important historic consequence of the coronavirus. It is even conceivable that the deal struck between German Chancellor Angela Merkel and French President Emmanuel Macron might one day be remembered as the European Union’s “Hamiltonian moment,” comparable to the 1790 agreement between Alexander Hamilton and Thomas Jefferson on public borrowing, which helped to turn the United States, a confederation with little central government, into a genuine political federation.

Admittedly, this sounds hyperbolic. The proposed sum for the recovery fund is small change in an era when politicians and central bankers conjure up trillions almost daily. And what about the gulf between words and action throughout the EU’s history? Skepticism about the Franco-German proposal is certainly understandable and may prove justified.

The plan amounts to only 3% of the EU’s GDP, compared with the 15% of GDP already committed by Germany to industrial support. Creating any EU recovery plan will require unanimous support from the EU’s 27 member countries – and this will involve unseemly late-night squabbles between the self-styled “Frugal Four” northern governments (the Netherlands, Austria, Finland, and Sweden), which have vehemently opposed funding for Mediterranean EU members which, according to Wopke Hoekstra, the Dutch Finance Minister, have mainly themselves to blame for “failing to reform.”

But to focus on these drawbacks is to miss the potential significance of the plan. What makes the Merkel-Macron deal a potential game changer is not the sum of money or their apparent backing for grants over loans; it is the financial mechanism to which both Merkel and Macron are now publicly committed and must now deliver or suffer enormous loss of face.

The Merkel-Macron proposal involves three crucial innovations, which may sound tediously technical but will vastly increase the flexibility of EU fiscal policy and could ultimately transform European politics in a way that really proves comparable to the Hamilton-Jefferson deal.

The key innovation is financing the recovery fund with bonds issued directly by the EU in its own name and guaranteed by its own revenues, instead of using funds raised by national governments, whether acting together or separately. Merkel presumably insisted on this mechanism to avoid the vexations of jointly guaranteed “Eurobonds,” which German public opinion deems politically toxic and possibly unconstitutional, because German taxes could end up paying for Italian or Spanish debts.

But by relying on the EU, instead of national governments, to issue bonds, the Merkel-Macron plan implies a second, more controversial, innovation, which is clearly necessary to create a fiscal federation, but which European politicians have always tried to avoid.

To guarantee and service hundreds of billions of euros of new borrowing on its own account, the EU will require more tax revenue than it now receives. Merkel and Macron have therefore proposed increasing the European Commission’s budget from 1.2% to 2% of EU gross national income, yielding about €180 billion per year in extra revenue.

To raise this amount, the EU will need to levy new taxes on its own account, in addition to the customs duties and small share of national VAT revenues which already flow automatically to Brussels. The exact nature of the EU’s new taxes will presumably be the subject of fierce debate and fiercer lobbying.

But a broad consensus seems to be emerging that pan-European taxes should be based on economic activities that transcend national boundaries, such as carbon dioxide emissions, financial transactions, and digital transactions. Some of this extra tax revenue will flow into recovery projects, but most will be needed for other EU spending, such as the “cohesion funds,” which subsidize the poorer eastern countries (and help to buy off governments that might otherwise block the recovery fund and other EU initiatives and reforms) – and also to replace the United Kingdom’s net contributions of roughly €10 billion per year.

That leads to the third game-changing innovation in the Merkel-Macron plan: permitting the EU to leverage its activities with borrowing, instead of just using the EU budget as a pass-through mechanism from pan-European taxes to current spending. Because of today’s near-zero interest rates for triple-A sovereign borrowers, the leverage potentially available to the EU from a modest amount of extra revenue is enormous.

If the EU issued ten-year bonds, it would probably pay interest of zero or below, potentially allowing almost unlimited borrowing, albeit with sinking funds to redeem the debts at maturity. But even a 50-year bond could probably be issued with a coupon no higher than the 0.5% yield on Austria’s 50-year bond.

Better still, the EU could issue perpetual bonds with no redemption date, similar to the now-retired British and US “consols,” as proposed by the Spanish government and George Soros. This would allow the EU to borrow €500 billion at an interest cost of just €2.5 billion per year.

To put it another way, if the EU borrows €500 billion this year for a European recovery fund, then it could easily borrow another €1 trillion next year for a digital inclusion fund, and then maybe €2 trillion for a vehicle electrification fund or €3 trillion for a comprehensive climate-change fund. Such simple calculations show why European economic and political conditions could be completely transformed by the Merkel-Macron plan’s financial innovations.

There are big obstacles in achieving the unanimity the plan requires. The Frugal Four will vehemently object to offering grants, rather than loans, to the bloc’s Mediterranean members. But it is hard to imagine that any of these governments will try to sabotage completely an initiative that equally “frugal” Germans support. Instead, the debate in Europe will probably accept the three technical principles just outlined, but focus instead on two separate controversies: the amount of new EU borrowing and whether EU support should take the form of loans or outright grants.

On these two issues, a compromise acceptable to both sides should not be difficult to forge. The size of the recovery fund could be increased to something near the €1 trillion recommended by the European Commission without imposing any strain on the EU budget. But in exchange, the Frugals could insist on offering 50% of the support through loans instead of grants.

A compromise like this would make the Merkel-Macron plan even stronger. Loans with near-zero interest rates and long maturities are economically almost equivalent to grants. And using loans instead of grants would make EU debt financially more sustainable, thereby maximizing the scope for further borrowing without risking the bloc’s triple-A rating.

The scope for such compromises suggests the EU could readily agree on a powerful recovery plan that preserves all three essential elements of the Merkel-Macron proposal: bonds issued by the EU in its own name; pan-European taxes on cross-border activities; and leverage to benefit from low interest rates. If EU leaders can rise to this challenge, Europe’s “Hamiltonian moment” will finally have arrived.


Anatole Kaletsky is Chief Economist and Co-Chairman of Gavekal Dragonomics and the author of Capitalism 4.0: The Birth of a New Economy in the Aftermath of Crisis. 

Copyright: Project Syndicate, 2020.
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