The writer is a senior fellow at Harvard Kennedy School and chief economist at Kroll
Russia’s war on Ukraine means the EU is set to become a big spender. The question is how to fund anticipated relief programmes and spending on defence and the green transition. Italian prime minister Mario Draghi suggests as much as €2tn may be needed. For the eurozone, how the money is raised may determine whether the bloc is plunged back into debt crisis or takes a step towards finally becoming an optimal currency area.
The EU is disproportionately affected by the war, given geography and its enormous reliance on Russia for energy. Oil and natural gas prices have spiked since late February; last week, European gas futures were up more than 1,000 per cent year-on-year. That is not a typo.
Higher energy costs will push up eurozone inflation from February’s already eye-watering 5.8 per cent annual rate. The continent’s leaders recognise rising inflation will create a massive income squeeze for consumers, dragging on demand. And in the weeks since the Russian invasion, Europe has found renewed resolve on two issues.
First, Germany embarked on a new era in defence policy with a €100bn fund to modernise the military and a pledge finally to meet its Nato commitment by boosting defence spending above 2 per cent of gross domestic product. Other European countries will follow suit.
Second, Europe has learnt the hard way that it must diversify its energy supply. The EU is studying plans to cut Russian gas imports by two-thirds over the next year. The proposal has yet to be adopted by member states and, even if it is, it pushes a lot of assumptions to their limits. It would require a flurry of investment in renewables and other technologies. The Bruegel think-tank in Brussels estimates that would cost about €175bn in 2022 and about €70bn each subsequent year.
Where are those euros to come from? One option for countries in the eurozone is the European Central Bank, which could continue suppressing borrowing costs so member states can raise funds in capital markets at low rates. The most powerful tool for doing this is asset purchases, but last week the central bank indicated it was set on a path to wind these down in the third quarter.
The ECB does have two other tools for addressing market fragmentation, although each is flawed. The central bank can reinvest the proceeds of maturing assets from its Pandemic Emergency Purchase Programme to strategically reduce yields, but with limits on the flexibility of reinvestment. Member states needing help could also sign up for the Outright Monetary Transactions plan. This, however, comes with strict conditionality that no eurozone country wants to accept.
If Frankfurt won’t help finance the spending, Brussels might. When the pandemic hit, the EU created the Recovery and Resilience Facility, a package funded by joint debt issuance providing loans and grants for EU member states to address the shocks from Covid-19. Brussels could make this facility permanent, or generate a new one. EU leaders discussed such a proposal at a summit in Versailles last week.
Opposition remains, particularly in Germany, where the coalition agreement rules out another recovery fund. If the EU jointly issues debt to finance the response to another asymmetric shock, what was a one-off during the pandemic may become a potential crisis-fighting tool for the future. Fiscal authorities might finally pick up the baton from the ECB and bring the eurozone closer to having a sustained fiscal union. The central bank would no doubt welcome this.
But that is a big “if”. It took more than six months to find political agreement on the pandemic RRF, in the face of a much deeper crisis and alongside a simultaneous debate over the EU’s multiannual financial framework that provided room for horse-trading and compromises. Negotiating a new facility could take as long under the current circumstances.
What Europe doesn’t need is for the ECB to stop its asset purchases, hoping that fiscal authorities will agree a new facility, and for EU member states to fail to come up with a financing plan. Then the necessary investments would be foisted on to already stretched national balance sheets, sowing the seeds for another euro debt crisis.
As always, programme details are scarce, and time is of the essence. The good news is that, so far, the Russian war has united EU countries on the need for a robust fiscal response. If the authorities pick up the mantle, the EU and the eurozone can emerge from this crisis more unified and far more resilient.
Source: Economy - ft.com
