EU budget struggles and the need for stimulus

Earlier this decade the European Union (EU) launched the grand €2.018 trillion package of spending. Of this, €1.2 trillion was allocated for the seven-year planned budgets 2021-2027, and €806bn was the new Next GenerationEU fund. This money is being borrowed by the EU and passed onto member states, with a mixture of grants and loans to promote post covid recovery and green transition.

Today there are many spending pressures on the EU. The cost of borrowing the money has gone up, and where it is used to pay grants, the extra interest becomes an additional charge on the annual budgets.

The EU receives a cut of the Gross National Income of each member state, and benefits from customs duties, a VAT levy, fines, a levy on recycled plastic and sale of carbon permits. It is looking at other possible taxes. Many would like to borrow more at EU level, avoiding the controls on member states borrowings and offering money to the more stretched member states from the Union. The EU is currently having to pay a higher rate of interest than either Germany or France to borrow, even though those two countries are with the other member states guarantors of the EU money.

Controlling member states borrowings

EU finance ministers have been struggling to agree in principle and then approve a legal text about controlling member states’ budgets. For some time, the old controls of limiting budget deficits to a maximum of 3% of GDP and keeping the stock of debt below 60% have been suspended. So too have the annual requirements on the many member states with high debt levels to be taking action to reduce the state debt as a proportion of GDP.

There is a deadline of the end of the year to put in place a new system. Everyone agrees the new system of control will be more flexible, subject to EU negotiation with each member state. There remain many views on how flexible, how much borrowing should be allowed, and what will qualify to justify higher borrowing.

Germany has traditionally been the repository of prudence. Germany only agreed to France’s demands to enter a single currency on the basis that there would be strict controls on the amount of debt each member could run up. Germany did not want free-rider states using the lower interest rates of the zone to borrow excessively themselves. Germany was also clear there would be no monetary financing of deficits, and no transfers from rich to poor under cover of the currency and the borrowing rules.

For this reason, they ruled out EU-level borrowing guaranteed by the member states collectively. In most currency unions there are large transfers through grants from the richer parts of the union to the poorer. The EU does have some of these regional policies, but not on the same scale as in a single currency nation-state.

Over the years Germany has lost a series of battles to keep these rules and controls. Germany had to accept money printing and bond buying by the European Central Bank. Whilst they said it was not monetising member states debts it was certainly letting member states borrow at record-low interest rates, kept in place by the big support for bond prices as they bought up so many. Germany during Covid-19 also had to accept a Recovery Fund set up by the EU that did borrow on the EU covenant. Germany has had in recent years to accept the suspension of the debt and deficit rules allowing member states to increase borrowings that were already well above the 60% of GDP mark.

Germany seeks prudence

Today, German finance minister Christian Lindner and the Bundesbank are trying to make common cause to re-establish some prudent control, to lower the risks of Germany having to accept joint responsibility for the weak finances of several member states that have borrowed a lot. They are also fighting a similar domestic battle, where the Greens and SPD in coalition with the prudent FDP Finance Minister are keen for Germany itself to find a way around her own deficit brake, borrow a lot more and be more relaxed about debt and deficit.

Germany and the EU have plenty of reasons they think might justify extra borrowing. Stimulating a weak economy, offsetting the high costs of energy that make them uncompetitive, rearming given the Ukraine war and the need to meet NATO requirements, and the demands for huge sums to invest in renewable electricity and in switching out of fossil fuel energy use all require big budgets.

Both the COVID-19 and energy recoveries which attracted special funds had the advantage of being one-offs which could be time and cash-limited. The problems with the vast spend needed for net zero and the open-ended commitment to substantial spending increases in defence is they are recurring items for many years which would normally be part of a regular annual budget paid for out of tax revenue.

The state of the argument over budget controls

The EU rows see France and Germany on different sides, despite their normal strong alliance and common working. France wants more scope to borrow, starting from a high budget deficit and with state debt around twice the permitted level. Germany with a low deficit if you ignore the special funds and with state debt at 66% to GDP favour a much tougher approach. Various other countries want an easier regime, especially the southern states including Italy, Spain, and Portugal with large debt positions.

Possible compromises include a slower pace of cutting an excessive deficit, a slower pace of getting to reducing the proportion of state debt to GDP and allowing items like recovery spending and defence to be outside the numbers used in the calculations. The EU is probably going to nudge states in the direction of allowing more money to be borrowed and raised at the EU level with more of each member states money coming from the Union as they pursue their centralisation policies.

The EU will not undertake the same large fiscal expansion to offset some of the monetary tightening that we have seen in the US. Nor will it restrain all the pressures to spend and borrow more, where even Germany now has a government seeking ways round its own constitutional controls over too much borrowing. There will be a series of compromises over how much the EU itself spends, borrows and taxes, with gradual increases in all three as the federal centre strengthens its position and does more. Member states under financial stress want more grants and loans from the centre, and the Union itself wants to extend its reach and likes the extra control over member states that lending and granting them money brings,

The member states themselves will need to exercise some restraint to satisfy the EU and market tests on their borrowings but are in no mood to cut what they spend or reduce their debt stocks any time soon. Slow and no growth limits revenue growth, and high-interest rates are a direct charge on the states that have borrowed. The spending pressures are very strong.