Common European Debt: a Fine Idea Unworkable Without True Federalization

In a working paper of the Belgian-based Bruegel think tank, entitled A sober look at the case for common European Union debt, economists Marie-Sophie Lappe and Jeromin Zettelmeyer examine proposals for expanding the share of common European Union debt. The authors distinguish between two different justifications for the proposals: financing all-European public goods (defense, industrial policy, and foreign policy) and achieving broader macroeconomic benefits: lower borrowing costs, greater financial stability, and a deeper capital market. They mainly focus on the latter justification to make rather a harsh finding: the full set of the benefits can only be generated by a true fiscal union – with EU powers comparable to a federal government’s.

Hidden behind this calm and academically worded analysis is a reality uncomfortable to European advocates of common debt. The authors show that mere expansion of temporary common debt with the current institutional limitations in place would most probably fall short of generating the results expected. The main reason is a narrow investor base. Investors still perceive European debt differently than major member States’ sovereign debt. A simple increase in bond issuance will not solve this problem on its own. Investors still consider EU securities a special asset, less liquid and less ‘safe’ than German and even French bonds.

The authors examine in detail a proposal by Olivier Blanchard and Ángel Ubide that a portion of national debts should be exchanged for European one. This could really create a constant and significant volume of common debt and thus broaden the market. However, even in this case they estimate that European bonds would hardly receive the supreme AAA credit rating. The cause is fundamental: debt backed by member-State payment commitments alone cannot simultaneously be top-rated, avoid subordinating national debt and avoid guarantees from the most reliable countries. Any attempt to solve one of these problems would immediately create another.

In practice, Europe is at a classical juncture. For its common debt to really become a safe haven and start bringing in macroeconomic benefits, the EU should move towards a fiscal union. This means vesting the European Union with real fiscal powers, including the right to impose its own taxes and levies. Such a step remains quite sensitive politically. Most member States are unprepared to give their right to raise and manage revenue away to Brussels. As a result, the debate on common debt is constantly reduced to compromises and half-hearted options that fail to address the core issue.

Marie-Sophie Lappe and Jeromin Zettelmeyer suggest two relatively modest steps. First, the EU should commit itself to either permanently roll over the debt of the NextGenerationEU program or maintain a minimum level of EU debt outstanding. Second, it should delegate to the European Commission limited emergency fiscal powers, including pre-identified revenue measures that would only be activated in the event that EU debt service falls short. In their opinion, these measures would strengthen the market’s confidence and bolster the prospect of the debt receiving a high rating. However, even the authors admit that this only means a modest step towards a fiscal union, not creating one.

The paper by Ms. Lappe and Mr. Zettelmeyer is quite indicative of the limitations inherent in the current European debate on common debt. Advocates of this idea promise cheaper borrowings, greater financial stability and a deeper capital market. In practice, these benefits remain inaccessible barring genuine delegation of sovereignty. Europe continues discussing technical schemes and temporary tools while dodging the main political question. Unless and until member States get ready to create a real fiscal union, common European debt will remain a lopsided instrument, useful in some cases but unable to solve the macroeconomic tasks assigned to it. As a result, the discussion risks staying much longer in the domain of good-looking but practically limited proposals.

Original publication: https://www.bruegel.org/working-paper/sober-look-case-common-european-union-debt