Thu, May 28, 2020 page9

• Europe is on the cusp of having its own ‘Hamiltonian moment’

  • By Anatole Kaletsky
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  The new Franco-German proposal for a 500 billion euro (US$550.1 billion) European recovery fund could turn out to be the most important historic consequence of the COVID-19 pandemic.

  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 EU’s “Hamiltonian moment,” comparable with the 1790 agreement between US founding fathers Alexander Hamilton and Thomas Jefferson on public borrowing, which helped to turn the US, 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 might prove justified.

  The plan amounts to only 3 percent of the EU’s GDP, compared with the 15 percent of GDP already committed by Germany to industrial support.

  Creating any EU recovery plan would require unanimous support from the EU’s 27 member countries — and this would 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, and which, according to Dutch Minister of Finance Wopke Hoekstra, have mainly themselves to blame for “failing to reform.”

  However, 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 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 might sound tediously technical, but would vastly increase the flexibility of EU fiscal policy and could 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 revenue, 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 debt.

  However, 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 would 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 percent of EU gross national income, yielding about 180 billion euros per year in extra revenue.

  To raise this amount, the EU would need to levy new taxes on its own account, in addition to the customs duties and small share of national value-added tax revenues that 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.

  However, 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 would flow into recovery projects, but most would be needed for other EU spending, such as “cohesion funds,” which subsidize 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 UK’s net contributions of roughly 10 billion euros per year.

  That leads to the third 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.

  Due to 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 10-year bonds, it would probably pay interest of zero or less, potentially allowing almost unlimited borrowing, albeit with sinking funds to redeem the debts at maturity.

  However, even a 50-year bond could probably be issued with a coupon no higher than the 0.5 percent 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 Hungarian-American billionaire George Soros. This would allow the EU to borrow 500 billion euros at an interest cost of just 2.5 billion euros per year.

  To put it another way, if the EU borrows 500 billion euros this year for a European recovery fund, then it could easily borrow another 1 trillion euros next year for a digital inclusion fund, and then maybe 2 trillion euros for a vehicle electrification fund or 3 trillion euros 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 would vehemently object to offering grants, rather than loans, to the bloc’s Mediterranean members.

  However, it is hard to imagine that any of these governments would 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 euros recommended by the European Commission without imposing any strain on the EU budget.

  However, in exchange, the Frugals could insist on offering 50 percent 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. Using loans instead of grants would also 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 cochairman of Gavekal Dragonomics. He is a former columnist at the Times, the International New York Times and the Financial Times.

  Copyright: Project Syndicate
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