Policy Research in Macroeconomics

Radically Transforming the EU Economy – and how to finance it

Image by SatyaPrem from Pixabay

The following article appeared on Progressive Post, the website of the Foundation of Progressive European Studies (FEPS)

Today’s capitalism cannot tackle climate breakdown and cannot prevent the loss of biodiversity. It considers work as a cost to be minimised, to the detriment of the economy and the social meaning of work.

High rates of return on capital (interest) require ever-rising extraction of the earth’s finite assets and the felling of its biodiverse ecosystem. Nature is crowded out by intensive agriculture, mineral extraction and housebuilding linked to expanded transport networks (shipping and airlines) and fuelled by hydrocarbons. These activities have stripped wildlife of habitats and brought societies into conflict with the animal world. More than 30 new disease-causing organisms have appeared in just the last two decades according to globalisation expert Professor Ian Goldin and Mike Mariathasan in their book, The Butterfly Defect. The new coronavirus has taught societies across the world that globalisation acts as a passport for pandemics, turning airlines and international journeys into disease vectors.

The lethality of the virus, and the threat of future pandemics has led to demands for more localisation of economic activity: for a reduction in both national and international flights, for more homeworking and for the reshoring of manufacturing.

And even investor concerns have accelerated demands for divestment in fossil fuels. Such concerns led British Petroleum (BP) on 4 August 2020 to become the first oil supermajor to begin abandoning its business model. It would cut oil and gas production by 40% over the next decade, and dramatically increase its investments in low-carbon technology. On 5 August, the Financial Times reported that “Peabody Energy had written $1.4bn off the value of the world’s largest coal mine, an acknowledgment of electricity generators’ permanent shift towards natural gas and wind”. On 18 August the world’s biggest mining group, the Anglo-Australian BHP “confirmed plans to exit thermal coal” as the company “prepares for a lower carbon future.” Analysts at Berenberg Capital Markets said it would be “fairly challenging” to find a market buyer for the coal operations because of growing investor concerns about CO2-heavy assets.

This is the fast-moving context in which the EU Commission president, Ursula von der Leyen, is leading the progress of the Commission’s ambitious Green Deal.

There is much to admire about the roadmap and key policies that make up the European Green Deal.

  • Firstly, it has opened up political space across the continent, and beyond, for debates on how economies can adapt to, and prepare for,climate breakdown and the loss of biodiversity.  The debate in Anglo-American economies on the Green New Deal has petered out – buried by the politics of identity, nationalism and protectionism.
  • Secondly, the Green Deal has set (and the EU is considering raising) ambitious and binding targets for 40% greenhouse gas (GHG) reduction from 1990 levels by 2030; for an increase in the share of renewable energy to 32% and indicative targets for energy efficiency. Subject to further debate, these targets will be enshrined in law.
  • Thirdly, the priority accorded to the climate crisis provides the Union with off-the-shelf policies and targets that could aid job creation and economic recovery from the coronavirus crisis. Meanwhile the increasingly uneconomic extraction of coal will likely mute Polish and Czech political resistance to the Green Deal.

While these are encouraging developments, the Green Deal suffers from three weaknesses.

  • The first is the failure to set specific carbon-reduction, energy efficiency and renewable energy targets for each country of the Union.
  • The second, more serious weakness is the pitifully small sums of money allocated for the immense programme of work required for the radical and urgent transformation of Europe’s energy, transport and land-use systems. This distinctly un-ambitious fund-raising plan can be explained by the structural flaws in Europe’s monetary system, designed to immobilise Union-wide fund-raising by public authority. Below we propose a plan that could, within existing Treaty-constraints overcome these flaws; one that would create a European safe asset for raising sufficient finance to implement the Green Deal across the Union.
  • The third weakness of the Green Deal is also structural, and can be located in the growing, and increasingly divisive economic divergences between Member States. This structural flaw can also be addressed, and we do so below.

Setting safe ecological loads or ‘Plimsoll lines’

The Green Deal’s carbon budget is a Union-wide budget and while GHG reduction targets are binding on Member States, the energy efficiency target is indicative only and targets for renewables, while binding at Union level, are not specified for each member state. Under the Union’s governance procedures Member States will have to submit progress reports and Climate Plans to explain progress in achieving these targets. These are bound to be wordy, time-consuming documents that will gather dust in libraries. Better if the Commission, having determined the safe carbon carrying capacity of the Union as a whole – the ‘Plimsoll line’, after the white line that is painted on vessels to show the most they can carry before compromising their seaworthiness – or optimum scale of GHG emissions for the European-wide economy, could then break down the Union’s carbon budget to arrive at ‘Plimsoll lines’ or carbon budgets for countries, regions and cities. In Britain, physicists at the prestigious Tyndall Centre for Climate Change Research, led by Prof. Kevin Anderson, have developed a low carbon pathway model, SCATTER (Setting City Area Targets and Trajectories for Emission Reduction) for Manchester, by quantifying the implications of the Paris Agreement for the city. This model could be replicated across Europe and if made public, could provide regional and local policymakers with toolkits for measuring the reduction of GHGs and engage activists and citizens in the achievement of ecologically safe ‘Plimsoll lines’.

Mobilising finance for the radical transformation of the EU economy 

Perhaps the greatest weakness of the EU Commission’s Green Deal is the dearth of finance it is proposed would be mobilised for this transformational programme. The meagre sums proposed can be explained by the inability of the EU Commission to draw on the power and resources of a Central Bank to generate the liquidity needed to finance public investment in economic transformation. Instead the Commission is forced to draw on Europe’s existing and limited public and private savings. These include a percentage of the paltry EU budget (barely 1% of the EU’s gross national income) plus savings mobilised by the InvestEU Fund and the EU Investment Bank. The EU Green Investment Plan aims to raise €1 trillion over ten years. The European Investment Bank will aim to support €1 trillion of investments in climate action and environmental sustainability “in the critical decade from 2021 to 2030. These negligible sums to be expended over long time periods are entirely inadequate for the scale of transformation needed if Europe is to achieve Green Deal ambitions.

Contrast these sums with the speed and scale of finance committed by the ECB and European governments in March, 2020 and designed to keep Europe’s private and globalised capital markets liquid. The ECB’s pandemic emergency purchase programme (PEPP) committed €1,350 billion to bail out the finance sector, and did so almost instantaneously. The interest rate on its main refinancing operations, the marginal lending facility and the deposit facility were quickly lowered to an extraordinary 0.00%, 0.25% and -0.50% respectively. This largesse was supplemented by tax breaks and fiscal spending by member states that drew on present and future contributions (savings) of Europe’s taxpayers. The unprecedented ECB interventions were intended to maintain life support for a European finance sector that has been in a comatose state since the Great Financial Crisis of 2007-09. Its lending to these institutions will add to unsustainably high levels of debts owed by financial and non-financial corporations, and will undoubtedly be gambled away on stock markets, on stock buybacks and on other forms of speculation. Green Deal investments, by contrast, could expand both private and public sector activity, and create jobs Europe-wide. Job creation will both revive the private sector, but also generate the tax revenues needed for repayment of public debt, while at the same time the investment would tackle the climate crisis.

How can we move beyond today’s rentier capitalism and build a different and better Europe? 

Europe’s problems are structural. The Union was built on the two narrow pillars of monetary union and financial integration. Its Hayekian design was intended to ‘encase’ private capital markets and protect them from the intrusion of democratic states. The recent bailouts prove the dependence of private capital markets on public resources.

The Union’s economic foundations are laid on volatile, globalised flows of private, mobile capital – beyond the reach of regulatory democracy. This fact was starkly exposed when the EU General Court rejected the Commission’s attempt to recover €13 billion in back taxes from Apple, whose profits are protected by the tax haven that is Ireland, an EU member state. This is the third occasion on which the General Court has upheld the primacy of mobile, globalised capital over the sovereignty of European regulatory democracy. (The other cases involved unlawful state aid granted to Starbucks by the Netherlands and Belgium’s excess profit exemptions granted to multinationals.)

Transforming the ESM into a new Debt Agency issuing a European Safe Asset 

Despite this setback, Italian economists have proposed a plan for issuing a European Safe Asset, that would overcome current roadblocks, and would mobilise large sums of finance for EU projects.

The plan draws on the recent suspension of the Stability and Growth Pact (SGP). Member states are now permitted to spend and go into debt beyond artificial constraints. Nevertheless, this suspension does not solve the problem of financing either new investments or existing debts. As the Italian economist Massimo Amato of Bocconi University and colleagues argue here, and here, what is needed is a radical new instrument – a safe asset – that would allow Member States to both raise sufficient finance and service affordable debts.

The Amato et al. proposal for a European Debt Agency (DA) would involve the transformation of an existing mechanism, the European Stability Mechanism (ESM). With its capital endowment of €700 billion (€80 billion paid and €620 billion of ‘callable shares’), the ESM can now grant direct loans of up to €500 billion to Member States. But the ESM could be transformed, argues Amato, from a fund that lends in the short to medium term, with potentially vexatious conditionalities, into a ‘debt agency’ (DA) capable of mobilising large quantities of finance on the markets, at advantageous conditions, and stabilising the returns of Europe’s public debt by structurally reducing spreads between states. It would do so by providing them with a genuine European safe asset even in the absence of improbable reforms of EU treaties. A European safe asset that would be comparable to that issued by the US Treasury, the Treasury Bill.

The debt agency would receive from each Member State an annual instalment calculated on the basis of its fundamental risk only, anchored to its official rating. The DA would then issue bonds that filter the market liquidity spread risk between Member States. It would collect liquid funds in markets by issuing plain vanilla sovereign bonds with finite maturity and use these funds to finance Member States with infinite maturity (perpetuity) loans. The overall flow of annual instalments from Member States, net of legal provisions, would allow the DA to remunerate bondholders at a rate in line with its high credit standing: it will therefore be at most equal to or lower than the fundamental cost for each Member State (corresponding to the returns of the DA’s underlying portfolio). EU states could then borrow through an agency that acts as a private entity in interfacing with markets but has the public mission of minimising borrowing costs for the states themselves and possibly also for the debts newly issued by the EU.

Without a eEurozone public and common safe asset, it will be very difficult to break the perverse link between national banking systems and their public debt. From a fund that provides loans in the short to medium term under potentially vexatious conditionality, the ESM can turn into a DA already adequately capitalised with respect to solvency requirements. It would thus be able to collect large amounts of funding in the markets at advantageous conditions, and to stabilise government bond yields (while structurally reducing spreads) as well as markets and financial operators’ balance sheets, in so far as it could provide them with an authentic European safe asset.

The ECB could indirectly support the activity of the DA by using its own instruments to ensure alignment of the new European ‘safe asset’ yields with the ‘risk free’ interest rate. These interventions, referring to a common bond that does not imply any kind of mutualisation, would be perfectly in line with the principle of the capital key. The European banking system would benefit from the availability of excellent collateral for its daily activities.

Ending Europe’s growing divergences 

But this is not the only radical reform that could help stabilise the imbalances that have arisen within and across Europe: divergences that have led to the rise of right-wing, nationalist and authoritarian parties, threatening the lofty purposes of the European Union for peace and unity. As Amato, Fantacci and I have argued here, we know that such divergences can be resolved because Europe has done it before, when the European Payments Union (EPU) was established between 1950 and 1958.

The EPU made it possible for each country to finance its current account deficits without relying on the vagaries of capital liquidity provided by international financial markets, by providing a ‘clearing centre’. The country’s position was recorded as a net position in relation to the clearing centre itself, and thus as a multilateral position in relation to all the other countries. A quota was set for each country corresponding to 15% of its trade with the other countries in the EPU. Credit and debit balances could not exceed the respective quotas. The system therefore set a limit on the accumulation of debts or deficits with the clearing centre and provided debtors with an incentive to converge towards equilibrium with their trading partners. The EPU also exerted strong pressure on creditor countries which, like Germany and the Netherlands today, failed to raise imports and cut their surpluses.

The result was an extraordinary, export-driven expansion in production, in Germany and Italy in particular, and the liberalisation of trade not only within the EU, but also well beyond. But what was most extraordinary was that this expansion of trade came along with rising employment and welfare in each partner country: the EPU was a part of a superstructure that provided countries with more autonomy to foster an economy led by domestic demand.

A new European Clearing Union

A modern version of this system could be created today. Better still, it could be introduced without changing the EU treaties. It simply requires enforcing the existing rules and reinterpreting the existing monetary infrastructures.

In the eurozone there is already a clearing house for the precise purpose of optimising the management of payments. TARGET 2 (the Trans-European Automated Real-time Gross Settlement Express Transfer) is a system that is used today to settle cross-border payments individually. Within this system, Germany, together with other surplus countries like the Netherlands, has built up substantial credits and has the highest positive settlement balance. Correspondingly, Portugal, Spain, Greece, Ireland and Italy have built up substantial debits, and therefore have negative settlement balances. These reflect the cumulative balance of payments imbalances between northern and southern Europe that were formerly financed by capital flows from the centre to the periphery, but which have since reverted in the wake of the Great Financial Crisis.

This accounting gimmick has played a crucial role in saving the system of the single currency. While not solving the problem of large interest rate spreads, the accumulation of positive and negative balances within TARGET2 has prevented the financial turmoil that resulted from the sudden stop of capital movements after the sovereign debt crisis from turning into a currency crisis.

Our proposal is to open a section of TARGET2 – call it ‘T2trade’ – designed to function, like the EPU, as a source of funding for temporary current account disequilibria, without having to rely on short-term capital movements. The result would be a new ‘European Clearing Union’. For this to work, four measures would have to be adopted:

  • Firstly, credit would have to be restricted in ‘T2trade’ solely to commercial transactions between European countries and to tourism. The idea of restricting certain facilities of the European Central Bank (ECB) to specific kinds of economic transactions is not new. It was introduced with the Targeted Longer-Term Refinancing Operations (TLTRO).
  • Secondly, there would have to be a limit on the possibility of accumulating positive or negative balances, commensurate with each country’s volume of foreign trade. This principle is perfectly consistent with European rules, specifically under the Macroeconomic Imbalance Procedure (MIP).
  • Thirdly, imbalances could be subjected to symmetrical charges. This option can, and we believe must, take on the form of a political proposal obliging all countries to face up to their responsibility in settling the imbalances in so far as they have enjoyed advantages in accumulating them. It would serve as a reminder to the creditor countries that they too have benefited from the single currency, thanks to the opportunity to export to the countries of southern Europe at a competitive real exchange rate. And it would serve to involve these countries in the adjustment process without having to appeal to their ‘kind heartedness’. Moreover, it would be consistent with what the ECB announced in summer 2014 when, after introducing negative interest rates on deposits, it stated that negative rates should apply also to TARGET2 balances.
  • Fourthly, there should be the possibility of adjusting real, if not nominal, exchange rates, should imbalances prove persistent.

Economic solidarity

While there is scope to argue about the specific measures that would need to be adopted to make either Amato’s debt agency, or our proposed European Clearing Union work, it is critical that any mechanism is based on the following political and economic principle: solidarity between northern and southern European countries, and solidarity between sovereign debtors and creditors, in order to restore a common purpose to the European project. Solidarity not in a moral sense, but in an economic one – of shared responsibility for stability and symmetric distribution of the burden of readjustment. Above all, in a sense of shared responsibility for the restoration of Europe’s ecosystem. The Green Deal can only prove truly transformational by basing itself on the solidarity of Member States, determined to work together to tackle the biggest challenges ahead: climate breakdown and biodiversity loss.

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