Ifo Viewpoint No. 162: Europe’s Shadow Budget

Hans-Werner Sinn
Munich, 20 February 2015

More details about the European Commission’s 315 billion euros investment plan for 2015–2017 have finally come to light. The program, announced by European Commission President Jean-Claude Juncker in November, amounts to a massive shadow budget, twice as large as the European Union’s annual official budget, that will finance public investment projects and ultimately help governments circumvent debt limits established in the Stability and Growth Pact.

The investment plan will be arranged through the new European Fund for Strategic Investment (EFSI), operating under the umbrella of the European Investment Bank (EIB). The EFSI will be equipped with 5 billion euros in start-up capital, produced through the revaluation of existing EIB assets, and will be backed by 16 billion euros in guarantees from the European Commission. The fund is expected to leverage this by a factor of 15 to bring total investment to the 315 billion euros target. One wonders what kind of investors would be willing to engage in such an undertaking.

The European Central Bank (ECB) gave an answer two weeks ago in the form of its Quantitative Easing programme, i.e. the announcement that it would buy up to 1.1 trillion euros in securities mainly in the form of government bonds but also as asset backed securities. Twelve percent of this programme, that is, 132 billion euros, are to be allotted to purchasing securities issued by European institutions, and will be subjected to joint liability by all central banks. Much of this money will in all likelihood flow into the European Investment Bank to kickstart the EFSI leveraging. It won’t be private investors, but taxpayers who, as silent partners in the ownership of the central banks, would jointly bear a significant portion of the risk. Chancellor Merkel’s categorical No to Eurobonds is being respected only inasmuch as a different semantics for their introduction has been chosen.

Though EU countries will not contribute any actual funds to the EFSI, they will provide implicit and explicit guarantees for the private investors. The fund will not be operational until mid-2015, and the EU member countries are busy submitting projects for the European Commission’s consideration.

An assessment of the application documents conducted by the Ifo Institute for Economic Research in December found that the nearly 2,000 potential projects would cost a total of 1.3 trillion euros, with about 500 billion euros spent before the end of 2017. Some 53 percent of those costs correspond to public projects; 15 percent to public-private partnerships (PPPs); 21 percent to private projects; and just over 10 percent to projects that could not be classified. Only a small minority of the projects were of a cross-border nature.

The public projects will presumably involve EFSI financing, with governments assuming the interest payments and amortization. The PPPs will entail mixed financing, with private entities taking on a share of the risk and the return. The private projects will include the provision of infrastructure, the cost of which is to be repaid through tolls or user fees collected by a private operator.

Unlike some other critics, I do not expect the program to fail to bolster demand in the European economy. After all, the 315 billion euros that is expected to be distributed over three years amounts to 2.3 percent of a yearly EU GDP. Such a sizeable level of investment is bound to have an impact.

But the program is legally dubious because it creates a massive shadow budget financed by borrowing that will operate parallel to the EU and the national budgets. There is also a substantial risk sharing burden imposed on tax payers. Because every country, regardless of its creditworthiness, can borrow at the same interest rate, projects will be undertaken in countries that have lately burned such huge amounts of capital that they can no longer tap financial markets for funding. Just like the many other “protective” measures taken during the crisis, this distortion of market processes will help to cement the sub-optimal allocation of European investment capital, hampering economic growth for years to come.

Making matters worse, only a fraction of the new borrowing enabled by the mutualization of liability will be factored into national budgets. This will render meaningless EU-wide debt-management agreements, including the Stability and Growth Pact, which limits the overall deficit to 3 percent of GDP, and the 2012 “fiscal compact,” which stipulates that countries whose debt-to-GDP ratios exceed the 60 percent limit should reduce them by one-twentieth annually until they are in compliance.

In recent years, banks have been berated for using shadow budgets, in the form of specialpurpose vehicles and conduits, to take on excessive risk. It is worrisome, to say the least, that the EU is now resorting to similar tricks.

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute

Published in similar form as “Europe’s Shadow Budget”, by Project Syndicate. Also published in German under the title “Europäisches Schattenbudget”, Handelsblatt, No. 27, 9 February 2015, p. 48.