Dalibor Rohac

The EU is sleepwalking into a debt trap

It’s been less than three years since the EU made the unprecedented decision to issue €750 billion of its own debt to help finance the EU’s post-pandemic recovery. Despite this supposedly being a one-time policy, the idea of issuing new debt is now rearing its head again – this time to fund the EU’s industrial policies.

The European Commission is pressing ahead with a ‘European Sovereignty Fund’, as a way of responding to the Biden administration’s Chips Act and Inflation Reduction Act, which created subsidies for electric vehicles. By doing so the Commission hopes to prevent member states from introducing their own national industrial policies that could fragment and distort Europe’s common market. 

Issuing common debt would be a disastrous mistake

‘We should consider the possibility to finance the Fund through common debt, like we successfully did with Next Generation EU,’ the EC president, Ursula von der Leyen, said in her State of the European Union address in September 2022. 

Member states should nip this in the bud. While the Commission is right to be concerned about runaway national industrial policies, issuing common debt would be a disastrous mistake. It would set the EU on an unmanageable fiscal trajectory that would worsen rather than improve the financial stability of the Eurozone. 

The arguments for common debt are unconvincing. If European banks and other financial institutions really need a ‘European safe asset,’ they could easily create a synthetic fund from the vast pool of existing public debt of member states. 

It is also far from clear that a Sovereignty Fund, used to finance everything from chips and batteries to hydrogen infrastructure, would truly provide essential European public goods – rather than throwing money at the fashionable policies du jour.  

But even if the Sovereign Fund was well spent, why should extra European debt by piled on top of the already massive national debt of sovereign countries? Remember that in history, borrowing has always been accompanied by major institutional reforms to provide borrowers with credibility. That is why England saw a new political settlement in the late 17th century: the Glorious Revolution. The strengthening of powers of Parliament over government spending and taxation dramatically improved England’s creditworthiness and drove down the risk premium on British debt. For the same reason, the US founding father Alexander Hamilton insisted that the central government would not bail out America’s states.

In contrast, expecting the EU – a convoluted multilateral body with no power to tax and few coercive powers in general – to act as a major borrower will only encourage free-riding from member states. Unlike in the late 18th-century United States, EU members know well that they can count on EU institutions and the ECB to bail them out should they find themselves in financial difficulty. 

Accordingly, while state-level debt across US states is small (roughly between 10 and 25 per cent of state GDP), in most EU countries debt is both high and on unsustainable long-term trajectories. In Greece debt has been as high as 200 per cent of GDP, in Italy it is around 150 per cent, and in France above 110 per cent. And by creating a new source of collective revenue, untethered to the domestic tax base, the EU will create the exactly wrong incentives for keeping domestic budgets under control. 

Instead of making national governments confront hard choices – as Macron is currently attempting to do in France to make pensions sustainable – EU borrowing would enable member states to provide public services increasingly at an EU level. These countries would then expect the EU budget to pay for improvements in domestic infrastructure, defence, or public administration. 

More European borrowing is worse than a solution in search of a problem. It is an exercise in magical thinking – hoping that more public spending can be squeezed out of the European economy without having to pay for it. To be sure, a ‘Sovereignty Fund’ might pay for some worthy causes. But, if they really want to spend money on their pet causes, member states pursue fiscal restraint at home to free up the necessary resources. Piling European debt on top of national debt, without adequate institutions to support it, is not a way to achieve geopolitical relevance – it is the road to ruin.