Shadow budget

More details about the European Commission’s 315 billion euros ($390 billion) investment plan for 2015-2017 have finally come to light.

The programme, 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 borrowing will be arranged through the new European Fund for Strategic Investment, operating under the umbrella of the European Investment Bank.

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 to acquire roughly 63 billion euros in loans, with private investors subsequently contributing some 5 euros for every euro lent — bringing total investment to the 315 billion euro target.

Though EU countries will not contribute any actual funds, they will provide implicit and explicit guarantees for the private investors, in an arrangement that looks suspiciously like the joint liability embodied by eurobonds.

Faced with German Chancellor Angela Merkel’s categorical rejection of eurobonds, the EU engaged a horde of financial specialists to find a creative way to circumvent it. They came up with the EFSI.

Though the fund will not be operational until mid-2015, EU member countries have already proposed projects for the European Commission’s consideration.

By early December, all 28 EU governments had submitted applications — and they are still coming.

An assessment of the application documents conducted by the Ifo Institute for Economic Research, of which I am president, 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 per cent of those costs correspond to public projects; 15 per cent to public-private partnerships (PPPs); 21 per cent to private projects; and just over 10 per cent to projects that could not be classified.

The public projects will presumably involve EFSI financing, with governments assuming the interest payments and amortisation.

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 programme 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 per cent of the EU’s annual GDP. Such a sizeable level of investment is bound to have an impact.

But the programme remains legally dubious, as it creates a massive shadow budget financed by borrowing that will operate parallel to the EU and national budgets, thereby placing a substantial risk sharing burden on taxpayers.

Because every country, regardless of its creditworthiness, can borrow at the same interest rate, projects will be undertaken in countries that recently have 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 mutualisation 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 per cent of GDP, and the 2012 “fiscal compact”, which stipulates that countries whose debt-to-GDP ratios exceed the 60 per cent 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 special-purpose vehicles and conduits, to take on excessive risk. It is worrisome, to say the least, that the EU is now resorting to similar tricks.

The writer, professor of economics and public finance at the University of Munich, is president of the Ifo Institute for Economic Research and serves on the German economy ministry’s advisory council. He is the author, most recently, of “The Euro Trap: On Bursting Bubbles, Budgets, and Beliefs”. ©Project Syndicate, 2014. www.project-syndicate.org