Europe’s Shadow Budget

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 in start-up capital, produced through the revaluation of existing EIB assets, and will be backed by €16 billion in guarantees from the European Commission. The fund is expected to leverage this to acquire roughly €63 billion in loans, with private investors subsequently contributing some €5 for every euro lent – bringing total investment to the €315 billion 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, with about €500 billion spent before the end of 2017. Some 53% of those costs correspond to public projects; 15% to public-private partnerships (PPPs); 21% to private projects; and just over 10% to projects that could not be classified.

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 that is expected to be distributed over three years amounts to 2.3% of the EU’s annual GDP. Such a sizeable level of investment is bound to have an impact.

But the program 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 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% of GDP, and the 2012 “fiscal compact,” which stipulates that countries whose debt-to-GDP ratios exceed the 60% 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.