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The new European Recovery Fund – Part One

August 31, 2020





It is hard not to share the widespread enthusiasm for the € 750 billion agreement reached earlier this week. A brand-new facility that represents more than 5% of European GDP at a time when governments need to push for a powerful recovery seems exactly what is needed. It also innovates sharply from past practice and demonstrates an impressive level of solidarity. And yet, beyond the headlines, and the relief, there is less than meets the eye and reasons to be concerned. I describe these concerns in three parts. In this first part, I show that the effective amounts are likely to be much smaller and to come too late. In a second part, I argue that the moral hazard concerns, which complicated the negotiations, have been too widely set aside. In a third part, I share my fears about the way the 750 billion will be used.



Start with the big picture: a taboo has been broken and a new path has been opened. For years, any call for some form of Eurobonds has been thwarted by an alliance of Northern countries led by Germany. Their logic was inescapable: they refused to be liable for debts incurred by countries that, for many years, have been unable to bring their public debts down from dangerous levels. Yet, another logic was equally inescapable: legacy high debts were a threat to the euro as they undermined the ability of the Eurozone to weather severe shocks. Under the view that there was plenty of time available for the highly indebted governments to finally act, Eurobonds and joint debt reduction schemes were put on the back burner. Of course, there never was plenty of time: shocks occur unexpectedly. Miracles too. Faced again with the risk of blow-out of the euro, Angela Merkel scuttled the old German dogma. Officially, this is a one-off, a response to a unique historical event. In fact, it is a precedent. Future shocks will be labelled unique and historical. It is a far cry from a fiscal union, a.k.a. a transfer union in Germany, but the first step has been taken. For further steps to follow, however, it is crucial that this experiment succeeds, and that is not a forgone conclusion.


As usual, numbers can be misleading. The stated purpose of the recovery fund is to allow countries hamstrung by high public debts to spend their way out of the recession. The time to act is now, and yet the fund is to be disbursed over three years (2021-3), so it really amounts to an annual average of 1.8% of European GDP per year, much of which will come probably too late. Assuming that a vaccine is made available some time in 2021, the recovery will not be entirely spontaneous. To be sure, once fear recedes, consumption will strongly recover, but only if the damage in terms of unemployment and bankruptcies has been contained in the meantime. Current support mechanisms to employees and firms have been substantial in many countries and need to be sustained. The annual costs run up to 5% of GDP and more.


Nearly half of the recovery funds will consist in loans to governments, which will increase public debts. The remainder, some € 390 billion, will be transfers (collective gifts from the EU) to member states, which is the real innovation. But who will pay for the transfers?


Curiously, this most important question has not been answered clearly. The Commission pleads for an increase in its “own resources”. In contrast to contributions agreed by member states, own resources are taxes – mostly receipts from duties, fines and a small fraction of VAT – that automatically accrue to the Commission. The Commission would love for its own resources to be significantly larger, because it would lessen its dependence on member states, which have been rather stingy so far. Until now, own resources amounted to about 30% of the Commission’s revenues. The agreement mentions new resources like a tax on plastic waste, a border tax on carbon emissions or a financial transaction tax (although income from duties will be reduced). All these taxes have been so far as controversial as the Eurobonds, though. Presumably, without a significant increase in own resources, most of the service on the $750 billion borrowing will have to be covered by additional payments [CW1] from member states to the Commission.


This means that each member states will receive transfers from the Commission’s borrowing over 2021-23 and will have to send transfers (contributions) back to the Commission later on when the debt is paid back, by 2058 at the latest. Two implications follow. First, it all amounts to joint borrowing now, via the Commission, to be collectively paid back later on. This is a good idea, which technically very much looks like the controversial Eurobonds. Second, the net transfers will be different from the gross transfers. By design, some countries (from the South) will receive more than they eventually pay back, others (from the North) will be in the opposite situation. The exact amounts will not be known until the end, but net transfers will be a fraction of the $390 billion, itself a fraction of 750 billion. A range of predictions about the size of net transfers have been made and attract wide attention, especially in political circles. In the Commission’s plan mooted before the agreement, Italy was listed as receiving over three years net transfers worth 3.2% of its GDP while Germany would pay 3.9% of its GDP. These impressive numbers may turn out to be misleading, once the agreement is implemented and each country fights for its own interests.


Before the agreement, until mid-June, according to the IMF, Italy had set in motion its own recovery plan, worth 3.5% of GDP while Germany’s own plan (which has been expanded since) reached 9.4%. The consequence of perceived borrowing capacities, this glaring asymmetry was economic nonsense and a political threat. The very existence of the agreement and the numbers that are floating around are likely to help high-debt countries like Italy to borrow on the financial markets. This could help a lot.

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