The European Union should take significant economic measures in response to the war in Ukraine, but a new Next Generation EU is not needed yet.
The COVID-19 crisis will remain a major turning point in the history of fiscal federalism in Europe. Before the pandemic, fiscal stabilisation was the sole responsibility of national budgets. But in 2020, EU leaders decided to create Next Generation EU (NGEU), a new instrument outside the EU budget financed by EU bonds, to stabilise the EU.
NGEU was intended as a one-off measure to deal with an exceptional situation. The war in Ukraine is a new exceptional situation that calls for an economic response. Is a new NGEU required, or is the EU budget a better vehicle?
Common borrowing for common stabilisation
There were at least three reasons for the EU to issue, for the first time in its history, common EU debt to stabilise its economy in the context of COVID-19:
- The nature and size of the shock: unlike previous crises, in particular the financial and sovereign debt crises, the COVID-19 shock was exogenous and affected all EU countries. It was the biggest economic shock ever to hit the EU, but most crucially people were dying in large numbers in the pandemic.
- The legacy from the previous crisis: the sovereign debt crisis had left the southern EU countries particularly vulnerable, economically and politically. With these countries again at the epicentre of the COVID-19 shock, there was a real danger of devastating consequences for the economic and political fabric of the whole EU.
- The geopolitical situation: at the start of the pandemic, the EU was already living in a “fragile world”, as European Commission President Ursula von der Leyen noted at the time. Repeating the mistake of the sovereign debt crisis – reacting to events too late and too little – was simply not an option. The EU had to act forcefully or risk losing its place in the world, and credibility with its citizens.
NGEU, a package of €750 billion in grants and loans financed by joint EU borrowing, was the boldest step taken in response to the crisis. Other measures included relaxation of EU fiscal and state aid rules, establishment of the Support to mitigate Unemployment Risks in an Emergency (SURE) temporary loan instrument with a total envelope of €100 billion, and the introduction by the inter-governmental European Stability Mechanism of a facility to help finance health-related expenditures, though no country has used it.
So far, EU countries have requested nearly €500 billion in grants and loans from NGEU; the main beneficiaries have been the four southern countries (Greece, Italy, Portugal and Spain) that alone have requested 62% of this amount.
Besides stabilisation and redistribution, NGEU also addresses the provision of public goods. Admittedly, it finances primarily national projects, but they must be within the six areas agreed on at EU level, of which the climate transition must account for at least 37% of spending and the digital transition for at least 20%. NGEU thus provides a form of European public goods “by aggregation”, delivered at the national level but respecting EU guidelines.
The COVID-19 and Ukraine shocks: similarities and differences
How does the economic situation created by the war in Ukraine compare to the situation during the pandemic, and how should the EU respond to this new situation?
Like COVID-19, the war in Ukraine is obviously an exogenous shock affecting all EU countries, albeit to a different extent because of geographical, economic and financial differences. However, the size of the growth shock caused by the Ukraine war appears to be far less severe than the COVID-19 shock, at least in the short term. In 2022, the global and EU economies may experience a recession due to a number of factors, including the war in Ukraine and the COVID-19 situation in China, but so far the economic impact is expected to be quite mild.
From an economic viewpoint, the pandemic was mainly a temporary shock, though with some long-lasting effects, like a shift to more teleworking. The main economic consequences of the Ukraine war, by contrast, will likely be structural, with EU countries having to devote increased resources to energy security and defence.
Economic and political cohesion in the EU was a problem after the sovereign debt crisis that partly explains why NGEU was needed during the COVID-19 crisis. By contrast, the successful handling of the COVID-19 crisis by the EU, with NGEU and the joint procurement of vaccines, implies that there is now both less of an immediate need for a massive joint EU response, but, hopefully, more willingness to do so should the need arise if the crisis worsens.
Meanwhile, compared to 2020, inflation has increased substantially, with fears that stagflation may be looming. And public debt levels, which were already high in many EU countries after the financial and sovereign debt crisis, increased further with the COVID-19 crisis. This may pose renewed problems of debt sustainability in some EU countries, especially southern ones.
Finally, the geopolitical situation has become much more challenging because of the dependence of many EU countries on Russian oil and gas, and the possibility that the Russia-Ukraine conflict could turn into a conflict between liberal western countries and the rest of the world, including but not limited to Russia and China.
Stabilisation and avoiding fragmentation
The EU and its members must pursue two economic objectives.
The first is to stabilise their economies. So far, the EU has reacted to the Ukraine crisis much like it did at the beginning of the COVID-19 crisis, though in a more limited manner since the initial economic shock has been less severe. EU guidance on fiscal policies has stressed the need for “agility” on the part of EU countries, and some flexibility has been reintroduced for state-aid rules. Crucially, the response has been tempered by the inflation threat. In the face of COVID-19, the European Central Bank introduced the Pandemic Emergency Purchase Programme (PEPP), with an original limit of €750 billion later raised to €1,850 billion, to help national fiscal authorities borrow sufficiently to support their economies. This time, the ECB appears less likely to support borrowing by national fiscal authorities with a PEPP-like facility. On the contrary, it has announced it will gradually wind down its PEPP holdings in order to fight inflation.
The combination of high public debt levels in some countries and high inflation in all euro-area countries is likely to create a trade-off for the ECB between price stability and the risk of fragmentation in the euro area in the event the macroeconomic situation worsens. If the ECB remains unwilling to revive PEPP because of the fear of stoking inflation, weaker euro-area countries may end up suffering from growing spreads on their sovereign debts, leading to insufficient fiscal stimulus and depressed economic growth. This could lead these and some other EU countries to demand stabilisation of the EU economy by again issuing EU debt with a strong redistribution component, as is being done with NGEU. Others would resist such a move on the grounds that COVID-19 was exceptional and NGEU was designed as a temporary instrument.
So far, the size of the economic shock from the Ukraine war does not seem to justify stabilisation by the EU with an instrument like NGEU or the issuance of new EU bonds. There is, however, a clear case for helping countries particularly hit by the consequences of the war with a new SURE programme.
A more difficult question concerns financial stabilisation to avoid fragmentation between stronger and weaker euro-area countries. This is obviously a task only the ECB can undertake. With PEPP being phased out, the only alternative would be an ECB facility that, unlike PEPP, permits the central bank to purchase assets from only one or a few specific euro-area countries. The Outright Monetary Transactions (OMT) facility has been in place since 2012 as a backstop tool for sovereign debt markets, but was not designed for exogenous shocks and its use is subject to European Stability Mechanism (ESM) conditionality. A central issue is whether conditionality would be required in the case of exogenous shocks like the Ukraine war, and if so, what form it should take. In 2018, Claeys suggested an ESM liquidity facility with no conditionality other than a positive assessment by the European Commission and the political validation by the ESM board that the public debt of the country requesting help is sustainable. However, under the current EU institutional arrangement, a stricter form of ESM conditionality would probably be necessary. Another option would be to create a new instrument that would replace the OMT in situations like the Ukraine war, with some form of conditionality, but not necessarily involving the ESM.
The EU also needs to help stabilise Ukraine. Garicano and Verhofstadt proposed to issue €25 billion in EU war bonds, similar to the NGEU bonds, to help the Ukrainian government cover its budget deficit during the war. But there is no need for a new instrument. The EU already has Macro-Financial Assistance (MFA), an instrument with a guarantee from the EU budget designed to help EU neighbours experiencing balance-of-payments crises. The EU already decided to grant Ukraine €1.2 billion of emergency MFA money this year, but the country needs much more. This would be possible under EU budget rules, though EU countries might need to raise their commitment ceilings to provide sufficient guarantee.
The EU’s other objective is to boost its strategic autonomy in energy and defence by significantly expanding investment in these two areas. As Pisani-Ferry noted recently, part of the new energy and defence programmes will need to be administered and financed by the EU. This would be logical, since energy security and defence are European public goods, but it also raises three important questions.
First, how much additional money will the EU and its members need to mobilise to meet the objective of strategic autonomy in energy and defence? At a guess, the range would probably be 0.5% to 1% of EU GDP on an annual basis for defence. In energy, the amount is probably far less, if only the additional investment beyond investment already planned to meet the climate objective is counted. Somewhere in the range of 0.1% to 0.2% of EU GDP during, say, five to ten years may be sufficient.
Second, how should responsibilities be divided between the EU and its members? It is a fantasy to imagine that EU countries will transfer to the EU the responsibility for financing and administering their energy security and defence programmes any time soon. More likely, national budgets will have to finance most of the additional expenditure. But it is crucial to also have EU money in the game to ensure sufficient EU coordination and coherence in these two areas, where such coordination and coherence have always lacked.
Third, what vehicle would the EU use to finance European public goods? One possibility would be to use the existing flexibility of NGEU to reallocate funds. This would be particularly useful for energy security, which would fit under NGEU’s climate priority area. But EU energy security requires much greater EU involvement than the type of coordination currently in place in NGEU that can only deliver EU public goods “by aggregation”. Defence is a different matter. Here the NGEU package is not an option since defence is outside the scope of its six areas of intervention. The EU budget already includes roughly €1 billion per year from 2021-2027 for the European Defence Fund, which finances collaborative defence research and capability development projects, complementing national contributions. This figure would need to be multiplied by 10 or 20 to start making a real difference, but even €10 billion or €20 billion could be financed by the EU budget, which in 2022 amounts to nearly €170 billion.
In summary, the war in Ukraine necessitates the following EU economic measures:
- Use of the flexibility of NGEU to help finance EU energy security;
- Use of existing EU budget instruments to finance a new SURE programme for EU countries, and MFA assistance to Ukraine;
- Increase the EU budget to significantly expand the European Defence Fund;
- Adapt the OMT or create a new ECB instrument to prevent fragmentation in the euro area in case of exogenous shocks, like the war in Ukraine.
These measures do not require a new NGEU package at the moment, but this judgement may need to be revised if the economic consequences of the war become much more severe than currently foreseen by most forecasters.