The Draghi Report (Draghi 2024) and Letta Report (Letta 2024) offer a number of useful proposals for the EU’s economic and broader strategy to confront current geopolitical developments. However, these ambitions may easily get stuck in the discussion how to finance them and how to share the bill. In this contribution we argue that a first step would be to use existing resources to finance European public goods (EPGs) that benefit all member states.

Large investment needs and key priorities

The EU will be confronted with large financing needs for the digital transition, the energy transition, the demographic transition, and defence (e.g. Dorrucci et al., 2024). A substantial fraction will have to be covered by public funding. These expenditures can to a large extent be provided as EPGs, because they feature strong economies of scale or cross-border spillover effects (e.g. Strauch 2024). ¹ However, the question is how to finance those EPGs. In view of the usual divide between the profligate and frugal countries, with the latter unenthusiastic about further expansion of collectively financed arrangements, it may be best to initially go for a more modest solution, namely, using existing funds to finance spending purposes that benefit all countries or leverage on the European Stability Mechanism (ESM) when financial instability risks arise. ²

One of the key priorities of the EU Commission 2024-2029 is “a strong and secure Europe”, and within this “strengthening EU security and defence…”. Defence and security may be the type of EPG on which all member states could find agreement. ³ A concrete example is European air defence (Wolff 2024): the air defence of one country will help to protect neighbouring countries, and jointly setting up such a system is cheaper and more effective than each country doing it for itself. Bolstering the EU defence industry through commonly financed R&D and joint procurement (Nicoli and Beetsma 2024, Beetsma et al. 2024) would be another example benefitting all member states. External border control concerns all countries because people coming from outside can travel without almost any hindrance through the EU. ⁴

How to pay for the EU’s ambitions?

The revised EU fiscal rules centre around net primary expenditure. The Commission will take into account a number of relevant factors when assessing the existence of an excessive deficit. An increase of government investment in defence would be explicitly recognised as one such relevant factor. In his report on the Single Market, Letta (2024) argues the need to boost European safe assets – debt issued by the EU, European Investment Bank (EIB) and the ESM/ European Financial Stability Facility) – which crossed €1 trillion in March 2024 (Anev Janse 2024), and suggests using the firepower of the ESM for defence. Available resources are increasing. Project funding by the EIB has fallen from its peak since the euro area debt crisis, while the EU has used just 30-40% of its NextGenerationEU (NGEU) lending capacity. The ESM lending capacity, currently €422 billion, will grow rapidly due to scheduled repayments by Spain and Cyprus. According to a recent ESM blog (Rey and Susec 2024), only 36% of the lending capacities available to the EU and euro area countries had been used by end of 2022. In funding EPGs, the competence of each institution should be exploited: project finance by the EIB, grants by the EU, and lending to preserve financial stability by the ESM. In general, financing the build-up of defence and security with debt would be justified by the fact that not only current but also future generations would benefit from these expenditures. ⁵ The usual short-term orientation of political leaders might actually help here.

For many years, there have been calls to develop European safe assets to mitigate country risk. In the last 15 years, the three safe assets have grown, developed, and have been appreciated by the market (Anev Janse 2023). In spite of identical repayment risk, yields on these assets exceed those of a number of EU sovereigns at the moment. They are anchored at a higher level that does not reflect the high rating, often AAA, of the European safe assets versus lower-rated sovereigns. There may be several (related) reasons for this, including the temporariness of these instruments, their absence from indices, the absence of a dedicated EU tax base and the prospect of potential ECB sovereign debt purchases. Another reason is the lower depth of the market for European safe assets compared with, for example, Bunds. Liquidity can be increased by having the international institutions issue more, but we have seen the EU widen spreads and yields increase when announcements are made about additional debt issuances without clarity of the future beyond 2026, which marks the end of NGEU as designed today. The market also distinguishes between capital-based institutions (the EIB and ESM), which are rated AAA across the board and based on balance sheets, and the EU and EFSF, which follow ratings of the member states and are still rated highly, but slightly lower. The EIB and ESM are more resilient when discussions around sovereigns take place, such as the downgrade of euro area sovereigns. The market price matters: borrowing from European safe assets is not taken up by countries when this borrowing takes place at higher rates, which in turn would put the overall idea of investing in common security and defence in jeopardy. The advantage of using the European safe assets is that they exist; no additional taxpayer money is needed ab initio. ⁶