Florian Dorn: Is increasing public spending the best way to make the economy more resilient

The NGEU programme money is fungible, and it will hardly be possible to prevent European funds from replacing national ones

Photo: ifo Florian Dorn.

The direct impact of the NGEU programme on economic stabilisation in the current crisis is rather limited. A large part of the spending will probably not start flowing until mid-2021 at the earliest and will thus hardly serve as a cyclical stabiliser to cushion the economic decline during the Corona crisis, says Florian Dorn, Economist at ifo Institute, in an interview to EUROPOST.

Mr Dorn, in a report co-authored with Prof. Clemens Fuest, you are challenging the economic rationale of NextGenerationEU (NGEU) and urging for improvements. What are your arguments?

We discuss the economic rationale from three perspectives - its stabilising, allocative and redistributive functions.

First, the direct impact of the NGEU programme on economic stabilisation in the current crisis is rather limited. A large part of the spending will probably not start flowing until mid-2021 at the earliest and will thus hardly serve as a cyclical stabiliser to cushion the economic decline during the Corona crisis. Nevertheless, the fund can already have a certain stabilising effect during the crisis, as planned future spending will have an impact on current expectations on the capital market (and expands the scope for a national stabilisation policy financed by government debt); moreover, the fund aims at making Europe's economy more resilient for future crises. So, the stabilising function can be justified to some extent.

Second, it is not clear whether increasing public spending is the best way to make the economy more resilient. It is questionable whether national spending programmes can be controlled from the EU-level to increase the resilience of national economies. Moreover, money is fungible, and it will hardly be possible to prevent European funds from replacing national ones if the Member States plan to do so. In terms of its allocation efficiency, it would be desirable for the NGEU to define a clearer boundary between areas where public spending may be justified or necessary and areas where private investors should be active. For example, if the NGEU's REACT EU programme aims to preserve and create jobs in sectors affected by the crisis, such as tourism or travel, the question arises as to what sustainable economic development can be achieved by public spending. Whether hotels or travel agencies create jobs is first and foremost a business decision. How government intervention can improve these decisions is less clear. The efficient use of public funds requires that they be used in areas where the private market does not function properly. It is questionable whether this is always the case with the NGEU programme.

From an economic perspective, a stronger provision of public goods at the EU level would be desirable. In principle, as NGEU prioritises, this includes environmental policy and digitalisation. However, this would also apply to areas such as foreign policy and defence, research and development, or development aid. Nevertheless, these policy areas are not the focus of NGEU. In any case, too little attention is paid to cross-border spillover effects in the guidelines for national NGEU plans. We recommend that in the negotiations on the use of funds, visible projects with European relevance such as cross-border infrastructure projects or technology funding should be promoted much more strongly. If the decision to retain control at the European level over how funds are used is to add value, a clear improvement would be to give much more emphasis on projects with EU-wide significance.

Third, one political goal of the fund is to support each other in the crisis. The NGEU's redistribution of funds among Member States is, however, not primarily determined by the scale of the pandemic's relative economic effects or relative health costs. Funds are redistributed from countries with higher per capita income to poorer Member States. It is true that particularly hard-hit countries such as Spain or Italy will also benefit from the redistribution. However, NGEU is not really an insurance policy against the coronavirus crisis, but rather an extension of traditional EU cohesion policy.

This unique tool has extremely clear priorities, in particular on green and digital transformation of the economies, and they should be part of the national plans in order to be approved. Where does your doubt come from that funds can change direction for other purposes?

First, Member States will not find it difficult to link a wide range of expenditures to the priorities listed by the European Commission. The fact that Member States will have wide discretion over how to spend the funds is also reflected in the way the guide defines investment. I quote:

“Member States should consider an investment as an expenditure on an activity, project, or other action within the scope of the Proposal that is expected to bring beneficial results to society, the economy and/or the environment… The Proposal is therefore consistent with a broad concept of investment as capital formation in areas such as fixed capital, human capital, and natural capital… Human capital is accumulated by means of spending on health, social protection, education and training, etc.” (European Commission, 2020)

This implies that spending that is normally considered consumption, such as on health or social welfare, is defined as investment. The definition confirms that Member States will have great freedom in the use of NGEU funds.

For those who want to use NGEU funds to steer national policies towards European priorities, there is a second challenge: money is fungible and NGEU may replace national funding for public investments. Thus, Member States can use NGEU funds for public investments that would have been financed from national sources anyway. The guidance document does attempt to address this issue and ensure that NGEU funds lead to additional investment. Member States are asked to report the average level of spending in previous years for items they have included in their plan. However, Member States can argue quite convincingly that the crisis has affected their ability to invest at the same level as before. It is virtually impossible to ensure that the expenditures financed by the NGEU would not have been made anyway in the absence of the fund.

What do you think is wrong with the proposal that the redistribution of NGEU funds between Member States be determined by their overall level of prosperity?

In political communication, the unique debt-financed expansion of the EU budget through the NGEU programme was justified by the fact that the Member States want to stand by each other in the crisis of the century. However, it is not the case that all countries which were more severely affected by the Corona crisis are benefiting from this programme.

There is a strong redistributive component from richer to poorer Member States. All countries with per capita incomes above the EU average are net contributors to the NGEU fund. The opposite is true for countries below the EU average in terms of per capita income, which are all net beneficiaries of the new NGEU fund. Consequently, the fund seems to serve little purpose in providing financial support to the states particularly affected by the pandemic. Some net contributors, for example, have suffered similarly high economic losses as net recipients. Belgium and France, for example, expect above-average GDP losses for 2020, but the two countries are nevertheless among the net contributors to the transfer system. Poland, as a counterexample, expects below-average losses from the crisis compared with the rest of the EU, but is nevertheless one of the net beneficiaries of the fund.

But isn't the agreed approach right, namely that poorer Member States should receive more grants and loans under this instrument so their economies recover?

It is not wrong per se if wealthier states support relatively poorer Member States. However, this is the core of EU cohesion policy and has less to do with an insurance policy and less to do with protecting each other against disproportionate damage from crisis. Even wealthier Member States can suffer disproportionate damage from the crisis for no fault of their own. The fund has little to do with mutual insurance, which is sometimes suggested in political communication.

Please, explain why do you think that NGEU is not really an insurance policy against the Corona crisis, but rather an extension of traditional EU cohesion policy?

When the EU is hit by an economic shock and different countries are affected differently, a common fund can act like an insurance policy. An obvious objection is that insurance normally requires an insurance contract that is signed before the damage occurs. No such contract was present. Therefore, the introduction of the fund can be a form of solidarity or assistance based on an implicit insurance contract. Such an insurance should be redistributed based on the damage caused to a country (through no fault of its own). The criterion could be, for example, the economic collapse or the health burden in the pandemic, which was caused by the crisis (and by no fault of the countries).

However, redistribution based on the relative consequences of the crisis (which equates to a mutual insurance policy) could lead to a situation in which Member States with lower per capita incomes would have to make payments to richer countries if their damage from the Corona pandemic was greater. It is reasonable to assume that this is one of the reasons why very limited emphasis is placed on the insurance principle in the distribution of NGEU funds.

In the distribution of expenditures to countries, the political decision was made that only 30% of the funds would be distributed according to the decline in GDP expected in 2020, while 70% of the funds would follow other criteria, in particular the level of per capita income. There is no deeper economic justification for this distribution and the thresholds adopted, except for the fact that a much stronger weighting of the consequences of the crisis could have led to redistributive effects in favour of richer countries.

To sum up, the crisis fund is not primarily designed to redistribute in favour of the countries that bear the most severe consequences of the crisis. This implies that, in terms of redistributive effects, NGEU is not really an insurance against the Corona crisis, but rather an extension of EU cohesion policy. The criteria for redistributing NGEU funds seem to be justifiable less in terms of the economic consequences of the crisis than in terms of political motives.

Critics fear that NGEU will establish a regime in which, by incurring common debt, some countries will live permanently beyond their means at the expense of others. Certainly, the next severe crisis will make it likely that the demand for joint debt financing will arise.

Whether this meets with the necessary consensus among Member States will depend on how successfully the NGEU funds are used. It may also be necessary to emphasise the insurance aspect more strongly, i.e., for the crisis fund to cushion the disproportionate losses that countries have actually incurred because of the crisis.

 

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Florian Dorn is an economist at the Munich-based ifo Institute for Economic Research. Prior to this, from 2016 to 2020, he was a lecturer at the International School of Management (ISM) in Munich and visiting Research Fellow, Public Economics Programme, at the London School of Economics (LSE).

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