Mr Juncker should look to an EIB-ECB alliance, not to the ESM

JunckerJean Claude Juncker had a good idea but looked in the wrong place for funding it. His good idea was to promote a sizeable investment program (€300 billion) that would help Europe end years of crisis, stem deflation and return the continent to growth. Unfortunately, Mr Juncker thought it a good idea to tap the European Stability Mechanism’s unused borrowing capacity in order to fund his investment program. Soon after putting forward this idea, Germany smacked it down. Why was Mr Juncker badly mistaken to suggest the ESM as a funding source? And what should Mr Juncker have proposed instead? Read on…

Mr Juncker’s idea of mobilising the ESM’s unused borrowing capacity was ill-conceived for three reasons, the first two of which (see below) were given ‘in evidence’ by the German finance ministry’s rejection of the Juncker proposal.

  1. The ESM’s ‘rules’ clearly specify the uses of its finds (and process by which it they are tapped), leaving no room for funding Mr Juncker’s investment drive. To change this, the EU would have to re-negotiate the ESM Treaty, opening up a well-known can of worms.
  2. Exhausting the ESM’s funding base in this manner would be tantamount to assuming that either no Eurozone member-state would need another bailout or that member-states (like Germany) would agree to an increase in the ESM’s borrowing capacity. Both of these assumptions are rejected by most in Berlin and in Frankfurt.
  3. The ESM’s funds are raised in markets by issuing bonds which (as I have explained elsewhere) are of a seriously toxic nature; resembling CDOs of the type that brought the crisis on and which contain, within them, the dynamic of the contagion that led to the sequential insolvency of Greece, Ireland, Portugal, Spain etc. Funding a European investment program by means of such toxic instruments seems to me like a bad idea.

Having said all this, Mr Juncker must be congratulated for promoting a large-scale investment program. What we must now do is to encourage the new President of the European Commission to become more ambitious and to look elsewhere for funds. In short, Europe requires a great deal more than the €300 billion worth of investments Mr Juncker proposed. In fact, this crisis has grown such deep roots that nothing short of between 6% and 8% of Eurozone GDP would do. But where would these funds come from?

Mr Juncker should enlist the EIB, with the ECB in a supporting QE-role, to the cause of an Investment-led European Recovery Program

The answer is: The funds should come from the European Investment Bank (and perhaps its offshoot the European Investment Fund)![1] Indeed, the EIB could issue its own bonds in order to raise all the necessary funding and then use these funds to administer a proper European Recovery Program – a European New Deal, if you want.[2] Meanwhile, the European Central Bank should be standing by to purchase, in secondary markets, sufficient quantities of these bonds to ensure that their yields stay at ultra low levels, thus making a European New Deal not only possible but also self-financing – and off the books of national budgets.[3]

The great merit of such an investment program are the synergies between (a) the effects of EIB’s mobilisation of idle savings and (b) the ECB’s actions that are tantamount to a form of ECB quantitative easing (as the central bank will be buying solid European bonds in the secondary markets) that is non-toxic (as it does not fund bubbles in various unsavoury paper assets) and does not require the revival of the ABS market (which Mr Draghi is now awkwardly and inefficiently trying to re-float).

Will the EIB not face unacceptable risks? Is the EIB being asked to take on risks that it now shuns?(*)

There are two understandable worries regarding the above proposal:

  1. Even if the ECB’s readiness to purchase EIB bonds in the secondary markets keeps the EIB bonds’ yields down, thus keeping constant the perceived riskiness (and credit rating) of the EIB in financial markets, would the large EIB-bond issues not affect adversely its capital adequacy ratio?
  2. Are you suggesting that the EIB invest in projects that it now considers too risky? Why would the EIB want to do that?

On the question of the EIB’s capital adequacy ratio, it is important to keep in mind that, while it operates (as it should) on banking principles, the EIB is not a commercial bank creating money out of thin air and in need of a capital cushion to prevent a bank run or the contagion of 2008. It is a public investment bank whose concern must be:

(a) the expected net return to its investments, and

(b) the financial markets’ expectation regarding the future value of its bonds.

In this sense, the point of a massive investment program led by the EIB, and with the ECB ready to enter the secondary markets in support of the EIB bonds’ prices, is that such a program would accomplish two things at once:

(i) It would boost (a) above; i.e. cause a rise in the expected net return to its average investments as a result of a Eurozone-wide multiplier-accelerator effect

(ii) It would improve its reputation in the financial markets [see (b) above] as a direct result of (i).

Point (ii) is easily understood by all: When the EIB’s expected net returns rise, financial markets push down its yields and buy its bonds more readily. Point (i) is harder to grasp. Most commentators err into assuming that the EIB is an expected-return-taker (just as a firm under perfect competition is a price taker). This is perhaps true nowadays, to the extent that the EIB’s total funding is rather small and its macroeconomic impact minuscule. But, if the investment-led European Recovery Program, that we are proposing, goes ahead, that will not be the case any more.

Size, in other words, matters. Put differently, the commercial viability of every project that the EIB funds under our scheme will rise (and the associated risks will fall) because of this scheme. So, in response to the view that we may be asking the EIB to take on greater risks, the rejoinder here is that:

(A) These risks are endogenous to the EIB’s aggregate investment levels when the latter exceeds a certain level (that makes the EIB macroeconomically significant)

(B) With the EIB relatively modest current funding, these risks are almost parametric (i.e. the EIB is currently macroeconomically insignificant)

(C) Under our European Recovery program, led by the EIB and supported by the ECB, the endogenous risks per project fall and projects that are currently too risky for the EIB to undertake will suddenly become less risky – and, in fact, reach levels of risk that the EIB currently considers reasonable.

Summary

Mr Juncker, in the face of a desperate situation, had the right instinct: Europe needs more public investment in order to crowd-in private investment that is now immobilised by the fear of deflation. As a result, he groped around, looking for some untapped public fund to finance his investment proposal. Thus he stumbled upon the ESM. It was a mistake. Nonetheless, it would be tragic to let a good idea die because Mr Juncker looked at the wrong place for funds. He should be encouraged to consider the idea of an EIB-led European Recovery Program fully funded by the EIB’s own bond issues, with the ECB using this as a splendid opportunity to kill two birds with one stone: To assist the EIB and in so doing to effect a simple, non-toxic, politically uncontroversial form of quantitative easing.

(*) The points raised below were the result of a Q&A with Ivan Lesay, whom I thank for the opportunity to develop these ideas.

[1] There is considerable evidence that, these days, supra-national investment banks and organisations are increasingly tapping into the financial markets, taking advantage of the low yields in order cheaply to fund investment projects. See here.

[2] See our Modest Proposal for more details of how this could be part of a wholesale resolution of the Euro Crisis.

[3] The logic of this proposal was first outlined in a post entitled How should the ECB enact quantitative easing? A proposal