Who Is the Ultimate European Taxpayer? Understanding the Problem of European Sovereign Debt

Commentary by Federico Steinberg

Published November 13, 2023

Financial costs for nearly all countries are rising due to climbing interest rates around the world to combat inflation. For example, the yield on a 10-year U.S. Treasury bill-the sovereign bond that anchors the international financial system-has reached 5 percent, the highest since 2007. In the European Union and the Eurozone, the rises in risk premiums, although nowhere near as alarming as those that occurred during the 2007­­-08 financial crisis and European debt crisis more than 10 years ago, are reopening the debate about the challenges to having a monetary union without a fiscal union.

Despite having a common currency among 20 of the 27 EU member states, the European Union does not have common debt. There are no "EU bonds." Instead, EU countries issue their own sovereign debt and therefore face different financing costs depending on the quality of their public finances and their growth prospects, despite sharing a currency with other members. Italy has higher rates than Germany, for instance. But in response to the Covid-19 crisis, the European Union launched its NextGenerationEU program involving a one-off joint debt issuance initiative, which will run until 2027. It was intended to finance the post-Covid recovery and transform the European economy, endowed with more than €800 billion ($860 billion). However, the rising cost of borrowing has soured EU officials on additional borrowing.

Given the current geopolitical situation and the need for investment in European public goods from research to defense, it is becoming increasingly clear that additional joint debt issuance and European fiscal resources are necessary. The European Union urgently needs to support Ukraine, upgrade its industrial policy, rebuild its military stocks, and critically accelerate the energy transition-not just to address climate change but also to lower current energy costs. The European Union and its leading economy, Germany, are facing higher energy costs amid Russia's war in Ukraine. The most effective way to address these costs is to accelerate the energy transition and increase the supply of energy alternatives, but that requires investment.

Failure to do so will deepen the inequalities between various member states as a result of their different levels of economic and financial strength, jeopardize the unity of the internal market, and make it impossible to continue supporting Ukraine. But above all, without these common funds, the European Union will face an unnecessarily harsh fiscal squeeze when it needs resources most, something that already happened with the austerity measures that followed the global financial crisis, measures which are now considered to have been a mistake. (Note that the European Union's Stability and Growth Pact, which imposes limits on deficits and debts in EU countries, is currently suspended, but it will be reactivated-hopefully after a period of reform-in 2024.)

The Way Forward

The way forward seems clear, but the word "Eurobonds" has become taboo in Brussels and Berlin. The creditor countries in Northern Europe do not quite trust Southern European countries to be fiscally responsible, have opposed new joint debt issuance, and are increasingly worried about the rising cost of financing. Additionally, despite the European Union receiving a AAA credit rating from markets, the interest rate it pays is higher than that of France or Germany. This is because international investors, the ones buying European debt, would like to know who the ultimate European taxpayer is. In the case of German debt, it is the German taxpayer. In the case of Italian debt, it is the Italian taxpayer, which is why Italian debt has a higher interest rate than German debt. But who is ultimately responsible for paying back the debt issued by the European Union? If this is unclear, which is the case today, there will continue to be uncertainty, raising the financing costs for the European Union and its member states. Moreover, as the debt issued by the European Union to finance the NextGenerationEU program will mature in 2058 and, for the time being, no new debt will be issued, EU debt markets are not as wide, deep, and liquid as those of its large member states due to insufficient supply. This also increases costs because a large supply of liquid safe assets is essential for investors.

A comparison with the United States, which is a fiscal and political union, may be useful here. In the United States, the federal government pays for most public goods by collecting federal taxes and issuing large quantities of U.S. Treasury bonds, which are rolled over when they mature and are considered "safe assets." The federal government is also responsible for bailing out banks when needed and insuring citizens' deposits in financial institutions. If necessary, it can do so through extraordinary debt issues approved by Congress, as in 2008. In addition, each state has a small spending and revenue-raising capacity, but this is secondary to that of the federal government. This all means that markets know that U.S. taxpayers collectively back U.S. debt. And they also know that the Federal Reserve stands ready to buy U.S. debt, if necessary, as has been the case during Covid-19 and the global financial crisis, thereby providing greater assurances of long-term market liquidity. In the European Union, where there is economic integration but very limited political and fiscal union, it is not clear who the sovereign is. There is no European demos or ultimate European taxpayer. There is no European "safe asset," and the European Central Bank is not entirely committed to act as a lender of last resort for individual member states (in part because buying the debt of different member states has distributional implications).

Therefore, if the European Union wants to reduce its financing costs, it has to do two things. First, it should clarify how it will repay its debt (i.e., who is ultimately responsible for it). Second, it should increase the amount of debt issued and, above all, make it clear that there will be debt issues indefinitely, just like any sovereign debt issuer, thus creating a European safe asset with an appeal to the broader market. Total debt issued by the European Union will peak at less than €1 trillion at some point before 2027; in comparison, outstanding U.S. debt is over $33 trillion, and the outstanding debt of all EU countries is €13.8 trillion ($14.7 trillion. Investors will then incorporate these "Eurobonds" in a stable manner in their portfolios. Clarifying how the European Union will repay its debts is a political problem; increasing the amount of debt issued and the timeline for issuance is more technical.

Since the Covid-19 pandemic, there have been efforts to increase the so-called "own resources" of the European Union, which are revenues collected directly by the European Union (and not by its member states). The European Commission presented in June 2023 an "own resources" package where €36.5 billion would be raised for the European budget each year (€19 billion from the EU emissions trading scheme, €1.5 billion from the carbon border adjustment mechanism, and €16 billion from a new European tax on corporate profits, which the European Union will implement following guidelines from the Organization for Economic Cooperation and Development). These sums are relevant, but they will clearly be insufficient to cover the whole EU budget, which stands at €169 billion. That means that a large majority of the EU budget will still depend on contributions from member states.

At this point, it seems unlikely that the European Union will increase its own resources further. European citizens resist new taxes, and member states do not want to reduce their own taxes only for the European Union to increase union-wide levies. This leaves higher contributions to the European countries to the EU budget (currently under discussion) and new debt issuance at the European level as the only alternatives to fund future costs. There is a window of opportunity to connect the reform of the Stability and Growth Pact with new joint debt issuance. Southern countries would be willing to accept stricter deficit and debt rules, which Germany is demanding, in exchange for new debt issuance at the supranational level. And, as noted, the list of European public goods that needs to be financed is quite clear.

Lessons from History

Historically, the concepts of nation, currency, and army have always gone hand-in-hand, and monetary unions have only ever been sustainable when they have been accompanied by fiscal and political unions, as in the United States. But the European Union is not yet a state, and therefore the euro, at the moment, is an orphan currency, which of course does not yet have an army (nor a common foreign and defense policy).

As long as this larger issue remains unsolved and EU continues subscribe to the fiction that money and debt are technical rather than political issues, which is particularly popular in Germany, the European Union will not be able to rise to its full potential. Continuing to move forward with technical patches that obviate distributional problems without attacking the root of the issue will continue to lead Europeans to a fiscal dead end, as well as raise legitimacy issues when European institutions make decisions that are not shared by the citizens of its member states, sometimes referred to as the bloc's "democratic deficit." Most importantly, these broader structural constraints will neither allow the European Union to rise to the geopolitical moment, nor take advantage of the lower financing costs that would result from large joint debt issuances that benefit the United States, which also then is empowered to use the dollar as a tool of economic statecraft.

All of this was already well known when the euro was created. Former German chancellor Helmut Kohl himself, in a speech to the Bundestag in 1991, stated, "Political union is the indispensable counterpart of economic and monetary union. . . . It is fallacious to think that an economic and monetary union can be sustained on a permanent basis without political union." Along the same lines, economist Paul De Grauwe argued in 2012: "The Euro is a currency without a State. For it to be sustainable, it is necessary to create a European state."

The problem is that the creation of a European sovereign state requires a certain level of political union, and this remains highly problematic both because of the resistance of some European countries to fiscal risk sharing, and because of the rise of new and emboldened nationalist movements. But if this resistance is not overcome, the rhetoric calling for a geopolitical Europe will be seriously undermined by the European Union's weak economic foundations.

Federico Steinberg is visiting fellow with the Europe, Russia, and Eurasia Program at the Center for Strategic and International Studies in Washington, D.C., and a senior analyst at the Royal Elcano Institute.

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