Structural funds vs debt pooling: the real cost of two different approaches to the European debt crisis

If Germany and France are to guarantee the debts of Italy, along with Greece, Ireland, Portual and Spain, pretty much everyone agrees that will take more than €1 trillion – probably more like two or three trillion. Suppose, mirabile dictu, that approach somehow ended happily, with no defaults by anyone and the Italians and others knuckling down to pay their debts and improve their competitiveness, instead of using the Franco-German money as an excuse for not properly reforming and to run up yet more debts. Then the Franco-German guarantees would not be called upon, so there would be no actual transfers of funds.

But that doesn’t mean it wouldn’t cost the French and Germans anything. Under the €2tr scenario, as presented on the Alphaville blog, RBS estimates German debt rising to 110 percent of GDP and French debt to 112 percent, as a consequence of the guarantees. That would obviously mean the end of AAA status. To get a sense of the implications, Italy has had debt of 100-120 percent of GDP for about the past twenty years. Its credit rating has sat in the A+ to AA- territory. As a member of the euro, before the sovereign debt crisis, its spreads over German bonds were probably kept down by the single currency. But if we consider non-Eurozone sovereigns with similar credit ratings to Italy, such as South Korea, Chile or Saudi Arabia, over the past decade the average cost of their government debt has typically been 100-200 basis points (1 to 2 percent) higher than that of Germany (the iconic AAA state).

Let us assume the impact on France and Germany would be at the low end here - say, just 100 basis points.  Germany’s total government debt stock (ignoring guarantees) is about €1.9tr, whilst France’s is about €1.7tr. So adding 100 basis points to the cost of their debts would cost Germany about €19bn per year, and France about €17bn – a joint cost of about €36bn (on this fairly optimistic scenario).

By contrast, consider the costs to France and Germany of the sort of scheme I favour – namely a greatly extended use of EU structural funds and other monies spent at the central EU level. Two of the great success stories for structural funds were Ireland and Spain during the 1990s. Structural funds are estimated by the OECD to have delivered a direct impact of around 0.5 per cent per year. Then, of course, there would be many spillover benefits from the effects of structural fund expenditure – as higher-productivity retrained workers improved the productivity of those around them, roads reduced transport times, and so on. Finally (and perhaps most important of all), the Irish debt consolidation programme, especially that introduced after 1987 (see discussion here, p84ff), was materially facilitated and made more credible by EU structural funds. Total annual Irish growth in this period regularly reached 6 per cent.

The Spanish experience was similar. Unfortunately, experience with structural funds expenditure in Italy is not perceived to have been so successful.  Perhaps in Italy we could not expect to add – what? - 2 per cent or more to annual growth for a decade just for the sake of 0.5 percent of GDP structural funds input.

But even if we only got one for one, adding half a percent to Italian GDP would cost only around €7bn-€8bn per year. An extra half percent on the Italian growth rate, with the monies focused on the least competitive Italian regions, could well be enough to make the difference between risk of collapse of the euro and its survival, since a slightly higher growth rate for Italy would make markets much more confident it would pay its debts.  We might need to put in half as much as that again for the PIGS minus Greece (which I still believe to be gone, every which way). So €10bn per year all up. Let’s suppose we had to put in twice that much for the first three years, just to make it credible.  And let’s suppose that the French and Germans between them put up two thirds of that money. Then for the first three years France and Germany would be transferring €12bn extra per year to the problematic regions, and €6bn per year thereafter.

So, the debt pooling scheme – even if it works - costs France and Germany some €36bn (or more) per year, whilst of course violating the Treaties and creating massive moral hazard, whilst the EU structural funds extension (without Treaty problems or much moral hazard) costs them about €6bn-€12bn per year. Which do you think they should go for?