Investment and Convergence: The Quest for Balanced Growth and the Role of New Budgetary Tools in the EU
Introduction
In the last five years, raising the banner of investment has been a key development in European economic policy. After years of financial crises and recessions, Europe needed a recovery; new ways to promote investment had to be found. Since, however, boosting investment through direct intervention was a new activity of the European Commission, the recipe for success was not at all obvious. How all this leads to stronger growth, job-creation and, most importantly, upward convergence, is still a question for many. In this paper, we examine what has emerged and what is still lacking in EU investment policy.
Europe’s investment drought
While the EU countries (and also the euro area) have been emerging from a recession in this period, they were supposed to do so without a specific and consistent EU recovery strategy. The European Union had a framework for growth, but it has been a cocktail of loosely connected plans rather than a single integrated program.
First, a long-term strategy for smart, sustainable and inclusive growth (Europe 2020) was adopted in 2010. An annual cycle of economic governance (European Semester) was built around Europe 2020, which also functioned as orientation for the budget (multi-annual financial framework or MFF) negotiations. The latter, unfortunately, ended up by cutting, instead of increasing, the EU budget for investment (thanks to the intransigence of four net contributor countries).
From 2012, the EU also had a long-term vision for the reconstruction of the monetary union (the Four Presidents’ report and Commission Blueprint), which, together with ECB interventions, contributed to short-term market confidence. But, in terms of EMU reconstruction, this merely resulted in the creation of a modest version of the Banking Union, with practically no progress made towards a Fiscal Union.
The assumption behind this policy framework was that the rapid establishment of the Banking Union would make it possible to restore the flow of funds to the real economy, while the European Semester would help in delivering crucial reforms for competitiveness. Thus, competitiveness would improve, enterprises would start investing again, and eventually growth and job-creation would return.
In theory, savings are supposed to be channeled and transformed into investment. In the EU, however, private banks were too slow to recover from the Great Recession, and the Banking Union came too late and remained too weak to revive this capacity, especially as concerns cross-border flows. And the newly created excessive imbalances procedure (EIP) turned out to be too timid to push surplus countries, and especially Germany, towards necessary and adequate levels of investment activity at home.
But investment in deficit countries has also been lacking, and perhaps even more. Here the crisis response measures were implemented with a strong bias towards the reduction of public deficits and public spending in general, feeding on neoliberal assumptions regarding the 'crowding out' effect, and ignoring the possibilities of 'crowding-in'. Internal devaluation strategies at the time of the eurozone crisis compounded the problem of falling external demand with shrinking internal demand, which altogether discouraged rather than encouraged, investment.
Finding a solution to this conundrum is up to individual countries but also the community as a whole. However, the remedy has to be identified in the right form and dose. A key question in stagnating deficit countries is that small- and medium-sized companies find it hard to borrow, develop their business and markets. What is at stake here is not simply to have a few percentage points’ higher growth rates. If the EU framework turns out to be insufficient to boost investment, member states start looking towards other sources, such as China. Thus financial fragmentation can also result in the loss of political cohesion.
Switching gear: the Juncker Plan and the recovery
In July 2014, investment was declared a priority by newly elected Commission President Jean-Claude Juncker. He identified one of the Vice-Presidents as the EU investment chief, and presented his investment plan to the European Parliament as early as November 2014. Having entered office, the Commission gave a more prominent role to investment also in the European Semester, the annual policy coordination cycle of the EU.
The push for an investment agenda was not without precursors. One year earlier the German trade unions were campaigning with the draft Marshall Plan, albeit without any immediate impact on either EU or German government policy. In 2012, shortly after the French presidential elections, the EU adopted a Growth and Jobs pact, promoting a capital increase for the European Investment Bank (EIB) as well as innovative financial instruments like project bonds. And, in the meantime, interest in financial engineering was energised by fiscal constraints at national and EU levels while the thinking about EU budget reform always pointed towards new ‘financial instruments’.
According to the Juncker Plan, the EU provides €16 billion from its own budget, supplemented by an additional €5 billion from the EIB. With this seed capital, the European Fund for Strategic Investment (EFSI) hopes to attract almost €300 billion in private sector investment. Member states are also encouraged to contribute and, indeed, in early 2015 there were initial signs that this would happen. Potential upgrading of the program has often been mentioned, depending on future developments and needs.
The operational method of the Juncker Plan represented an important innovation and played a role in the economic recovery through mobilising finance but also by proposing to exclude member state contributions from national deficit and debt rules. However, the Juncker Plan also came with the downgrading of transformational goals of the EU budget, in particular by weakening the link between EU funded investment and the Europe 2020 strategy. It was also criticised for lacking a social dimension. It was not launched as a tool to promote cohesion or convergence, but to encourage the EIB to roll out projects that would be too risky otherwise. On the other hand, thanks to the Juncker Plan, the work of the EIB has received a lot more attention than before, and it also helped to develop a more positive general attitude towards ‘national promotional banks’.
To what extent the Plan contributed to the European recovery and the reduction of the ‘investment gap’ requires careful judgment. It is open to question whether more risk taking is really happening or not (in the absence of ECB backing for the EFSI instrument), or whether EFSI is not crowding out other instruments. And, even if the EU cushion does mobilise more finance, the EU capacity to influence the selection of projects remains very limited (can the €16bn tail really wag the €300bn dog?).
Investment budgets beyond 2020
At the end of 2016, the Juncker Plan was extended until 2020, and in 2018 the Commission proposed an upgraded replacement program beyond 2020 called InvestEU. In the proposed new MFF (2021-2027), InvestEU is aiming at €650 billion in additional investment.
For the InvestEU program to make a qualitative difference, early as well as recent critiques of the Juncker Plan will have to be taken into account. It would be crucial to specify what forms of investment are needed in which parts of the EU, which is far from being a uniform economic space. Eurozone imbalances also need to be acknowledged. In the ‘North’ and in particular in countries with current account surpluses, there is need and space for massive infrastructure investment. On the other hand, in the ‘South’, or in countries experiencing stagnation and fiscal challenges at the same time, the key question is how to boost investment in productive companies. The ability of enterprises with growth potential to access the equity market is critical. In the East, whether inside the eurozone or outside, overcoming the middle-income trap has become a major issue, whereby a strategic investment plan should help in this effort.
The 2018 MFF proposal takes one more step to address current limitations. Having understood the importance of the MIP (macroeconomic imbalance procedure) for analysis but also its limitations in practice, the EMU reform process has had to keep in focus the need for a fiscal capacity for the euro area with a stabilisation function. Juncker took the view that such a capacity should be embedded in the long-term budget of the European Union. In its proposal for the new MFF the Commission has included two new tools connected with the eurozone. These are: a Reform Support Programme (RSP) with €25bn over seven years, and a European Investment Stabilization Function (EISF) with €30bn over the same period.
EISF, the second smallest among the newly proposed eurozone fiscal instruments, is supposed to maintain the continuity of investment projects in times of crises. However, this is not a source of transfers but loans, in order to compensate for interest rates potentially hiking in a turbulent period. This tool would indeed serve a useful purpose, but at this stage it still raises question marks. In case of a major crisis, it is not unnatural to reprogram investment projects but this also takes some time. This may cause delay to the support arriving from the EU level. Besides, the crisis also means that some economic actors may transform or even disappear in the meantime, which causes further complications. Crucially, any support from this facility would be destined for a particular project, which probably means that the effect would be local, or at least territorially concentrated. The EISF could thus provide asymmetric support in times of asymmetric shocks, and may result in a situation where large parts of a country and its population remain uncovered. One way to mitigate this risk would be to modulate the EISF in such a way as to include general budget support that can be used also for co-financing country-wide social investments, e.g. teachers’ salaries. And, at the end of the day, there is no substitute for the genuine counter-cyclical stabilisation tool: unemployment insurance or re-insurance.
Reformed Cohesion Policy needed
Improving investment performance in the EU does not only require new tools but also reforms in existing ones. This applies particularly to Cohesion Policy. While the contribution of Cohesion Policy, including the European Structural and Investment Funds (or ESIF), to increasing investment volumes has been obvious in regions lagging behind, the effectiveness of these old budgetary tools in a new environment of East-Central Europe and the Balkans has been questioned in both qualitative and quantitative aspects.
It is well understood that Cohesion Policy and EU funds are certainly not 'gifts' for member states, but indispensable parts of a balanced and fair functioning economic governance and single market in Europe. On the other hand, we have also seen that systemic corruption can lead to a situation where EU funds simply do not fulfill their original goal of improving competitiveness, developing infrastructure and investing in human capital or better governance. And, in some countries, the situation is indeed grave: there are examples of state-level fraud being organized by political actors. That results in a scandalous waste of EU resources but, more profoundly, inevitably undermines democracy, the public interest and the rule of law. Because of weaknesses of control, some even accuse the EU of funding a kleptocratic and autocratic regime in Hungary.
Beyond the extant procedures of interruptions to and suspensions of funds, sanctions can play a stronger role in stamping out irregularities, abuse and systemic fraud. However, the triggering of sanctions needs to be objective and transparent and this requires a solid set of indicators and benchmarks as opposed to party political considerations. Besides, any sanction must be well targeted to hit the perpetrator of fund abuse rather than innocent hostages.
One option for the EU is to take funds, or at least some of them, into its own hands and distribute them in the member states according to the original goals. In other words, the Commission in cases of repeated abuse or systemic fraud should suspend shared management. That would mean the EU’s actions cannot be regarded as blackmail while it could avoid the corrupted allocation channels and financing of oligarchs close to governments.
Direct management solutions could be also introduced in a gradual and proportional manner: first, only those payments could come under direct Commission control where it has already rejected payments as a consequence of significant irregularities or detected fraud. As a next step, in case of systemic problems in operative programs or the failure of management systems and democratic control mechanisms (audit) in a member state, direct management could be introduced in a more comprehensive form. Alternatively, a third type of management method – assisted management – could be invented by placing EU experts in national agencies without completely sidelining these. This could be either requested by the member state or, above a certain threshold (frequency of errors, suspensions and OLAF anti-fraud investigations), assisted management could be launched by the Commission.
In other words, the solution should not be to punish the civil societies of the affected member states but to repair the management system in a way that can efficiently prevent systemic misuse of funds by national political or management systems. Choosing the best way forward is by no means easy, especially with such a highly politicised instrument. However, a greater effort in defense of EU values and resources is necessary. Defending the rights and opportunities of the victims of misbehaving governments (i.e. the citizens of the member state in question) through reforming Cohesion Policy and establishing an EU level public prosecutor is a key task today.
Social investment imperative
When it comes to the need for investment, most examples point towards infrastructure, while in most countries this is not exactly the missing link. Excessive focus on infrastructure investment can often be well intentioned, but misguided. For sustaining economic growth in East-Central Europe, but also for reproducing long-run growth potential in that region, a first necessary step would be for governments to rethink their role in the development of human capital and place greater emphasis on investing in it. This is particularly important in countries and regions experiencing population decline, and we find these mainly in the East.
Greater social investment is not only a public sector responsibility but in the best interest of companies. However, survey data confirm that businesses in east-central Europe tend to attribute lower priority to human capital issues than their western European peers. This is especially true for businesses in Romania and Bulgaria.
Poland also stands out as a country with splendid economic performance but questionable social sustainability. On the one hand, Polish business is optimistic when it comes to the availability of skilled, educated, competent and experienced human resources. On the other hand, investments in human capital formation (apprenticeships, attracting talents, training, workers' motivation) tend to be seen as a lower priority compared with the EU average. Such an attitude may be explained by the strength of the cohorts entering the Polish labour market in recent years but cannot be sustained when the workforce begins to age and shrink as in the rest of Europe.
The great human capital challenge in east-central Europe (CEE) is also well illustrated by data on workers’ participation in lifelong learning. With the exceptions of Slovenia and Estonia, CEE member states tend to have a far lower percentage of workers or unemployed people who participate in training and education compared to ‘older’ member states. In Romania, Slovakia and Bulgaria the share is only around 5%.
The necessity to step up investment in human capital should be reflected by the way CEE countries make use of resources available from EU Structural and Investment Funds. The European Social Fund (ESF), for example, could play a much greater role than previously in helping to promote the employment of women, young professionals starting their career (by introducing the Youth Guarantee), Roma integration, labour market integration for people with disabilities and active ageing.
The ESF+, as it is called in the new MFF proposal, can also make a major contribution to improving the quality of education systems. The EU has established a rule for 2014-20 that a certain minimum share of each country’s allocation from the Structural Funds has to be dedicated to human capital investment through the ESF. However, more effective financing of these programs depends primarily on the political will in the individual countries.
Towards an Investment Union?
Shifting the focus of European economic policy to investment in the past cycle became necessary for both cyclical and structural reasons. First, EMU reform has not been deep or fast enough, which means that resources and confidence are still insufficient for more dynamic growth and sustainable job-creation in the private sector. The EMU’s weakness in dealing with cyclicality and asymmetry has not been addressed.
Second, not enough happened to revamp Europe’s broken business model. Financial sector regulation has made good progress in the last five years, but the Banking Union still has to be completed with deposit insurance (EDIS), and more could be done in the area of industrial policy, especially by linking it systematically to greater territorial cohesion and investment in human capital.
However, discussions about the Juncker Plan and its successor, InvestEU, have highlighted several further options and opportunities, as well as issues that remain to be tackled along with these. In principle, combining all these new elements with the existing plan could be developed under the umbrella of an 'Investment Union'.
Back in 2014, in their report to the German and French ministers of economy, advisers Jean Pisani-Ferry and Henrik Enderlein offered a broader concept of investment coordination, in a way more tailored to country-specific situations and policy agendas. Constraints for some member states are more objective and for others more subjective. The EU therefore would need an agreed methodology to channel investment to countries that have performed below potential.
It is indeed crucial to specify what forms of investment are needed in which parts of the EU, which is far from being a uniform economic space as we have noted. Eurozone imbalances also need to be taken into account. In the ‘North’ and in particular in countries with current account surpluses, there is need and space for massive infrastructure investment. On the other hand, in the ‘South’, or in countries experiencing stagnation and fiscal challenges at the same time, the key question is how to boost investment in productive companies. The capacity of enterprises with a growth potential to access the equity market is a key question.
All this could form part of a new EU level industrial policy, the demand for which has spectacularly grown in the 2018-19 period. There is now a genuine opportunity to connect the investment agenda with an ambitious industrial policy, in particular promoting the green transition. A more advanced investment plan, or Investment Union, could reach all the way to corporate governance, and introduce suggestions for reform initiatives. It also needs to have a meaningful social investment chapter. More space and support could be provided for the social enterprise economy.
A robust investment policy needs more detailed vision as well as greater confidence about the availability of resources it aims to mobilise. Its promoters also have to be aware that even if EU-level efforts on behalf of coordinated investment prove successful, they cannot be a substitute either for EMU reform or a performance-oriented strategy such as Europe 2020. Whether the EU can deliver more solidarity and help in generating convergence with greater confidence is a vital question today for both economists and politicians – and the path we take regarding investment will be key.