Something strange is happening in Europe that is difficult to explain to a non-European.
Europe faces conflicting demands to dramatically accelerate investment in climate change while at the same time lowering its debt ratio.
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Investor demand for government debt (light blue) is well above the annual climate change investment needs of countries (red and pink), representing 1-3% of GDP. (photograph: Ludwik Suttle-Sorrel Bass)
A growing number of economists believe that most, if not all, of Europe’s hundreds of billions of dollars of annual public climate change investment can be financed through sovereign debt issuance.
But right now, EU leaders are negotiating new spending limits that will set them apart from their main competitors, the United States and China, prioritizing debt reduction over other goals such as the green transition and competitiveness.
What is the problem?
money is cheap
First of all, it’s not because you don’t have money.
Ludwig Sattor Sorrell, senior policy researcher at the financial NGO Finance Watch, recently published the following paper: report There are also important figures showing that EU countries can easily meet their climate change investment needs by issuing new government bonds.
Annual debt service costs are relatively low in Europe. European countries spent an average of 2.9% of their annual revenue on debt service in 2021, according to World Bank statistics.
Even in relatively indebted countries like Italy, the cost of debt is relatively low at 8.4% of revenue, compared to 14.3% in the US and 23% of total income in India.
Another important factor is people’s desire to invest in European government bonds. Investor demand for EU sovereign bonds is strong, significantly outstripping existing supply.
“Unmet investor demand could easily cover all the public debt needed to bridge the climate mitigation financing gap,” Sattor-Sorrel wrote.
Investing in climate change with debt can be beneficial in many ways. Now taxpayers don’t have to bear all the up-front costs, and investing in clean power and heat pumps actually saves people money. Finally, and most obviously, to reduce climate risk by preventing further warming.
“The debt resulting from qualitative investment will put a lighter burden on the shoulders of future generations than not having to deal with it,” Sattorsoler told EU observers.
EU debt concerns
But EU leaders are reluctant to issue more debt.
As Sator-Sorrel argues, the widespread European debt overhang concerns are the aftermath of the European debt crisis of 2010-2012. Interest rates rose to double digits in some countries, effectively bringing the entire economy to a halt. This was caused by panic in the bond market.
It’s too complicated to describe it all here, but the point at this point is that the preconditions for that panic no longer exist today. In contrast to then, the European Central Bank (ECB) now acts as the lender of last resort, meaning investors can sell their government bonds at any time, even in the midst of a crisis.
This is why sovereign bond rates in each member country have remained relatively stable despite the recent crisis.
But many politicians have not adapted to this reality. The meeting of EU finance ministers in Brussels last week agreed to “reduce the fiscal deficit and debt ratio” from 2024 onwards.
New fiscal rules are due to be reintroduced by the end of the year, requiring countries with high debt ratios to reduce their debt to 60% of GDP, albeit at a slower pace than the current rules.
Even if many economists, including Sattor-Sorrel, deem it “arbitrary,” a flat debt ratio is believed to boost a country’s creditworthiness and thereby improve financial stability.
German Finance Minister Christian Lindner said in June that “for financial markets debt is debt and too much debt leads to instability”.
But by analyzing what investors actually value when assessing a country’s investability, Sattor-Sorrell shows that investors don’t really care much about debt ratios.
creditors don’t care
First, the investor commissions a sovereign risk assessment to a credit rating agency.
Ratings matter because the higher the rating, the lower the interest rate investors will charge the country, and the easier and cheaper it is for the government to obtain the funds it needs to meet its goals, with AAA being the highest and Triple C being the lowest.
All major credit agencies such as Fitch Ratings, Moody’s, S&P and Scope Ratings judge a country’s creditworthiness along much the same checklist, including institutional quality, debt-bearing capacity, GDP growth and GDP per capita.
Debt-to-GDP ratio is also on the list, but is a low priority for all major institutions. For example, Fitch’s rating is based on a debt-to-GDP ratio of 8.3%, but 53.2% of the final credit rating is determined by “institutional strength” (including political stability, governance and GDP per capita).
Similarly, the European Investment Bank 2022 working paper found no correlation between a country’s creditworthiness and its debt-to-GDP ratio, while annual debt costs, GDP per capita, economic growth, and the World Bank’s Global Governance Index had a significant impact on credit ratings.
By the way, most of the high-priority items on the list are those that EU countries excel at, which is why all European economies except Greece benefit from an “investment grade” rating (BBB or above).
So while financial markets have developed fine-grained methods for judging the quality of a country’s fiscal policy, Europe’s fiscal rules focus primarily on just one fluctuating debt-to-GDP ratio, which just so happens to be wrong.
“Financial markets care little about the debt-to-GDP ratio, but Europe’s economic governance framework makes it a major compass,” Sattor-Sorrel concluded.
Contradiction
As Jean Pisani Ferry, a senior researcher at the Brussels-based think tank Bruegel, recently pointed out, the EU is already committed to cutting emissions, debt relief or not.
“Clearly the question of whether climate action should take precedence over debt reduction cannot be ignored,” he said. wrote in an editorial.
Instead of worrying about rising debt levels, politicians might be more worried about what they’re going to do with it.
“Future-oriented” investments in climate, education and research should be exempt from arbitrary budget deficits and spending limits, Sattor-Sorrel argues.
Done right, these investments could improve the debt sustainability and economic strength of European countries, leading to higher credit ratings and lower borrowing costs.
By the way, this could also avoid, or at least mitigate, the conflict between climate action and debt relief.
