Explained: the Insurance Properties of Common Debt Issuance in the European Union

The Covid-19 crisis has led to a common European fiscal response in the form of the €750 billion Next Generation EU (NGEU) package agreed by EU leaders in July 2020.

One important novelty of this package is that it will involve, for the first time, the issuance of substantial common European debt. Part of this debt will finance loans which have to be repaid by Member States. But a substantial part, around €360 billion, finances grants. The common debt which finances these grants will have to be serviced by EU sources of funding. The most important source of funds for the EU budget is a contribution of around 1% of GDP from each Member State.

This implies that if the economy of a Member State is hit by a negative shock - if it grows less than the Union average - its contribution to the service of the common debt is correspondingly reduced.  By contrast, the service of national debt, which is typically fixed in nominal terms, becomes more difficult in case of a negative idiosyncratic shock. 

In a federation of sovereign states such as the European Union, this means that common debt can provide insurance against economic shocks experienced by individual Member States, even without financial transfers being made to the affected state. This insurance against these idiosyncratic shocks arises automatically when common debt is financed by a levy on members that is proportional to national income.

A key problem for national debt, usually fixed in nominal amounts, is uncertainty about growth. A fall in output makes a given debt burden very costly. The cost of public debt increases more than proportionally with the debt/GDP ratio as the government has to squeeze tax revenues from a smaller base.

Common European debt, which is financed by a pro-rata levy on the output of Member States, provides an insurance function against this problem because countries that grow less contribute less, and those that grow more have to contribute more. This insurance function becomes more important the longer the debt horizon and, with it, the uncertainty about economic performance.

To understand the future of this common European debt, we can look back to the famous US debt assumption by Secretary Alexander Hamilton in 1790. Assuming the outstanding debt of the US states at the federal level distributed the risk across individual states. This distribution of risk, though unpopular at the time among states that had already repaid their debts, proved important when the southern states entered relative decline and contributed much less to the repayment of the federal debt.

In the same way, the financing of the NGEU package through common EU bonds represents an important step forward by providing an incipient shock-absorption mechanism. Common debt issuance can provide an important insurance function, even if there is no transfer of resources once future debt service has been accounted for. But common European debt does not represent a free resource - in the end it has to be serviced in one way or another, by all Member States.