While Europe is ramping up its efforts to rebuild its military, the sordid state of the continent’s public finances is becoming a real issue. Figure 1 reports the budget balances in 2024, with deficits as share of total government spending:
Figure 1
The EU measures deficits as a share of GDP, which is a more ‘lenient’ measure, but if we want to know how functionally dependent a government is on borrowed money, we look at how many cents a government borrows of every euro that it spends.
With only six of 27 governments paying all their bills themselves in 2024, there is an understandable sense of desperation across the EU when it comes to funding military expansion. Normally, politicians and economists would be looking for faster growth in GDP as a source of faster-growing tax revenue, but there is virtually no hope for that. As sad as it is to admit it, Europe is practically devoid of credible efforts at stimulating economic growth.
The only other hope, then, is to borrow more money, but new debt comes with a price tag. Last week, the European Central Bank came to the rescue, at least of debt-hungry member states in the euro zone; the others will have to fend for themselves. The ECB’s Governing Council decided to cut the bank’s three interest rates:
In particular, the decision to lower the deposit facility—the rate through which the Governing Council steers the monetary policy stance—is based on its updated assessment of the inflation outlook
The rate cut was 0.25 percentage points, with the so-called deposit facility—the most important of the three—now at 2%. The other two, the rates on refinancing rate and marginal lending, are now at, respectively, 2.15% and 2.4%.
From a broader economic viewpoint, these are not big rate cuts; a 0.5 percentage-point cut would have made more sense in terms of stimulating the economy. However, the ECB’s primary goal was not to stimulate growth, but to help lower the costs of government borrowing. The bank gives away its motive in an otherwise inconspicuous paragraph on page 4 in its transcript from the monetary-policy press conference (emphasis added):
While the uncertainty surrounding trade policies is expected to weigh on business investment and exports, especially in the short term, rising government investment in defence and infrastructure will increasingly support growth over the medium term.
This reference to increased government spending is deliberately measured; plainly, the bank is walking a fine line between two mutually exclusive policy stances. On the one hand, the ECB cannot be a proponent of increased government debt; it would be an almost defiantly obvious violation of the central bank’s statutory role as an independent monetary authority.
On the other hand, the bank shares my assessment that there are no private-sector sources of economic growth in the euro zone. Therefore, the only way the European economy can be saved from perennial stagnation is by means of more government outlays. This would also generate new, desperately needed tax revenue in coming years.
Torn between its obligation to not encourage government borrowing and its duty to light some kind of light in Europe’s perennial economic darkness, the ECB strikes a carefully worded middle ground.
It refers to military and infrastructure spending as a generator of economic growth.
In other words, the ECB welcomes bigger government budgets, and they welcome the use of credit to fund that new spending. The reference to defense and infrastructure outlays as “investment” carries strong signal value to economics and finance insiders. To see why, let us clarify the difference between consumption and investment.
According to national accounting principles, as well as established public finance practice, defense spending is a form of government consumption, not investment. The difference is essential:
- Consumption is an outlay for something that we use here and now, and therefore value here and now;
- Investment is an outlay for something that has no intrinsic value, but gains value because it helps other economic activity, thus generating income over an extended period of time.
Our national defense is a case in point. We have a national defense for everyday protection against our enemies. Our running defense outlays are like an insurance policy against war, much like the budget for your local police department is insurance against intolerable crime rates.
In contrast, infrastructure is of no use in itself. It becomes useful only when we can transport cars on the roads we build, trains on our railroads, power through power lines, etc.
Normally, government consumption is paid for with current tax revenue, and the economists at the ECB are very well aware of this. Therefore, when they change the definition of defense spending from consumption to investment, they subtly send a signal to Europe’s public finance officials that as far as the ECB is concerned, it is perfectly fine for them to finance increased military spending the same way they finance investments: with borrowed money.
When we view the ECB’s rate cut in this context, the cut itself makes perfect sense. But so does the 0.25 percentage-point size of the cut; a cut at 0.5 percentage points would have been appropriate if the goal was to stimulate private sector growth, but it would have been too much as a means to fund more government borrowing.
The bigger cut would have dipped the euro zone back into negative interest-rate territory. This would have had significant effects on the market for euro-denominated government debt, i.e., the market for treasury securities:
- Currently, an investor who buys euro-denominated government debt with a maturity of two years or less gets a negative return: the debt security pays 1.94% for a two-year treasury bill;
- If the interest rate on that bill changed on par with the ECB’s rates, the rate would fall to 1.44%.
All euro-denominated treasury securities with a maturity of five years or less would suddenly be paying investors a negative interest rate.
Securities with relatively short maturity, such as five years or less, are essential to governments when they are rapidly increasing their borrowing. When investors are generally a bit iffy about putting more money into government debt, a short maturity means a relatively more predictable return. This lower level of uncertainty comes with a lower return; in comparison, the interest rates on euro-denominated government debt maturing 20 years from now exceeds 3.5%.
However, that debt also comes with a significant level of risk for the investor—a risk that increases with more borrowing. Therefore, if the rate were to fall too low, prudent investors would go buy gold or Swiss debt instead.
The message in all this technical analysis is that euro-zone governments are in desperate need of borrowing more money. At the same time, the European Central Bank acknowledges that this very borrowing is the key to any positive movement in the euro-zone economy—for the foreseeable future. Therefore, the ECB helps debt-hungry governments out by cutting its interest rates just enough to lower the cost of that new debt while still—hopefully—keeping investors interested enough to buy that debt.
