The European Commission’s recovery plan: applying the principles of impact investing to address moral hazard risk

At the current juncture, given the origin and the extent of the economic shock, the case in favour of fiscal transfers between eurozone countries has never been stronger.

In order to bridge the gap between countries which, quite understandably, insist money provided should be used properly, and those which count on some solidarity in difficult times whilst keeping their policy autonomy, the EU might wish to consider taking a leaf from the private sector. Instead of arguing over loans versus grants, why not turn the premise around and provide member states with loans with positive impact incentives in exchange for better financing terms. Positive impact in this case means reaching milestones which have been agreed upon in advance. 

The Covid-19 pandemic is hitting all countries but some are suffering more than others. This is of course due in part to how early or late people were contaminated, but other factors also play a role such as the sector structure of the economy, and the weight of small and midsized enterprises, which often tend to be financially less resilient than large companies. To a large degree, this is more about bad luck rather than bad policy. Admittedly, the latter does play a role when looking at fiscal policy leeway, which depends on public sector debt as a percentage of GDP. When a relative, friend or neighbour suffer from bad luck, people will feel inclined to help them financially. One of the strongest arguments in favour of solidarity between states is that economic divergence between the Eurozone members would increase, given that some are in a better position than others to tackle the crisis by boosting their economy. A point made rather forcefully by the European Commission last week when presenting its proposal.

And also, let’s not forget that the way in which we deal with the current situation, will be used for many years to come, as the yard-stick with which European citizens assess the willingness and ability of the EU to cooperate under severe stress. The Five Presidents’ report of 2015 compared EMU to a house built over decades but only partially finished. If there was a time to shore up the building, it’s now.

Yet, the old stereotypes are back in the public debate and on social media. It’s the uncomfortable triangle between solidarity, conditionality and moral hazard.

The ‘frugal four’ have expressed a preference for loans over grants but the press conference last week of Commission Executive Vice-President Dombrovskis and Economy Commissioner Gentiloni had countless references that the milestones that should be agreed upon between a government and the Commission have nothing to do with the conditionality seen in the past. To quote Gentiloni, “this is not the troika”.

So how can we bring those member states who advocate for fiscal responsibility and those who call for solidarity to the table? One potential way might be to consider stowing the stick and taking out a carrot. Under the former, access to funding is dependent upon meeting certain conditions. Presented like this, conditionality is like an expression of distrust, which may trigger very emotional reactions in the recipient country.

The carrot strategy works the other way around and is inspired by certain types of impact investing. The beneficiary of the financing can obtain better conditions if certain milestones are met. This creates a big incentive and it should be easier for a government to win popular support: let’s work together for this shared purpose and everybody will benefit.

Conditions than become a vote of trust: countries providing the financing express their trust that the beneficiaries can meet their targets. They actually hope they will succeed because it will create a win-win in the form of faster growth, positive spillover effects, a stronger EMU. Moreover, the enhanced effectiveness of ECB monetary policy would pave the way for higher interest rates, something which would be welcomed by savers, especially in the frugal countries.

Under such an impact investing approach, the EU would issue bonds and countries would pitch for a slice of the cake.

Milestones would serve to adjust the conditions over time: the greater the achievement, the bigger the improvement in the conditions charged to the borrower. One could consider that if the achievements are sizeable enough, part of the loans provided to a country would not need to be paid back and would be converted into a grant.

Clearly, all this requires a lot of fine-tuning: how are the milestones set? Who makes the assessment (the European Commission or the Commission and the other Eurozone members)? What is the bang per buck, the reward for reaching a milestone? To what extent could a loan be converted into a grant?

Despite these and other questions, framing loans in an impact investing framework should be instrumental in bringing the different sides closer to each other and bring the much needed fiscal solidarity.       

William De Vijlder

Group Chief Economist, BNP Paribas

12 June 2020