Who should pay for the cost of climate policies?

There should be little doubt that drastic measures are required to protect the planet from environmental catastrophes. But who should pay the bill for these urgent environmental policies? This is the question that is central today and that was placed on the political agenda recently by the “yellow vests” protestations. Many want to save the environment but few want to bear the cost. Yet without resolving this question of who will foot the bill no progress can be made in developing effective climate policies. 

The problem exists at two levels. There is the question on which shoulders of the current generation the greatest burden will be placed. There is also the question of how the costs will be spread between current and future generations. 

The first question is receiving most of the attention today. It is indeed important to design redistributive policies that will ensure that those with the “strongest shoulders” bear a proportionally larger part of the cost of climate policies. This could be achieved by transferring the whole (or part) of the proceeds from the taxes on fossil fuels to those in the lower income brackets. It appears that although this simple principle is easy to formulate, the political conflicts that arise when one wants to apply it are intense.

The second distributional question, the one between the present and future generations is of equal importance. This is the one I want to address here. When we impose extra taxes on households and businesses today to finance environmental policies, we actually ask them to pay the full cost of a policy that will benefit the future generations. Many people resist this today, and then rationalize this resistance by denying the urgency of climate change.  It is therefore important to set out a policy that ensures that the costs are spread between current and future generations in such a way that the distribution of these costs also reflects the distribution of the benefits over time.

There is one policy domain where we can actually apply this distributional rule, and that is public investment. The latter, together with private investments, are essential to transform the economy from the use of fossil fuels to renewable energy sources. Public investments must be made in new energy infrastructure, in public transport, in research and development, and in many other areas. 

The formula that achieves the objective of spreading the costs over time is to finance public investment through the issuance of government bonds. The issue of bonds today provides the financing for the investment project while the payment of interest costs is spread over time. Thus, such a financing distributes the costs of the investment between present and future generations. The latter will enjoy most of the benefits of those investments and will also contribute to their costs. Such a financing also makes it possible for the current generation to be partially relieved of the costs of these investments. This reduces the resistance to costly environmental policies.

Unfortunately the European authorities have put sticks in the wheels. The budgetary rules imposed today by the European Commission prevent the costs of public investment from being spread over time. The rule that the government budget must be (structurally) in balance makes it impossible for public investment to be financed through the issuance of bonds. The reason is that the latter creates a structural deficit in the budget and that is forbidden by the fiscal rule. 

The consequence is that when Eurozone governments want to make environmental investments, they are obliged to increase taxes and/or to reduce other government expenditures (e.g. social security). In other words, they are obliged to force 100% of the costs of these investments to be paid by today’s households and firms. And quite naturally, these resist and rightly so.

The solution to this problem is actually very simple and is sometimes called the “golden rule”. The European authorities should allow public investments to be put into a "capital budget". These may be financed through the issuance of bonds. The European rule of structural balance would then only apply to the ordinary budget consisting of current spending and taxes. Since current spending represents more than 95% of the total budget in most European countries, this would ensure that more than 95% of the budget would be subject to the balanced budget rule. 

The only thing that stands in the way of this solution is the dogma that government debt is always bad. Public debt is indeed bad when it serves to finance consumption. Public debt is good when it serves to make productive investments that help keeping the planet safe from future environmental catastrophes. 

The problem with the dogma that government debt is always bad is that it originates from an obsession that only looks at the liabilities side of the balance sheets of governments. We would never do this when we want to evaluate the financial health of private companies. We would always look at both the asset and liabilities sides to make a judgment about the solvency of these companies. Yet when we make such a judgment about a government we close our eyes for the asset side of its balance sheet; a wholly irrational procedure. When the counterpart of the higher government debt consists of productive assets whose returns exceed the cost of the debt, there is no problem of raising this debt.  The debt can then permanently exceed 60%, or 100% for that matter. It then makes no sense for the European Commission to desperately trying to force public debts into unconditional surrender. 

It is time we shed the dogma that government debt is always bad. We have to shed this dogma to make it possible to massively invest in projects that will prevent climate change from destroying the planet. Such investments can only be made if the costs are shared by current and future generations. 

The European Commission should accept democratic change in Italy

The Italian budgetary and financial crisis is getting worse. The conflict between the Italian government and the European Commission on the proposed budget is intensifying. It does not seem likely that the Italian government will yield to the demands of the Commission to adjust the budget. This conflict leads investors to continuing to sell Italian government bonds leading to a surge of the yields on these bonds. It has become the major source of upheaval in the Italian government bond market and risks escalating into a full-fledged crisis of the Eurozone.

Time to think again about the budgetary rules that are being applied by the European Commission.

Since the Eurozone’s debt crisis in 2010, the European Commission has seen a dramatic increase in its power to supervise and control national budgets. This development was motivated by the will of the creditor countries to impose budgetary discipline on the debtor countries, such as Greece, Ireland, Spain and Portugal. As a result, the Stability and Growth Pact was strengthened and the power of the European Commission over the budgetary process of the euro zone member states was tightened.

The new responsibilities of the European Commission create a problem of democratic legitimacy. Not in the sense that the Commission's tighter role in the budgetary procedures of the Member States have been achieved in an undemocratic manner. This increased power of the Commission is the result of decisions in the Council of Ministers and in the European Parliament. These are bodies that have been established in a democratic manner and that have decided to give the European Commission more power over national budgetary procedures after applying the majority rule. Formally there is nothing wrong with the legitimacy of the European Commission.

However, I am talking here about political legitimacy. The European Commission can now force countries to increase taxes and reduce expenditures without, however, having to bear the political costs of these decisions. These costs are borne by national governments. This is a model that does not work.

National governments bear the political costs of expenditures and taxes. The risk therefore arises that they will contest the decisions of non-elected officials who do not bear these costs. This has happened a few times in the past. In 2003-04, when their economies were not doing well, the German and French governments collided with the European Commission about their budgets. The European Commission wanted to force these governments to reduce their budget deficits. Both governments refused to do this and the rules were changed "à la tête du client".

Today the Italian government is doing the same. It is a government that has made a number of election promises and wants to implement them now. That has budgetary implications. The European Commission is now trying to force the Italian government to abandon these election promises without having to bear the political cost of doing so. The new Italian government would pay the political price for shredding its election promises. It will not do so, as the French and German governments did not do in 2003-04.

The model of top-down budgetary control does not work in Europe. It does not work because the whole process of decisions on taxes and expenditures still exists at the national level. It is also at the national level that the democratic principle of "no taxation without representation" is implemented. The European Commission's attempts to bring Italy into line today are therefore also attempts to impose exceptions to this democratic principle. It does not work, and fortunately so.

The only way out of this institutional crisis is to go further into political unification. This implies that large parts of the national budget processes would be transferred to the European Parliament. The principle of no taxation without representation would then be applied at the European level. This would raise the democratic legitimacy of the budgetary process to a higher European level.

We are very far from such a political unification today. This means that, at regular intervals, democratically elected national governments will reject the European Commission's attempts to go counter the will of the electorate.

One would hope that the European Commission understands this quandary and that it takes a flexible position, allowing the Italian government to have its budget deficit of 2.6%. It would be a bow of the Commission to the outcome of a democratic change in Italy. It would also take away a major source of upheaval in the Italian government bond market, and the risk that this entails for the Eurozone as a whole. 

Why Russia is politically and militarily strong while being an economic dwarf

Last week I saw a surprising statistic: the GDP of Russia is of the same order of magnitude as the combined GDP of Belgium and the Netherlands. In 2017 Russian GDP was 1,469 billion dollars (according to the International Monetary Fund). Belgium had a GDP of 491 billion dollars and the Netherlands 824 billion dollars; together $ 1,315 billion. In GDP terms, Russia is only 12% larger than Belgium plus the Netherlands.

This perplexing statistic prompted me to ask why politically Russia weighs so much more in the world than Belgium and the Netherlands, while economically that country is hardly stronger than these two countries bordering the North Sea.

Before answering that question, first some other figures that illustrate how an economic lightweight Russia is. US GDP reached USD 19,362 billion in 2017. With GDP as a yardstick, the US is 13 times bigger than Russia. In the same way, other countries can be compared with Russia. China is economically 8 times larger than Russia; Germany 2.5 times more, France 1.8 more, and the European Union as a whole is 12 times bigger than Russia.

The economic size of a country is one of the most important factors that determines its military and political importance in the world. A large economy is needed to provide the means that gives the country military and political weight in the world. So it is clear: Russia is boxing above its economic weight on the international scene.

The fact that Russia means so little economically implies that the country must exert extraordinary efforts to create a strong military potential. In 2017, Russian military spending  amounted to 61 billion dollars (according to the International Institute of Strategic Studies). The US spent nearly 10 times more, namely $ 603 billion. China spent $ 151 billion on defense. France and Germany together spent 90 billion dollars on defense, 50% more than Russia. And yet all these countries spent a much smaller proportion of their GDP on the military than Russia.

Russia is not a major player in the field of military spending. To have a certain military weight, that country must reserve a much larger share of its GDP for defense than the other countries. To mean something militarily, Russia has to put a heavy burden on its own economy.

I come back to my question: why is it that Russia, which economically is a lightweight, has such an importance politically and militarily? Here is an attempt to answer that question.

First there is the fact that, at the time of the Soviet empire, Russia built up a nuclear arsenal that, together with the USA, gives this country a unique position in the world. This is the position of "Mutually Assured Destruction" (MAD). This means that the country has the capacity to completely destroy the opponent in the event of a nuclear attack on its own territory. No other nuclear power (outside the US) has that capacity today. As long as Russia has such a terrible MAD capacity, it will be politically heavier than its GDP suggests.

Russia is also an important supplier of raw materials, including oil and gas. This gives the country a political lever with regard to Western Europe. It is possible by turning the tap (or threatening to do so) to exert pressure on a number of European countries. However, that effect should not be overestimated. Russia also knows that the use of this weapon will in time encourage European countries to find other sources of supply. The power of Russia is limited in this domain because the country does not have a monopoly in oil and gas.

Finally, and that is my most important point, Russia is powerful because Europe grants that power to Russia. Europe has built up an economic union but not a defense union. The European Union is economically 12 times larger than Russia; A huge potential power. However, this economic power is not converted into military and political power because defense has remained a national matter. By merging their military capabilities, it would be possible for France and Germany to build a credible defense against Russian threats, without having to spend more. The combined military spending of such a Franco-German defense union would be 50% higher than Russian military spending. Enough to offer a counterweight to a Russian dictator whose political and military ambitions in Europe remain unknown.

"Si vis pacem, para bellum" said the Romans. If you want peace, you should prepare the war. Translated to the European situation of today this means that Europe should build a credible defense union. This by itself would reduce the military and political power of Russia.