The Great Recession broke out in late 2008, gained full force in 2009, and plagued the global economy into 2011 when an unassuming recovery period began.
During that recession, many European countries fell into unmanageable debt. One of the responses from the EU was to create a financial institution dedicated to loans to debt-burdened euro-zone members. This institution, known as the European Stability Mechanism, ESM, has provided some assistance to distressed countries—but it has other plans for its own future.
Powerful figures in the bloc are pushing for the [ESM], worth €422 billion, to move beyond its original role rescuing drowning economies, according to five people with knowledge of the discussions. It could instead take on the task of distributing cheap loans to buy weapons, one of them said.
Why would this outfit suddenly want to branch out into defense funding?
The reason is as cynical as it can be in politics. To get there, let us first note that the easiest way for the ERM to help member states with their defense spending would be to simply dole out its cash, apparently €422 billion, in portions, until it was all gone.
It would last a while: in 2022, the latest year for which Eurostat reports country-by-country defense spending, the 27 EU member states together spent €203.6 billion on defense. This represented a 10.5% increase over 2021, but it is still only half as much as the money loitering in the ESM’s bank account. The spending boost would also be very helpful to smaller EU states: only six of the EU’s 27 members appropriate more than €10 billion per year to national defense.
A drawdown of the ESM’s funds at 20% per year would boost EU-wide defense spending by approximately 80%—for five years. If I were in charge of the ESM and I really wanted to boost defense spending in these perilous times, I would go for this plan.
But that is not what the ESM has in mind. As Politico mentions, the plan is instead to extend defense-dedicated loans to EU member states. That sounds fair, but the big question is: why do they want to do this—and why now?
The “now” part may seem obvious—there is a war in Ukraine—but if that was the primary concern, then the five-year drawdown of the ESM funds would be a more solid, and definitely more reliable path to bigger military appropriations. Since this is not what the ESM leadership has in mind, we have to start digging to find out what is really going on.
According to its 2022 annual report, the ESM
is a crisis resolution mechanism established by the euro area countries. Since its inception in October 2012, the Luxembourg-based institution has provided financial assistance to ESM members experiencing or threatened by severe financial problems to safeguard the financial stability of the euro area as a whole as well as its member states.
To fund its aid—which so far has been limited to Cyprus, Greece, Ireland, Portugal, and Spain—the ESM sells debt instruments to institutional investors in the open debt markets.
Right here, we get a big clue as to why the ESM wants to lend money for defense funding instead of giving it away. The ESM is a traditional financial institution that borrows money on a free market. Out there, the ESM competes with its solvency and solidity against countless competitors; investors get daily, even hourly evaluations of whether or not to lend their money to ESM.
This means that the parts of the ESM’s liabilities that emanate from the debt market are as demanding as they can be. This means that the ESM needs to have assets that are competitive compared to others whose debt investors can choose to buy instead.
In short: the ESM needs a strong portfolio. But it does not have a strong portfolio: its assets consist to a large degree of loans to troubled euro zone governments. These are countries that have difficulties getting takers for their sovereign debt—which is why the ESM is there. It provides the liquidity that the market for low-credit sovereign debt so badly needs.
With liabilities and assets varying to such a degree in quality, the ESM suffers from a structural imbalance. The borrowing takes place on an open market where investors have access to debt instruments from financial institutions with very highly rated asset portfolios. The ESM, by contrast, was created for the very purpose of buying assets from governments (and presumably troubled financial institutions) that have less-than-stellar credit ratings.
In a normal market, this means that the financial institution must pay a higher interest on its liabilities than competitors with a broader portfolio. So long as the risk premium on its assets is correctly assessed, the cash flow works and everyone is happy. The clouds start appearing on the horizon when the risk of defaults among low-grade sovereign debt suddenly goes up.
The slowly emerging European recession is an eminent cause of sudden default risks. When people lose their jobs, they transition from being taxpayers to living on the government’s dole. Budget deficits rise rapidly, forcing governments with weak credit into a quick default-bound fiscal spiral.
This is the scenario that lies before the ESM. To provide some mitigation, they have shareholder-provided capital in their portfolio: the states that are members of the euro zone are also shareholders in the ESM. In that capacity, they pledge—or subscribe—capital funding that supposedly serves as a counterweight to the subprime treasury securities the ESM has bought from troubled governments.
If you read the ESM’s balance statement, presented on page 62 of the 2022 annual report, you get the impression that the ESM is a highly solvent outfit. Yet upon closer look, that is not the case at all. Using a trick that I thought was not permissible in regular accounting, the ESM reports among its assets an item called “Subscribed capital unpaid.” It is worth €624.3 billion, thereby accounting for 76.8% of the €812.7 billion in total assets.
Again, these are unpaid funds that the ESM-owning euro-zone countries have pledged but not chipped in. These promises are listed as assets alongside “cash in hand” and loans to member-state governments who are paying regularly on those loans.
If we deduct the unpaid shareholder funds from the ESM’s total assets, we end up with only €188.5 billion in assets. This is still a healthy margin above the €107.9 billion in liabilities, but given that the item “Loans and advances to euro area member states” is worth €86.2 billion, and given that these loans are not of the highest quality, it does not take much default from credit-challenged euro zone states before the ESM is in trouble.
Still: as long as those loans pay, they are more reliable as assets than unpaid member-state contributions.
But what does all this have to do with funding defense spending across the EU?
Simple: it is a popular spending item, and it allows the ESM to sell loans to countries that have good credit, along with those that have bad credit. Their asset portfolio improves, and they can continue to borrow money at a moderate cost.
In short, the ESM will survive as a financial institution—a government-run bank that moves away from its socially significant original purpose because it wants to make a buck or two.
Only one question remains: who is going to help troubled euro zone countries that are drowning in their own sovereign debt?
