EUO’s Thematic BlogSpot (#11) – Eurozone fiscal union
The original sin: monetary without fiscal union
The lack of fiscal union is one of the critical design failures of the Economic and Monetary Union (EMU) according to De la Dehesa and Fabrizio Saccomanni, with two critical problems: (i) the absence of an institution that monitors or controls the area-wide fiscal stance and (ii) the lack of fiscal resources for risk sharing:
Fiscal stance—Giavazzi and Tabellini point out that from 2011 to 2013, euro zone fiscal policy was pro-cyclical. Mario Draghi criticized the euro zone’s aggregate fiscal contractionary stance, which complicates the conduct of monetary policy. Draghi called for stronger coordination and for a large EU-level public investment program.
Risk sharing—Mark Carney stresses that the eurozone needs institutions that are observed in any successful currency union, namely financial integration and common fiscal arrangements—to ensure both private and public risk sharing.
This institutional flaw (centralized monetary policy coexisting with decentralized fiscal, economic and financial stability policies) is described by George Soros, echoed by Vitor Constâncio. Sapir and Wolff argue that two factors are particularly at fault: differences between countries within the euro zone, and inadequate euro zone economic governance.
What Are the Main Weaknesses of EMU Fiscal Governance?
The initial framework for EMU fiscal governance was set by the Stability and Growth Pact (SGP) in 1999. In 2005, reforms made the framework flexible, with country-specific medium term objectives (MTOs) for headline deficits.
Weaknesses and critical gaps. Allard et al. highlight three critical gaps exposed by the crisis: (i) sovereigns can be priced out of the market or lose market access; (ii) private borrowing costs can differ widely within the union; (iii) contagion can occur. Goyal et al. explain that public imbalances can exacerbate private imbalances by increasing private sector stress via the bank-sovereign nexus. Faced with country-specific shocks, fiscal federations provide macroeconomic insurance through fiscal transfers while reducing moral hazard with spending and borrowing constraints on subnational entities. Martine Guergil adds that non-provision of public services at the euro zone level may not be sustainable.
Guergil underscores differences between the EU and 13 fiscal federations: absence of a political union; very small federal budget, almost entirely dependent on transfers from members; lack of shared policy instruments for fiscal discipline. Experience shows that subnational fiscal crises have often shaped fiscal sharing arrangements in federations.
What Reforms Have Been Made to EMU Fiscal Governance?
Successive reforms to improve fiscal and economic governance (summarized by Allard et al.) include: the Six-Pack (Dec. 2011); the Fiscal Compact (Jan. 2013); the Two-Pack (May 2013); and the Four Presidents’ report (December 2012 and July 2015).
Important gaps remain… Eyraud and Wu highlight the complex design of fiscal rules and weak enforcement mechanisms. They call for more effectively enforcing structural balance targets and limiting the ability of states to spend revenue windfalls. Reza Moghadam adds that private sector imbalances and divergent competitiveness can constitute vulnerabilities for public balance sheets. Examples include bank bailouts in Ireland, lost revenue and increased spending from deep and prolonged fall in output in Spain. Michel Aglietta notes that the SGP does not take into account the intertemporal dimension of public debt sustainability.
In particular the lack of fiscal transfers for which European rules are no substitute according to Tim Duy. Paul Krugman suggests that the US Savings and Loans crisis illustrates how transfers cushion asymmetrical shocks. Jean Tirole explains the rationale behind such insurance. IMF work confirms that, on average, 15 to 30 percent of the initial shock is cyclically smoothed by fiscal transfers from the center, with long-term flows of federal transfers helping smooth long periods of adjustment or imbalances across areas.
Asymmetry and lack of democracy—Michel Aglietta argues that Europe has taken a major historical and institutional step forward by moving to a single currency, and must now unify its debt markets, as the US did in 1790. Existing fiscal rules only work in the restrictive sense—no automatic rule could force a government into an expansionary stance. EuroIntelligence cites an analysis by Jean Pisani-Ferry on needed governance changes arguing that EU governance system does not favor an appropriate fiscal policy stance over the cycle and creates risks of pro-cyclicality and under-provision of fiscal stabilization, still contains a fiscal bias in terms of surveillance, under-represents common euro zone interests, and maintains weak institutions despite strengthened procedures. For Aglietta, the lack of democracy in the European Semester could be palliated by better coordinating national fiscal councils.
Inadequate oversight of fiscal policies is noted by Allard et al. who call for better oversight, temporary transfers or common provision of public services, a common backstop for the banking union, and borrowing at the center. Huw Pill (Goldman Sachs) identifies fiscal mechanisms that can either reduce the likelihood of asymmetric shocks by generating a more synchronized business cycle, or provide an alternative adjustment mechanism to monetary policy (such as financial transfers).
Lessons and open questions
Is the experience of the US relevant for the EU, notably for the sequencing of monetary, member state bailouts and fiscal policy integration? Vitor Gaspar (IMF), drawing on Thomas Sargent (Nobel lecture), notes that constitutional change and the need for centralized fiscal capacity were at the origin of the creation of the Bank of England and the foundations of US public finances. Sargent notes that, in the US, nationalized fiscal policy (including a comprehensive bailout of the government debts of individual states) preceded the management of a common fiat currency, contrary to the Euro zone. He highlights important differences between the US in 1787 and the EU now: government redistributive activity was minimal in the US then; in the EU, social safety nets and retirement and medical systems are pervasive and absorb large shares of national budgets; minimum wages, unemployment and disability benefit schemes and employment protection laws differ widely across the EU.
Is fiscal union necessarily a road to a transfer union? Harold James reminds us that the euro was born out of a need to tackle problems of the international monetary order (following the collapse of the Bretton Woods system) and to respond to tensions created by Germany’s current account surplus. Jörg Bibow (LSE Financial Markets Group) proposes to set up a euro area treasury that would act as a pool for public investment, allocating investment grants based on GDP shares and collecting taxes to service debt costs in line with GDP shares. This would limit the union to a fiscal rather than a transfer union, as benefits and contributions would be proportional to GDP shares.
What can existing welfare states teach us about transfer unions? Significant differences in wealth across regions may hamper the effectiveness of a fiscal union. Scott Sumner contrasts the evolution of southern Italy and Eastern Germany. For Martin Sandbu, what matters is fiscal “insurance” rather than fiscal transfers. Allard et al. find that most of the shock absorption in federal countries takes place via private channels (credit markets, banks, investment), with fiscal insurance compensating only 15 percent of local downturns in the US and 10 percent in Germany.
What Solutions for Fiscal Union?
Three types of fiscal union solutions have been proposed:
Limited fiscal union—Marzinotto, Sapir and Wolff call for the creation of a euro zone finance ministry, with a minister with veto rights over national budgets that could threaten euro zone sustainability. Huw Pill calls for a euro zone “finance chief” and managing an area-wide single budget with tax-raising powers and issuing pooled debt liabilities. Emmanuel Macron called for a full fiscal union, headed by a European Commissionner who would allocate investment funds and have authority to borrow money in the markets, in line Benoit Coeuré’s proposals (EuroIntelligence), for a euro zone finance ministry that would help prevent excessive private and public sector imbalances and would have an independent budget and be accountable to the European parliament. Wolfgang Schauble is supportive of the idea of a euro zone finance ministry, but as an enforcer rather than the head of a fiscal union.
Deeper fiscal integration—Tressel et. al. suggest that greater fiscal integration would facilitate adjustment in euro zone deficit countries. Political hurdles are considerable in the short-term. In the future, conditional on better governance and stronger incentives for national policies, including more credible and tighter budget constraints, some system of temporary transfers or joint provision of common public goods or services would help achieve some fiscal risk sharing and facilitate adjustment.
Simplified fiscal union—More recent IMF work (Andrle et al., 2015) highlights the complexity of fiscal constraints imposed on EMU countries by the existing framework. The authors propose three options to reduce this complexity: simplifying the overall fiscal governance framework design; introducing a single fiscal anchor (the public debt to GDP ratio) with a single operational rule (an expenditure growth rule); further bolstering enforcement through greater automaticity and a gradual step-up in enforcement, a more credible set of sanctions that better reflect economic circumstances; and a better coordination of fiscal policy monitoring between national fiscal councils and the European Commission.
What Fiscal Governance Changes Are Realistic?
Political capital for further EU integration is scarce and should be used wisely (Huw Pill and Simon Wren-Lewis)—therefore focusing on measures that (1) are complements rather than substitutes, and (2) act as a catalyst for an endogenous virtuous cycle of greater integration. While the Italian proposals for EMU governance changes (via the FT) are timid, the Spanish (via El Pais) proposals include common euro zone fiscal capacity, and eurobonds in the longer term.
The differences between Germany’s ordoliberal view of fiscal policy and France’s Keynesian view are substantial, irreconcilable according to Philippe Legrain—if a fiscal union materializes it will likely be a German-inspired supranational fiscal enforcer with control over national budgets, close to what Jean-Claude Trichet had in mind in 2011. EuroIntelligence further suggests that Germany would require a eurozone exit option to be in place for countries whose fiscal position becomes unsustainable. The Five Presidents’ report is vague regarding required steps to achieve an area-wide fiscal stabilization function, calling for further coordination and pooling of decision making on national budgets with commensurate democratic accountability, and the creation of an advisory European Fiscal Board. Bruegel’s Ashoka Mody argues that a fiscal union is politically impossible, notably because of the “no bailout” commitment in the Maastricht Treaty and Lisbon Treaty.
