What should/can be done to improve fiscal governance in the Euro-Area?
Despite progress made these past few years a much-needed reform of the governance of the euro area is lagging today, possibly because of a lack of common understanding of the roots of its crisis, according to Sapir and Wolff.
Framework for euro area governance : flaws and insufficiencies
Before the crisis, the euro area suffered from (i) an accumulation of macroeconomic and external imbalances (ii) a divergence in prices and wages (iii) not enough attention payed to debt sustainability (Bruegel). According to Pisani-Ferry the crisis also revealed that deeper problems in the governance regime, such as non-fiscal risks arising from credit booms, asset-price developments or an appreciation of the real exchange rate, were not addressed.
Fazi points out that the financial crisis has highlighted the deep flaws of the euro area: Maastricht’s Original Sin, meaning that the Monetary Union was created without a Fiscal Union. A point also made by Darvas, who states that most roots of the euro area crisis lie in the mismatch between a currency union and the means given to make it work economically—with no mechanisms to prevent the built up of imbalances. Nor tools to deal with them (no lender of last resort, no fiscal transfers to replace capital inflows, and only a limited labour mobility). The crisis became worse because the EU has no solidarity or rescue mechanism. Country experiences through the crisis were different (Sbaihi, Bloomberg).
For the European Commission, one of the main lessons of the crisis has been that fiscal policies are of vital common interest in a Monetary Union—as illustrated by the US example (The Guardian). Unsustainable fiscal policies harm financial stability and lead to financial fragmentation. The Maastricht Treaty deprives countries from their fiscal autonomy (SocialEurope) (i) by removing from them the power to issue money (ii) by binding them to limit their public deficit (3% of GDP) and debt level (60% of GDP) through the Stability and Growth Pact (SGP). Yet there is some criticism regarding the enforcement of theses rules: Stacey (FT) argues that double standards are applied in case of non-respect of the rules as shows a lack of sanctions towards France and Germany. The Five Presidents’ Report criticizes the coherence of the framework by comparing the Economic and Monetary Union (EMU) to a house, built over decades, but only partially finished.
Between 2011 and 2013, fiscal policy was pro-cyclical. Wren-Lewis (VoxEU) argues that they dampened the recovery, a criticism also made by Mody and confirmed by Blanchard and Leigh. However, as admitted by Wolff, austerity was a side-effect of unsustainable debt levels.
Fiscal policy coordination is a necessary step for the Eurozone to recover, according to Boitani and Tamborini. However, Sapir and Wolff argue that even in a true federation like the US, governance mechanisms to address certain imbalances (wage divergences) are absent.
New Instruments implemented: do they serve their purpose?
Significant reforms have been adopted with a view to address and remedy the SGP deficiencies. They introduce new preventive and corrective measures for fiscal surveillance: the Six-Pack (2011)—to strengthen the SGP; the Fiscal Compact (2013); and the Two-Pack (2013)—to strengthen monitoring. These measures have contributed to strengthen fiscal governance in the Eurozone and introduced greater flexibility, according to the IMF.
However, the “second generation” reforms have increased the complexity of the framework, and also hampered (i) effective monitoring (ii) public communication, (iii) and compliance. . They created risks of overlap and inconsistency between rules, while not allowing to deal with the debt overhang issue. The IMF article IV consultation advises to simplify and strengthen the fiscal framework in order to enhance its effectiveness by focusing on two main pillars: a single fiscal anchor (public debt-to-GDP) and a single operational target (an expenditure growth rule, possibly with a debt correction mechanism).
The Eurozone fiscal governance framework – what are the flaws and issues in design and implementation? (IMF)
Fiscal rules have become too complex to guide policymakers effectively, reports the FT, due to new constraints and procedures.
The structural budget balance is undermined by large measurement errors: calculations rely on output gap estimates which are generally underestimated.
The SGP may reduce incentives to foster long term growth: The SGP limits space to finance structural reforms and the 3% deficit cap discourages public investment.
Enforcement mechanisms may need to be strengthened further: Sanctions and corrective actions are mild compared to existing federations. Moreover the EU governance undermines incentives for strict implementation.
In addition, remaining problems for euro area fiscal governance are identified:
Lack of a “federal ministry of finance”—and no common fiscal resources except through the ESM (European Stability Mechanism) dedicated to risk sharing with a lending capacity of €500 billion. For Furceri and Zdzienicka, a more efficient supranational fiscal risk sharing mechanism, as it exists in federal states like Germany or the USA would be able to better insure Euro Area countries against severe, persistent and unanticipated downturns.
Heterogeneity—The prevailing low inflation makes fiscal consolidation harder by automatically reducing growth in nominal GDP and all else equal, raising the debt to GDP ratio, observes The Economist. This delays much-needed convergence between Eurozone core and periphery countries, an important condition for the EMU to work efficiently (Five Presidents’ Report). As highlighted by Sbaihi, the Macroeconomic Imbalances Procedure, (MIP) is a clear example of weak mechanism unable to promote convergence.
Missing coordination—The Economic, Financial, Political and Fiscal Unions depend on each other and must develop in parallel, argues the European Commission (Juncker et al). The success of a Fiscal Union that delivers fiscal sustainability and fiscal stabilisation depends on the other three.
In practice: what flexibility for national fiscal policies in Europe?
With the costs of fiscal austerity (SocialEurope), Ruparel discusses the fiscal flexibility required to alleviate those while abiding by the current fiscal rules—and finds that the flexibility allowed by the SGP is limited: countries outside the EDP can exceed the 3% rule by up to 0.5% of GDP, using the Structural Reform Clause, while the Investment Clause concerns countries in the EDP. There are important differences between countries under the preventive and the corrective arm of EDP (e.g. below and above the 3%-level), possibly creating strong incentives to respect this threshold (Leandro). Akitoboy, Gupta and Senhadji (VoxEU) affirm that fiscal flexibility is no longer a taboo, with a few steps in this direction for Italy and France, in the implementation of the Fiscal Compact (FC).
These are important considerations when fiscal measures are needed to complement monetary policy. Buti and Carnot (VoxEU) remind us that flexibility does not mean an end to discipline. Feldstein argues that fiscal policy is a safe and efficient complement to QE, and Mario Draghi (and Giavaza and Tabellini) notes that a strong recovery could not go without fiscal and monetary coordination.
Carnot explores a rule of thumb that puts at its core a balancing act between fiscal sustainability and macroeconomic stabilisation. The rule of thumb combines the primary gap and the summary of cyclical conditions to determine the desirable stance. Buti and Carnot applied this rule of thumb in the Eurozone, and they recommend moderate consolidation for France and Spain, lower consolidation in Italy, and moderate stimulus in Germany. This illustrates the need for coordination between fiscal policy’s countries in the zone.
What next steps?
Should the next step of integration be a fiscal union to complement the single monetary policy? With some tax and expenditure decisions made at a supranational level, a difficult political endeavour (Peterson). For Paul Krugman, there are no good answers for Europe, especially in the absence of a political union. Sinn warns of the dangers of a fiscal union, which could help sustain false relative prices and prevent southern European countries from regaining competitiveness. But he agrees with Krugman that a political union is the fundamental requirement for functioning monetary and fiscal unions in Europe.
The danger of muddling-through—Arestis and Sawyers point out the dangers of continuing a Pseudo Fiscal Union. As Varoufakis puts it, the euro area is at crossroads: it faces a decision between moving ahead with fiscal integration (Marzinotto et al.), or implementing a fully decentralised solution in which fiscal decisions are taken solely at the national level (Mody).
Dismantle the Eurozone—to avoid this costly outcome, De Grauwe proposes a debt-pooling scheme which includes compensating the more economically sound countries and promotes fiscal sustainability.
Split the Euro in order to save Europe—Granville, Henkel and Kawalec note that only cross-border transfers or internal devaluation can deal with competitiveness gaps and increasing external imbalances, but that this would weaken domestic demand.
Integrate in a Fiscal Union, e.g., a centralized budget with national contributions—Emmanuel Macron asks for a European economic government with its own budget. That would imply a centralized budget with national contribution. Marzinotto, Sapir and Wolff propose “a limited fiscal union”, with a Euro Area finance minister. While a greater fiscal integration is suggested by Tressel et al., despite hurdles in the short term, they believe that in the long term such structure could help achieving risk sharing, and facilitate adjustment of national imbalances. The Five Presidents’ Report recommends the creation of an advisory European Fiscal Board, for better compliance with common fiscal rules, a better informed public debate and stronger coordination of national fiscal policies.
A way to get a Fiscal Union through the backdoor––Quéré, Ragot and Wolff recommend a move towards a European unemployment insurance scheme targeted at ‘large’ shocks, with varying contributions from countries, and a minimum set of labour-market harmonisation criteria.
Stabilize the Area—the status quo, with the new institutions improving stability. According to Draghi, we do not need to choose between extremes in order to have a stable euro. Legrain cautions against too much integration: (i) it is hard to believe that the inefficiency of Euro Area governance can be solved by deeper integration (ii) and pursing that path would be the German way or no way.
Add more flexibility—for example by introducing a debt sustainability equation in accordance with today’s economic outlook: this would allow countries to exceed the 3% deficit in times of economic downturns (The Economist) and thus allow them to countercyclical policies that lead to economic relief, allowing for a more balanced Fiscal Union (European Commission). Quéré, Ragot and Wolff join this argument suggesting that Eurozone countries should be allowed in bad times to exclude some specific incremental spending from the measurement of the government deficit. Therefore the corresponding amounts would be put in the adjustment account and in good times, the expenses of the adjustment account would be reinjected into the calculation of the deficit.
