Which Fiscal Union for the Euro Area?

Which Fiscal Union for the Euro Area?

Breuegel Institute

At the current level of political and societal integration, a large federal budget is unrealistic in the euro area. But...

 

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Summary

The construction of the euro area left aside the question of a fiscal union, but the crisis re-opened the debate.

Of the three classical functions of fiscal policy – provision of public goods, redistribution and stabilisation – only the last provides a clear justification for fiscal policy at euro-area level. Unsustainable fiscal policies in one member state could destabilise the entire euro area, and national policies could also have direct and indirect demand effects with an impact on area-wide inflation. ‘Every man for himself’ is not an option. But coordination is difficult because it involves 19 national budgetary processes and a common central bank.

Empirically, fiscal policy in the euro area and elsewhere often tends to accentuate rather than attenuate the economic cycle. The discretionary part of fiscal policy, as opposed to automatic stabilisers, is responsible for this unfortunate feature, while automatic stabilisers generally work well. Fully-fledged federations assign fiscal policy stabilisation largely to the federal level, based on a relatively large budget. In the euro area, a large federal budget is unrealistic at the current level of political and societal integration, and fiscal stabilisation will continue to rely mainly on national policies.

We make three recommendations that would lead national fiscal policies to be more stabilising with respect to the economic cycle, while achieving long-term sustainability. First, the euro area should avoid imposing self-defeating fiscal adjustments on crisis countries. To achieve this, sovereign debt restructuring should be made possible by further strengthening the banking sector and extending the remit of the European Stability Mechanism. Second, fiscal policy in exceptionally good or bad times should be guided by the planned independent European fiscal board, while the Stability and Growth Pact (SGP) would apply strictly in ‘normal’ times. Of course, fiscal coordination is mostly needed in exceptional times, when the European Central Bank can no longer by itself stabilise the euro area. Third, the Stability and Growth Pact should be able to adapt in a more flexible way to the economic cycle by shifting incremental investment and unemployment spending from bad to good times based on national adjustment accounts, rather than through unclearly defined discretionary measures as is presently the case. This third proposal would strengthen automatic stabilisers that were in fact cut in some cases during the crisis.

In addition, we recommend a move towards ‘federal’ insurance for very large shocks. This should be based on automatic stabilisers and should not involve conditionality when it is activated. The best option is likely to be a European unemployment (re-)insurance scheme for large shocks. All countries that comply with a minimum set of labour-market harmonisation criteria would be required to participate, with their payments into the scheme based on objective criteria. Labour market harmonisation is also desirable for the functioning of monetary union and could be incentivised by the re-insurance scheme.

Introduction

The idea to complement European Monetary Union with some form of fiscal federalism is not new. In 1977, the MacDougall report suggested the introduction of a small budget of around 5-7 percent of GDP as a first step, the long-term objective being “a Federation in Europe in which federal public expenditure is around 20-25 percent of gross product as in the USA and the Federal Republic of Germany” (Commission of the European Communities, 1977, pp10-11).

Fifteen years later, the Maastricht Treaty did not incorporate any form of ‘fiscal union’, except in the very narrow sense of fiscal discipline: fiscal profligacy at national level was rightly identified as a major risk to the monetary union, so each member state committed to maintain sound finances. The Stability and Growth Pact (SGP) details the operationalisation of fiscal discipline. A common budget existed but it was a European Union, not a euro-area, budget.

This was, of course, no accident. There was strong political resistance in many countries to the sharing of fiscal resources and political sovereignty. And while academics and senior civil servants were arguing the case for fiscal integration, no political agreement was found. Some argued that fiscal and political union would eventually follow monetary integration. Others contended that the Maastricht set-up was stable.

The discussion re-emerged in 2010 with the financial and fiscal crisis in several member states. The European Financial Stability Fund (EFSF), followed by the European Stability Mechanism (ESM), were established in order to have a fiscal instrument to deal with systemic risks in the euro area. The EFSF-ESM would lend to troubled governments provided they engaged in adjustment programmes designed to ensure that they remained solvent. Moreover, in the context of banking union, a small but single resolution fund was decided on.
In December 2012, Herman Van Rompuy and the presidents of other EU institutions (Van Rompuy et al, 2012) further proposed to introduce a “fiscal capacity” in the euro area, in order to “improve the absorption of country-specific economic shocks, through an insurance system set up at the central level” (p5). In June 2015, the so-called Five Presidents’ Report (Juncker et al, 2015) noted that “all mature Monetary Unions have put in place a common macroeconomic stabilisation function to better deal with shocks that cannot be managed at the national level alone” (p14). It proposed to work on a “fiscal union” that would “improve the cushioning of large macroeconomic shocks and thereby make EMU over all more resilient” (p14).

This Policy Contribution discusses what type of fiscal instrument in addition to existing tools would best improve the functioning of the monetary union.

1. Why discuss fiscal union?

States typically have significant fiscal resources at the central level with regional government spending generally not exceeding 50 percent of total government spending (Figure 1)1. In federal countries, the share of regional spending is larger, up to 76 percent in Canada. If one were to consider the EU as a federation, it would be a complete outlier, with ‘local’ (ie member state) budgets representing 98 percent of total expenditure. As for the euro area, it has no budget except the lending capacity of the ESM (€500 billion in 2016, equal to about 10 percent of euro-area member states’ combined budgets).

Following the conventional classification of public intervention (Musgrave and Musgrave, 1989), the purpose of a federal budget is threefold. First, it should finance those public goods that are common to all regions, such as research, infrastructure, diplomacy and defence. Second, it may carry out transfers between regions to correct geographical or historical disadvantages and maintain national cohesion. Third, it ensures macroeconomic stabilisation, ie smoothing out business fluctuations in line with the GDP trend at national level and across the regions, local budgets being generally constrained by tight balanced-budget rules2.

The small EU budget has so far been entirely devoted to the first two objectives. This raises three questions. First, should the EU budget be expanded and/or re-purposed? Second, does EU and national spending need to be complemented with spending at other levels of government, such as the euro area or Schengen area? Third, does the euro area need federal resources for fiscal stabilisation?

On the first question, we agree with those who argue that the EU budget needs to become more efficient and future-oriented3. The second question is related to the issue of multi-layered European integration. For instance, security and refugee policies and the control of external frontiers are common public goods mainly for the Schengen area, which has a different composition to both the EU and the euro area and could justify a Schengen-specific budget. At the euro-area level, although there is no budget in a strict sense, the ESM contributes to a common public good specific to the euro area, namely financial stability.

Should the euro area be equipped with a budget in order to finance public goods such as infrastructure, energy transition, human capital, refugee and asylum policy or security? It can be argued that growth spillovers are especially significant within the monetary union, because of their impact on debt sustainability. Additionally, labour mobility is key to the smooth functioning of a monetary union; thus euro-area countries might have more at stake than others to secure the Schengen agreement. Finally, euro-area countries have already accepted more sharing of sovereignty than others. However, it is difficult to argue in favour of another layer of spending without first reconsidering the EU budget, and more generally reconsidering the assignment of policies across the different levels of governance within the EU. Such a re-examination could lead to deeper policy integration in the euro area in some fields with public goods, if the political will is greater in the euro area and the appropriate governance can be put in place.

From a strict economic viewpoint, we are left with the stabilisation issue when thinking about a ‘fiscal union for the euro area’. In this this respect, the Maastricht set-up was sensible. In normal times, the European Central Bank (ECB) would act to stabilise shocks affecting the euro area as a whole: it would cut the interest rate in downturns and raise it in upturns. As for shocks affecting individual countries, there would be ample room to address them through national fiscal policy, provided fiscal discipline fully applies in good and normal times.

The Maastricht set-up failed both before and during the crisis4. Before the crisis, for various reasons, the SGP failed to eliminate the sovereign debt crisis risk. During the crisis, the ECB soon exhausted its most efficient monetary easing tools, while a large number of member states were obliged to tighten fiscal policy because of market pressure, SGP rules or national fiscal rules.

In order to correct these different failures, the euro area began to equip itself with the ESM, the banking union, and the reshuffling of fiscal and macroeconomic surveillance (six-pack, two-pack, fiscal compact). The question is then whether additional tools are needed, or whether existing tools need to be revised in the narrow perspective of macroeconomic stabilisation, which is the issue that is really specific to the monetary union5.

Figure 1: Ratio of local to general government expenses in 2013 (in %)

Source: International Monetary Fund, Government Finance Statistics, September 2015. Dark red: federal countries.

Figure-1

2. Fiscal stabilisation in the euro area

Fiscal stabilisation is the use of fiscal policy to support the economy through higher spending or lower taxes in a downturn, and to eliminate the budget deficit in an upturn. Fiscal policy is important at the country level to cater for country-specific shocks and at the federal level in circumstances when monetary policy is less effective than usual. However fiscal policy is not the only tool for macroeconomic stabilisation in federal countries.

2.1 The role of the federal budget for macroeconomic stabilisation

In federations, one important task of the federal budget is macroeconomic stabilisation at the sub-national level (through temporary net transfers) and at the country level (through federal borrowing). This stabilisation tool also operates through two other channels which are in fact more powerful: the diversification of financial portfolios, and the ability of public and private agents to borrow or lend at sub-national level6. Interestingly, responsibility for bank supervision and market stability is always assigned to the federal level, not to local authorities. Against this background, the idea to create a European capital markets union that deepens capital markets and increases cross-border capital flows, in particular in the form of equity, is highly welcome. However, the European Commission’s current proposals are far too timid to achieve the goal of integrated and stable capital markets. Deeper and more integrated capital markets will require major steps in the areas of harmonisation of accounting, insolvency, corporate transparency and taxation (Véron and Wolff, 2015).

It is sometimes argued that, once the monetary union is made more stable thanks to a more resilient banking sector and lower public and private debt, there will be no need for stabilisation instruments at euro-area level: ‘risk reduction’ would be a substitute for ‘risk sharing’ (Gern et al, 2015). This is at best a long-term vision, however. Although efforts to strengthen the banking sector through micro and macro prudential supervision are clearly welcome, it will never be possible to completely rule out a serious financial and economic crisis. It is therefore necessary to have sufficient stabilisation instruments.

In crisis times, whatever the ‘flexibility’ of the SGP, a national government might lose its capacity to smooth consumption. This is the raison d’être of the ESM, which will temporarily substitute for private lending and provide conditional funding. However, the ESM is not a substitute for a euro-area budget. As highlighted by Pisani-Ferry (2011), it is a mutual assistance scheme, not a common budget involving the delegation of some competences to the centre.

Shifting significant parts of national government spending to the euro-area level would be an enormous step towards European integration. Such a decision would go far beyond the issue of macroeconomic stabilisation policies –it would go to the core questions of national preferences, political preferences, democratic legitimacy and long-standing historical differences between countries. Although the case for more collaboration in areas such as environment, defence, intelligence services and refugee and asylum policy has never been stronger, we doubt that countries are willing to shift the corresponding legitimacy for such decisions to the appropriate level to federalise their operation. Moreover, even such steps towards federalisation would barely be enough to generate macroeconomic stabilisation tools of sufficient size at the euro-area level, because the corresponding spending is unrelated to the economic cycle.

As the build-up of any meaningful federal budget is not plausible in the short and medium terms, it will remain essential to improve the coordination of national fiscal policies. The euro area will likely remain a hybrid model in which fiscal policy is largely national but decision-making over that policy is shared7.

2.2 Macroeconomic stabilisation through national budgets

In the euro area, in the absence of a federal budget, aggregate fiscal policy is the result of 19 national fiscal policies. The challenge then is to make sense of these combined national policies,
for three different reasons:
Monetary and fiscal policies interact: when fiscal policies are loosened, demand and thereby inflation expand, which might trigger a monetary policy tightening. National fiscal policies therefore affect other member states via the reaction of monetary policy.

Fiscal policy may supplement monetary policy. When monetary policy is constrained by the zero lower bound (ie the inability to further cut the interest rate), fiscal policy would need to be activated to increase inflation and demand. In such a situation, the sum of national fiscal policies becomes particularly important.

National fiscal policies have direct cross-border effects. In normal times, these direct demand spillovers are limited and depend on the size and the openness of the economies concerned. At the zero lower bound, however, a fiscal stimulus in one country has unambiguous effects in neighbouring economies8. This externality is generally not taken into account at national level.

These three effects provide strong arguments in favour of coordination of fiscal policy by the 19 euro-area member states, and between them and the ECB. For instance, significant fiscal consolidation in several member states, as happened in constrained countries in 2012, in a situation of negative GDP growth and decelerating inflation, should have been accompanied either by a fiscal expansion elsewhere or an easing of monetary policy in order to stabilise euro-area wide inflation. When monetary policy is at the zero lower bound, coordination of fiscal policies becomes crucial in order to prevent a deflationary spiral9. It is then a matter of collective choice about who should do how much in terms of fiscal stabilisation policy, beyond the more structural policies that matter for inflation.
Fiscal policy coordination has proved unsatisfactory since the inception of the euro. The euro area’s fiscal policy has not played its macroeconomic stabilisation role since 2008, except in

2009 and 2011 (Box 1). While the relative role of fiscal and monetary policy in 2012-13, and the relative role of market constraints versus fiscal rules, can be debated, the overall macroeconomic performance of the euro area and the persistently low euro-area inflation rates are in our view enough of reason to argue for an improved system. The European governance toolkit does not presently allow a desirable aggregate fiscal stance to be distributed across the different national budgets of member states10.

The pro-cyclicality of fiscal policy in the euro area (ie its inclination to accentuate rather than attenuate the cycle) is not a pure result of the crisis. On average from 1995-2008, both the fiscal impulse and the discretionary parts of fiscal policy were expansionary in upturns and contractionary in downturns11. This feature is not specific to the euro area: the United Kingdom, Canada and Australia also display pro-cyclical policies. However, the United States, Japan and Switzerland proved able to carry out counter-cyclical policies. Fiscal stabilisation is not an easy task, but the euro area seems to be particularly bad in its decision-making process: discretionary fiscal stabilisation seems not to work, while counter-cyclical automatic stabilisation only partially compensates for pro-cyclical discretionary policy12.

The political economy approach to fiscal policy can easily explain why discretionary fiscal policy is mostly pro-cyclical: in an upturn, there are strong political incentives to spend the windfall gains, rather than to curb government debt; and because the debt has not been curbed, fiscal space is lacking in the subsequent downturn to support the economy through more government deficits. The question then is whether and how fiscal union could change this situation, in which the SGP has failed. Since national budgets are likely to remain prominent in the foreseeable future, we start by examining stabilisation capacity at the national level before moving to possible euro-area wide tools.

Box 1

 

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