Enhance the eurozone’s fiscal capacity

Economic opinion

Last week the European Parliament launched a call to enhance the fiscal capacity of the eurozone.Two reports on institutional reinforcement (among which the Verhofstadt report) were also approved. Against the backdrop of Brexit and the burst of nationalism in other EU countries the members of parliament seem like other-worldly voices in the wilderness. They are nevertheless right. Indeed, for the ultimate stabilisation of the eurozone, a strengthening of the fiscal capacity at the union level is absolutely necessary.

A monetary union without a budget...

The eurozone is the first monetary union with a fully centralized monetary policy, while almost all fiscal policy tasks remain with the sovereign states. The states decide on expenditure and revenue. That is a problem. One of the specific budget functions, namely economic shock absorption, is most effectively performed via a central budget. This not only applies to the absorption of a shock affecting one or only a few countries (asymmetric shocks) but also to shocks affecting the union as a whole (symmetric shocks), such as a severe downturn of the business cycle. Besides this stabilisation function, the central government level is in principle best placed for income redistribution policy, at least to the extent that there is sufficient consensus within the federation on the desired degree of distribution. Collective goods that are useful to all citizens of the union or that entail clear economies of scale, such as defence, foreign policy or transport infrastructure, are preferably procuded centrally from an efficiency point of view.

A comparative study of 13 federal unions (Cottarelli, C. & Guerguil, M. (ed.), 2015) shows that even in the most decentralized federations around half of total public expenditures are spent by the federal government. Usually this amounts to 15 to 20% of GDP. In most cases, revenues are even more centralized than expenditures. In most federations revenues mainly stem from federal taxes on income or consumption. The central government level often transfers part of its revenues to the lower government levels.

Owing to the fact that neither the European Union nor the eurozone are real political unions, this typical budget model sharply contrasts with the EU budget. The budget represents only around 2% of total government expenditures in the EU or about 1% of the European GDP. Member states spend by far the largest part of the expenditures. The fiscal capacity of the EU remains extremely limited. Over 80% of the EU budget is financed by transfers from the member states, thus the opposite direction of what used to be the case in typical federations. The small EU budget includes instruments to foster economic cohesion between countries. They aim to prevent asymmetric shocks but can’t absorb them. Business cycle stabilization via the EU budget is out of the question.

...remains unfinished...

The organization of budget tasks in the eurozone reflects history. In contrast to most federal states, the eurozone membership countries were well established welfare states with a large government sector when the euro started. That made the transfer of government tasks and taxes to the union level politically difficult. Nevertheless, there is a large consensus amongst economists that the eurozone cannot survive without a political keystone in the form of a fiscal stabilisation function at the union level. Although economists still vigorously discuss what this keystone should look like.

With respect to asymmetric shock absorption relatively little discussion exists. It works as an insurance for a member state in financial distress as a result of such a shock. The European Stability Mechanism (ESM) is a start to this, but probably insufficient, as its financial resources are not unlimited. Symmetric shock absorption is more discussed. For this, the union needs to be able to decide in one way or another on business cycle sensitive revenues or expenditures, such as income taxes or unemployment benefits. In the US, most of the stabilization is done through tax revenues. That brings also inter-state income redistribution about - a phenomenon that is even more observed in Canada and Australia. Nevertheless, permanent income transfers across member states are to be avoided as much as possible because they take away incentives to implement structural adjustment policies. The Belgian experience with consumption federalism is in that respect an example to be disregarded. The German experience with transfers towards the former East German “Länder” shows that it is difficult to prevent transfers from becoming permanent.

... and cripples fiscal policy

In the absence of a central budget the eurozone has to make do with hopelessly complex budget rules. These need to reconcile public finance sustainability with economic shock absorption. Over time the rules continuously became more complex because the right balance between the two objectives was difficult to find. As a result, an appropriate fiscal policy stance can still hardly be found. Countries that are most in need of a softer stance are mostly forced into a budgetary straitjacket. Applying the budget rules flexibly, as the European Commission currently does, becomes then the obvious way. But it puts confidence at risk because the perception of arbitrariness is never far. Indeed, economics has few laws of the Medes and Persians. A repeat of the euro crisis always lurks in the shadows. In the meantime, fiscal policy in the eurozone impedes a powerful economic recovery much more than in the US, where they can run up government debt with impunity.

Need for a quantum leap

The establishment of a fiscal stabilisation function in the short or medium term appears utopian, although it is urgently needed. It touches upon tax policy, which pre-eminently touches upon national sovereignty and is linked to democratic legitimacy. The establishment of a fiscal stabilisation function thus requires some kind of fiscal union, which in turn requires a further developed political union. In other words: a quantum leap in integration. This sharply conflicts with recent tendencies of disintegration. In that respect, the European Parliament seems like an other-worldly voice in the wilderness. Yet, those who leave its calls unanswered and withhold a stronger fiscal capacity from the eurozone, are ultimately giving it the kiss of death.

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