«It is all but impossible to design a fiscal union that offsets temporary shocks without also transferring resources on an ongoing basis.»
The Euro Crisis is the gift that never stops giving. The crisis inTurkeyhas put a damper on the prospects for stabilization inGreeceandCyprus. The European Central Bank’s reluctance to cut rates in the face of deflation risk exposes the continent to new dangers, while the decision of theGerman Constitutional Courtraises questions about the feasibility and effectiveness of the central bank’s efforts to backstop the bond markets. Perhaps most ominously, recent data on industrial production in the zone’s four big economies,France,Germany,ItalyandSpain, are disappointing. Is this the recovery we were promised?
And even if it is true that the sun is now breaking through the clouds, there is still the task of putting the roof onEurope’s monetary house before the next rainstorm blows up. There is agreement on the need to create a banking union to accompany the monetary union. Europe’s big banks will have a single supervisor by the end of the year. Eventually they will have a resolution mechanism, backed by a fully capitalized resolution fund. Details remain to be worked out, but there is agreement on the goal.
Where there is no agreement is on whetherEuropealso needs a fiscal union to complement its monetary union. The academics who did the pioneering analytical work on monetary union certainly thought so. The monetary union of 50U.S.states works smoothly, they observed, only because theU.S.possesses a federal fiscal system that transfers resources from booming to temporarily depressed states.
Many Europeans – academics and non-academics alike – resist this idea. The residents ofEurope, they observe, lack the common identity needed to support a federal budget. Germans and Greeks view themselves as Germans and Greeks, not as Europeans. The European Parliament lacks the power to hold those responsible for the operation of a prospective fiscal union accountable for their actions. And inGermany, fiscal union is seen as code for “transfer union.” The worry there is that budgetary transfers would go only one way, fromGermanytoSouthern Europe.
This concern is not entirely unwarranted, for in practice it is all but impossible to design a fiscal union that offsets temporary shocks without also transferring resources on an ongoing basis. In theUnited States, federal taxes and transfers offset 31 cents of a temporary $1 decline in a state’s income, but they also have ongoing distributional effects. They regularly transfer 22 cents for every $1 by which incomes differ in the country’s high- and low-income states, mainly through the higher federal tax payments by residents of high-income states, likeCalifornia. Europeans will of course be familiar with this redistributive aspect of national fiscal systems from the ongoing transfer of resources from Western to Eastern Germany and from Northern toSouthern Italy.
Experts at Bruegel, the Brussels-based think tank, have considered a number of schemes for fiscal federalism inEurope. None of these. it turns out, is free of redistribution. The most appealing scheme moves corporate taxes from national budgets to the EU budget uses the resulting revenues to pay the costs of unemployment compensation. This would help to insulate member states experiencing unusually severe recessions by paying for their unemployment benefits with resources from other more prosperous member states. But it would also result in large ongoing transfers from states with profitable corporations, likeGermany, to states with high unemployment, likeSpain, and generous unemployment insurance schemes, likeBelgium.
Eurozone member states might agree to a system that implies ongoing redistribution were it negotiated “under a veil of ignorance” – that is, if they had no idea who would be on the sending and receiving ends. In practice, however, there exist strong priors inGermanyin particular about who the donors and recipients would be in any prospective fiscal union.
The alternative to fiscal union is to rely on national budgets to offset country-specific shocks. If governments run budget surpluses in expansions and deficits in slumps, that by itself would help to buffer downturns. The idea that governments should be free to adjust national fiscal policies when the freedom to adjust national monetary policy is lost, as in a monetary union, is straightforward in principle. But it is not straightforward Europea, where the case for countercyclical Keynesian policies is not widely accepted and there is little confidence that governments can be trusted to use their fiscal instruments responsibly.
The EU has sought to address these concerns by distinguishing automatic fiscal stabilizers, which are allowed to operate, from discretionary changes in fiscal policy, which it does not endorse. The Fiscal Compact in place since January 2013 limits the “structural” budget deficit (adjusted for the business cycle) to ½ per cent of GDP but allows countries to run larger deficits if these result from cyclical downturns that reduce tax receipts and raise transfer payments.
A step in the right direction
The Fiscal Compact is a step in the right direction. It provides more flexibility than the Stability and Growth Pact that preceded it. It is also more credible, since its rules must be embedded in the national constitutions or adopted as a national law in each member state.
That said, automatic fiscal stabilizers as currently structured offset only a third to a half of a given output decline. Tax reforms that accentuate the sensitivity of revenues – by, for example, relying more on capital gains taxes, which vary strongly with the cycle – would strengthen their effect, but there is no consensus on the desirability of such changes.
Then there are worries that even cyclically-adjusted budget balance rules embedded in national constitutions lack credibility. Governments chronically overestimate prospective tax revenues and underestimate future budget deficits. If they are allowed to construct their own forecasts, old problems of excessive deficits will be quick to return.
In fact this problem has an easy solution, namely outsourcing the task of forecasting to an independent committee or agency while requiring governments to formulate fiscal policy on the basis of its forecast. The Fiscal Compact already requires member states to create independent agencies to monitor their compliance its dictates. ButEuropeshould go a step further by requiring member states to delegate the forecasting function to such institutions and mandating that governments utilize the resulting forecasts.
The other obstacle to letting automatic fiscal stabilizers work isEurope’s debt overhang. A cyclical downturn that widens budget deficits would raise renewed concerns about debt sustainability inSouthern Europe, where governments are already laboring under very heavy debt loads. Spreads on government bonds would rise at the first sign that deficits were widening. This would push up other interest rates, crowding out investment. Self-insurance via automatic stabilizers may be the logical alternative to coinsurance provided through the creation of fiscal union, but it is feasible only if the existing debt overhang is first removed.
In the end,Europemust choose. It can opt for fiscal union, despite the unsavory transfers that fiscal federation would entail. Alternatively, it can allow the member states to rely on their own automatic stabilizers, but only if it first writes off the heavy debts of the crisis countries. The one thing is cannot afford to do is nothing. For doing nothing will only cause the euro’s roof to cave in again the next time there’s a downpour.