The Case for a European Fiscal Union?
by Mike Tan
An Overview of the Eurozone Crisis
In 1999, the Euro was launched and monetary policy autonomy was surrendered to the European Central Bank, which now controls interest rates of all Eurozone countries. However, countries retained control over their fiscal policies and this lack of coordination lay at the heart of the Euro crisis. Countries like Portugal, Greece and Spain were able to borrow heavily to finance deficit driven spending at much lower rates. This was because creditors believed that the stronger economies like Germany and France, which were now bound by a common currency with these heavy borrowers, would intervene in the case of default. Unsustainable fiscal policies persisted as borrowing was continually undertaken to pay off debt. The Eurozone became increasingly interconnected as intraregional lending and borrowing increased.
The 2008 financial crisis in the US halted the flow of credit into the Eurozone and countries which had pursued unsustainable fiscal policies faced troubles repaying their debts. This threatened the destabilisation of the entire Eurozone given how entrenched the financial linkages between member countries were. Ultimately, Germany agreed to bail out distressed member countries conditional upon these countries adopting austerity measures.
The Euro crisis illuminated within the Eurozone the fundamental mismatch between its monetary union and lack of fiscal integration. Key figures like French president Emmanuel Macron have propounded greater fiscal integration with his proposal of fiscal transfers between Eurozone members, with ex-ECB president Mario Draghi taking it one step further and calling for robust commitment towards the creation of a fiscal union to secure the long term prospects of the Eurozone.
So what exactly is a fiscal union?
A fiscal union entails greater centralisation of fiscal policies as well as instruments that reduce risk and absorb any shocks. What a fiscal union comprises is rather subjective and there is no concrete agreement of its constituents. Below is an overview of the components where a fiscal union could potentially compromise.
1. Rules and coordination
Given the excessive deficits taken on by several governments prior to the Euro crisis, rules serve to guide fiscal policies of member states to avoid a repeat of history. The Stability and Growth Pact (SGP), which set rules including that of balanced budgets and for public debt to constitute less than 60 percent of GDP, sought to achieve prudent fiscal spending to reduce the impact of spillovers from distressed states. However, this was clearly insufficient as seen from the occurrence of the Euro crisis. Following the crisis, reforms to the SGP such as the Six-Pack, Two-Pack and Fiscal Compact were initiated to improve coordination of policies, put national budgets under greater scrutiny and enshrine balanced budget rules at the national level.
In addition to ex-ante coordination which is what was mentioned above, there could be a case for ex-post coordination as well. This is especially so in today’s policy environment where monetary policy is restricted by the zero lower bound, giving prominence to fiscal policy. When a country adopts an expansionary fiscal policy, this reduces the output gap for other countries due to an increase in imports. While the cost of an expansionary fiscal policy is borne by one country, the benefits spill over to others. Each country will be incentivised to free ride on others, leading to a less than optimal aggregate fiscal policy stance within the Eurozone which necessitates coordination of fiscal policy.
2. Crisis management mechanisms
In times of crises, speculation over the solvency of a currency could easily cause risk premia to surge, leading to self-fulfilling solvency issues from liquidity problems. As a result, it is essential that crisis management mechanisms be established to mitigate any initial shocks to reduce the probability of the situation being exacerbated. The Eurozone has taken several steps in this direction through the European Stabilisation Mechanism (ESM) which provides financial help to countries which have been cut off from international capital markets or are facing liquidity issues.
In addition, the Outright Monetary Transaction (OMT) programme was also conceived to allow the European Central Bank (ECB) to act as a lender of last resort in drastic situations. Its use is conditional upon the distressed country having tapped on the ESM. The distressed country could potentially sell a limitless amount of bonds to the ECB with maturities of up to 3 years under strict conditions. This helps to reduce the fear of the distressed country dropping out of the Euro, reducing the risk premia faced by that country.
A potential limitation of crisis management mechanisms is that of moral hazard where borrowers are disincentivised from pursuing fiscally sound policies. It could also make defaults more likely as borrowers know that the ECB will act as a lender of last resort to prevent a banking crisis.
3. Banking union
A banking union entails the alignment of banking policy on the EU level. Its aim is to make European banking more transparent, more unified and safer. In the aftermath of the Eurozone crisis, several steps have been taken in this direction. Firstly, the Single Supervisory Mechanism (SSM) was created to ensure that Eurozone banks are aligned with a common set of regulatory policies geared towards a stable and safe European financial system. This is envisioned to increase confidence investors have in the European banking sector and improve the resilience of financial institutions.
As a failsafe, the Single Resolution Mechanism (SRM) was also created for banks that fail despite having received stricter supervision under the SSM. The SRM manages failing banks whilst incurring minimal costs to the broader economies via a Single Resolution Board (fully independent EU agency representing the banking union) and a Single Resolution Fund financed by the banking sector.
Both of these serve in tandem to reduce excessive leveraging taken on by banks and to improve shock absorption in the case of bank failure. However, critics remain concerned about the lack of a joint fiscal backstop which can be seen as a secondary source of insurance funding should the mechanisms under the banking union fail to suffice and push for a sufficiently large fiscal buffer.
4. Fiscal insurance
The role of fiscal insurance is to stabilise the volatility in consumption and income during economic shocks. One possible means of going about doing so is via a rainy day fund which facilitates transfers from Eurozone members experiencing economic upturns to members experiencing recessions. The widely discussed “cyclical shock insurance fund” proposed that countries with output gaps larger than the Eurozone average contribute to the fund even if they are experiencing negative output gaps. This might not be politically viable as it would require countries affected by a recession to make transfers to those more affected, driving down government expenditure. Furthermore, a “cyclical shock insurance fund” addresses only country-specific shocks and not Eurozone-wide shocks. Hence, there have been suggestions to create a fund which smooths intertemporal consumption by conducting transfers based on a country’s cyclical condition rather than as mentioned before. This fund could also be able to borrow from financial markets should this insurance fund run a deficit.
More recently, the focus has been on a European unemployment insurance scheme that acts in a countercyclical manner to shocks, absorbing the impact of recessions. Under this scheme, short-term unemployment benefits would be transferred directly to EU citizens who meet the agreed criteria. Restricting coverage to newly unemployed for a maximum duration and activating coverage only during instances of significant negative shocks would help in mitigating moral hazard.
5. Joint debt issuance
Joint debt issuance refers to a joint guarantee by all non-borrowing Eurozone members of the debt taken on by the borrowing member. An example of this could occur via the issuance of Eurobonds. Should this be adopted, the Eurozone would need to decide on the conditions upon which Eurobonds can be issued, how much debt should be covered by the bonds, the duration of the bonds, and the incidence upon non-borrowing countries in the case of a default.
The issuance of joint debt via a Eurobond could improve financial stability within the Eurozone should the Eurobond be perceived as a safe and liquid asset, reducing the possibility of huge outflows of capital out of the Eurozone. Eurozone members who borrow funds via this instrument might then be able to default without triggering ramifications across the entire region just as we saw during the crisis.
Similar to the crisis management mechanisms, this could lead to moral hazard concerns given the Eurozone’s need to defend the credibility of these bonds.
Will we be seeing a fiscal union anytime soon?
Effective fiscal governance might necessitate member states to give up their political sovereignty by surrendering control over fiscal policy to a higher authority, forming something akin to a “United States of Europe” which is highly unrealistic given its political unpalatability. Even so, the Eurozone might not necessarily be doomed to failure. An alternative path Fuest et al, proposes would be to keep the threat of “no bailout” credible, focusing on fiscal responsibility on a national level and devoting more resources to maintaining financial sector stability. More stringent capital requirements and reforms to risk rating regulations will need to be undertaken. Government bond holdings will also have to be diversified. However, there may be a time-inconsistency problem where at the point of crisis, it may not be optimal to persist with “no bailout”.
Just last year during the onset of the coronavirus pandemic, a Franco-German proposal for large-scale mutualised debt, arguably a variant of “coronabond” promulgated by the southern countries, rekindled hopes for a transformative step towards greater fiscal integration, especially with Germany at the forefront of this proposal. The initial 500 billion euros worth of grants proposed was eventually reduced by a significant amount to 390 billion euros in the EU Recovery Fund that was agreed upon under pressure from the “Frugals”. The path towards greater fiscal integration seems to remain a rather elusive one and the road ahead will be one filled with difficult compromises which the Eurozone will need to urgently manoeuvre along to be ready for the next crisis.
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