The EU Fiscal Union

Fiscal federalism literature provides indeed useful lessons but no simple recipes to guide future steps in the design of the fiscal union under the EU Economic and Monetary Union (EMU).The reason is that fiscal union models come in many forms (Cottarelli and Guerguil, 2014; Bordo and James, 2010). Each model is based on particular historical roots and social preferences, and has evolved to cope with its own challenges and crises. Every fiscal union is in some sense unique but the EMU model is even more sui generis (Eichengreen, 2010, James, 2012).

What these models have in common is that they find equilibria between risk mitigation and risk sharing, and between public and private channels.They include rules and institutions to mitigate risks to a level deemed acceptable by their members, and risk sharing arrangements to both reduce the costs from asymmetric shocks and apportion them in a politically feasible manner. Too much weight on mitigation without sufficient burden sharing, or vice versa, makes the system unstable.

The design of the fiscal union at the initial stages of the EMU followed a preference for maximum fiscal decentralisation. Having foregone monetar y policy, member states were keen to retain fiscal powers. On the other hand the pre-EMU loose budgetary policies were not compatible with a monetary union. The compromise was a rules framework, monitored and weakly coordinated at EU level. Risk sharing mechanisms consisted of a very small EU budget and a few, relatively minor, common financial facilities. The choice of system was also consistent with a series of assumptions about the capacity of monetary and fiscal policies and of the financial sector to mitigate shocks. Economic and fiscal surveillance would ensure convergence and the private integrated financial system would provide the means to share risk and respond to shocks. And financial markets’ scrutiny would help prevent governments from running unsound policies. Hence, in the steady state, automatic stabilisers would be sufficient and shared stabilisation instruments were deemed unnecessary.

The global financial crisis and the subsequent euro area sovereign debt crisis showed that some of these assumptions were too brave. The scope of mitigation rules was too narrow, and compliance of existing ones was often too loose, leaving the EMU vulnerable to shocks. When these did come (larger than expected), national stabilisation tools were insufficient to cope with them, turning shocks into recessions and contagion to other member states, even endangering the overall system. Private financial markets re-fragmented along national boundaries and stopped providing the risk-sharing capacity they were assumed to ensure. Moreover, the crisis provided tough lessons about the “sovereign-financial vicious circle” where shocks in the financial sector could knock down public finances and, vice versa, unsound fiscal public finances harmed financial stability.

An impressive number of reforms urgently introduced during and after the crises have addressed several of the above mitigation and risk-sharing gaps. Reforms went in both directions, but with a higher weight on mitigation. But both official and academic assessments have shown that a stable fiscal union will require further integration.

The current official roadmap, proposed earlier this year in a report by the “Five Presidents”1 delineates a number of steps in two stages stretching until 2025.The European Commission adopted the first batch of implementation measures on 21 October 20152.

In the first stage, covering until mid-2017, the plan aims at reversing the banking sector geographical fragmentation, and thus restoring the private risk-sharing channel. Centralising supervision and creating a privately funded single bank resolution fund went in the direction of mitigating taxpayers risk, and thus made it easier to advance also in the direction of sharing the residual risk.The next step would hence be to address possible shortfalls of the single resolution fund through a public backstop. A further and crucial step, also contemplated for the first stage, is the creation of a central deposit guarantee scheme to mutualise the risk of current national arrangements. This will complete the banking union, which is intimately associated with the fiscal union, and will pave the way for European cross-border banks. Moreover, the banking risk sharing channel will be complemented with more developed and integrated capital markets.This is the intention of the capital markets union that the European Commission has already launched and intends to develop over the coming years.

Policy risk mitigation will also derive from increased resilience and economic convergence by improving the coordination framework and the local scrutiny of decentralised policies. Independent national watchdogs of fiscal (national fiscal councils) and structural (competitiveness authorities) policies will scrutinise government policies, as well as productivity, prices, and wage developments.They will coordinate at EU level and provide independent advice on the appropriate euro area policy stance to the European Commission. Further risk sharing will come from a European investment plan, launched by the European Commission and the European Investment Bank (EIB) last summer.The initiative will boost demand from the central level without increasing the size of the central budget. It will earmark a small amount from the current EU budget and combine it with some lending capacity from the EIB to catalyse other public sources and leverage private funding.

This plan could be the embryo of a larger stabilisation capacity that the Five Presidents contemplate for the second stage “as the culmination of a process of convergence and further pooling of decision-making on national budgets”. Convergence should become more binding through common standards on labour markets, competitiveness, business environment, and some tax policy areas, and progress towards these standards would be closely monitored. The Presidents postpone to Spring 2017 the definition of more details of the common stabilisation function in a white paper that will draw on the results of an expert consultation. They envisage however that a first step could identify a pool of financing sources and investment projects“to be tapped into according to the business cycle”. They also underline that the stabilisation function would not involve income equalisation or crisis management, and that it should be designed so as to avoid weakening incentives to sound policies.

In the last few years, official and scholarly circles have put forward several other ideas for turning the EU’s economic and monetary union into a deeper fiscal union.3 More recently, Draghi (2015) and Cœuré (2015) have called for moving from the rules-based system to an institution-based one, centralising onto a euro area finance ministry the powers to enforce the rules to prevent and correct economic and fiscal imbalances, manage crises, and run the fiscal capacity envisaged in the Five Presidents Report4. Andrle et al (2015) also support such a “centre-based approach” to guide national fiscal decisions. They propose several choices like legal challenges at the national level or a veto power from the centre.

The options for sharing arrangements to enable countries to avoid having to run pro-cyclical fiscal policies in case of shocks, fall under the two typical approaches. One consists of centralising the provision of some public goods and services. Another is to keep expenditure decentralised and ensure access to finance in bad times either through an off-budget (“rainy-day”) insurance mechanism or common issurance of debt.

For the former, some categories of expenditure like growth- enhancing R&D and infrastructure investment, are natural candidates for centralisation because they tend to be slashed in bad times. An alternative is expenditure aligned with the cycle like unemployment insurance, where either a basic universal tranche, or a cyclical component, could be transferred (Cottarelli and Gueguil, 2014).Transferring unemployment insurance faces challenges such as the differences in eligibility and benefits across countries, or methodological difficulties of discerning between the cyclical and structural components.

An off-budget stabilising facility could be organised using the European Stability Mechanism (ESM). Member States would make payments to this mechanism in good times and draw from it when hit by shocks. Alternatively pooling debt provides a way to secure access to markets at affordable rates. Several options have been proposed in the past, including eurobills (Philippon and Hellwig 2011, Philippon 2015), EsBies (Brunnermeier et al.), blue-red bonds (von Weiszaecker and Delpla 2010), or stability bonds (European Commission 2012). More recently Ubide (2013, 2015) has suggested a scheme of stability bonds whereby Member States would regularly transfer a portion of their tax revenue and receive in exchange a share of joint debt issuance, up to 25 percent of their GDP. Besides the risk-sharing function, joint issuance has the important additional advantage to create a risk-free asset in sufficient quantities that would help banks and other investors diversify and dilute the home bias. It can thus contribute to remove the bank-sovereign loop, promote market integration, and financial stability (Corsetti et al. 2015, Ubide 2015).

The distribution of tax bases or revenues in a fiscal union is as impor tant as the appor tionment of expenditure and debt financing. The EU generates some revenue from its own resources (customs duties and levies of all imports collected by Member States on behalf of the EU, and a small percentage of a notional, harmonised VAT base calculated for each country) but with increasingly open markets these sources continue to decline. Statutory contributions from Member States, proportional to their relative GNI (Gross National Income), are called to balance the budget, since the EU is prevented by its Treaty to issue debt to finance the budget. A number of zero-sum adjustments are then made to prevent that net balances exceed agreed thresholds.

Several attempts to reform this revenue system have resulted in only marginal adjustments for two main reasons. First, any amendment will induce changes in Member States’ net positions, which are closely scrutinized.Thus, a number of tax bases that lend themselves for centralisation, such as corporate income, carbon emissions, or financial transactions are not evenly distributed across countries and will therefore change the burden sharing. Second, these tax bases are loosely correlated with total expenditure, or with national income, on which it is aligned. If the balanced budget rule is to be maintained then either expenditures will be vulnerable to cuts to face revenue shortfalls, or else Member States will have to provide some system of credit lines. Faced with these difficulties, the status quo, with minor adjustments, has so far prevailed. A high level group has received the mandate to look again into this issue and deliver in 2016 options for more transparent, simple, fair, and democratically accountable ways to finance the EU. Monti (2014), in its provisional report, underscores the complexity of the fairness criterion and indicates their intention to extend their scope and review not only how EU policies are financed but also the policies themselves, since both sides of the budget equation determine fairness.

As discussed above, the EU fiscal union, as any other, has been shaped by its history and its challenges. It has changed significantly as a response to the recent crises. More reforms, for both risk mitigating and risk sharing, are contemplated in the Five Presidents Report, and some argue that more will still be necessary to ensure that the fiscal union supports stable growth and public finances, and financial stability. Some of these reforms involve short-term political costs to prevent longer-term benefits that are often difficult to quantify.They are therefore side-lined because they do not match with political cycles. We can expect that politicians will have learnt from recent crises that the risks are real and that the costs of not preventing them cannot be understated. Filling the gaps before the next recession comes is a good investment.

References

Andrle,M., Bluerdon,J., Eyraud,L., Kinda,T., Koeva Brooks,P., Schwartz, G. and Weber, A. (2015): “Reforming Fiscal Governance in the European Union”, IMF Staff Discussion Note, SDN/15/09, May 2015

Bordo, M. and James, H. (2010): “A long term perspective on the euro”, in Buti, M et al. The Euro. The First Decade, Cambridge University Press.

Bordo, M., Markiewicz, A. and Jonung, L. (2011): “A Fiscal Union for the Euro: Some Lessons from History”, NBER,WP 17380.

Brunnermeier,M.,Garicano,L.,Lane,P.R., Pagano,M.,Reis,R.,Santos, T., Thesmar, D., Van Nieuwerburgh, S. and Vayanos, D. (2011): “European Safe Bonds: ESBies,” Euro-nomics.com, 26 September.

Coeuré, B. (2015):“Drawing Lessons from the Crisis for the Future of the Euro Area”. Speech by Benoît Coeuré, Member of the Executive Board of the ECB, at “Ambassadors Week”, Paris, 27 August 2015.

Corsetti, G., Feld, L., Lane, P., Reichlin, L., Rey, H., Vayanos, D. and Weder di Mauro, B. (2015): A new start for the Eurozone: Dealing with debt, Monitoring the Eurozone 1, CEPR.

Cottarelli, C., and Guerguil, M. (editors), (2014): “Designing a European Fiscal Union: Lessons from the Experience of fiscal federations”, Routledge Studies in the European Economy.

de Lecea, A. and Drayson, N. (2014): “Key elements of fiscal integration in the Euro area”, Papeles de Economía Española 141 (in Spanish).

Draghi, M. (2015): Speech at SZ Finance Day 2015, Frankfurt am Main, 16 March 2015.

Eichengreen, B. (2010): “The euro: love it or leave it?”, VoxEU European Commission (2012):“A Blueprint for a Deep and genuine Economic and Monetary Union— Launching the Debate”, Communication from the Commission, 30 November .

James, H. (2012): Making the European Monetary Union, Harvard University Press, Cambridge, MA.

Juncker, J.C., in close cooperation with Tusk, D., Dijsselbloem, J., Draghi, M. and Schulz, M. (2015): “Completing Europe’s Economic and Monetary Union”, European Commission.

Monti, M. (2014): High Level Group on Own Resources First Assessment Report, European Commission, Brussels, 17 December.

Philippon, T. and Hellwig, C. (2011): “Eurobills, not Eurobonds”, VoxEU.org, 2 December.

Philippon, T. (2015): “The State of the Monetary Union”, VoxEU. org, 31 August.

Ubide, A. (2013): “How to Form a More Perfect Banking Union”, Peterson Institute for International Economics Policy Brief, 13/23.

Ubide, A. (2015): “Stability Bonds for the Euro Area”, Peterson Institute for International Economics Policy Brief, forthcoming.

von Weizsaecker, Jakob and Jacques Delpla (2010), “The Blue Bond Proposal”, Bruegel Policy Brief, Issue 2010/03, 6 May.

Endnotes

*The opinions expressed in this article are solely those of the author and do not necessarily represent those of the European Commission. The author thanks Angel Ubide for his very helpful comments.

1 The President of the European Commission, of the European Council, of the Eurogroup, of the ECB, and of the European Parliament (Juncker, 2015).

2 http://europa.eu/rapid/press-release_IP-15-5874_en.htm

3 See de Lecea and Drayson, 2014 for a review.

4 “How would the Governing Council of the ECB have dealt with the crisis if it was just a club of 19 national governors making decisions by consensus?” (Cœuré, 2015).

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