The activism of central banks during the recent financial crisis was a phenomenon common to all OECD countries, mostly due to a sort of pre-crisis consensus that favors monetary policy over fiscal policy, the latter being subject to political biases and lags. Yet, the European Monetary Union (EMU) is unique in thata reluctant ECB was projected to the front of the scene by the inertia of fiscal authorities engaged in consolidation (i.e. debt reduction and a focus on its sustainability) while other countries implemented stimulus plans.
There is little doubt that without decisive (and at times controversial) ECB action, the Eurozone would probably no longer exist today. Yet, the difficulties that the ECB continues to experience in its fight against deflationary pressures show that more is needed. The limits monetary policy is displaying today call for a reassessment of the role of fiscal policy. How should it be conducted at the European level?
An answer comes from the dominant narrative on the crisis, what we may called the “Berlin View”. This blames Europe’s economic troubles on the supposed fiscal profligacy of peripheral countries. In a nutshell, it postulates the efficiency of markets. If left free to operate without distortions, these would tend to spontaneously converge to “optimal” equilibria. The emphasis is then on supply-side measures. Credible structural reforms would boost profits and productivity expectations, thus leading to increased demand and growth (possibly through exports). Barring exceptional circumstances, this view considers aggregate demand management, whether via monetary or fiscal policy, useless if not harmful.
The Berlin View is already embedded in the EMU governance framework. The Stability and Growth Pact bans discretionary policies and calls for a sort of “bottom up coordination”. EMU countries should aim at a balanced budget and low debt. This is why EMU core countries joined peripheral countries in a fiscal consolidation effort from 2010 onwards, even if their public finances were not in distress, thus yielding a contractionary aggregate fiscal stance. And this is why the only institutional changes to fiscal policy that Germany allowed so far carefully avoid any type of transfer and boil down to stricter rules (the Fiscal Compact).
The German proposal of fiscal union is consistent with this view. If the only problem is a lack of discipline (and insufficient enforcement by the Commission), the creation of a European Finance Minister with the power to sanction and impose changes to national budget laws would finally compel fiscal discipline from all member states and hence allow markets to thrive.
However, the German notion of Fiscal Union runs into a number of problems.
First, the crisis proved that markets are more often than not inefficient, and then austerity nearly killed the patient. Peripheral countries’ debt is still unsustainable, decent growth is nowhere to be seen, and social hardship is reaching unbearable levels. Coupling austerity with reforms proved to be self-defeating, as the short-term negative impact on the economy was much larger than expected and as the long run benefits failed to materialize.
Countries may actually need different policies according to different timetables; coordination, rather than synchronization, is the keyword. If, for example, fiscal consolidation in peripheral countries had been accompanied by a fiscal expansion in the core, the effort by the former would have been less painful and more effective, with benefits for all.
Even if the economics of the Berlin View were appropriate, the German-style Eurozone Finance Minister would pose a problem of democracy and accountability. The power to tax and spend, which implies inherently political acts, needs to stay where accountability is. Either it remains with national authorities, or if it is transferred at the supranational level, accountability needs to be transferred too. In other words, there cannot be a European fiscal policy without a federal structure.
To sum up, the Berlin View Fiscal Union would be more of the same, only on a stronger institutional foundation: a proposal that does not seem apt to solve the problems highlighted by the crisis.
On the other hand, a key argument of the proponents of a federal Europe was, and still is, that fiscal transfers seem unavoidable to ensure economic convergence. A seminal paper by Xavier Sala i Martin and Jeffrey Sachs, published as early as 1991, showed that even in the US, where market flexibility is substantially larger than in the EMU, transfers from booming states to states in crisis account for almost 50% of the reaction to asymmetric shocks. In other words it was already clear (25 years ago) that without some form of federal transfers there would be no capacity of the system to curb divergence, and to ensure long-term sustainability of the single currency. The problem is that the federal project never made it into the political agenda. The crisis further deepened economic divergence and reciprocal recrimination, highlighting national self-interest (defined in a shortsighted manner) as the driving force of policymakers. As I write, the Greek crisis, the refugee emergency, and all the other centrifugal forces shaking Europe appear as a potential threat to the Union, rather than a push for further integration as it happened in the past.
If market flexibility alone cannot ensure convergence (rather the opposite) and if the federalist project seems to have suffered a fatal blow with the crisis, what is left?
A politically feasible strategy for current Eurozone woes requires two pillars. The first pillar consists of putting in place a sort of de facto Fiscal Union, i.e. designing politically feasible surrogates of a federal government that may help limit divergence without incurring in the hurdles the original federalist project ran into. The following policies and institutions, which are currently being implemented or discussed, may play an important countercyclical role.
A European unemployment benefit scheme: countries temporarily experiencing higher-than-normal unemployment would draw from the scheme, and then chip in when experiencing a boom. Such a proposal has already been aired by the Commission, and more recently by the Italian Government. It would need to be designed so that national preferences concerning the welfare state are preserved.
A properly designed banking union: this would be linked to common supervision and crisis resolution mechanisms (already implemented), as well as to some form of common deposit insurance. Countries experiencing a financial crisis could then rely on a pool of common resources, and therefore avoid the vicious cycle between private and public debt that sank the EMU peripheral economies in 2010-2012.
A partial mutualization of public debt (Eurobonds): This would allow the financing of Pan-European investment projects that could be used in the same spirit as the Juncker plan for crowding-in private investment and fostering long term convergence (taking the place of structural funds), but on a larger and more efficient scale. More importantly for the purpose of income stabilization, it could also finance investment projects to sustain regions or countries experiencing temporary slumps.
All of these instruments, and others responding to the same need, would have to make sure that each country’s net contribution is zero along the business cycle. To be surrogates of federal transfers, they should not take the form of permanent transfers – which would critically remove most of the core countries’ current objections. Furthermore, they should be managed by the Commission under the control of the European parliament in order to minimize the risk of abuse.
It is of course unlikely that these surrogates of countercyclical fiscal transfers may alone suffice in absorbing asymmetric shocks, especially when they are of the size of the current crisis. This is why a second pillar is necessary, namely a real coordination of European macroeconomic policies. The Eurozone experience since 1992 teaches us that relying on the efficient-market hypothesis as a guide for policy is not a wise strategy. The US shows that markets and governments, which are both imperfect institutions, interact in delivering growth. This calls for abandoning the Berlin View rule-based governance, and for adopting a flexible approach to countercyclical fiscal policies based on coordination among national governments. Lacking a real federal administration, the Council is the place where this coordination should happen.