NEED FOR CHANGE IN THINKING ON EUROPEAN FISCAL UNION

NEED FOR CHANGE IN THINKING ON EUROPEAN FISCAL UNION

Alan W. Gray, Chairman of London Economics, Managing Partner of Indecon Economic Consultants

 

Introduction

As we know to our cost in Ireland policies can be introduced without an assessment of their full economic consequences or even without clearly understanding what problems the policies were designed to address.  It sometimes appears that someone thinks up a policy intervention and then retrofits it to a problem rather than the other way around.  The disastrous and unjustified extensive property based tax incentives in Ireland which fuelled an already unsustainable property bubble is but one example of this.   So in considering the necessity or the merits or otherwise of fiscal union let us not start with the policy proposal but with what problem it might be focused on solving.

Within Europe my view is that there are four distinct but related problems all of which would not all be solved simply by fiscal union.  These are:

  1. Recession or low growth in European countries and escalation of high levels of long term unemployment.
  2. A dramatic sovereign debt crisis whereby even rich and large European countries are being excluded from borrowing at reasonable rates on international bond markets.  This is in part due to the toxic link between bank and sovereign debt and uncertainty re financial outcomes.
  3. Near collapse of the banking sector in most EU countries combined with recognition of the scale of undercapitalization.
  4. A crisis in the public finances in many countries, with painful austerity adjustment programmes under way.

A key issue in deciding on whether fiscal union is a necessary or a sufficient solution to these problems is to have a clear understanding on what fiscal union might mean.


What is Fiscal Union?

There are many different policy initiatives which could be called fiscal union and their consequences would be very different as is the likelihood of implementation.  So let’s first consider what are the current EU proposals and also the potential options for the shape of such a fiscal union.

Current EU Proposals

The proposals from the European Council along with the Commission and the European Central Bank involve:

  • • Setting upper limits on member states’ annual budgets.
  • • Prior approval for issuing government debt beyond levels agreed.
  • • Issuance of common debt as a medium term option.
  • • Setting up an EU Treasury office.
  • • Closer coordination on labour mobility and taxation.

They also involve moves towards a banking union, and further steps towards political union.

The EU proposals represent a sub-set of four general options for fiscal union. The main potential options are as follows:

Option 1:   Centralised EU fiscal policy with centralised expenditure and tax decisions.  This is the United States model.

Option 2:   Fiscal transfers between Member States.

Option 3:   Co-ordination of aspects of taxation including VAT, excise duties, income tax and possibly corporate tax.

Option 4: Centralised co-ordination of fiscal budgets.  This is already in place to some extent but the key is what sanctions or mechanisms would apply to countries which do not meet targeted deficits.

 

Is Fiscal Union Feasible?

It is useful to consider whether any significant form of fiscal union is likely to be feasible.  We need to be careful on this, as what would have appeared like fantasy five years ago no longer appears so.  This includes the ECB investing billions to support sovereign bonds, establishment of a major euro emergency bail-out fund, common stress testing of banks, and most dramatically the likelihood of EU emergency funds being lent directly to banks rather than to sovereigns.  We therefore need to be very humble in forecasting likely outcomes and in recognising the limits on our knowledge and the extent of future uncertainties.  The tendency for humans to be obsessed with always being right and in attacking people who are proved wrong, has led to a dangerous arrogance and a revisionary approach to interpreting past events.  Maybe this is why people always pretend they are certain of their views in a world of bewildering uncertainty.

While recognising the uncertainties, my own view is that we are likely to have some form of fiscal union in Europe and this will be characterized by a number of features.  At the core I think we will see some fiscal decisions taken centrally, but nationally governments will continue to decide on most government expenditure and taxation within certain rules.  A centralised EU fiscal policy with centralized expenditure and tax decisions, as per the United States, is very unlikely to happen.

There will however be more centralised control on aspects of fiscal policy and this will be a condition for larger more successful countries providing future fiscal transfers to countries most in crisis.  The extent of financial transfers will be less than we might think appropriate in Ireland unless the level of political intervention and integration in Europe changes fundamentally.   This is because of major tensions in Europe.  This was evident in the reaction of the German deputy foreign minister to the current proposals by the European Council.  For example, he indicated that “parts of it read like a wish list”.  He argued that the proposals lead “towards various models for mutualising debt.  What comes up short is improved controls”.

I however believe that there will be elements of a fiscal union involving fiscal transfers between member states but this will require Europe to overcome two major political problems:

  • • Political opposition by taxpayers in countries who are paying the bill for what they see as incompetence and profligacy in supported countries.
  • • Also opposition in countries receiving aid to what their citizens see as unjustified conditions on spending and reforms.

The outcome on fiscal union will be messy, piecemeal and less than ideal.  The only comfort one can take is that full fiscal union is probably neither necessary nor sufficient to solve the four crises in the EU or to prevent speculation on sovereign debt.

For example in addressing the sovereign debt crisis many changes will be required.  These include the possibility that we will have to move to a world whereby potentially vulnerable countries such as Ireland operate with near balanced budgets and lower debt.   This would restrict the rate of growth in Ireland but could make us less vulnerable to external shocks.

The reason why I believe full fiscal union will not happen is that fiscal policy is very value-based and is primarily although not exclusively distributional in nature, and probably can only be accommodated in the context of a nation state.  While I believe we will see aspects of a fiscal union, most German fiscal decisions will remain in the Bundestag and in Ireland with the Dáil.  Certain narrow fiscal decisions will however be centralized within a given percentage of EU budgets.

We could also have a scenario whereby fiscal deficits beyond levels agreed would result in an adjustment mechanism whereby public expenditure or taxation would be automatically adjusted. Randall Henning and Kessler (2012) have suggested a scenario whereby “By law, public salaries, social transfers and gross transfers” would be adjusted.  Gruen (1997) suggested a similar idea on the tax side by proposing to achieve budget targets by varying the tax rates. Thus while a full fiscal union is very unlikely, Europe needs to move quickly to elements of a fiscal union and there is a need for radical change in thinking.  In this context Ireland should support a form of fiscal union, and recognize the likely shape of future developments and position our policy to influence and adjust to such outcomes.

Recommendations

I outline below a number of recommendations which I believe could be of benefit to the survival of the euro and to Ireland’s future.

Recommendations For EU Action

  1. Europe needs to implement additional automatic measures to ensure budget targets are met.   The current EU plan involves a requirement that national governments would collectively agree “upper limits” for each member state’s annual debt and deficit levels.  The key issue however is how to ensure targets are met.  There may be merit in considering the introduction of automatic mechanisms which would confirm adherence to fiscal discipline, and a mainly expenditure based mechanism may be least damaging.  Ireland should consider unilaterally introducing such mechanisms which could help change perceptions of our sovereign risk and could provide a model for Europe.  This could have very positive signaling benefits.
  2. Europe should also start long term planning for nearly balanced budgets and lower debt in euro states likely to be subject to risk in sovereign debt markets.  This should be combined with increased measures to support certain fiscal transfers between EU states to deal with the banking crisis. This will require further fiscal co-ordination and Ireland should be willing to agree to this.
  3. The EU should consider partially financing the bail-out by common European taxes.  After the American War of Independence common debt was serviced by customs duties and excise taxes and it may be necessary to have some centralized federal taxes as an element of the solution in Europe.   Ireland is however right in ensuring that there is no change in the co-ordination of corporate taxation.
  4. Europe should also move quickly to a euro area deposit insurance combined with effective EU banking supervision.  In this context Ireland should support the immediate establishment of an EU banking supervisory agency which is likely to be a condition for direct funding to Irish banks.
  5. To address unemployment, larger countries should start stimulating their economies and this should be included in the design of any fiscal union plan.

 

Institutional Recommendations

  1. Ireland’s input to EU policy formulation should be based on ensuring that policy changes which would benefit Ireland recognizes the longer term interests of major countries as well as of smaller member states.  In most policy areas we no longer have an equal voice to major players but we can punch above our weight if we have better ideas and work smartly in developing relationships and understanding in Europe.
  2. To do this, Ireland needs to invest much more resources in understanding and influencing thinking in Germany, France and Italy.  At a simplistic level the scale of change in focus needed can be seen by asking a few simple questions.  How many Irish government senior officials and advisers are fluent in German, French and Italian? More fundamentally, how many have worked full time or even worked on secondment in these countries?  How many have completed undergraduate or post graduate degrees in Germany, France or Italy?  How many German or French nationals have been recruited into central government or to our policy making institutes in Ireland?  How many German officials have been facilitated to undertake training or specialized education in Ireland? How many leading German economists have been invited to address the Cabinet or government officials on emerging thinking on Europe? Ireland needs to have an ambition to replicate in Germany, France and Italy the benefits we have secured in US/Ireland relations from the familiarisation, personal contacts, common language, shared culture and deep understanding between Ireland and the US.  The significance of this is evident to me every time I work with economists in Germany and I am struck by the divergence of their views compared to the views of Irish economists.
  3. Ireland’s most effective approach will be to continue to build common positions with EU partners and to secure support from IMF and European Commission as well as other EU countries. This co-operative approach has been used effectively by the government and was also used by the European Council President in his recent report which he co-authored with the President of the European Commission, the head of the European Central Bank and the head of the Eurozone finance ministers.
  4. As a country we should have an ambition to take a leadership role in developing intellectual thinking on the solution of Europe’s problems.  We should have the confidence and vision to invest in and engage with the best economic minds in the world, including leading Nobel Prize winners and should actively be seen as a catalyst in disseminating such ideas.  We do not have an equal voice in Europe’s decisions but we can facilitate the generation of new ideas which will influence policy. Keynes was undoubtedly correct in suggesting that ideas rule the world both when they are bad ideas as well as good ones.
  5. Ireland may also need to find a mechanism which has public support to prevent the necessity for numerous referenda to the Constitution for any EU changes which might be deemed to result in any diminution of our economic sovereignty.  We are faced with a situation whereby Irish governments are free to make decisions without referenda on issues with fundamental long term national consequences such as the decision to agree the IMF/ EU programme. Much more minor decisions such as recent so-called Fiscal Treaty required a national referendum. This does not make sense to me, and unless changed, could constrain our effectiveness in influencing EU policy.

Concluding Remarks

In considering any fiscal union proposals it is important to recognize that the issue must not be allowed to be exclusively, or even mainly, about government debt and public finance deficits.  Part of the story is that Europe introduced a single currency before having the conditions necessary for a sustainable euro. A single currency was set up but there were inadequate banking policies and fundamentally no mechanisms to deal with a crisis.   Even as far back as 1996 the German economist Jorgen von Hagen and the US economist Barry Eichengreen were questioning the credibility of the ECB restriction on acquiring any public debt.   The ECB will therefore need to play a more significant role in sovereign bond markets while reforms are being implemented, but a fiscal union in some form is also probably inevitable.

Does this mean that Europe will become more like the US so that if, for example, there is a property collapse as happened in Florida, then the FederalState largely picks up the bill?   The answer is ‘no’, but aspects of US fiscal policy will to some extent be reflected in Europe.  This will require more centralised decision making and Ireland needs to be at the heart of the generation of ideas on what precise changes are needed.

In considering fiscal union, even in the narrow sense of tighter rules on deficits, there is a real danger that a one-size-fits all approach will be used, which would lead to an inappropriate fiscal consolidation plan.  Indeed under current policies it is likely that the UK and most of Northern Europe may be cutting too much too quickly and Ireland should attempt to build alliances to highlight these risks.  Finally, Ireland should be willing to change our policies concerning some aspects of fiscal union and refocus on influencing central decisions on the future of Europe.  We have done very well in our European policies over the past year but the extent of the ongoing challenges requires new thinking. This must recognise the interdependence of the various challenges faced by the euro area and the scale of the problems yet to be overcome.   It should also be based on the recognition of the need to understand and influence thinking in the major countries who dominate decision making.

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