THE SURVIVAL OF THE EURO REQUIRES FISCAL UNION AND MORE
Professor Brigid Laffan, University College Dublin
The global financial crisis posed a series of interrelated challenges to the EU and more particularly the euro area. As the crisis unfolded, European institutions and the euro member states struggled to respond in a manner that convinced the markets that the political capacity and financial muscle existed to address Europe’s woes. When a series of ad hoc measures, best characterised as muddling through, failed to contain the problem, the Union set out to agree a ‘comprehensive package’ at its March 2011 meeting of the European Council.
Notwithstanding numerous further meetings of the European Council and the Euro group, the search for solutions to the crisis continues and the economic situation within the euro area deteriorates for many euro states. There was initially a deep reluctance and then numerous ideological, political and institutional barriers to addressing the issues raised by the crisis. Given its nature, the crisis has received extensive coverage from economists in academic papers, blogs and media commentary. The politics of the crisis has received less attention although at its core are important issues of political economy and politics. In ‘hard times’ existing paradigms come under strain and a high level of contestation concerning policy prescriptions is to be expected (Gourevitch, 1992,17). The crisis mutated from a global financial crisis to a crisis of the euro area, or to put it another way, the global crisis took on a distinctive euro area character in Autumn 2009, when the Greek government identified a serious ‘fiscal gap’ following the October election that saw George Papandreou return to power. In its third year, the euro area continues to struggle to stabilise the crisis. The extent and depth of the crisis has continued to deteriorate since summer 2011 with short periods of relative calm followed by renewed turbulence. The evidence of serious contagion in Spain and Italy, the third and fourth largest economies in the euro area respectively, brings the systemic nature of the crisis sharply into focus. It could be argued that considerably more political and policy time has gone into preventing future crises than managing the complexities of the crisis as it evolved. This paper covers three issues.
First, it will be argued that a Fiscal Union on its own is insufficient to solve the crisis because of the inter-relationship between sovereigns and banks in Europe. Second, a Fiscal Union, if this implies permanent inter-regional transfers in Europe, may not be an available policy solution. Third, the politics of the crisis have pitted debtors against creditors and have brought the primacy of domestic politics to the fore. If a solution to the euro crisis requires deeper economic and fiscal integration, then it may also require political union, however defined, and the consent of Europe’s peoples. Before addressing the key questions, I will begin with a short synopsis of why Europe’s politicians are finding it so difficult to stabilise the problems of the euro area.
Distributive Politics: Who Bears the Costs?
The euro area faced its first major challenge not as a normal downturn of the business cycle but during the most serious economic dislocation since the Great Depression, hence its title, the Great Recession. A young currency and central bank were and are faced with an existential crisis just over a decade since its creation. The crisis requires collective action from the ECB and the 17 member states in an environment of deep divergence of preferences and interests. Not all euro states are experiencing the crisis in the same way and suffering the same consequences. Divergence of economic performance and experience across the member states adds to the difficulties of agreeing solutions. Whenever there is an economic downturn of this magnitude, the distribution of costs across countries, sectors, families, and individuals is a major issue. In the euro area the core cleavage is between creditor and debtor countries, notwithstanding the deep interdependence between them. Debtor countries want salvation through solidarity and are thus committed to policy solutions that distribute the costs beyond their borders. Creditor countries, on the other hand, want to insulate their tax payers from exposure to the debtor states and are reluctant to discuss large scale burden-sharing.
Another way of identifying the cleavage is between those states that can borrow at sustainable rates from the financial markets and those that have already left the market or are under severe strain. The level of contestation about the nature of the crisis and the policy toolkit revolves around three difficult questions. First, who bears the cost of the losses incurred in the boom and bubble that preceded the crisis? Second, who carries the burden of adjustment in the aftermath of the crisis and three, who carries the risk and how much risk in addressing the problems? Hence the costs relate to the past (losses), the present (adjustment) and the future (risk). The public purse in many countries has carried a significant amount of the losses incurred by banks although the proportionate costs across states have differed greatly. The IMF data base on systemic banking crises concluded that in 2008 eight euro area states experienced a systemic banking crisis with a further four euro states representing borderline cases. Hence the financial systems of twelve of the 17 euro states were in considerable stress in 2008. Cyprus subsequently joined this group in 2012 and the banking situation in Spain deteriorated. The cost to the euro states of the banking crises ranged from a high of over 40% GDP in Ireland to 0.3% for Italy. Some taxpayers in Europe have borne very large losses incurred by their banking systems.
The June 2012 European Council/Euro Area Summit appeared to change course by concluding that it ‘is imperative to break the vicious circle between banks and sovereigns’ (Euro Area Summit, 29 June 2012) and by agreeing that the ESM might be channelled directly to banks without enlarging the debt burden of a euro area sovereign. This will only become operational following the establishment of a euro area supervisory authority.
So Far Fiscal Rules not Fiscal Union
The title of a Commission research report published as agreement on EMU was secured, Stable Money and Sound Finances (1993) captures the core of the euro paradigm. The euro was designed around the twin goals of stable money and sound finances enshrined in the Treaty on European Union (TEU), the Maastricht Treaty, and the 1997Growth and Stability Pact (GSP). Underpinning the single currency was a policy consensus that privileged low inflation (McNamara, 1998). Monetary policy was characterised by a single centre of authority, the European Central Bank (ECB) buttressed by the national central banks in the European System of Central banks (ESCB). The ECB was given treaty based guarantees of its independence in what was to be an ECB centric euro-zone (Dyson, 2000, 12). The treaty was definitive on the key goal and responsibility of monetary policy as laid out in TEU: ‘The primary objective of the ESCB shall be to maintain price stability’ (Article 105, TEU). The power of the ECB was buttressed by the fact that it was responsible for defining what price stability was and did so in a ‘hawkish’ manner from the outset by agreeing an inflation objective of below 2 per cent (Dyson, 2000, 12, ECB 1999). A strong and independent ECB was accompanied by a ‘no bail’ out clause which specified that neither the Community nor a member state government would become liable for the commitments of another member state. The ECB in turn was prohibited from directly buying debt instruments (Article 104).
The centralised and unified monetary pillar was complemented by a significantly weaker economic pillar, thereby creating an asymmetrical EMU from the outset. Although the interdependence between the two pillars was evident in the TEU, the means of assuring an equally strong economic policy pillar were absent. The French government of the time argued strongly for the inclusion of provisions on ‘economic governance’ to counterbalance the ECB but this was unacceptable to the German government, lest this would impact on the independence of the ECB, the core of the monetary union. The difficulty of specifying the ‘economic’ in EMU was not just because of the ‘high politics’ of ECB independence but also because economic policy can be ‘varied, nuanced and phased to a much greater degree than monetary union’ (Laffan et al, 1999, 144).
The EU did not put in place mechanisms (Fiscal Union) to offset asymmetric shocks to one part of the monetary union even though the likelihood of such shocks was greater in Europe than in the US. This reflected the underlying integration bargain in the EU; the small European budget would assist member states ‘catch up’ but was far too small and rule bound to engage in inter-regional transfers of the kind found within a state (Laffan 1997). Nor did the EMU design encompass a framework for the maintenance of the stability of the financial system. One of the functions of the ECB provided for in the TEU was a responsibility to oversee ‘the smooth operation of the payments system’ which had a supervisory dimension but one not specified in the treaties or the ECB Statutes. Given that financial integration was proceeding in Europe at an accelerated pace, the absence of a financial pillar in EMU greatly accentuated the design faults of the single currency. The euro was created in an environment in which there was ‘a firm belief that free markets were the best guarantee of sustained high growth, stable prices and currencies, and the optimal use of resources, including capital’ (Goodhardt, 2008, 7). The euro delivered sound money in its first decade of operation but faced an existential threat shortly after its 10th birthday.
The Crisis and the Search for Solutions
At the onset of the crisis, economic governance was placed firmly on the agenda and considerable effort has been devoted to enhancing economic governance in the euro area. The strategy was to strengthen the rules based system of the SGP. There has been agreement to a six-pack of legislation, a Fiscal Compact and further rules are being negotiated (two pack). The focus of the regulatory framework was on the collective co-responsibility of the member states within the euro area. This is captured in the following quote from a letter sent by Chancellor Merkel and President Sarkozy to the President of the European Council, in December 7th, 2011. In it the two most influential office holders in the euro area stated:
We need more binding and more ambitious rules and commitments for the euro area Member States. They should reflect that sharing a single currency means sharing responsibility for the euro area as a whole. They should pave the way for a new quality of cooperation and integration within the euro area
(Letter from Chancellor Merkel and President Sarkozy to Herman Van Rompuy, 7th December 2011).
The creditor states led by Germany, with the support of the ECB, sought a quantum leap in economic governance from the onset of the crisis. Their focus was on tighter surveillance of national budgets and economic policy and tougher sanctions. The Chancellor’s search for even greater assurance in economic governance was based on the over-riding German commitment to ensuring that the GSP, that had proven incapable of preventing the near collapse of the euro, would not fail in future. The ‘six pack’ which contained much of what Germany wanted, was based on secondary European law and hence could be revised through the normal EU legislative procedures. A Fiscal Compact, on the other hand, was an instrument of treaty law, although not a formal European treaty, because the UK vetoed treaty change at the December 2011 European Council. In summer 2011 when under pressure from the markets, the Italian government embarked on fiscal consolidation; this was accompanied by ECB intervention in the secondary markets (SMP) to buy Italian bonds. Once the pressure eased on Italian spreads, PM Berlusconi slowed the adjustment process domestically. This sealed his fate as an unreliable partner and added to Chancellor Merkel’s conviction that the euro states needed to go beyond the ‘six pack’. Much of what emerged in the Fiscal Compact was already contained in EU treaties and laws but there are a number of innovations in terms of primary law that enhance EU level economic governance.
The euro states have created a new regulatory and institutional framework for national budgetary and economic policy, one that encases them in a wider euro area framework of responsibility. The new framework puts flesh on the commitment already contained in the Maastricht treaty to the ‘common concern’ of the member states. The aim of the emerging system of economic governance is to strengthen the ‘ties that bind’ each euro state to the collective and to limit the freedom of manoeuvre of any one state. The evolving system has been achieved not only with EU law but the incorporation of new rules into the domestic by means of a ‘debt brake’. The latter is intended to make it more difficult for any future euro area government to ignore EU level law. In order to bind the other euro states, each state has submitted to being bound by collective rules.
The creditor governments led by Germany demanded these changes in return for action in bailing out stressed states. Reciprocal responsibility as a member of the euro area significantly reduces domestic budgetary and economic policy autonomy, alters the timing and cycle of budgetary preparation and brings the ‘outside’ in at an early stage of budgetary planning. EU intrusion and surveillance is designed to ensure that euro states put their public finances in order and once order has been restored, maintain them within the rules. Putting the house in order poses formidable challenges to many euro area states. In 2012, 12 of the 17 euro member states were in an excessive deficit procedure and of those, four countries were in bail-outs.
Greece, Ireland and Portugal, already in their fourth year of austerity, face many difficult years ahead, as do states with high levels of debt. All five countries with a high stock of debt (+90%) face the challenge of eliminating deficits and then running surpluses to bring down the overall stock of debt.
Almost all euro states face a prolonged period of heightened EU level scrutiny as they consolidate their public finances and re-gain their competitiveness. If euro states fail to achieve the targets outlined in the ‘six pack’ and the Fiscal Compact, the corrective arm is much stronger with provision for automatic sanctions. Given the experience with the rules-based GSP, it is difficult to say if the new regulatory regime will lead to more prudent economic and budgetary management within the euro area.
The Van Rompuy Report
The emerging economic governance regime is a set of fiscal rules, not a fiscal union, because it does not have a transfer mechanism to redistribute income across the euro area. The EU budget, representing 1% of EU GNI, is too small to act as an economic stabiliser although the structural funds represent a mechanism of redistribution. The integration bargain is based on assistance to the less developed countries and regions of the EU to ‘catch-up’. It was never intended as a platform for permanent inter-regional transfers and does not have a role in inter-personal transfers. The euro area was designed without a mechanism for fiscal transfers because a political consensus was not available to agree such a system. With the onset of the euro area crisis, the question of a ‘transfer union’ was back on the agenda.
On 26th June 2012, the President of the European Council, Herman Van Rompuy presented a seven page report to the European Council entitled Towards a Genuine Economic and Monetary Union. The purpose of the report, drafted in conjunction with the Presidents of the Commission and ECB, was intended to set out a vision and working method for the further development of the euro area.
The report identified four essential building blocks that would constitute the completion of the currency union. These were:
The second pillar, an integrated budgetary framework, argued that ‘a qualitative move towards fiscal union’ was a necessary part of the currency area. Fiscal union was identified in the report as requiring a further ‘pooling of decision making on budgets commensurate with the pooling of risks’ and effective mechanisms to prevent and correct unsustainable fiscal policies. The report referred to collective agreement on upper limits of domestic budget balances and government debt limits. This marks a further pooling of budgetary decision making. The report went on to specify other dimensions of a fiscal union such as the issuance of common debt in the medium term provided that there was a robust framework in place for budgetary discipline and competitiveness. The report suggested that different forms of fiscal solidarity (unspecified) could be envisaged at some future date. The creation of a treasury office (Finance Ministry) was also identified as part of a fully-fledged fiscal union.
Fiscal union was also the subject matter of a report published by Notre Europe in June 2012 under the patronage of Jacques Delors and Helmut Schmidt. It was dedicated to Tommaso Padoa-Schioppa, an Italian European steeped in the construction of the EU as senior Commission official, member of the European Central Bank and Italian minister. A report published in 1987 as the output of a study group on the future economic system of the EU was very influential in its time prior to the establishment of EMU. The 2012 report on Completing the Euro offered a number of prescriptions on a fiscal union for the euro area. It called for a ‘sui generis form of fiscal federalism’ guided by the principle of ‘as much political and economic union as necessary, but as little as possible’ (Notre Europe, June 2012). The latter principle was at the heart of the integration process from the outset. However, the establishment of a single currency and its maintenance requires deeper political and economic union than envisaged in the Maastricht treaty. The report identifies two elements of a fiscal union to buttress the single currency. First, it argues for a cyclical stabilization insurance fund to assist the currency union in the event of an asymmetric shock to any one part of the currency area. Countries would pay into the fund in good times and be able to draw on it in the event of a down turn. The purpose of such a fund would be to assist in the process of internal devaluation. According to the authors, the receipts from the fund could serve as ‘buffers in a downturn’ (Notre Europe, June 2012, 31). The scheme is not intended as a ‘hidden instrument of permanent transfers’ (ibid). Second, the report advocates the establishment of a European Debt Agency. The agency would act in a flexible manner to deal with all kinds of situations from facilitating the issuance of debt in normal times to the worse-case scenario whereby a country needs bailing out. In the latter case, a country would only be bailed out in exchange for ‘a nearly complete transfer of sovereignty’ (ibid, 38). The tenor of the report on fiscal union is to reassure the stronger countries by establishing institutions and rules to establish boundaries on risk sharing.
Even if the euro area could agree elements of a fiscal union that went beyond fiscal rules, fiscal union would not be sufficient. As the crisis deepened, the ties between sovereigns and banks have strengthened with the result that insolvent banks have damaged sovereigns and vice versa. It could be argued that the fragility of Europe’s financial system poses the greatest threat to the euro area at this juncture. The June euro area summit acknowledged the problem of the sovereign/banking nexus in Europe when in the opening line of its statement, the HoSG affirmed ‘that it is imperative to break the vicious circle between banks and sovereigns’ (Euro Area Summit Statement, 29 June 2012). The ECB has argued consistently for a banking union in the euro area which would consist of a banking supervisory authority, a deposit insurance scheme and a bank resolution mechanism. The June summit may or may not be the first steps on the road to fully fledged banking union. The decision that the ESM may inject capital directly into banks is a move in that direction but this may only happen when a European wide supervisory capacity exists. In the aftermath of the summit, it appeared as if Germany was back-tracking from the summit commitments when Finance Minister Schauble suggested that this may take a long time. The Van Rompuy report was far more specific on the dimensions of an integrated financial area than a fiscal union. The Notre Europe report also argues strongly for a banking union.
The politics of keeping the show on the road
The crisis in the euro area is the deepest crisis in the history of European integration. It is a systemic crisis of the euro area and if the euro area cannot be maintained or implodes, it will also prove systemic for the EU as a whole. If the single currency survives, it will survive on the basis of more integration within the euro area as the ‘hardest of hard cores’ and hence deep divisions between the ‘ins’ and ‘outs’. The politics of maintaining the euro through the crisis are profoundly challenging and again if the crisis is stabilised and resolved, the political consequences are likely to represent a step-change in political integration.
By and large in most euro states, however, voters have opted for the available opposition of either the centre left or right to form the next government rather than putting ‘challenger parties’ in power. Only in Greece was a crisis election followed by a failure of government formation and the holding of new elections. In the second election, New Democracy narrowly beat Syriza, a challenger party. If the crisis endures, the impact may go well beyond a rotation of parties in power to further fragmentation of party systems, substantial losses for established governing parties and more electoral success for extreme populist parties. See Table 1. Greater voter volatility, poor performance by incumbents and the success of populist parties were evident in Europe’s party and electoral systems before the crisis but have been greatly accentuated by it. Fiscal consolidation which is inevitable given the debt overhang from the 2000s has been met with protests and electoral volatility. Precisely at the time when political elites throughout Europe require a capacity to engage with their electorates on the choices that they face, is precisely the time when trust in politicians is weakest.
The politics of constrained choice is much more difficult for parties and electorates than the politics of ‘you can have it all’. Ireland experienced a decade of the politics of ‘you can have it all’ and thereby squandered a once in two hundred year chance to set Ireland on course for a prosperous and stable future. The societies in Europe that will have a stable and prosperous future are those societies that have the political and institutional capacity to identify problems in time, to address them and to ensure that ‘vested interests’ and ‘rent seekers’ do not benefit disproportionally from the public coffers. To date, Irish politics and the Irish state elite have failed far too often to identify, protect and promote the public good. For its part, the Irish electorate has not demanded that the public good be protected.
The crisis has placed demands not just on the vulnerable states but also on the creditor state, or those states that can borrow at affordable rates in the financial markets. There remains deep resistance in the creditor countries to risk sharing without guarantees and they are unsure which rules and institutions would afford them adequate protection. Germany is the swing country among the creditor states as it is the largest euro area economy and would carry a higher risk than other states. The German government is operating in a highly constrained environment. The institutional constraints emanate from the Constitutional Court which has become very active in the crisis and the Bundesbank which acts as a watch-dog for monetary orthodoxy. The German government and its Chancellor remain adamantly opposed to the mutualisation of debt in the form of euro bonds. Prior to the June European Council, the Chancellor said that she did not ‘see total debt liability’ as long as she lived at a meeting with her coalition partners, the Free Democrats. She has also referred to euro bonds as ‘economically wrong and counterproductive’ (EurActive, 27 June, 2012). In addition, euro bonds are considered unconstitutional in Germany. Furthermore, a civil society group opposing redistributive policies in the euro area has emerged under the title, Nein zur Transferunion. Opposition to fiscal union remains strong in the Netherlands and Finland. In thinking through what the policy toolkit needs, it is imperative to identify what Germany in particular might agree to and how such proposals are framed. Framing is crucial in a crisis as there is a high degree of uncertainty about means and ends.
Political Order in the Longer Term
If the euro is to survive in the long term, it will necessitate a deeper level of political integration than exists at present in the EU. The issue of the ‘finalité politique’ of the EU is back on the agenda, twelve years after Joshka Fischer’s Humbolt speech in May 2000 on the future of Europe. The Van Rompuy report acknowledged the need for greater democratic accountability and legitimacy but just how this might be delivered is very challenging. Liberal democratic politics evolved within states based on a high degree of congruence between bounded territory, bonded people and a set of agreed functions for public policy and public power. Democratising political space above the state is the challenge of the 21st century given the level of internationalisation that characterises contemporary economies and societies. The EU has built democratic institutions, norms and practices over the last thirty years but these do not amount to a democratic polity at EU level.
Developing political union at EU level must be attentive to the continuing importance of national democracies in Europe. National elections remain the most legitimate channel for selecting political office holders in Europe. European parliament elections are second order political events. As the euro area assumes more responsibility for banking, budgetary and economic policy accompanied by the intrusion of euro level actors into domestic policy making, the functional dimension of political union is strengthened. The key challenge therefore is to strengthen accountability structures at EU and national levels and to provide channels for national and euro wide discussion about budgetary and economic policies and priorities. There is also the deeper question of the consent of the people. If the euro area reaches a federal moment and a federal question, then the consent of Europe’s peoples must be sought at least within the euro area. This suggests a euro wide referendum on any major step change. The referendum would have to be euro wide as no one member state should have the possibility of vetoing such a development.
If the euro is to survive, it will necessitate the development of a fiscal union that has a capacity to stabilise the euro wide economy and assist countries facing asymmetric shocks. This should not amount to permanent transfers to any one country but a system to assist countries adjust when faced with a severe down-turn. A fiscal union is not sufficient given the interdependence of Europe’s financial systems. The euro needs a centralized banking system and bank resolution mechanism. These two steps are both technically difficult to design and deliver politically, but have been recognized by the Presidents of Europe’s three supranational institutions as the building blocks of a genuine EMU. Such developments must be underpinned by enhanced accountability and legitimacy within the euro area which places the question of the finalité politique firmly on the agenda. And this in turn brings the consent of Europe’s peoples sharply into focus. Greatly expanding the policy reach of the euro area should not be embarked on without the consent of Europe’s electorates. Consent will be difficult to achieve given the euro crisis but without it the currency would not be sustainable in the longer term.
History tells us that monetary unions that have survived have been embedded in a political union. Fiscal, banking and political union are questions for the medium to long term. The euro area cannot conjure them up overnight. This leaves the question of how to bring stability now, given the level of contagion in the system and the vulnerability of Spain and Italy. Given the political difficulty for creditor state governments of major policy initiatives, the euro crisis will come down to the action of the ECB. Italy is too big to fail and too big to bail. The euro will not survive a situation whereby the markets leave Italy.
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