Underlying the democratic deficit and political tensions within EU member states is a fiscal architecture that has outlived its usefulness. It's time for a rethink on the principles of mutual economic insurance
Almost exactly 25 years ago (June 27, 1989), the Committee for the study of economic and monetary union (ie. the Delors Committee) was presenting its report to the European Council outlining the process of European monetary unification and setting out the architecture of the single currency to be.
The idea that the monetary union wouldn’t be an optimal currency area in the sense of the economist Robert Mundell was well understood quite early on. The Delors committee and European leaders accepted the sub-optimality of the monetary union but suggested it could be overcome in part by deep financial integration. Financial integration became an instrument of economic convergence and an essential foundation of the monetary union. This explains why Europe has been such a key global promoter of financial liberalisation not only in Europe but also globally.
Yet, despite warnings, it wasn’t clear that a single monetary policy for a heterogeneous zone effectively created the conditions for bigger booms in good times while the rigid interpretation of the prohibition of monetary financing failed to prevent bad equilibria in sovereign debt markets in bad times. Finally and contrary to all the previous work on European monetary unification (the MacDougall report, the Werner Report), and despite some members of the Committee expressing reservations, Delors understood well that granting an autonomous right to raise taxes, spend and borrow as well as any centralisation of fiscal policy would be politically unacceptable.
As a result, the compromise found, in particular to win over the sceptical members of the Committee, was to ensure that fiscal policy would remain a national prerogative with, on the one hand, the 'no-bail out' clause (article 125 of the Treaty on the Functioning of the EU), and on the other hand, a fairly loose monitoring and decentralised coordination of fiscal developments in the form of the Stability Pact.
This founding compromise gave way to a typically ambiguously constructed agreement in which some parties believed that Europe had set in motion a genuine monetary union that would be completed over time, while others read in the text of the Maastricht treaty, the contours of an exchange rate arrangement only marginally superior to the European Monetary System but not fundamentally different.
The euro crisis since 2010 has showed the limits of the 'Delors consensus' and some of its obvious fragilities are being addressed under duress since the beginning of the crisis. In particular, the benign neglect of the fact that financial instability and fragmentation could become an existential threat to the currency union is slowly sinking in. However, moving towards a banking union is inextricably linked to major political and fiscal considerations. Indeed, transferring the sovereignty over the banking system (an essential part, if not the most important part of the economy) to the European level is an important transfer of sovereignty and sharing the fiscal responsibility for possible future bank failure is a major common implicit fiscal liability.
As a result, beyond reestablishing financial integration, rebuilding the architecture of the monetary union does involve a pretty fundamental political and fiscal discussion, which so far, has been largely avoided.
Indeed, the inter-governmental insurance mechanisms that have emerged organically during the crisis are understood to have offered an alternative path to buttress the Maastricht architecture but they might well be economically insufficient and political unsustainable.
Economically, the mutualisation of economic risks that has started tacitly through various mechanisms (European Stability Mechanism, interventions by the European Central Bank) will be inadequate to address most economic shocks. These instruments were indeed designed to face very large external or idiosyncratic shocks but they seem to disregard the fact that Member States’ ability to absorb shocks and run contra-cyclical policies has been tremendously impaired by high debt levels and the structural weakening of sovereign credits.
Politically, these instruments can only be activated alongside far more intrusive economic policy monitoring that is essentially equivalent to a take-over of national economic policy by a hardly identified and hardly accountable process. This form of 'federalism by exception', essentially confiscates economic policy in bad times and provides for insufficient economic policy coordination in good times. As the recent experience demonstrates, it is likely to fuel democratic deficit and political tensions between the core and the periphery of the euro area. This highlights the inherent economic and political limitations of the current mutual insurance system.
An alternative to the mutual insurance mechanisms is a real move towards a form of fiscal federalism that allows in effect restoring the ability to lead contra-cyclical policy while respecting basic democratic and political principles. The international history of fiscal federalism can prove a useful guide in this respect. In their lessons from US history for the architects of Europe's fiscal union, analysts Randall Henning and Martin Kessler recalled quite clearly that even though the assumption of the war of independence's debt in 1790 by the Federal Government orchestrated by Hamilton set in motion America's fiscal federalism and largely redefined the institutional and power balance set out in the 1787 Constitution, it also fell short of providing the real backbone of a complete and stable fiscal union. Hamilton obtained only a part of the fiscal union he had sought and fell short of the definition of economic prerogatives for the nascent federal government and a clear definition of its relationship with States.
There are important parallels to draw with the current debate on EMU's architecture and the future shape of fiscal federalism in Europe. If the mutualisation of debt may have powerful economic effects, alone, it is a poor substitute for a comprehensive definition of the system that organises the relationships between the Member States and the federal level in the design, coordination and implementation of economic policy.
The creation of an embryonic euro area budget could therefore address the weaknesses of the mutual insurance system. Economically, it would not need to replace it altogether and could potentially evolve as its natural extension by delivering the mutualisation of economic risks and deliver what Richard Musgrave refers to as the stabilisation function usually best delivered at the central level. Politically, such a process would force us to distinguish the economic prerogatives that are truly European from those that should remain national, within a system that would be respectful of subsidiarity andwould clearly delineate economic responsibilities.
Shahin Vallee is a former visiting fellow at the Bruegel think tank and economic adviser to the cabinet of European Council president Herman Van Rompuy. This post first appeared in full on the Bruegel blog
