FISCAL UNION IS CRUCIAL TO THE EURO´S SURVIVAL / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Fiscal union is crucial to the euro’s survival

By Wolfgang Münchau

Published: November 14 2010 20:34

The euro has been dogged by logical inconsistencies since it began. The best known is the combination of “no bail-out, no exit and no default”. This particular inconsistency is now in the process of being resolved – through a permanent crisis resolution mechanism that will allow default. But the attempt to resolve one inconsistency has given rise to another: the possibility of default, persistent imbalances and lack of a fiscal union.


The German anti-crisis proposal is all about default, and has large support. Angela Merkel, the German chancellor, says the taxpayer cannot shoulder cross-border transfers to pay for a sovereign default. That is undoubtedly true in a monetary union with the present political and legal set-up. Imagine a situation in which the Bundestag is asked to sanction a multibillion transfer to Ireland or Greece, when Germany is cutting welfare payments to its own citizens. The “no bail-out” clause that underpins the monetary union is more than a legal constraint. In a decentralised monetary union, a system of cross-border transfers is politically out of the question. I would expect that to be true even if it were in Germany’s ultimate interest to make such transfers – for example, to maintain an undervalued real exchange rate to boost exports.


The second inconsistent condition is the persistence of internal imbalances. These are rising again, globally and inside the eurozone, and there is no credible political plan to constrain them. Last week’s failure by the Group of 20 leading nations to agree a common agenda is the greatest calamity in the post-crisis global economic management. The European Union has no credible plan either.


Cross-country imbalances are aggravated by friction in the financial sector. Finance and banking are national industries, regulated nationally, bailed out nationally, and with insufficient European co-ordination and burden-sharing. If a problem arises, it stays in the country where it arose.


The third element of inconsistency is the absence of a fiscal union. I am not talking about a superstate, but a minimally sufficient fiscal union. I have heard a calculation according to which a discretionary budget of as little as 1 per cent of gross domestic product might be enough. But even that is not going to happen. The establishment of a fiscal union would require such a massive change in the European treaties that it is hard to see how it could be done.


A further important constraint is the position of the German constitutional court. Its ruling on the Lisbon treaty makes it explicit that political control over fiscal policy is a part of national sovereignty that cannot be transferred to Brussels.


So why are the possibility of sovereign default, persistent imbalances and lack of a fiscal union incompatible? You can have a system in which two of the three are present, for example by allowing default and large imbalances. But then you would require a fiscal union that acts as a systemic shock absorber. That is the case in the US, where a common fiscal superstructure makes intra-state divergences sustainable. However, without a single state, in the presence of imbalances and of default, it is hard to see how an economically integrated single currency area could survive a severe crisis. Imbalances produce large cross-country financial flows. In the absence of central financial regulation, these flows lead to distortions in the financial sector that end up as a liability of governments. In the absence of a common fiscal shock absorber, and without the possibility of devaluation, countries can find themselves in a situation from which they cannot escape without outside help. That may be happening in Ireland now. In a monetary union with dispersed debt ownership, such crises are also highly contagious.


The next question is whether this inconsistency can be resolved, for example in the European Council. I fear not. European leaders have implemented several ad hoc measures. The maximum structural change they are about to agree is a permanent crisis resolution regime, and even that could still run into political and legal difficulties. But resolving the inconsistency of default, imbalances and fiscal disunion would require structural change of a scale for which they are simply not prepared.


The establishment view in the eurozone is that such resolution is not necessary. Any crisis can be solved with sufficient fiscal discipline. I think Greece, Ireland, and maybe Portugal too, may soon show that this is not the case. A monetary union can live with fundamental inconsistencies – but not forever. We knew 10 years ago that the eurozone’s governance framework was insufficient. But what we thought would happen only in the long run has already occurred. I would expect the present set of inconsistencies to explode in a shorter time frame than the previous one – some time this decade.

With a resolution system based on default, and persistent economic imbalances, a fiscal union becomes a necessary condition for the euro’s survival. And if the message from Berlin and Brussels is that a fiscal union is unrealistic, we should not be surprised if investors are betting that the eurozone will break up into a core and a periphery. It is quite simply the logical implication of the new crisis resolution mechanism.


Copyright The Financial Times Limited 2010.