Germany is winning the debate on fiscal union
December 4, 2011 6:36 pm
by Gavyn Davies
The leaders of the eurozone have finally reached crunch time. This is the week in which Angela Merkel’s “grand bargain” is due to reach fulfillment at the European summit.
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On one side of the bargain, the eurozone will be required to accept Germany’s demand for “fiscal union”. On the other side, Germany will agree to the provision of funds to help indebted countries to remain liquid while they reduce government deficits and debt ratios, and thereby regain market access. These provisions of liquidity will come from the EFSF, which will transform into the ESM in 2013, and potentially from the ECB.
.
Given that fiscal union will play such a central role in this bargain, it is surprising that its exact contents have received such little examination, at least in the financial markets. What might it include, and to what extent is it desirable?
.
It is now almost universally recognised that the design of the eurozone was flawed, because it did not include a working procedure for fiscal union to underpin the monetary union. However, different sides of the economic debate mean very different things when they say this.
.
On the “soft” side of the debate, it is suggested that there was no mechanism in the treaties for fiscal transfers between the strong and the weak members of the euro, so the latter would receive no compensation for the disappearance of their ability to remain competitive by devaluing their currencies, or for their inability to cut interest rates during recessions. Lately, the “soft” side of the debate has added a new argument, which is that the ECB should assume a “lender of last resort” role in government debt markets, thus preventing self-fulfilling runs on sovereign debt. As a broad generality, France tends to take this line.
.
On the “hard” side of the debate, championed by Germany, none of these factors are given very much, if any, consideration. Instead, the flaw in the treaties is viewed as the lack of an effective mechanism to ensure fiscal discipline in the member states. The Stability and Growth Pact (SGP) was intended to limit budget deficits to under 3 per cent of GDP, and to reduce debt/GDP ratios to under 60 per cent.
.
The treaties contained elaborate procedures to shift countries towards these objectives, but they were enforced only by peer pressure in the Council of Ministers, and they never worked. Therefore the “hard” line holds that new mechanisms are needed to ensure that the budget targets are in fact achieved, and that countries are penalised for failing to hit them.
.
These two interpretations of fiscal union have very different implications for what should be done next. Ultimately, some idealists who favour the “soft” line may like to see a fiscal union in which a central eurozone budget would grow in size, with taxation and public spending being conducted largely at the federal level. This is what is done in the US, where the federal budget dominates the budgets of the states, and ensures that there are significant, automatic fiscal transfers from the strong states to the weak. This may be one reason why the US fiscal union has proven so durable.
.}
However, in the eurozone, any immediate comparison with the US is no more than a pipedream. The EU budget is only 1 per cent of GDP, while the budgets of member states amount to 44 per cent of GDP, so a US-style fiscal union is unrealistic. Instead, the “soft” line favours the creation of a eurozone transfer union, in which there are flows of resources from the strong national economies to the weak, either through enlarged fiscal mechanisms (ie the EFSF/ESM, or eurobonds) or through the balance sheet of the ECB.
.
The hard-liners take a completely different view. They see fiscal union as involving a binding agreement between all members to run national budgetary policy so that no inter-country flows would ever be necessary. If this binding agreement fails, then the hard line says that countries should be allowed to default on their debt, with the private sector taking their fair share of losses from such defaults.
.
Which side of this debate will emerge triumphant from this week’s talks? It seems overwhelmingly likely that it will be the hard line, championed by Germany. Discussions are already very far advanced in this direction.
According to a recent publication from the Commission, the new fiscal union will involve four departures from the SGP which it will replace:
.
First, countries will be subject to new limits, not only on their budget deficits, but also on the ratio of public spending/GDP, designed to ensure that spending is forced downwards if debt and deficit ratios are above targets.
-
Second, there will be a new procedure which will force countries progressively to reduce their debt/GDP ratios so that all of them will reach no more than 60per cent of GDP over the next 20 years. (German finance minister Wolfgang Schäuble proposed one example of exactly this procedure this weekend.)
.
Third, there would be financial sanctions, such as compulsory interest free deposits, or outright fines, amounting to 0.2-0.5 per cent of GDP for countries which are in breach of the procedure.
.
Fourth, member states would be expected to adopt a common set of practices into their national budgetary frameworks, so that the targets which had been agreed at a eurozone-level would be enshrined in their own domestic fiscal rules. These rules might include “balanced budget amendments in national constitutions or legislation.
.
It seems that only the details of this plan are left to be agreed. The details will matter, including (importantly) whether sanctions will be imposed automatically or by Council decision, and whether countries will be given greater leeway to miss their fiscal targets during recessions. I hope to write more on these details in future blogs.
.
But it is already perfectly clear that the German hard line has won the overall debate. And that means that the eurozone is about to lock itself into a fiscal regime which will increase the likelihood of medium term budgetary tightening, come economic hell or high water.
Given that fiscal union will play such a central role in this bargain, it is surprising that its exact contents have received such little examination, at least in the financial markets. What might it include, and to what extent is it desirable?
.
It is now almost universally recognised that the design of the eurozone was flawed, because it did not include a working procedure for fiscal union to underpin the monetary union. However, different sides of the economic debate mean very different things when they say this.
.
On the “soft” side of the debate, it is suggested that there was no mechanism in the treaties for fiscal transfers between the strong and the weak members of the euro, so the latter would receive no compensation for the disappearance of their ability to remain competitive by devaluing their currencies, or for their inability to cut interest rates during recessions. Lately, the “soft” side of the debate has added a new argument, which is that the ECB should assume a “lender of last resort” role in government debt markets, thus preventing self-fulfilling runs on sovereign debt. As a broad generality, France tends to take this line.
.
On the “hard” side of the debate, championed by Germany, none of these factors are given very much, if any, consideration. Instead, the flaw in the treaties is viewed as the lack of an effective mechanism to ensure fiscal discipline in the member states. The Stability and Growth Pact (SGP) was intended to limit budget deficits to under 3 per cent of GDP, and to reduce debt/GDP ratios to under 60 per cent.
.
The treaties contained elaborate procedures to shift countries towards these objectives, but they were enforced only by peer pressure in the Council of Ministers, and they never worked. Therefore the “hard” line holds that new mechanisms are needed to ensure that the budget targets are in fact achieved, and that countries are penalised for failing to hit them.
.
These two interpretations of fiscal union have very different implications for what should be done next. Ultimately, some idealists who favour the “soft” line may like to see a fiscal union in which a central eurozone budget would grow in size, with taxation and public spending being conducted largely at the federal level. This is what is done in the US, where the federal budget dominates the budgets of the states, and ensures that there are significant, automatic fiscal transfers from the strong states to the weak. This may be one reason why the US fiscal union has proven so durable.
.}
However, in the eurozone, any immediate comparison with the US is no more than a pipedream. The EU budget is only 1 per cent of GDP, while the budgets of member states amount to 44 per cent of GDP, so a US-style fiscal union is unrealistic. Instead, the “soft” line favours the creation of a eurozone transfer union, in which there are flows of resources from the strong national economies to the weak, either through enlarged fiscal mechanisms (ie the EFSF/ESM, or eurobonds) or through the balance sheet of the ECB.
.
The hard-liners take a completely different view. They see fiscal union as involving a binding agreement between all members to run national budgetary policy so that no inter-country flows would ever be necessary. If this binding agreement fails, then the hard line says that countries should be allowed to default on their debt, with the private sector taking their fair share of losses from such defaults.
.
Which side of this debate will emerge triumphant from this week’s talks? It seems overwhelmingly likely that it will be the hard line, championed by Germany. Discussions are already very far advanced in this direction.
According to a recent publication from the Commission, the new fiscal union will involve four departures from the SGP which it will replace:
.
First, countries will be subject to new limits, not only on their budget deficits, but also on the ratio of public spending/GDP, designed to ensure that spending is forced downwards if debt and deficit ratios are above targets.
-
Second, there will be a new procedure which will force countries progressively to reduce their debt/GDP ratios so that all of them will reach no more than 60per cent of GDP over the next 20 years. (German finance minister Wolfgang Schäuble proposed one example of exactly this procedure this weekend.)
.
Third, there would be financial sanctions, such as compulsory interest free deposits, or outright fines, amounting to 0.2-0.5 per cent of GDP for countries which are in breach of the procedure.
.
Fourth, member states would be expected to adopt a common set of practices into their national budgetary frameworks, so that the targets which had been agreed at a eurozone-level would be enshrined in their own domestic fiscal rules. These rules might include “balanced budget amendments in national constitutions or legislation.
.
It seems that only the details of this plan are left to be agreed. The details will matter, including (importantly) whether sanctions will be imposed automatically or by Council decision, and whether countries will be given greater leeway to miss their fiscal targets during recessions. I hope to write more on these details in future blogs.
.
But it is already perfectly clear that the German hard line has won the overall debate. And that means that the eurozone is about to lock itself into a fiscal regime which will increase the likelihood of medium term budgetary tightening, come economic hell or high water.
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