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Which fiscal union for the euro area?

Listed author(s):
  • Agnès Bénassy-Quéré
  • Xavier Ragot
  • Guntram B. Wolff

Highlights Fully-fledged federations assign fiscal policy stabilisation largely to the federal level, based on a relatively large budget. In the euro area, a large federal budget is unrealistic at the current level of political and societal integration, and fiscal stabilisation will continue to rely mainly on national policies. For aggregate fiscal policy to become more stabilising with respect to the economic cycle, while achieving long-term sustainability, it is necessary (i) to avoid imposing self-defeating fiscal adjustments on crisis countries by making sovereign debt restructuring a real possibility (which involves strengthening the banking sector and extending the remit of the European Stability Mechanism); (ii) to task the planned independent European Fiscal Board with delineating exceptional times during which fiscal coordination is needed on top of monetary policy; (iii) to make national fiscal policies more stabilising by allowing incremental investment and unemployment spending to be shifted from bad to good times based on national adjustment accounts. We also recommend a move towards a European unemployment (re-)insurance scheme targeted at ‘large’ shocks, with varying contributions from countries and a minimum set of labour-market harmonisation criteria, which in any case are desirable for the functioning of monetary union. For footnotes and references, please see the PDF version of this publication. Summary The construction of the euro area left aside the question of a fiscal union, but the crisis re-opened the debate. Of the three classical functions of fiscal policy – provision of public goods, redistribution and stabilisation – only the last provides a clear justification for fiscal policy at euro-area level. Unsustainable fiscal policies in one member state could destabilise the entire euro area, and national policies could also have direct and indirect demand effects with an impact on area-wide inflation. ‘Every man for himself’ is not an option. But coordination is difficult because it involves 19 national budgetary processes and a common central bank. Empirically, fiscal policy in the euro area and elsewhere often tends to accentuate rather than attenuate the economic cycle. The discretionary part of fiscal policy, as opposed to automatic stabilisers, is responsible for this unfortunate feature, while automatic stabilisers generally work well. Fully-fledged federations assign fiscal policy stabilisation largely to the federal level, based on a relatively large budget. In the euro area, a large federal budget is unrealistic at the current level of political and societal integration, and fiscal stabilisation will continue to rely mainly on national policies. We make three recommendations that would lead national fiscal policies to be more stabilising with respect to the economic cycle, while achieving long-term sustainability. First, the euro area should avoid imposing self-defeating fiscal adjustments on crisis countries. To achieve this, sovereign debt restructuring should be made possible by further strengthening the banking sector and extending the remit of the European Stability Mechanism. Second, fiscal policy in exceptionally good or bad times should be guided by the planned independent European fiscal board, while the Stability and Growth Pact (SGP) would apply strictly in ‘normal’ times. Of course, fiscal coordination is mostly needed in exceptional times, when the European Central Bank can no longer by itself stabilise the euro area. Third, the Stability and Growth Pact should be able to adapt in a more flexible way to the economic cycle by shifting incremental investment and unemployment spending from bad to good times based on national adjustment accounts, rather than through unclearly defined discretionary measures as is presently the case. This third proposal would strengthen automatic stabilisers that were in fact cut in some cases during the crisis. In addition, we recommend a move towards ‘federal’ insurance for very large shocks. This should be based on automatic stabilisers and should not involve conditionality when it is activated. The best option is likely to be a European unemployment (re-)insurance scheme for large shocks. All countries that comply with a minimum set of labour-market harmonisation criteria would be required to participate, with their payments into the scheme based on objective criteria. Labour market harmonisation is also desirable for the functioning of monetary union and could be incentivised by the re-insurance scheme. Introduction The idea to complement European Monetary Union with some form of fiscal federalism is not new. In 1977, the MacDougall report suggested the introduction of a small budget of around 5-7 percent of GDP as a first step, the long-term objective being “a Federation in Europe in which federal public expenditure is around 20-25 percent of gross product as in the USA and the Federal Republic of Germany” (Commission of the European Communities, 1977, pp10-11).

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Paper provided by Bruegel in its series Policy Contributions with number 12893.

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Date of creation: Feb 2016
Handle: RePEc:bre:polcon:12893
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