Mr Bini Smaghi gave a speech in Hall, Germany, on February 14. His St. Valentines gift to Europe is interesting and much more complicated than this comment from the FT’s money supply leads us to believe. Honestly, I am not very impressed with the coverage…
His speech was very dense and it addressed, first, the imbalances arising and leading to the present sovereign debt crisis and then the relevance of fiscal union as a solution. It concluded by arguing that the emphasis should be put on stronger national fiscal discipline. Because the causes of the crisis are quite well known, I assume that mentioning them is unnecessary.(If you are interested in this topic and are not very informed, he is a good source and provides a concise summary, so you may want to check the above linked text) Therefore, and because of its focus, this post focuses mostly on the second part of his speech.
For the sake of fairness I reproduce the middle section of his speech below. For the sake of brevity I will leave my comments for a separate post, so that they may be clearer and so that the reader might be able to think briefly about this issue before I start shooting around.
(Unless stated other wise, any emphasis is added by me and is always in bold and italics)
“The desirability of achieving a fully fledged fiscal union to complement monetary union can be assessed on the basis of the three main criteria characterising economic policy: stability, efficiency and equity. I would like to consider the first two and omit equity, which has a deeper political connotation and may be less relevant for the sustainability of a monetary union.
Let me start with stability.
The key economic rationale for having a fully fledged fiscal union is to establish a common pool of resources that can be used to insure its members against adverse macroeconomic shocks and to reduce macroeconomic imbalances. In a monetary union, fiscal policy is the only instrument that domestic policy-makers can use in response to country-specific macroeconomic shocks. Since monetary policy is uniform within the currency union, it cannot be tailored specifically to the economic conditions in each country. If, for example, a downturn proves to be especially pronounced in one country, the monetary stance adopted for the entire currency area may not be appropriate. This implies that fiscal policies may need to play an active role in stabilising macroeconomic developments at the domestic level. At the same time, the capacity of individual countries to adopt stabilising fiscal policies is very limited. In particular, if countries enter a downturn with weak budgetary positions, or if economic developments prove to be very unfavourable, market confidence in the sustainability of public finances can evaporate quickly. This is the experience of a number of countries in EMU which – after failing to exploit the good times prior to the crisis to consolidate public finances – very quickly faced excessive budget deficits when economic conditions deteriorated. In such a situation, fiscal expansion through the national budget would be counterproductive as the ‘negative confidence’ effect from a further budgetary deterioration would outweigh any direct demand effect.
The separation between monetary and fiscal policy in EMU, which prevents the use of monetary instruments for solving budgetary problems, further tightens the sustainability requirements for the public finances of the Member States. Rising public debt cannot be curbed by keeping interest rates low or through inflation, but only through budget adjustment. Markets might be inclined to test the ability and willingness of the countries to maintain a tight control over their budgets even in a severe economic downturn. As doubts mount in the markets and credit spreads increase, self-fulfilling expectations may arise which worsen the debt dynamics.
A further problem in the euro area derives from the role played by governments as shock absorbers in the financial sector. Public funds are used to prop up banks which suffer losses in a financial crisis or to guarantee banks’ liabilities in case of bank runs produced by outflows.
In a fully-fledged fiscal federation these problems do not arise, as asymmetric shocks are partly offset by cross-region transfers through a federal budget. Furthermore, the stability of the banking system does not depend on the soundness of local or regional finances, but on that of the federation. The smaller the size of local or regional authorities’ budgets, the lower the risk that asymmetric shocks will endanger the stability of those authorities’ finances as the stabilisation function is performed by the federal budget.
In essence, this mechanism aims to insure individual countries against idiosyncratic shocks which in turn could reduce macroeconomic volatility. Theoretically, this mechanism could even be designed so as to strengthen incentives to reduce macroeconomic imbalances such as unit labour cost divergence and high and persistent current account deficits. Contributions to intergovernmental grant schemes or access to joint bond issuance could, for example, be made conditional on a country’s progress with its structural and fiscal reform agenda.
A federal budget does not necessarily mean, however, that the stabilisation function is better performed at the federal level, in particular when facing symmetric shocks. The experience of the recent crisis shows that the deficit and debt levels of several countries, some of them with federal systems, others centralised, have increased even further than in some countries of the euro area. For instance, both the UK and the US experienced larger deteriorations in their fiscal positions from 2007 to 2009 than the average in the euro area. Over this period, the budget deficit of the UK increased from 2.7% to 11.4% of GDP while that of the US increased from 2.8% to 11.2%. These deficit ratios are comparable to that of Spain, which is one euro area countries where the public finances have been particularly severely affected by the crisis.
It can actually be argued that, with the market pressure which arises in a monetary union, its members have to think more about the long-run stability of their public finances than they do if monetary policy eliminates the pressure by ensuring the financing of the deficit. Under pressure from the markets the euro area countries have adopted corrective measures which are expected to stabilise the public debt-to-GDP ratio in the coming years. In Spain, for instance, the latest available stability programme (which dates back to January 2010) aims at stabilising the government debt-to-GDP ratio at a peak of 74% in 2013. Moreover, since then, the Spanish government has responded to market tensions by frontloaded to 2010 and 2011 some of the fiscal adjustment planned for 2012 and 2013.
To sum up, a federal budget might ensure greater stability in the face of asymmetric shocks, but when such shocks are large enough to affect the whole economy a federal system might not necessarily provide greater stability.
Let me turn to the second criterion that characterises economic policy – efficiency in the allocation of resources. Here the experience of German unification may be interesting because it helps us understand the challenges that a union composed of countries in different economic conditions may face in integrating those economies and adopting the same currency. This experience suggests that a single fiscal regime may impose obstacles to economic integration, particularly for catching-up regions. In the euro area, countries which entered with a lower per capita income caught up with the average much more quickly, maybe too quickly, as I mentioned earlier, than eastern Germany and attracted capital and labour inflow. There are several reasons for that. One is that the budgetary integration entails a harmonisation of taxation and public expenditures which may have a differentiated impact across regions, depending on their level of wealth. A given distribution of the tax burden may be appropriate for a given level of income but not necessarily for a lower one, and may lead to larger rather than smaller differences. Regions with less physical capital may for instance require lower taxation, and maybe also lower expenditure, to attract the capital necessary for the catching-up. There is extensive literature on these issues, so I won’t elaborate further on this.
Another aspect refers to all the effects that arise, in terms of harmonisation, as a result of fiscal integration, such as tariffs, administrative costs, public wages, etc. which weigh indirectly on the costs borne by business. If a country needs to grow faster, such costs should be reduced.
The same applies to other aspects of legislation which tend to be harmonised as a result of fiscal union and tend to penalise catching-up regions. These costs are offset by resource transfers, from the richest to the poorest regions. However, experience in Germany, Italy and other dualistic countries shows that if these transfers are not well designed and are only the result of the integration of the tax and public expenditure systems, they may create disincentives for growth and employment. These distortions lead to labour migration from the poorest to the richest regions. In countries like the US, labour migration used to be considered as a “good” and somewhat natural adjustment process, resulting from the country’s westward expansion. The recent housing crisis has shown, however, the costs of an adjustment process which relies on such a mechanism: migrants have to sell their homes in depressed regions at depressed prices. In Europe, migration is valued if it represents an opportunity rather than a lack of alternatives. Given the prevailing cultural differences, sometimes even within countries, migration entails welfare losses.
In more general terms, some form of competition between regional budgets, in particular in terms of taxation, but also expenditure, may enhance efficiency and best practice. The fact that some countries have been able to better control public finances before and during the crisis may set an example to others. This applies also to the quality of public expenditures and to the reforms related to the costs of ageing, health care and unemployment. Decentralisation also enhances accountability and allows better supervision by the voters. It would be quite damaging if “Brussels” were to be blamed also for the poor state of public finances, rather than the capitals of the Member States.
To sum up, a federal budget is better capable of addressing asymmetric shocks, but not necessarily symmetric shocks, and may not be the most efficient approach in an area which catching-up countries will continue to join. On the other hand, if decentralised budgets are better attuned to the requirements of the catching-up countries, such budgets may lead to excessive pro-cyclicality and to instability if the catching-up is too quick and unsustainable.
The above considerations suggest that it would be risky for the euro area to move to greater fiscal and budgetary integration in order to avoid the instability associated with the current system. While solving some of the problems of the current system, the new regime could import new problems which might be politically even more difficult to tackle.”