Thank you Mr Bini Smaghi, but Fiscal Federalism is not Centralisation…

As I mentioned in an earlier post, Mr Lorenzo Bini Smaghi recently gave a speech where he addressed the issue of European Fiscal Union, at length. That post gave a pure report of the speech and made no efforts to comment on its content. In that sense, the present post is much more editorial. Although I have all the respect that may be laid at the feet of an economist with the career of Mr Bini Smaghi’s, I must admit that I take issue with his comments. I profoundly appreciate the structure which he gives to his discussion and hope to remember it for future posts, but I do believe he chose to give a certain angle to his analysis based on the emphasis he decided to put on some of the issues. This is what I will elaborate on and for it I am extremely pleased, as it gives me the opportunity to address well founded and well argued criticisms to fiscal federalism, which I believe will at least partially dominate this discussion for the years to come. For this opportunity at a break from listening to preachers to the choir and from raged Eurosceptic ignorants, I am extremely grateful to Mr Bini Smaghi.

In his speech he took a practical two step approach where he considers some of the stabilisation and efficiency pros and cons of fiscal union. My issue throughout this discussion is that I believe Mr Bini Smaghi’s account is that of a total and unqualified transfer of fiscal powers from national capitals to Brussels. In raising the worst case scenario and thus providing a practical yardstick for bad European Fiscal Federalism, he does contribute immensely to the debate, but I clearly disagree with him. Just because European federalisation could be done badly it does not mean that it will, and therefore one should not infer that it is necessarily to be avoided. Such an argument can be made whenever one discusses the possibility of pooling resources one step further and therefore is an argument generally applicable to upholding the status quo. The rest is a description of how I believe Mr Bini Smaghi articulates this argument.

Stabilisation

His argument about stabilisation is an elegant reformulation of the discussions found in Baldwin and Wyploz and in DeGrauwe. On the “pro-side”, a monetary union without a transfers’ union allows for asymmetric shocks, where a member of the currency union benefits at the detriment of (an)other(s). If member states enter the new recessionary period (brought on by that asymmetric shock) with a bad budgetary position (Greece, Portugal, Italy), or if the shock is extremely large (USA, UK, Ireland and Spain), those negatively impacted countries will not have the necessary budgetary space to navigate the turbulent new waters. However, the con is that federal transfers do not guarantee that stabilisation after symmetric shocks is “better“. This is not a moral or normative “better”, but rather seems to refer to the ability to enjoy low levels of macroeconomic volatility, which is an appropriate positive yardstick.

Particularly, federal transfers offer no incentive for countries to keep an eye out for the “long term stability of their public finances“. This point goes a long way back. The idea is that market and monetary union without fiscal union provides incentives it to address structural fragilities, which would be mitigated if a fiscal union was created. If you control your own currency you can finance your debt through inflation. This is the economic mechanism known as seigneurage, where a country that is in too much debt pays it by borrowing money from the central bank at low interests. Although it is related to quantitative easing, they are not one and the same thing. Brutishly put, seigneurage is a special form of QE, applying only to state treasury, and it stems from the priviledged institutional relationship that exists between the government and its dependent central bank. Anyway, the point that he makes is that if monetary policy has a union outlook, rather than a national one, then seigneurage will no longer be a possibility. Lacking these tools, national governments will become more fiscally prudent, pursuing more long term sustainable policies. This fact is exacerbated by the competitive pressures created by the single market. Therefore, the creation of a fiscal transfers union might mitigate this incentive, thus creating more volatility, which would be “bad”. This might  not be a fair summary of Mr Bini Smaghi’s thoughts, but it does very much sound as though he is trying to say that federations are more prone to run deficits than other institutional arrangements. I believe this to be his line of thought because he goes on to illustrate this argument by pointing out that the public finances of the USA, UK and Spain as being more volatile than the average Eurozone country. Now, I’ve had a look at the data and the only thing I can say without running a regression is that it is very risky to establish a connection between federalism a higher levels of deficits and volatility in public finances.

As the above figure shows, the UK, Spain and the USA do indeed have higher levels of volatility, than the majority of the other countries. However, Austria, Canada and Switzerland are the least volatile countries despite also being federations. Germany is around the middle and more importantly, Portugal is at the bottom while Ireland is at the top. Looking at average public deficits, rather than at their variance, describes reality better, but the relationship is still hard to disentangle. In that case you will notice that the largest average deficits in the last 15 years can be found in Eastern Europe, which is coherent with infrastructural catching up. The USA and the UK continue to have large deficits, but so does Portugal and France. Canada has an average surplus, while Greece and Japan are the most deficitary countries. I believe that Mr Bini Smaghi is exaggerating the relevance of federalist institutional arrangements as determinants of public deficits or their volatility.

Mr Bini Smaghi paints a very extremist view of fiscal federalism, where that arrangement in equated with fiscal centralisation instead of subsidiarity. Listening to him speak one ended up with the idea that member states would be completely unable to levy taxes or spend funds independently.

Efficiency Concerns

To a large extent, his overview of the efficiency aspects of a fiscal union is an extension of the cons he highlights in the previous discussion of stabilisation. Here the discussion revolves around the issue of fit between fiscal policies and economic conjuncture. The issue of efficiency can be understood as a problem of calibration and possible mismatch between economic demands and fiscal policy supply caused by not enough specialisation. The point that the speaker tries to make is that monetary union already decreases the contents of the economic toolkit available to national policy makers. Therefore, eliminating the fiscal policy tool would only destabilise matter further. If, on top of eliminating the monetary policy tool, the member states also lack the ability to set fiscal policy, then there is no tool left that can be used to address the specific needs of national economies. Mr Bini Smaghi takes a bleak look at fiscal union for fear that too much EU policy wouldn’t be able to match the needs of all member states. He does this in three ways:

  1. First he uses analogy when he compares Eastern Germany to “countries which entered with a lower per capita income”(I suppose he means Ireland, Spain, Portugal and Greece…). This is probably the weakest part of his argument, and it is clear he himself understands that. According to him, the periphery countries would be to a European Fiscal Union what Eastern Germany was to the German Federal Republic, uncalibrated. His line of thought is that fiscal union would be bad to southern European countries as it would put them in the same position as Eastern Germany after reunification. In that case, because policy was set for two very distinct economies, and with stabilisation as a priority, Eastern Germany was not given the conditions necessary for catching up as fast as say Portugal or Greece. However, his line of thought is argumentatively suicidal because he basically says that fiscal union would negatively impact on Southern European countries by putting them in the same position as Eastern Germany after reunification. There, because policy was set for two very distinct economies, and with stabilisation as a priority, Eastern Germany was not given the conditions necessary for catching up as fast as say Portugal or Greece. A much better analogy would have been Eastern Europe, but unfortunately, there are so few of those countries that belong to the Euro-zone that one can understand his need to resort to Eastern Germany. The problem, however, is that as he himself aknowledges, the periphery countries grew much “too quickly”. Because stabilisation was nowhere in sight of the priorities of periphery countries what happened was a complete lack of foresight, that led to the present sovereign debt crisis. Basically, at a time when Portugal is the envy of no one, Mr Smaghi says that European Fiscal Federalism is a bad idea because otherwise it will economically end up like Eastern Germany. This is a bit lengthy, but the truth is that that’s already true for Portugal and Greece. In the last 20 years, they’ve created very little value added. By any measure of competitiveness they are at the bottom and there is very little sign of respite.
  2. His second point about efficiency is not so much an argument as it is a warning about the construction of the incentives created by fiscal policy transfers. He therefore takes this stage of the speech to warn against the risks of what has become known as “mezziogiornalisation” (i.e.: that which refers to making things like the mezziogiorno region of Italy) and the risks of creating a culture of dependency of the poorer countries of the EU on their richest neighbours, instead of fomenting development and growth. In that sense, mezziorgiornalisation can be understood as the complete and total lack of competition between sub-units in a federal polity.
  3. Finally, he concludes this part of his speech by arguing that fiscal competition is not necessarily a bad thing and that therefore fiscal independence should be maintained. This is pretty much an extension of the issue of incentives which he had started to address with mezziogiornalization. The problem that I have with this line of thought is that it presumes that fiscal competition is only possible if there in the absence of fiscal federalism. However, this is not true. Fiscal competition is a function of many things, such as the mobility of taxed resources, the transparency of the budgetary process of the authorities involved and the manner in which the revenue burden is spread relative to the benefits distributed. I will write something about this later on because it is a very complicated issue. For the sake of this argument it is sufficient to compare Sweden to the UK, where more than 30% of the funds available to local authorities come from the central state. The rest is mostly sales and council tax. Local Councils in England are only able to raise revenue from real estate taxation. In Sweden, closer to 70% of the revenue of local authorities is levied locally, through income tax (Sweden has a two tiered income tax system, where the central government and the local authorities each levy a tax on your wage, which can amount to 60% of your income. Nonetheless, if you look at the competitiveness numbers, Sweden still ranks highly). The local authorities arrangement where they share funds, and whoever makes the highest revenues in excess must support those who can’t make it up. Notwithstanding this,  they have much more responsibilities as they have to bear a large part of the weight of providing educational and health care services. It is clear that the Swedish system by making local authorities responsible before their neighbours and their constituents for the funding necessary to fulfil their obligations creates an incentive for efficiency that does not exist in England. Fiscal federalism, if well constructed, is not detrimental to fiscal competition, which if left unchecked could also be theorised as being something bad. As with everything else, it is a matter of fine tuning.

The speaker took a clearly negative outlook on fiscal union. He went on to conclude that “it would be risky for the euro area to move to greater fiscal and budgetary integrationand that “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”.

I could also argue the case that his comment on migration is outside the purview he set himself at the beginning of the speech, to not address political concerns and that migration, unpleasant a necessity though it might be, is an economic fact and an integral part of the functioning of the adjustment mechanisms of a currency area (as described by Robert Mundel’s OCA theory). But I won’t…

Conclusion

This being said, he does indeed provide a good structure for debate. Following his discussion, I would say that European fiscal federalism would solve the asymmetric shock part of the stabilisation problem in a way that no other solution could. The best way to guarantee adequate stabilisation during symmetric shocks is through countercyclical fiscal policy, but the truth is that stabilisation can never fully be achieved due to the intrinsically cyclical nature of the economy. Stabilisations are better or worse, never perfect. Fiscal federalism has nothing to do with it. If anything, due to duplication efforts lack of federalism will cause higher costs, thus worsening the crisis by increasing debt or taxation. On the other hand, the issue of policy matching is indeed relevant and requires that fiscal federalism be achieved slowly and carefully.

Clearly there is a role for a EU level of social security, healthcare and unemployment benefits, as they are insurance policies, which benefit from spreading risk through as wide a net as possible. How much, then, becomes the question. To that effect the safest solution is to create a tiered system similar to the one in Chile. In our case we could have a EU wide level of supply and contribution that would guarantee the bare minimum standards, upon which national and subnational (public and private) levels could be added at the discretion of the member states, employers and consumers in order to ensure matching of services and taxes with the needs of all. Moreover, these programmes are automatic, so that there is little interference from corrupt politicians.

The best funding tools would probably be income taxation and VAT because they would be progressive, thus targeting the richest by income, not country of origin, so that if a country is hit by a shock and his neighbours are not, it can lower income taxes while the EU can increase them. Therefore it would increase the funds available to deal with the problem without imposing a disproportionate burden on those suffering the most. Moreover, because the EU’s level of provision would also be the lowest, it would only be triggered in the worst case scenario, thus providing assistance to those who need it most and to those who will surely consume most of their income, which in itself would help kick start any depressed economy.

This structure would clearly be built in parallel to macro prudential arrangements such as the ESRB, the EFSF (or the EMS by then) and some appropriate incentives from the fine tuning of the Stability and Growth Pact. The number of tools should remain small, and highly controlled by the member states and the European Parliament..It would of course imply transfers but it would ensure respect for subsidiarity and a calibration between the appropriate levels of revenue collection and provision necessary to maintain control of competitive incentives, welfare needs and equity concerns. We could then build on this, and fine tune it to our needs and what we’d learn from future macroeconomic experiences. Certainly to reject reform out of fear, cannot be more than the advocacy of status quo for its own sake. For that, and despite all my gratefulness, I must say I am not impressed with the substance of Mr Bini Smaghi’s contributions.

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