Options for Europe – Part 52

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).


1992 – The backfilling begins

The design of the EMU agreed on in Maastricht reflected a range of factors, none of which made any real macroeconomic sense. The French were obsessively motivated by its desire to end the threat of German militarism within Europe forever. The Germans, suffering an unspoken shame for their past militarism and associated deeds, had only their economic success including the ‘discipline’ of the Bundesbank as a source of national pride. They wanted to be part of the ‘European Plan’ to demonstrate a rejection of their past history but their obsessive fear of inflation meant that this had to be on their own terms, which meant that the new Europe had to accept the Bundesbank culture. Within the German ‘stability’ environment, it was seemingly overlooked that the nation relied on robust import growth from other European nations. The fact that not all nations can have balance of trade surpluses was ignored. They also wanted political integration via a strengthened European Parliament but that fell by the wayside as the Maastricht negotiations concentrated on the economic and monetary goals.

Overlaying this political play-off between France and German, which had dominated European affairs since the end of the Second World War, came an even more destructive force – the surge in Monetarist thought within macroeconomics, first within the academy, then into policy making and central banking domains. Unemployment became a policy tool to allegedly maintain price stability rather than a policy target as it had been up until the mid-1970s. National governments deliberately created persistently high levels of unemployment by suppressing spending as they sought price stability. The import of the new paradigm in economics for the design of the EMU was two-fold. First, there was a rejection of any need to develop a European-level fiscal function to work in tandem with the proposed European Central Bank. All sorts of sophistry was used to justify this decision, including a specious appeal to the principle of subsidiarity but the reality is that the politicians, infested with Monetarist thought, which eschewed the use of active fiscal policy, didn’t want much fiscal latitude to be built-in to the design of the EMU. Second, once it was clear that the fiscal and social policy functions would continue to be the responsibility of the national governments, the politicians had to ensure the straitjacket could be applied down to that level. The proposed imposition of tight fiscal rules – deficits no greater than 3 per cent of GDP and public debt no greater than 60 per cent of GDP – would they thought accomplish that goal. As we have learned earlier, these rules had no economic motivation. They were arbitrary but considered to be tight enough to satisfy the priority for price stability even though no research was published to robustly demonstrate how these fiscal rules would be necessary or sufficient to maintain a stable and low inflation environment.

The whole process had a surrealistic air about it at the time.

Once the Treaty was signed in March 1992, the European Commission and a phalanx of sympathetic economists set about ‘backfilling’ – producing research papers, which apparently provided intellectual and evidential authority to justify the decisions that had been made and to ‘prove’ how sound the Treaty parameters were. It was theatre, of the high farce variety.

In 1993, the European Commission’s own in-house economics journal, European Economy, published a “Report of an independent group of economists” on “Stable money – stable finances”, which summarised the more detailed papers presented in an accompanying publication The economics of Community public finance (see Commission of the European Communities, 1993a, 1993b, respectively). A footnote to the title of the summary report noted emphatically that the “opinions expressed in this report remain the sole responsibility of the group members and not that of the Commission and its services”, and, if we weren’t already convinced that this was an ‘independent’ study, the Preface opened with the statement that the ” European Commission’s Directorates-General for Economic and Financial Affairs and Budgets asked a group of independent economists to examine the role of the Community public finance in the perspective of economic and monetary union” (Commission of the European Communities, 1993a).

A “core issue” dealt with in the Report was “whether European union will … need a big central budget, to make EMU successful and sustainable” (Commission of the European Communities, 1993a: 3). The Report indicated it was following in the footsteps of the 1977 Macdougall Report, which was the product of a similar exercise, whereby the European Commission assembled a group of economics to study how federal systems function in a fiscal context (Commission of the European Communities, 1977).

It is very interesting to briefly compare the reports. The Macdougall Committee assembled for the first time in April 1975 and met on fourteen occassions, finally reporting in April 1977. The 1993 Report was produced after only four meetings of the group of ‘experts’ in a much shorter time frame.

The panel of European economists assembled also sought advice from economists in non-European federal systems. In the case of the 1977 committee, it called on the services of Professor Wallace Oates, who was then at Princeton and had published some seminal works on public finance, and Professor Russell Mathews, who was at the Australian National University. Both Oates and Mathews were Keynesian economists.

Oates’ first major piece on the topic was published in 1968. In that paper he argued that (Oates, 1968: 44):

… the case for the central government to assume primary responsibility for the stabilization function appears to rest on a firm economic foundation … local government cannot use conventional stabilization tools to much effect and must instead rely mainly on beggar-thy-neighbour policies, policies which from a national standpoint are likely to produce far from the desired results. The central government, on the other hand, is free to adopt monetary policies and fiscal programs involving deficit finance where it is necessary to fulfill the compensatory function. Thus, the Stabilization Branch must do its job primarily at the central-government level.

In other words, when a federal system is experiencing an economic downturn, perhaps due to a fall in private consumption or investment spending, which may be asymmetric in incidence (that is, affect states within the federation unequally), then the federal government must be able to use deficit spending to compensate for the loss of private spending.

The Australian economist Russell Mathews was a long-time supporter of a strong federal stabilisation function. His final co-authored book – The Public Sector in Jeopardy – the authors argue that Australia’s poor economic performance in the late 1970s and into the 1980s was due to the adoption by the Federal government of Monetarist ‘fight inflation first’ policies, their attacks on public expenditure, and their unqualified belief in the virtue of self-regulating free markets (Mathews and Grewal, 1997).

Contrast that with the non-European economists that the 1993 exercise engaged. First, Canadian economics professor Tom Courchene, who was at the conservative Queens University in Kingston, a centre of Monetarist thinking in the 1980s and 1990s, promoted the concept of ‘hourglass federalism’, which believes “that very generous levels of federal-provincial welfare support and interprovincial equalization transfers have created in Canada a version of ‘transfer dependency'” (Commission of the European Communities, 1993b: 6). The transfers were also alleged to undermine the “natural economic adjustments”, such that unemployed workers would move to areas where jobs were available in times of recession, a major article of free market doctrine that denies that unemployment can become entrenched. When mainstream economists talk about ‘natural’ forces they are not considering anything to do with nature or physics – rather using code for the alleged free market outcomes, that so often never appear in the real world. Courchene also claimed that the design of the EMU with its “more severe fiscal restraints” (p. 6) relative to Canada would lessen the damage done by federal spending.

The other economist was Cliff Walsh, who was at the University of Adelaide in Australia at the time and a well-known advocate of the alleged benefits of dismantling regulation and of the government running surpluses. He argued that the traditional literature on federalism (for example the work of Wallace Oates) was of “limited direct application” to the European situation because of the “unique constitutional and political arrangements in the Community” (p. 27). He claimed that, unlike “mature federations” where a “substantial degree of homogeneity in preferences for core public sector services” exists (p. 49) and supports a strong central fiscal function (a basic finding from the traditional literature), the situation in Europe is different. He surmised that “the differences in preferences may be sufficiently large in the Community to suggest that to transfer to the Community level many of the functions naturally allocated to central governments … elsewhere … would impose excessive uniformity costs” (p. 27). He also suggested contrary to the “traditional glib assertions in the fiscal federalism literature, the presumption that macroeconomic management should be essentially and virtually exclusively a central government function … is strictly required”. He concluded that coordinated fiscal rules across decentralised fiscal units “may provide the most effective framework for macroeconomic management” (p. 46).

While the 1993 Report was used to justify the design of the EMU that the politicians had agreed on at Maastricht, the 1977 Macdougall Report provided sufficient analysis and evidence to allow us to predict that the creation of the EMU in the form that was eventually agreed in the 1991 would fail.

The Macdougall Report involved (Commission of the European Communities, 1977: 11):

… a detailed and quantitative study of public finance in five existing federations U.S.A., Canada, Australia, Switzerland) and three unitary states of Germany, (France, Italy and the U.K.) … and in particular the financial relationships between different levels of government and the economic effects of public finance on geographical regions within the countries.

In other words, the panel sought to work out how a common currency system might operate where there are decentralised government structures with fiscal capacities and a currency-issuing central bank. What sort of fiscal function should be allocated to the federal ‘government’?

A close reading of the Macdougall Report will leave one wondering why the Eurozone was ever created. The major issues they highlighted were clearly still relevant in the 1990s as the European political elites rammed through their ill-thought out plan for a single currency.

The Macdougall Report concluded that (p. 11):

It is most unlikely that the Community will be anything like so fully integrated in the field of public finance for many years to come as the existing economic unions we have studied.

The panel found that per capita income inequality was “at least as unequal” between the EC states (9 at the time) and the 72 regions that comprise these states “as they are on average between the various regions of the countries we have studied” (p. 12). Once the “equalising effects” of national government spending and taxation was taken into account, “regional inequalities in per capita income” in the nations studies were reduced “on average” by “about 40%” (“by more in Australia and France, by less in the U.S.A. and Germany”) (p. 12). But the “redistributive power between member states of the Community’s finances, by comparison, is … very small indeed (1%); partly because the Community budget is relatively so small” (p. 12). The “redistribution through public finance between regions in the countries studied tends to be reflected to a large extent … in corresponding deficits in the balances of payments on current account of tbe poorer regions, with corresponding surpluses in the richer regions. These deficits and surpluses are of a continuing nature” (p. 12).

Significantly, for our purposes, the panel concluded that (p. 12):

As well as redistributing income regionally on a continuing basis, public finance in existing economic unions plays a major role in cushioning short-term and cyclical fluctuations. For example, one- half to two-thirds of a short-term loss of primary income in a region due to a fall in its external sales may be automatically offset through lower payments of taxes and insurance contributions to the centre, and higher receipts of unemployment and other benefits.

In other words, an effective federation required a strong fiscal presence at the federal level to smooth out economic fluctuations at the sub-federal level. In that regard, the Macdougall Report concluded that (p. 12):

… there is no such mechanism in operation on any significant scale as between member countries, and that is an important reason why in present circumstances monetary union is impracticable.

The factors that the panel of ‘experts’ considered in 1977 would have rendered monetary union then “impracticable” in 1977 were subsequently built-in to the Maastricht Treaty.

The tone of the 1993 Report was very different indeed and reflected the dominance of Monetarist thinking in macroeconomics at that time. It concluded that (Commission of the European Communities, 1993a: 1):
Community-wide stabilization should be achieved by the single monetary policy and the coordination of national budget policies.

Under the bolded heading “Beware of centralization” (p. 4) we learn that centralisation undermines the delivery of public services “tailored more to the preferences of the population” and that “democratic control is more effective” at the local level. These propositions were advanced by the new ‘public choice theory’ which became one of the neo-liberal ‘attack dogs’ used to undermine the legitimacy of government service provision and deficit spending.

It is ironic to consider these claims to democratic superiority of a decentralised EMU, which were used to justify the design of the EMU in the first place, in the context of the austerity regimes imposed by the Troika (the European Commission, the European Central Bank and the International Monetary Fund) in recent times on elected Member State governments of the EMU. We will return to that discussion in a later chapter.

The 1993 Report came up with the necessary conclusion under the bolded heading “A small budget will do” (p. 6). The panel concluded that:

The central message of the report is that a small ‘EMU budget’ of about 2% of Community GDP is capable of sustaining European economic and monetary union … This is clearly contrary to much of the conventional economic wisdom, reflected in the MacDougall report as well as in the literature on economic and monetary union.

So how did they justify a denial of the evidence base to date? They simply asserted that the “principle of subsidiarity is applied rigorously” (p. 6), even though we have already learned that a correct understanding and application of that principle would support the MacDougall ‘wisdom’. Second, the merely asserted that there would be “No explicit role for the Community budget in Community-wide macroeconomic stabilization” (p. 6). Why not? Simply, because consistent with the Monetarist religious doctrine only monetary policy mattered and the creation of the European Central Bank would be more than enough to prevent recession. In addition, they asserted that the coordination of fiscal policies across the Member States would prevent individual governments from undermining the independent monetary policy. They also concluded that the “shock-absorption mechanism” built into each Member State fiscal policy (automatic fluctuations in taxation and spending as economic activity varied) would be sufficient “to provide a cushion against adverse developments” (p. 7). To give you an idea of how lacking in understanding this panel was they concluded (p. 7):

For a shock absorption scheme based on changes in unemployment rates, the group estimates that the average annual expenditure might be of the order of 0,2% of EC GDP.

As we will see, the fluctuations in 2008 that actually happened were of a scale significantly larger than this, such that one could consider their estimates comical, if they were not part of a regime that has caused millions of workers to lose their jobs.



Additional references

This list will be progressively compiled.

Commission of the European Communities (1977) ‘Report of the Study Group on the Role of Public Finance in European Integration’, April 1977 (MacDougall Report). http://ec.europa.eu/economy_finance/emu_history/documentation/chapter8/19770401en73macdougallrepvol1.pdf

Commission of the European Communities (1993a) ‘Stable Money – Sound Finances’, European Economy, 53.

Commission of the European Communities (1993b) ‘The economics of Community public finance’, European Economy – Reports and Studies, No. 5.

Mathews, R.L. and Grewal, B.S. (1997) The Public Sector in Jeopardy: Australian Fiscal Federalism from Whitlam to Keating, Centre for Strategic Economic Studies Victoria University.

Oates, W. (1968) ‘The Theory of Public Finance in a Federal System’, Canadian Journal of Economics, 1, 37-54. http://www.econ.umd.edu/research/papers/335

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

This Post Has 2 Comments

  1. Bill, wouldn’t you agree that Oates was a tad optimistic when he wrote that “the nature and effectiveness of stabilization policy by central governments are now relatively well understood”? I would have thought that Osborne’s, and others’, austerity policies show that he, and they, fail(s) to understand what might well have been understood by enlightened policy-makers when Oates wrote this. Too bad we seem to be going backward in time to the 1920s when virtually everyone advocated austerity as “the solution”.

  2. Q re Oates’s equations: if the commodities market and trade balance equations entail that the financial asset market is in equilibrium (according to Walrus’s law) according to Oates, then if the financial asset market is never, or almost never, in equilibrium (the relevant equation is never, or hardly ever, true), either the commodities market equation or the trade balance equation must be wrong in some way. Or am I missing something?

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