Options for Europe – Part 71

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).

Part III – Options for Europe

Chapter 22 Establising a European fiscal capacity to save the Eurozone

An obvious economic solution for the Eurozone is to bring the fiscal policy responsibilities (spending and taxation) into line with the monetary responsibilities. The necessity of this alignment was recognised by the Werner Committee in 1970 and the MacDougall Study Group in 1977 but ignored, for ideological reasons, by the Delors Committee in 1989. Reflecting on our earlier discussion, the Werner Report (1970: 10) concluded that for EMU cohesion “transfers of responsibility from the national to the Community plane will be essential”. Moreover, the “transfer to the Community level of the powers exercised hitherto by national authorities will go hand-in-hand with the transfer of a corresponding Parliamentary responsibility from the national plane to that of the Community. The centre of decision of economic policy will be politically responsible to a European Parliament” (p.11). In a similar vein, the MacDougall Report (1977: 12) concluded in relation to the need for a mechanism to cushion “short-term and cyclical fluctuations” that “because the Community budget is so relatively very small there is no such mechanism in operation on any significant scale, as between member countries, and this is an important reason why in the present circumstances monetary union is impracticable.” Pisani-Ferry et al (2013: 1) also argue, in the light of the experience, that “a monetary union requires some form of budget for fiscal stabilisation in case of shocks, as a backstop to the banking union”. Paul De Grauwe also argues that abandoning the common currency “would have devastating consequences” but the only other choice for salvation is to “move toward fiscal union” even though he considers it to be a “distant prospect” (De Grauwe, 2013).

The current design of the Eurozone determines that the Member State governments are not ‘sovereign’ in the sense that they are forced to use a foreign currency and must issue debt to private bond markets in that foreign currency to fund any fiscal deficits. Their fiscal positions also must take the full brunt of any economic downturn because there is no ‘federal’ counter-stabilisation function. The EMU is a federation without the most important component. These defining characteristics introduce extreme vulnerability to economic fluctuations, such that the Member State governments face default risk (they can become insolvent) if the bond markets decline to purchase their debt, and, further, they are unable to guarantee the viability of their financial systems (that is, their banks can become insolvent). One of the major consequences of creating a central bank with no corresponding fiscal government is that the Member States must issue debt in what is effectively a foreign currency – the Euro. De Grauwe notes that this means the governments “cannot provide a guarantee to bondholders that the cash will be available to pay them at maturity” (De Grauwe, 2013). It is a basic characteristic of any monetary system that the government can only create risk free liabilities if they are denominated in its own currency. The fact that the political leaders chose this design is astounding given it stood no chance of withstanding a major event such as the GFC. While the GFC has been an unusually severe negative ‘shock’ to the world economy, in that it was caused by unsustainable private borrowing and a collapse of asset prices, which then infiltrated the real economy, the Member States in the Eurozone would also have been vulnerable if the recession had been of more usual origins – a decline in private investment sentiment, which reduced the rate of capital formation. The design of the Eurozone ensured it was a disaster waiting to happen.

The establishment of a full fiscal union would bestow on the ‘federal’ fiscal authority (hereafter FFA) the capacities that we outlined in Chapter 18 and would certainly offer a relatively speedy solution to the economic mess. The FFA could also benefit from Overt Monetary Financing (OMF), which we discuss in Chapter 23. Combined with the abandonment of the SGP, the FFA could set about restoring domestic demand in the Member-State economies through a combination of direct employment schemes, investment in improved education, health and training capacity, increased pension and fixed income entitlements where appropriate, major public infrastructure projects including better and greener ports, airports and public transport systems. The spending injections would kick start the regional economies, increase household and business confidence and inspire a private spending recovery as incomes and jobs became more secure. It is likely that the FFA would have to run fiscal deficits significantly higher than those allowed for under the SGP, which means that any attempt to impose such fiscal rules on it would be self-defeating.

The establishment of a FFA would address the major constraints on recovery at present. First, it would directly redress the stagnant spending conditions across the Eurozone. Second, it would mesh perfectly with the proposal to create a full banking union. The FFA would be uniquely equipped to ensure that bank deposits were not vulnerable. Consistent with the observations that the Werner Committee made about the need to ensure the loss of national fiscal power to the centre did not undermine democratic processes, the FFA should become responsible to the European Parliament. There should be no capacity for the European Commission or Council of Ministers (Ecofin) to dominate this new ‘governmental’ body. In Australia, for example, the federal government regularly meets with the Premiers and Treasurers of the State governments but the latter group are not part of the federal treasury or economic and finance ministries. The role of the FFA is to take a federal view of things rather than be a forum for deal mongering, which primarily reflect national level intrigues and enmities.

The notion of a FFA also has implications for how public debt is issued and who is responsible for it. While OMF would be the preferable way to consolidate the fiscal policy responsibilities and operations of the FFA with the monetary policy obligations and related liquidity management functions of the ECB, we will assume that the FFA issues its own debt to the private bond markets to match any fiscal deficits that they would run. That is, the FFA would have to possess the capacity to issue federal bonds, which because it was intrinsically linked to the currency-issuer (the ECB) would carry no default risk. The FFA Eurobonds would have the same risk-free status as debt issued by the Japanese, US, UK, Australian and other ‘sovereign’ governments. Debt issued by the Member State would still carry default risk but that could be significantly reduced through guarantees provided by the FFA. Another option could be that the FFA uses its superior borrowing capacity to raise funds on behalf of the Member States using some sort of federal-state partnership agreement. All of these arrangements are, however, nuances of the overall fact that the creation of an FFA with its own debt-issuance capacity would solve the so-called sovereign debt crisis immediately in the Eurozone. The ECB could also easily subsume all the outstanding Member-State debt and write it off as a new beginning. If there was truly a federal spirit operating, none of the ‘better-off’ Member States would begrudge this sort of debt redemption.

The FFA would replace the existing European Stability Mechanism (ESM), which is not equipped to fulfill the required fiscal role. While the necessary changes to the Treaty were being made, the European Parliament could set up the FFA and establish its mission and operational capacities. In the transition phase, the ECB could continue to guarantee all Member State debt via the Outright Monetary Transactions’ Programme (OMT), which was introduced in September 2012 to replace the Securities Markets Program (SMP). Both programs had the same intent – the ECB would stand ready to buy up Member-State government bonds in the so-called secondary markets (that is, after the government had already issued them by auction tender to the private bond markets) to ensure that demand was always strong and, hence, yields (interest rates) were low. As we learned in the previous chapter, the flaw with the OMT program is that the ECB imposes so-called ‘conditionality’ on the governments in question – which is code for austerity. The conditionality has two effects. First, it locks the nation into recession with persistently high and in some cases rising unemployment. Second, the on-going economic stagnation that it causes means that the fiscal position remains above the fiscal rules, which leads to further calls for austerity. It is a vicious cycle of stupidity. The OMT could easily support increased fiscal deficits at the Member-State level while the Treaty was being changed to allow the FFA to take over. The point is that the OMT program (or similar) is a very effective device imposed by the currency-issuer, to render the private bond markets powerless to influence bond yields. The ECB can effectively buy up all the debt as it is issued and deal private sentiment out of the picture. This is the capacity that any central bank has in a more traditional federation. It should definitely use that power but not then impose conditions on its use, which are self-defeating.

The problem is that this option is not politically or culturally tenable as the MacDougall Study Group clearly understood. An essential requirement for an effective monetary system is that the citizens have to be tolerant of intra-regional transfers of government spending and not insist on proportional participation in that spending. The other side of this coin is that a particular region might enjoy less of the income they produce so that other regions can enjoy more income than they produce. To achieve that tolerance there has to be a shared history which leads to a common culture and identity. Are the citizens first and foremost Germans or Europeans. Language is an aspect of this but not necessarily intrinsic. In a successful federation such as Australia, people in the states of NSW and Victoria might complain that the smaller state of Tasmania gets a disproportionate amount of government assistance relative to its ‘tax base’ which invokes the claims that some Australian states ‘subsidise’ others. However, when it comes down to it there is no serious discussion that these federal transfers should stop or that the the states with the weaker economies should be forced to endure a lower material standard of living than any other state. Further, when there is a major dilemma facing one state (perhaps a natural disaster or a significant economic downturn), it is assumed, without question, that the federal government will offer financial assistance to the beleaguered state. The point is that an effective federal system has to share a common sense of purpose and togetherness to ensure that the monetary system works for all states rather than those that have powerful economies. That capacity and required tolerance is largely non-existent in the Eurozone, which is why talk of a fiscal union will be largely inconsequential.

An example of this political and cultural shortfall in Europe is the fact that within a European Union, politicians think it is appropriate to refer to large economies such as Spain and Italy as “peripheral” nations. The core-periphery nomenclature came out of development economics with the peripheral nations or regions being under- or less developed without basic infrastructure or human capital. To refer to civilisations as rich as Italy and Spain in this way indicates a deep malaise. George Soros noted that “the terms ‘center’ and ‘periphery’ have crept into usage almost unnoticed, although in political terms it is obviously inappropriate to describe Italy and Spain as the periphery of the European Union. In effect, however, the euro had turned their government bonds into bonds of third world countries that carry the risk of default. This fact was ignored by the authorities and it is still not properly recognised. In retrospect, that was the root cause of the euro crisis” (Soros, 2013).

Moreover, it is not just a matter of historical and cultural differences that are at odds with the idea of a fully integrated economic and political union. It is clear that for the FFA to provide effective fiscal support for growth and prosperity in the Eurozone, a major paradigm shift in economic thinking is required. The combination of the old hatreds and suspicions in Europe with the emergence of the Monetarist, neo-liberal economics as the dominant mindset led to the Delors Report and the subsequent design of the Maastricht Treaty. That mindset biases the Eurozone towards stagnation. A new way of economic thinking, which recognises the opportunities that a truly sovereign federal government has if it utilises its currency appropriately, is required. If that way of thinking could emerge then the design of the FFA and its operational charter would follow easily. The expectation would have to be, however, that no such change will be forthcoming on a European-wide scale, such is the grip that neo-liberalism has on the economics profession.

In that context a number of what we might call ‘hybrid’ schemes have been proposed, which mostly offer compromises to the status quo, which means they will not be able to deliver lasting prosperity and reduced vulnerability to Eurozone nations.

[TO BE CONTINUED – CONCLUDING REMARKS FOR THIS OPTION WILL COME TOMORROW]

Additional references

This list will be progressively compiled.

De Grauwe, P. (2013) ‘Debt Without Drowning’, May 9, 2013. http://www.project-syndicate.org/commentary/the-debt-pooling-scheme-that-the-eurozone-needs-by-paul-de-grauwe

Soros, G. (2013) ‘How to save the EU from the euro crisis’, UK Guardian, April 10, 2013. http://www.theguardian.com/business/2013/apr/09/george-soros-save-eu-from-euro-crisis-speech

Varoufakis, Y., Holland, S. and Galbraith, J.K. (2013) ‘A Modest Proposal for Resolving the Eurozone Crisis, Version 4.0’, July 2013. http://varoufakis.files.wordpress.com/2013/07/a-modest-proposal-for-resolving-the-eurozone-crisis-version-4-0-final1.pdf

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