The global financial crisis exposed the euro’s original sin of depriving member states of their fiscal autonomy without transferring this spending power to a higher authority. This left member states utterly defenceless in the face of economic crises such as the 2008 booms-gone-bust. Yet, the crisis didn’t bring about, as one might have expected, a loosening of the budgetary constraints imposed on individual governments (thus allowing them to pursue counter-cyclical stimulus policies) or by moving towards a fully-fledged fiscal union (or at least a modicum of economic coordination between surplus and deficit countries). Instead, we got the worst of both worlds: further restrictions on national fiscal autonomy and no increase in federal fiscal capacity. The result, as predicted by many non-mainstream economists, has been a deeper and more prolonged crisis than that of the 1930s (resulting in all-out humanitarian crises in a number of countries).
There are now a number of official proposals on the table – most notably the European Council’s 2012 Towards a Genuine EMU, the European Commission’s 2015 Completing Europe’s EMU and several reports by the European Parliament – that propose to address this structural flaw by creating a fiscal and (ultimately) political union. This would be a welcome development, were it not for the fact that the ‘brave new eurozone’ envisioned here falls very short of the kind of fiscal and political union advocated by progressive federalists.
Politically, it raises serious problems of accountability and democratic scrutiny/participation, since this proposed transfer of sovereignty does not foresee any analogous and proportionate transfer of democratic legitimacy, accountability and participation to the supranational level. Economically, it doesn’t foresee any real spending powers for this new supranational authority (such as the ability of EMU to run budget deficits with the support of the ECB, fiscal transfers from richer to poorer countries, etc.); it is likely instead to revolve first and foremost around the creation of a European budget commissioner with the power to reject national budgets. It’s not hard to see why such a development would be politically unsustainable, further exacerbating the union’s centrifugal tendencies. At the same time, we have to acknowledge that political conditions are not ripe for a move towards a fully-fledged fiscal and political union, along the lines advocated by progressive federalists. So – barring a break-up scenario – what options does that leave us within EMU?
A decentralised fiscal stimulus
The only sensible solution in the short-to-medium term is to allow individual member states to adopt a more expansionary fiscal stance. It has been argued that this could be realised within the current institutional framework – making optimal use of the ‘flexibility’ contained in the SGP, say, or reconsidering the Commission’s method of cyclical adjustment – to obtain a eurozone-wide expansionary fiscal stance of 2-3 per cent of GDP. While this would be welcome, we believe that for some countries it would be insufficient, given the extensive damage caused by years of fiscal austerity. We posit that a better way forward would be to adopt a balance sheet recession approach to the problem, as suggested most notably by Richard Koo. This means understanding that a number of eurozone countries, especially those of the periphery, are in so-called balance sheet recession – where individuals and companies, following the burst of a debt-financed bubble, collectively focus on saving rather than spending, thus reducing aggregate demand – and hence should be allowed to pursue much more expansionary fiscal policies until private sector balance sheets are repaired.
More specifically, it means that private-sector savings levels have to be taken into account when evaluating the ‘optimal’ fiscal stance of member states. According to 2015 flow of funds data, private-sector savings amounted to 10.8 per cent of GDP in Ireland, 7 per cent in Spain, 6.8 per cent in Portugal and 6.3 per cent in Italy. This means that there are sufficient levels of excess (i.e., unborrowed) savings to support a fiscal expansion in the order of 6-8 per cent of GDP in most periphery countries. Unfortunately, the EMU’s current budgetary rules – which prohibit governments from running sustained deficits of more than 3 per cent of GDP regardless of the size of private-sector savings – make no provision for this type of recession.
It is often argued that German taxpayers would never sanction a fiscal stimulus in periphery countries, but the existence of huge pools of private savings there means that if those savings were to return to the domestic government bond markets, the ultimate cost to those German taxpayers would be zero. That said, periphery countries need to ensure that idle savings in these nations do not flow abroad but are invested in local government bonds. As Koo argues, this could be achieved by ‘re-internalising’ fiscal policy in the EMU: that is, by limiting the sale of governments bonds to the citizens of each country. A softer version of this plan would involve the introduction of different risk weights for local and foreign bonds. The proposed new rule would allow individual governments to pursue autonomous fiscal policies within its constraint. In effect, governments could run larger deficits as long as they could persuade citizens to hold their debt.
The role of the ECB: the need for a new ‘whatever it takes’
It goes without saying that this decentralised fiscal stimulus can only work if the ECB evolves into a fully-fledged lender of last resort, because member states need to be insulated from any doubts that financial markets may have concerning their solvency or euro membership. In practical terms, the ECB would simply have to pledge to do ‘whatever it takes’ to keep the interest rate differential between member states below, say, 30 basis points. This would ensure that member states would be able to finance themselves at reasonable costs even after the tapering of the ECB’s QE programme. The ‘fiscal effect’ of such a decision would be no different from that of the QE programme, and thus should not raise concerns of ‘monetary financing’ of government deficits.
It could be argued that the ECB would be taking on a big risk – and mutualising it – by buying the bonds of potentially insolvent governments. This is irrelevant for two reasons. First, as with the OMT programme, it is likely that the ECB will not have to directly intervene in secondary bond markets to keep the spread within the predetermined boundary. Second, even assuming that the ECB were forced to intervene, and that the value of those bonds were then to decline (or if the country in question were to default on its ECB-held debt), this would not expose the ECB or the other governments of the EMU to any losses in the traditional sense of the word, as convincingly argued by De Grauwe and Ji. As noted in a recent ECB paper, modern central banks, quite simply, cannot default:
Central banks are protected from insolvency due to their ability to create money and can therefore operate with negative equity.
This implies that the central bank needs no fiscal backing from the government(s). A more serious issue is that of moral hazard. As with all insurance mechanisms, this risk exists. But, as De Grauwe notes, ‘this risk of moral hazard is no different from the risk of moral hazard in the banking system’, or in any extra-EMU country for that matter:
It would be a terrible mistake if the central bank were to abandon its role of lender of last resort in the banking sector because there is a risk of moral hazard. In the same way it is wrong for the ECB to abandon its role of lender of last resort in the government bond market because there is a risk of moral hazard.
Ultimately, the best insurance against moral hazard is to ensure that the decentralised fiscal stimulus that we propose is put to good use. We believe that the benefits of such a solution far outweigh the risks: not only would it have an immediate macroeconomic impact, it would also engender a more positive attitude towards European institutions (no longer seen simply as enforcers of watertight fiscal rules), thus slowly re-creating the conditions for eventually moving towards a true solidarity-based and democratic fiscal and political union.
A more exhaustive version of this proposal can be found in the paper Why further integration is the wrong answer to the EMU’s problems: the case for a decentralised fiscal stimulus, winner of the 2016 Progressive Economy call for papers in the category ‘Reforming the Economic and Monetary Union’.