The Eurozone: Out Of The Ashes?

I was at a gathering a year or so back in which sensible economists were thinking about the transition path for the Eurozone to full fiscal (and banking) union. They viewed recent events as confirming that monetary union alone was not tenable, and that fiscal union was the way forward. Many share that view. I remember asking whether there was any likelihood that the treaty changes required for fiscal union would find democratic support, given recent events. To say that this interjection was regarded as unwelcome was an understatement.

In one sense this reaction was understandable. Democracy within the Eurozone is a strange thing. On occasions it has been of the ‘last time you voted you got the answer wrong, but don’t worry, we are going to give you a second chance by having another vote’ variety. On others it has been ‘if you vote the wrong way you will have to leave’ type. In these circumstances worrying about democratic opinion and fiscal union may seem beside the point.

But in a way, that is the point. My interjection at that meeting could have been far blunter. How can you be planning to move towards fiscal union when the governance structures of the Eurozone have clearly failed with a more limited set of tasks? That would be a classic economist’s mistake: of designing a set-up which works well in the hands of a benevolent social planner, but falls apart when run by actual politicians.

Take, for example, the ECB. Compared to the US Fed or the UK Bank of England, it comes a poor third. It actually raised interest rates in 2011, making its own contribution to the subsequent recession. It has consistently gone well beyond its remit in promoting certain fiscal policies or structural reforms. It took two years before coming up with OMT, giving us two years of continual crisis. It is only now thinking about QE. A basic problem is that it is not accountable for its actions, which is a serious deficiency for an unelected institution with such power.

The other reason for the 2012 recession was fiscal contraction. If you regard some fiscal contraction in the periphery countries as necessary to correct a lack of competitiveness, then the problem has been the lack of offsetting fiscal expansion elsewhere (not just Germany, but countries like the Netherlands). This has not happened in Germany in part because there is no compelling need within Germany for fiscal expansion: it has been benefiting from the lack of competitiveness of other countries, as its current account surplus shows.

In a fiscal union, fiscal policy is decided at the centre, so these national obstacles to fiscal expansion could be brushed aside. (This, of course, is one good reason why Germans might be rather reluctant to vote for such a union.) But in practice what would aggregate fiscal policy determined in Brussels look like? All the indications are that it would look much like the fiscal policy we currently have: obsessed with debt, and completely ignorant of any significant multiplier effects. The fundamental misunderstandings about fiscal policy that are embedded in German thinking are now deeply ingrained elsewhere.

Governance Evolution For The Eurozone?

To make the more general point, if a core problem is with the governance structures of the Eurozone, then handing those structures more power through fiscal union could be a huge mistake. But this realisation seems to leave us in a horrible position: we do not like the place we are in, we cannot and/or should not ‘go forward’ to fiscal union, yet ‘going back’ by leaving the Euro seems too traumatic. (See, for example, Kevin O’Rourke.)

Yet this may be a too limited, one dimensional point of view. As I have argued before, the 2010-12 crisis and the subsequent recession demonstrated the failure of one version of monetary union, but there are other possible versions. As studies before the formation of the Euro showed, monetary union needs countercyclical fiscal policy. The Eurozone ignored this point, partly because it worried that fiscal policy in the Eurozone would no longer be ‘disciplined by the market’. Until 2010 this fear was understandable, but after Greek default the opposite is true. So the need for central control on that account has disappeared.

The current Eurozone fiscal architecture is chaotic, but within it there are now two mechanisms to discipline national governments. The first and currently dominant is central control from Brussels. The second is national control through a combination of fiscal rules decided at the national level and independent national fiscal councils. Having two systems in place can be a nightmare, but the optimistic view would be that this presents the opportunity for evolutionary change. The central control mechanism could be gradually phased out, but held in reserve for when the national system broke down.

Many years ago I suggested that Eurozone countries could be allowed to opt out from the Stability and Growth Pact if they established their own sound fiscal rules and institutions. There are now enough fiscal councils around that it would be easy to get advice on whether countries had established these sound fiscal rules and institutions. A great advantage of this form of fiscal control is that there are established channels of accountability at the national level. Memories of the 2010-12 crisis, and market discipline, should ensure that a combination of fiscal rules and fiscal councils prevent deficit bias, yet leave scope for countercyclical action when required.

Commission based monitoring would be still needed in the background for two reasons. First, if a government persistently ignored the advice of the fiscal council, or compromised its independence, control at the Eurozone level could be re-established. Second, there may be occasions (like now) when coordination of national fiscal decisions is required, and here a Commission role would be essential.

I am not optimistic that this evolutionary change is going to happen anytime soon. Like any bureaucracy, the Commission will resist a reduction in its power. Germany’s own regional fiscal setup involves strong central control, so it will resist a change like this. Arguably this unholy alliance has helped create the dysfunctional system we now have. However, perhaps at some point countries like France will become galvanised by harmful pressure from the Commission to argue for some kind of alternative. That alternative does not have to be fiscal union, and in some countries a good part of an alternative institutional structure is already in place.

This column was first published on Mainly Macro