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A fiscal policy for the euro

In the past two days, Free Lunch has focused on refuting the most common reasons advanced for the supposed imperative of greater fiscal resource sharing (a “fiscal union”) between euro countries. They include the need for fiscal risk-sharing to counter economic disruptions that affect different members differently (“asymmetric shocks”), which for countries with their own currency would result in exchange rate movements. In fact, monetary unions function well with private risk-sharing through financial markets so long as excessive debt is not stopped from being restructured. They also include the claim that Europe’s banking union necessitates common fiscal resources; in fact banking union makes fiscal union less necessary, not more.

In response, several readers have raised another argument for a fiscal union in the form of a common eurozone budget: the desirability of countercyclical fiscal policy at the aggregate eurozone level. In particular, if the common central bank is technically or politically constrained from stimulating further, expansionary fiscal policy through greater deficits in the aggregate can mitigate recessions. Today we round off our considerations on eurozone fiscal union by addressing this argument.

It is certainly economically desirable to improve the fiscal management of aggregate demand management of the eurozone. As the chart below shows, the euro countries engaged collectively in an extreme degree of fiscal tightening in the 2010-12 period, which combined with monetary tightening to cause an entirely self-inflicted double-dip recession. It took several years just to undo the damage. As the chart also shows, fiscal policy never made much of a positive contribution to demand growth, even after it had stopped doing outright damage.

But this does not show that a eurozone budget is necessary. In fact it does not strictly demonstrate even that a countercyclical eurozone-level fiscal policy is necessary. If monetary policy had been much more stimulative, it could have lifted aggregate demand even in the face of fiscal contraction. Some advocates of eurozone-level fiscal Keynesianism rely too heavily on the assumption of a zero lower bound — the assertion that monetary policy runs out of ammunition when interest rates hit zero. But there is no zero lower bound, and the European Central Bank has proved as much. Admittedly, counteracting the contractionary effect of the eurozone’s fiscal tightening would have required sharply negative interest rates and a much earlier resort to (potentially bigger) securities purchases by the ECB. That would have been an extremely lopsided policy mix, but not one obviously misplaced if it had stimulated sorely needed investment spending (even in Germany).

But it is unfortunate to have to rely solely on monetary policy. In general it is better to have room for manoeuvre in fiscal policy as well, so as to secure the best balance between the two tools. And leading European policymakers have drawn the right conclusion, namely that it is economically desirable to be able to steer the overall eurozone fiscal policy stance. This view was expressed three years ago by ECB president Mario Draghi in a speech at Jackson Hole, although he unfortunately later moved his focus elsewhere. More recently, the European Commission has started to pronounce on the all-eurozone fiscal stance — late but no less welcome for that.

Still, this does not close the case for a eurozone budget. A budget is neither sufficient nor necessary for having a countercyclical policy for the eurozone as a whole. It is not sufficient because the degree of macroeconomic stabilisation is typically much smaller than the size of a budget. As I have written before, national budgets in eurozone countries that make up 40-50 per cent of the economy only manage to smooth a much smaller fraction of output swings (13-27 per cent according to one study). A common budget that was even 5 per cent of the eurozone would be hugely politically ambitious — and could be expected to have a stabilising effect only a quarter to one-fifth as strong as national budgets.

Conversely, to have substantial stabilising potential, the eurozone budget would need to be allowed to run large deficits and surpluses — with swings of perhaps 5 per cent or more of economic output over the cycle. In other words, the amount of annual borrowing (or saving) could be greater than an entire annual budget of a politically realistic size: the stabilisation tail wagging the budget dog. One may ponder whether this is achievable, or whether one would not instead be left with a budget that did not achieve much stabilisation at all.

Fortunately, a eurozone budget is also not necessary for doing aggregate fiscal policy. The commission’s recent focus on the overall fiscal stance points the way to an alternative: Brussels could make the eurozone’s fiscal stance central to how it exercises its surveillance over national budgets. When an aggregate fiscal stimulus is required, the commission should suspend any limitations on national deficits, and discourage or even penalise national budgetary plans that are insufficiently stimulative (which is not the same as penalising surpluses — only growing surpluses). As I have argued before, this would not be in violation of the EU’s fiscal rules; there is a good argument that the EU treaties demand such flexibility. The power is in any case in the commission’s hands.

As with the other arguments, fiscal union is likely not to live up to the responsibilities advocates place on its shoulders. That makes it politically unwise to pursue. Not just because it would waste energy and attention better deployed elsewhere (such as the alternative way of achieving the right aggregate fiscal stance proposed here, or to reinforce bail-in and private risk-sharing). But also because it would create political risks of its own. Suppose a fiscal union is forced through painfully in the face of popular resistance (against resource sharing in creditor countries, and against centralised control in debtor countries), on the basis that it is economically necessary to make the euro function. What then, if the fiscal union sees the light of day but fails to fulfil its promise — and deep recessions and debt panics happen anyway? Support for the euro would be badly damaged. That happened once, after the awful experience of the eurozone “rescue” programmes put in place in 2010-13 — temporary fiscal unions in all but name.

The euro is regaining its popularity as the damage from crisis and those mistakes begins to recede. The last thing Europe needs is to double down on the same toxic politics.

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