11 April 2013

Deutsche Bank: Do all roads lead to fiscal union?

This paper argues that every step in the direction of a fiscal capacity, of whatever nature, would require a strong supervisory authority that is not only able to prevail over opportunistic governments, but also able to exert influence on negative structural developments in the individual countries.

The report examines some of the options for achieving deeper fiscal integration in the eurozone that are currently being discussed most:

1. a common budget,
2. an insurance mechanism against strong cyclical fluctuations,
3. a common unemployment insurance scheme and
4. an equalisation scheme for interest burdens.

While all of these mechanisms are based on economic foundations, they open the door to moral hazard incentives for the member governments. As the Stability and Growth Pact has shown, this is why instruments are needed to discipline governments and to respond to negative developments. This insight is crucial for any reform of the fiscal architecture in the eurozone.

Compared to the United States as a long-existing, successful monetary union, the eurozone has substantial shortcomings when it comes to absorbing regional shocks. This is the consequence of a smaller degree of financial and real economic integration and a federal architecture without reactive stabilisation components. For this reason, fiscal instruments to drive the synchronisation of business cycles and absorb asymmetric shocks may indeed be in the common interest of all the euro countries.

The options under discussion at present would mean a fundamental departure from the European framework. This mainly raises the question of how they could be put into practice without this leading to irreversible negative developments. After all, the eurozone is a much more heterogeneous economic area than the United States in many respects, and there is arguably less of a sense of solidarity between its members. Given the fundamental imbalances in Europe, however, fiscal integration will not be manageable without redistribution components.

Citing the current crisis as justification for a fiscal union would be misguided, though. The sovereign debt crisis had its roots in the combination of a largely symmetric shock, which only developed strongly asymmetric effects over time, and severe country-specific shocks. Since the GIIPS countries generate roughly 25 per cent of eurozone GDP, the countries hit less hard would probably only have been able to fund a fiscal capacity with negative repercussions for their own growth. A fiscal capacity would not solve the structural problems of the member states anyway. In the worst case, it would tend to delay their elimination since it would reduce the immediate pressure to push through reforms.

Full paper

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