One money, one polity: the case for fiscal union

Compare and contrast. Here is the Christian Democratic Union and Christian Social Union (CDU/CSU) manifesto for the forthcoming German election:

“The associated European borrowing is temporary and one-off. It is not – and must never be – an entry into a debt union. For a responsible financial and budgetary policy in the member states, liability and responsibility must remain in one hand. The treaties speak a clear language: each member state is liable for its own debts. We continue to reject the communitarisation of member state debts or risks. For we want a genuine stability union and not a debt and liability union.”

And here is their leader, Armin Laschet, talking to the Financial Times on 21 June:

“All in all, I think we need an ever closer union … We need more qualified majority voting, including in foreign policy. We need a stronger economic commissioner … We need to move towards a common economic policy, not only a common monetary policy  … and towards a European constitution.”

While it is not unusual for a leader never to have read his own party’s programme, German manifestos matter because they are the basis for the coalition negotiations which must begin immediately after the close of polls. One hopes Laschet is not a victim of what Jürgen Habermas calls the smug self-deception of German pro-Europeans. The outcome of September’s elections in Germany matters to the future of Europe. The next Bundestag may well have to approve constitutional changes to allow the EU to move forward to fiscal union. The Federal Constitutional Court at Karlsruhe, not a stranger to pedantry, remains vigilant against unorthodox fiscal behaviour which might breach the EU treaties or the German Basic Law.

The ultra-orthodox statement by the Christian Democrat party apparat is the more alarming because very few people outside Germany still cling to the notion that the construct of Economic and Monetary Union (EMU) designed in the conditions of the 1990s is stable or defensible. In fact, both Jacques Delors and Helmut Kohl were adamant at the outset that the process of EMU would not be complete without political union. Inventing a single currency before the Union created a treasury seemed mighty odd. Centralising monetary policy while leaving fiscal policy in the hands of the member states was never going to be a long-term solution. Obliging the Commission to try to coordinate national economic policies while denying it the powers to run a common economic policy for the whole of the eurozone was a fool’s errand. That these lacunae were known accentuated the fear of moral hazard and lessened the appetite for risk sharing.

At the time of the Maastricht treaty it was believed that pressure from the financial markets would serve to impose self-discipline on all stakeholders to respect the EMU rules. This proved not to be the case as investors preferred to chase cheap money across the eurozone. Britain’s refusal to join the euro club, which gave the City of London a free ride, effectively reduced the incentive to regulate Europe’s banks on a supranational basis. The next generation of political leaders were less committed politically than Kohl and Delors to the completion of the EMU architecture. Economic convergence was not sustained. Without fiscal instruments to correct disequilibrium, regional imbalances inside the eurozone rose. No attempt was made to form a core group of the eurozone states under the enhanced cooperation provisions of the treaties.

It is worth recalling that the provisions of the Maastricht treaty have been more disrespected than respected. The convergence criteria for joining up to the single currency were treated cavalierly from the start, particularly by Greece. Subsequently, Sweden is in breach of the treaty because it refuses to become a member of the eurozone despite qualifying for membership. Since 2012 the European Central Bank (ECB) has intervened controversially in government bond markets through its programme of outright monetary transactions (OMTs), raising doubts about conformity with treaty constraints concerning market intervention. The European Banking Authority has been unable to prevent loose lending by national and regional governments. The excessive deficit procedure has proved unworkable and the fiscal rules first adopted in 1998 in the form of the Stability and Growth Pact have never been scrupulously applied and are now flagrantly broken. German-led efforts to impose even tighter rules through the Fiscal Compact Treaty of 2012 have failed to be implemented. And valiant attempts by the Commission to squeeze the tax and spend plans of the member states into a ‘European semester’ have become little more than an academic exercise.

The European Stability Mechanism (ESM) was established in 2012 to bypass the no bail-out rule. But the ESM clause inserted into the treaty served to complicate and not to simplify or clarify how financial risk is to be shared between member states. The ESM, founded by an intergovernmental agreement, is still not an EU official institution. Its use is far from unconditional, and with its lending capacity capped at €500bn it is too small to cope with another major financial crash. Although a reform is in train to let the ESM act as the backstop to the Single Resolution Mechanism for failing banks, decisions within the ESM are still to be taken confederally — which means that Germany has an effective veto in its deployment.

The ESM is not the only weak element in the governance of the euro system. The Eurogroup of the 19 eurozone finance ministers remains ‘informal’ and lacks coherence. Meeting too often in the surreal ‘inclusive format’ — that is, with all 27 states — it manages to duplicate ECOFIN, the Council of finance ministers, as well as evade proper scrutiny. The ECB has only limited powers to supervise the whole financial industry. And while national central banks have lost control of their currencies, the ECB does not enjoy the status of the Union’s lender of last resort. The crisis management measures put in place after the crash are overdue for review. Belatedly, the first elements of a banking union have been erected but progress on a deposit insurance scheme is stalled. A plan for the better integration of capital markets, reducing tax, legal and regulatory barriers to trade, has been launched by the Commission but remains stuck in the Council.

It is not the Maastricht rules but pragmatism and a good deal of luck that have saved the euro — doing “whatever it takes” to preserve the euro, as Mario Draghi famously said. The ECB’s unorthodox monetary policy has weathered the legal and financial storms. Grexit has not happened. The weaker states have returned to the market. But relief that the stability of the eurozone has been recovered should not blind us to the basic defects in the construction of EMU.

Enforced austerity is not the way out of the pandemic crisis. Instead, Keynesian policies are back. This sea change in politics prompts a review of the structures of economic governance and of its fiscal rules. The EU has suspended these rules for the duration of the crisis — at least until 2023. An ambitious economic recovery programme has been agreed involving the EU in unprecedented levels of borrowing.

To finance Next Generation EU, the Commission, on behalf of the member states, will borrow up to €800bn on the capital markets— about €150bn per year between 2021 and 2026. As the holders of the eurobonds are to be paid out of the EU budget, the cap on the Union’s revenue or ‘own resources’ is raised to accommodate the extra spending from 1.4% of GNI to 2.0%. The first eurobonds were launched successfully in June, being many times oversubscribed. The Commission is charged with overseeing how the money is spent by the member states according to established criteria, mainly through the Recovery and Resilience Facility (RRF). €407.5bn is to be made available in grants; €386bn for loans. The Council must approve by qualified majority voting (QMV) the implementation of the Commission’s spending proposals.

The RRF places a premium on structural reforms aimed at boosting sustained productivity. Although European added value is not an explicit criterion, the importance of greening the economy, advancing digitalisation and modernising transport infrastructure are challenges which clearly demand the investment of public money on the supranational dimension. The loan element of the programme is less attractive to EU states already labouring under huge public debt — and at a time when interest rates are in any case at rock bottom. The grant element, by contrast, provides a real fiscal boost, especially to Italy and Spain. The innovation represents a significant rebalancing of EU fiscal and monetary policies, relieving the ECB of its hitherto almost lone responsibility for macroeconomic stabilisation. Both the loan and grant elements will become steadily more attractive as and when interest rates rise to counter high inflation and the ECB slows its programme of quantitative easing.

Although the economic recovery scheme involves significant short-term fiscal transfers between member states, it does not promise a centralised fiscal policy for the longer term. The so-called frugal member states, led by the Netherlands, insisted that Next Generation EU must be a one-off, never to be repeated, emergency risk-sharing measure. No permanent European safe asset has therefore been created.

Surely this is nonsense. When the current bond issue concludes in 2026 it will also be time to renegotiate a new budgetary settlement. If the eurobonds have been a success — and how can they not be? — it will be crazy not to continue with a similar scheme. Why would the Union opt to reduce its fiscal instruments and downgrade its assets? A political decision by the EU to renationalise bonds would be certain to discombobulate investors. It is more likely, in truth, that the Union, bolstered by its new fiscal capacity, will seize its next chance to extend and enlarge its eurobond operation in order to establish permanent, effective measures for contracyclical macroeconomic policy.

So armed, the EU will have to learn how to conduct its fiscal affairs in a federal manner. Fiscal union will not come by magic but by an orderly and determined package of constitutional reform on the basis of which capital market integration and banking union can be fully accomplished. There are several elements to the necessary reforms.

First, federal eurobonds will be issued not on the joint guarantee of individual members states but on the joint and several liability of the Union as a whole. To ensure this change of gear, bondholders will no longer be paid by that part of the EU budget financed by contributions from member states. Instead, the floatation of eurobonds will be supported by revenue accruing directly to the Union from federal taxation and customs duties. This reform implies compartmentalising the budget into two tiers: the top slice financed by the EU taxpayer and voted by the European Parliament; the bottom slice financed by the fees paid by national finance ministries according to the GNI peg and voted, as now, by national parliaments. Such a rebalancing of the federal and confederal elements of the EU budget will accelerate pending decisions on new forms of own resources. In a future article I will discuss how reform of the European Parliament can strengthen its democratic legitimacy and equip it to assume new responsibilities regarding taxation in accordance with the cherished principle of subsidiarity.

A restructuring of the European budget in the way suggested will allow the EU to reduce its unhealthy obsession with juste retour — the unseemly scramble between net gainers and losers in which Margaret Thatcher, pre-eminently, indulged. Fiscal union should usher in a more rational debate about bringing supranational added value to European public goods.

Secondly, the ESM must be turned into a European Monetary Fund and fully incorporated into the law of the Union. Its mandate can be expanded to include crisis prevention as well as crisis management. The EMF, like the IMF, will take decisions by QMV not unanimity, building political and market confidence. A vice-president of the Commission should be designated Treasury Secretary and empowered to chair the EMF board. In an earlier Critical Thinking piece, published on 9 May, I suggested how the Commission should be readied to assume this larger executive authority.

Third, the Eurogroup should be formally reconstituted under the enhanced cooperation provisions of the treaty. In the interest of consistent fidelity to the general interest, the Eurogroup should be chaired by the Treasury Secretary. He or she would vote only on executive and not legislative matters. Ideally, the new Eurogroup would comprise all 19 eurozone states, but so long as few as nine countries are willing to act as pioneers the critical step towards fiscal union can be taken, with others joining later, including Sweden. If the new German government turns out to be eurosceptic, ordoliberal and anti-Keynesian, will President Macron assemble the nine without Germany? He should dare to try.

Once inside the enhanced cooperation system, the vanguard group should decide to leave unanimity behind and operate only by QMV. Such differentiated integration based on the eurozone is much facilitated by the retreat of the UK from the field of play. In a previous contribution to Critical Thinking, published on 14 June, I suggested ways to encourage the use of enhanced cooperation by a core group of integration minded states.

Enhanced cooperation will bring more decisive government to the affairs of the eurozone. A better run eurozone will make membership of the single currency more attractive and accessible to non-euro states. The new style Eurogroup and EMF can become the valid fiscal interlocutor of the monetary ECB, working together to consolidate the currency and advance economic convergence. Its goals will be to articulate high standards of fiscal prudence that command democratic respect and to prepare the eurozone to withstand future shocks. The more coherent leadership will serve to reinforce the international role of the euro. Participation of the Treasury Secretary in global monetary institutions will clarify usefully for its partners the EU’s direction of travel.

Finally, it will be necessary to adjust the treaties to codify these changes, to simplify the rules and to eliminate the legal uncertainty that prevails at present. The target date of 2029 seems eminently feasible. The Conference on the Future of Europe would do well to consider these proposals.

Europe will not have a ‘Hamiltonian moment’ when a new federal state assumes the sovereign debt of its members. Rather, fiscal union will permit the gradual and incremental growth of federal debt not as a substitute for national debt but as a complement to it. National treasuries, not least the Bundesministerium der Finanzen in Berlin, will save money out of European fiscal union. Banking union will be assured. The EU citizen taxpayer will benefit from a more state-like, capable federal union with decent spending power.

Andrew Duff’s new book, ‘Britain and the Puzzle of European Union’, is to be published by Routledge in September.