Why the Macron plan for the eurozone is misguided

France’s economy minister Emmanuel Macron has suggested a fundamental reform of the eurozone involving much larger financial transfers between its members. He knows his plan will provoke allergic reactions, notably in Germany, but the upside is that it could revitalise the debate about the eurozone’s future.

The Macron Plan has three key elements. First, he wants the eurozone members to contribute more to a common budget. Macron hasn’t yet specified how large he would like the budget to be, saying only ‘the larger the better’. Second, there would be an ‘economic government’ headed by an EU Commissioner with far-reaching responsibilities. It would administer the new budget, offer financial help to members in economic difficulties while also seeing that they carry out economic reforms. Third, a ‘eurozone parliament’ would be created to control the economic government and provide democratic legitimacy.

What would be the role of financial transfers in all this? Macron has suggested three types of transfer; he wants them for countries experiencing temporary crises, he argues that they are required to alleviate public debt burdens that have accumulated during the recent crisis. He also thinks there should be fiscal equalisation transfers from rich to poor countries.

The question is whether this plan could pave the way towards a more stable and prosperous eurozone? It is a plan with significant flaws because it neglects a number of important reform issues and conveys an overly pessimistic assessment of the current economic situation. The risk is that it might lead us to repeat some of the errors that caused the eurozone’s crisis.

The most important issue the plan fails to address is how the eurozone should deal with future cases where member countries are not just illiquid but insolvent. Macron’s emphasis on transfers suggests that other member states should foot the bill. But this would create the wrong incentives; prudent economic and fiscal policy would be penalised and fiscal laxity by governments as well as imprudent lending by investors would be rewarded. The errors that contributed to the eurozone debt crisis would thus be repeated.

Another misguided element of the plan is the financing of the new eurozone budget. Macron wants to finance it not by new taxes but by issuing debt. He argues that tax financing would be too unpopular. It is true that debt can be used for some time to conceal the costs of public spending, but eventually the debt accumulated by the new eurozone government will become unsustainable and taxpayers will have to face the bill. By then, though, it will be too late to stop the spending. The eurozone needs more transparency and honesty vis-à-vis the voters and taxpayers, not less.

Another flaw in the Macron plan is that it paints too pessimistic a picture of Europe’s economic situation. Macron argues that the highly indebted eurozone members cannot recover without debt relief. Although it is true that high levels of public or private debt slow down the recovery, the upswing in Spain and Ireland has shown that economic recovery is possible despite high debt. Moreover, by concentrating on financial transfers, the plan conveys the message that solidarity does not exist under the current institutional framework. This is incorrect, as there are at least three forms of solidarity. In the first place, the EU budget involves significant redistribution, with poorer countries like Bulgaria, Poland, Portugal or the Baltic States receiving net transfers that range between three and five percent of their respective gross national incomes. Also, the countries most affected by the eurozone debt crisis have received considerable support, mostly in the form of credit at very favourable conditions. The European Stability Mechanism says that Greece received hidden transfers through reduced interest rates and maturity extensions amounting to 5% of its yearly GDP. The new aid package for Greece will involve even higher transfers. Lastly, the European Central Bank, through its OMT programme, has issued an implicit guarantee to investors that they will get their money back if they lend to highly indebted member states, massively reducing the interest burden on them. The risk that this guarantee may one day be needed is shared by all member countries.

Of course, it’s debatable whether the present degree of solidarity will be enough. We shouldn’t forget, though, that tax levels in the more prosperous eurozone countries that would be called on to finance the transfers are already among the highest in the world, so increasing this burden further doesn’t seem a realistic option. Nor is there any reason why there should be permanent transfers from rich to poor countries just because they share a common currency. The loss of the exchange rate mechanism can justify fiscal insurance that provides help in a crisis situation, but no more than that.

It is worth taking a closer look at the composition of a possible eurozone parliament. As its activities would be to focus on income redistribution, its members from countries with below average incomes would have a common interest in expanding the budget. With the current composition of the eurozone, the parliament would have 492 seats, so that 247 seats would form a majority. If GDP per capita is used as an indicator of income, the countries with below-average incomes would have 219 seats. Of those countries with above-average incomes, France is the poorest. But the 74 French seats would be required for a majority. If voting behaviour were to be driven by national financial interests, France would clearly be in a strong political position. Of course, the parliamentarians might not vote according to narrow financial interests of their own countries, but it seems unlikely that the net contributor countries, where the population rejects the idea of a ‘transfer union’, would want to give this parliament the right to make decisions about significant financial transfers between member states.

If the Macron plan is unconvincing, what would be the right direction for reform of the eurozone? There is potential for a larger eurozone budget, but it should focus on expenditure that would create added-value rather than redistribute income between countries. There is potential for added-value in areas like foreign policy, defence, internal security and the development of European communication, energy and transport networks, and a budget focused on these policies would potentially benefit all member states.

Fiscal governance in the eurozone needs to make sure that private creditors also suffer losses if government debt becomes unsustainable. When private creditors are always bailed out by taxpayers they will engage in imprudent lending, and governments will borrow too much because the cost of overborrowing is going to be borne by taxpayers in other countries. This incentive to overborrow will be so strong that it cannot be neutralised by fiscal policy surveillance alone. The trouble here is that forcing private investors to bear losses in a crisis may jeopardise financial stability. Therefore, reforms in financial sector regulation are required which enable banks and other investors to absorb losses if a eurozone member state experiences a debt crisis. These reforms should prevent banks from holding government debt without appropriate equity. Government debt should primarily be held by well diversified investors such as pension funds with a long-term perspective, and with the ability to absorb losses.

A third important element is about making the eurozone members more resilient to economic shocks. This is an area where transfers between countries can make sense, but only in the form of fiscal insurance offering transitory help rather than permanent transfers, and then only in the case of large shocks. The most important reaction to asymmetric shocks is adjustment within countries. Since members of a currency union cannot adjust their exchange rate if they are hit by a crisis, they need much more flexible markets, particularly labour markets, than do countries with their own currency. Members of a currency union should also have low levels of debt so that there is space to absorb shocks. A possible form of fiscal insurance in the eurozone which would help in the case of large shocks could be based on labour market performance, so if unemployment rises by more than two or three percentage points within a year, the increased cost of unemployment benefits could partly be borne by a eurozone insurance system. Participation in this could be made conditional on flexible labour market institutions, so while the system would provide some insurance against economic shocks it would not imply any permanent redistribution.

Perhaps the clinching reason why other eurozone governments should not follow the Macron plan is that a new budget focusing on financial transfers would exacerbate existing conflicts between rich and poor or creditor and debtor countries, making the problem of soft budget constraints for governments worse. Instead, Europe should focus on policies that create added-value, set clear incentives for sound economic and fiscal policies and improve the ability of member states to absorb and adjust to economic shocks.