The fiscal union of Europe

This blog reported on the EU summit to fix the Euro zone in October, which included a second bailout of Greece, followed by an overview of the dilemma the region is facing, namely reinforced integration (a US-like federation) vs breakup. This blog discusses the EU’s solution, the fiscal compact.

Recap on events

Recall that the Greek government had announced (to the dismay of EU leaders), that it would submit the agreement for approval by its people via a referendum. But that is no longer relevant because the October agreement (which superseded a prior one in July 2011) fell apart. A third, critical, summit was to be reconvened January 30. While it failed to deliver on the second bailout (discussion still ongoing), the Euro council has agreed on new treaty:

According to the new “fiscal compact” treaty, national budgets are required to be in balance or in surplus, a criterion that would be met if the annual structural government deficit does not exceed 0.5% of nominal GDP.

In the interim, France lost its AAA rating, which gives an idea of the contagion of the debt crisis from peripheral countries to the larger economies, whereas Portugal is walking in the footsteps of Greece. As a result, we are seeing a repeat of the 2008 bank funding crisis with the ECB “plugging [liquidity] holes”.

Impasse

The impasse is summarized by this paragraph from Lessons for Europe’s fiscal union from US federalism:

The rules of the fiscal union in the US evolved in a distinct sequence [, during the American revolution era]. The federal government first developed a robust fiscal capacity, with the assumption of state debt, issuance of federal debt, and access to its own tax revenue. Once that was established, the states could adopt balanced-budget provisions. By introducing strict balanced-budget rules prior to a robust fiscal union – assuming that some of them harbour ambitions for such a union – European policymakers are attempting to reverse this sequencing. Adopting such rules might reassure the ECB and smooth the path for further expansion of its operations, both of which are desirable, but it leaves the Eurozone short in terms of countercyclical tools.

Creating a common capacity for countercyclical action – through a more robust central budget, issuance of euro bonds, backed by tax authority – is more reliable. But this route of course requires strong political cohesion and robust institutions for the monetary union that would match those through which Hamilton worked.

Misconception

These problems were anticipated before the Euro began (read The Euro, a bad idea, it won’t last), and recent research favors the hypothesis that Euro’s problem are of systemic nature, rather than the fiscal irresponsibility of a few countries. Essentially, except for Greece, peripheral countries were paragons of fiscal virtue. But, the sudden stop of capital bonanzas from the core to the periphery (associated with CA deficits) caused a backlash.

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