The Dangers of Pseudo Fiscal Union in the EMU

Philip Arestis and Malcolm Sawyer

We write this as people who have long argued that a currency union such as the Economic and Monetary Union (EMU) would need to be accompanied by what could be termed a fiscal union (see, for example, Arestis, P., McCauley, K. and Sawyer, M. (2001), “An Alternative Stability and Growth Pact for the European Union,” Cambridge Journal of Economics, Vol. 25, No. 1, pp. 113-130.)

It would then seem that we should be celebrating the proposed moves in EMU towards what is termed fiscal union; we rather, however, write of the dangers of the proposed fiscal union. The fiscal union, which we would view as required, would be one where there are substantial tax raising powers at the EMU level, say of the order of 10 per cent of EMU GDP (compare this with the Federal government in the USA raises taxes of the order of 20 per cent of GDP).

This fiscal union would involve a significant amount of fiscal transfer from richer countries to poorer countries: a proportional tax regime would raise absolutely more money in richer countries than in poorer countries, and a progressive one also relatively more. Provided that public expenditure did not exactly match tax revenue in a particular region, but rather was to some degree related to population size and to need, there would be transfer of resources from rich to poor.

Another key element of such a fiscal union would be the ability of the relevant Federal authority (Ministry of Finance) to operate a fiscal policy with deficits and surpluses as appropriate for the state of the economy. Further it would require the support of the European Central Bank in the operation of fiscal policy and willingness to buy where the bonds issued by that Federal authority.

The type of fiscal union currently under discussion is rather different. It does not involve any EMU level tax raising powers nor the ability of EMU itself to run budget deficits (or surpluses). Fiscal policy remains with the national governments but subject to severe constraints and monitoring, all summarised under the new ‘fiscal compact’ (see “The ‘fiscal compact’ has not solved the euro crisis”).

The policy rules now proposed have two major problems. First, they are likely to operate in a de-stabilising manner. Attempts to balance a government budget with no regard to the economic circumstances would involve raising tax rates and cutting public expenditure in the face of economic slowdown, thereby exacerbating the slowdown. The rules may be modified to allow for the position of the business cycle (that is focus on the so-called structural budget position).

This would though exclude the use of discretionary policy measures, which would be deemed to increase the structural budget deficit. It would also face difficulties of calculating the structural budget position (assuming that a structural budget position is a well defined concept; see Malcolm Sawyer, ‘The contradictions of balanced structural government budget’ in H. Herr, et. al. (eds), From crisis to growth? The challenge of imbalances and debt, Metropolis Verlag, Marburg.)

Second, there is the presumption that the desirable budget position for every country in every year is that of a balanced budget. A major element of the euro crisis arises from the pattern of current account imbalances amongst EMU member countries, and the lack of the means for countries to resolve those imbalances, and yet the external borrowing required to fund the current account deficits is not available.

The imposition of the same budget position in all countries requires that the sum of net private savings (savings minus investment) plus current account deficit are the same. It is possible that such a requirement can accommodate large differences in current account deficits provided that there are corresponding large differences in net private savings. But it is more likely that the differences in current account deficits cannot be so accommodated.

The fiscal union of the type being discussed would heap further austerity on the EMU countries. This approach assumes that an upper limit of 3 per cent of GDP is consistent with a near balanced structural budget despite the swings in economic activity and associated swings in budget deficits as the automatic stabilisers take effect. As a rule of thumb, a 1 per cent fall in GDP below trend leads to around a 0.7 per cent rise in the budget deficit – hence a more than 3 per cent drop in GDP before trend with a structural deficit of 0.5 per cent would lead to a country breaching the limit. Note that this is a drop in GDP below trend – and could come from an actual drop of more like 1 per cent (with a 2 per cent trend growth rate). The implication of automatic sanctions is that the sanction is applied whenever the budget deficit exceeds 3 per cent of GDP whatever the reason. A shortfall in demand, a financial crisis which brings recession, the need to respond to a national disaster are not apparently to be countenanced.

The aim of a balanced average (‘structural’) budget is actually a significant budget surplus when calculations are made (as they should) in real terms; that is with allowance for the impact of inflation on real value of government debt. But more significantly it would involve a very substantial excess of tax revenue over current government expenditure (excluding interest payments).

Further, it makes no allowance for governments to be able to borrow to fund public investment. The profoundly undemocratic nature of this approach is clear – the unelected European Commission can ‘request’ that the elected national Parliament and government to change its budget. Let us also note the problematic nature of assessment of budgets. The forecast of budget for the year ahead requires forecasts of growth, employment, inflation etc. for that year. The assessment of structural budget position requires estimates of potential output (which have often been subject to revisions many years after the event).

It is clear that the major objections to the fiscal compact, and the old SGP, are that it seeks to impose without any justification a balanced budget and that it poses restrictions in the use of fiscal policy in the face of economic crises. And as we have argued recently, proper fiscal union is the only way forward.

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