We believe that the European Union needs fiscal integration if it is to stay strong and we are not the only ones to think so!

This year’s Nobel laureates in economics Christopher Sims and Thomas Sargent made a point at apress conference held at Princeton University at the beginning of the month that “If the euro is to survive, the euro area will have to work out a way to share fiscal burdens”.
 So what exactly do we mean by fiscal integration? Fiscal policies broadly encompass the ability to decide upon a tax system and apply it to the economy, the ability to borrow money (typically done through the central bank, by issuing government bonds) and the ability to spend the money raised towards the provision of public goods. On top of this, fiscal policies form the core of government powers because through tax and spending changes the government can influence the decisions businesses and individuals make everyday.

At the moment, two fiscal rules, described in the Stability and Growth Pact, are enforced in the Eurozone. In theory, these two rules constrain member states to limit their debt and deficit below a reasonable (though somewhat arbitrary) percentage of their GDP. In practice, the sanctions applying to states breaching these rules are difficult to execute. As a result, they have not been respected in the past, even Germany has breached it. The current debt levels of member states are a result of this lack of fiscal discipline. More importantly, the lack of coordination between member states and the European Central Bank (ECB) can create major economic problems where you have monetary and fiscal policy contradicting each other. Having 17 fiscal policies in one currency zone means that often Governments are left working against each other and the ECB.

In other words: the Eurozone works well when the economy is growing, but is incapable to respond appropriately to a crisis situation.

This is demonstrated by the difficulties that Greece and other southern European countries are currently facing. Christopher Sims warned in a paper published in 1999 that the European Monetary Union (EMU) would not survive without proper fiscal cooperation between member states. He shows that the lack of coordination between the central bank and the national budgetary institutions can prove fatal to the Eurozone and that countries with loose fiscal policies can be encouraged to spend more by the possibility of being bailed out by other member states. This bailout clause implicitly meant that countries like Greece could borrow at the same rate as Germany, despite being considerably less credit-worthy. As soon as Greece indicated it may be illiquid and investors realised that other member states may not be able to bail Greece out its rates shot up.

With a fiscally integrated Europe, a situation like the Greek sovereign debt crisis would probably not arise again. Having a common budget would allow politicians to ensure that the debt issued can be repaid and remove the moral hazard element (since states would be borrowing together rather than one state implicitly borrowing under another’s name). Of course, a common budgeting capability on its own would not be sufficient. We need the ability to dramatically reduce tax avoidance, have a fair system to decide how the funds raised are to be spent, etc. But that is another aspect of policy which we will come back to. Sims and Sargent also insist in their press conference that having a joint fiscal policy is not a magic recipe. You need to tailor tax and spending to fit the context, and to take a serious look at the data. All of this requires transparency, honesty and collaboration between member states.

This is the economic theory behind it. However as Sargent puts it, when asked what he thinks about the current state of Europe:

"There is no new issue in economic theory with Europe and the Euro […] the difficult thing is politics and I can't help you with that, but maybe someone else can."

We think that it is time for European leaders to step in and offer:

• A tax system common to all members of the Eurozone, at the corporate, individual income and VAT levels, with help for member states whose tax systems fail to raise the funds required by these tax levels.
• An institution similar to a treasury or ministry of finance, that has the power to raise money and spend it (through a democratic budget process involving the European Parliament and Commission).
• The possibility for this institution to issue Eurobonds to raise debt at the European level to avoid lose fiscal policy in the future.

Do you agree?

Additional resources:

The Broad Economic Policy Guidelines, another tool of the European Union to encourage cooperation in the area of economic policy: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2008:137:0013:0024:EN:PDF

An academic paper that describes well the Broad Economic Policy Guidelines and the Stability and Growth Pact, as well as their shortcomings: http://bs.gsu.edu.tr/akademik/spolat/policy-mix-1.pdf

Mervyn King on the need for fiscal integration: http://www.bloomberg.com/news/2010-05-12/king-says-crisis-shows-it-s-very-clear-that-euro-area-needs-fiscal-union.html