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Should Europe Become a Fiscal Union? A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Keuschnigg, Christian Article Should Europe Become a Fiscal Union? CESifo Forum Provided in Cooperation with: Ifo Institute – Leibniz Institute for Economic Research at the University of Munich Suggested Citation: Keuschnigg, Christian (2012) : Should Europe Become a Fiscal Union?, CESifo Forum, ISSN 2190-717X, ifo Institut - Leibniz-Institut für Wirtschaftsforschung an der Universität München, München, Vol. 13, Iss. 1, pp. 35-43 This Version is available at: http://hdl.handle.net/10419/166470 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu Focus SHOULD EUROPE BECOME A problems that have led to the current crisis. The final section offers some conclusions. FISCAL UNION? Economic and fiscal imbalances CHRISTIAN KEUSCHNIGG* Prior to monetary unification, the guiding principle of Introduction European unification was the notion of subsidiarity. The subsidiarity principle implies that the power to The European unification process started with the levy taxes, to spend on public goods and services, and creation of a common market area to allow member to regulate the behavior of the private sector should countries to benefit from the economic gains of free be decentralized whenever possible, and remain in the trade and factor movements in Europe (Keuschnigg realm of autonomous sovereign countries (CEPR and Kohler 1996). A key turning point was the adop- 1994). The introduction of the common currency was tion of a single currency to complete the economic unification process by eliminating exchange rate risks a decision to give up independent national monetary within the euro area, creating more liquid and inte- policy and to transfer responsibility for price stability grated capital markets, and guaranteeing price stabil- to the European Central Bank (ECB). It also elimi- ity at the European level (Sapir 2011). The current nated a country’s independent exchange rate as a key financial and fiscal crisis puts these achievements at relative price that could adjust to avoid large trade risk, has revealed a political conflict over how to deal imbalances and unsustainable international borrow- with the crisis and how to reform the institutions, and ing as a result of divergent wage and productivity may even endanger the continued existence of the growth rates. The smooth operation of a common euro area. It is important to remember that the eco- curren cy area requires that independent exchange nomic and monetary unification process was driven rates are replaced by other adjustment mechanisms. by the economic as well as political goals of establish- Economic theory lists four such mechanisms (see e.g. ing not only prosperity, but lasting peace in Europe. De Grauwe 2009; Beetsma and Giuliodori 2010): These fundamental political objectives, however, are (i) wage flexibility to realign unit labor costs with not automatically guaranteed by deeper economic international competitiveness; (ii) labor mobility integration. Institutions must be reformed in a way across regions; (iii) central fiscal institutions to pro- that economic integration itself doesn’t become a vide insurance against asymmetric shocks; and (iv) source of new and dangerous political conflict. strict fiscal rules to prevent negative spillovers of national fiscal policy to other member countries. Should Europe opt for a fiscal union? The answer requires a consensus on whether Europe should move Divergent competitiveness towards a closer political union and develop into a federal state with substantial fiscal capacity at the cen- Up to very recently, none of the four conditions for an tral government level. It also depends on whether one optimal currency area seems to have been fulfilled. expects the creation of a fiscal union to be instrumen- Few member countries have reformed labor market tal in solving the current economic crisis in Europe. institutions to allow sufficient wage flexibility that The following section analyzes the emergence of the could compensate for the exchange rate as an adjust- economic and fiscal imbalances that led to the current ment mechanism. Due to cultural and language barri- crisis (see also Keuschnigg 2012). The third section ers, labor mobility across countries tends to be low in discusses the case for a fiscal union and argues that Europe and is certainly not happening to an extent establishing a fiscal union will not address the key that could significantly reduce major differences in unemployment and labor market conditions more * University of St. Gallen. generally. There is no central layer of government 35 CESifo Forum 1/2012 Focus with a budget that could provide Figure 1 fiscal insurance against asym- UNIT LABOR COST metric shocks and thereby damp- base year 2000 en regional economic fluctua- 1.4 tions. If a US state experiences 1.3 an income loss of one dollar, 1.2 about 40 cents are compensated by fiscal insurance as that region 1.1 pays fewer taxes to the central 1.0 government, but collects more 0.9 transfers from unemployment Greece 0.8 insurance and other social pro- Euro area Germany grams. The European Union 0.7 budget is far too small to achieve 0.6 1993 1995 1997 1999 2001 2003 2005 2007 2009 any similar automatic stabiliza- tion. Finally, the fiscal rules of Source: OECD. the Maastricht treaty, which are meant to limit deficits to 3 percent and debt levels to induced by a capital market failure. Figure 2 shows 60 percent of GDP, have not been credible and have that interest rate differentials in the euro area relative been plainly ineffective in preventing the current sov- to Germany largely disappeared after the introduc- ereign debt crisis in Europe. One must conclude that tion of the euro, eliminating risk premia and inducing the consistent violation of those principles led to the a real estate and investment boom in the South. The current crisis (see, among others, Buiter and Rahbari inflow of capital and low capital costs might have 2001; Feldstein 2011; Roubini 2011; Sinn and facilitated wage increases not backed by long-lasting Wollmershäuser 2011). productivity gains. When interest rate differentials appeared again in the last two years, a large part of I believe that the single most important problem is the these investments were probably no longer profitable divergent trend of unit labor costs in Europe, as illus- with increased capital costs. The failure of capital trated in Figure 1. Eventually, this persistent diver- markets to price in risk premia and the resulting allo- gence must cause large trade imbalances, leading to cation of capital towards uncompetitive economies is accumulation of net foreign debt by weak countries in probably itself the consequence of a lack of credible the southern periphery and net foreign claims by fiscal rules and represents regulatory failure in other, more competitive countries such as Germany. Europe. These divergent trends have not been corrected by an exchange rate nor a wage adjustment for a long time. The Maastricht criteria were not effectively imposed For an uncompetitive economy, this implies the need and lacked credibility right from the beginning. for either an external or an internal devaluation, in Capital markets also seemed to conclude that the no- both cases making a country’s exports cheaper in bailout rule would not hold up in a crisis since bank- world markets and imports more expensive, allowing ruptcy of a highly indebted member country would be the country to settle on a sustainable path of income perceived by the Union to be even more costly (this growth consistent with national productivity. While way, high debt creates a negative externality on other Germany went through a prolonged period of wage countries). Given this belief, banks and other inves- moderation and painful labor market reform (Hartz tors must have expected to always get their money reforms), Greece, Portugal, Spain and Italy (Ireland) back, making government debt an apparently very have increasingly fallen behind. Rigid labor markets safe investment. Under these circumstances, there was and nominal wage stickiness have prevented the req- no need to include a risk premium, which would have uisite adjustment in these economies. increased interest costs in southern countries in the EU and could have helped to impose market disci- The wage costs per unit of output increase with high- pline and to restrain the tendency towards excessive
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