What Fiscal Union Means

I was looking over FT Alphaville’s recent summary of Nomura’s Richard Koo’s work on the root cause of imbalances in the Eurozone.  The main thrust of the thesis is that the ECB held interest rates low last decade to support Germany because Maastrict rules forbid a fiscal policy solution to Germany’s woes.  But rates were excessively low for the periphery, triggering the emergence of bubbles and unsustainable imbalances. Basically, the root of the problem was a one-size-fits-all monetary policy worsened by an inflexible fiscal structure.

So far so good.  What caught my eye was this quote from Koo:

Unfortunately there have been growing calls in the eurozone for fiscal union. But that would only make the problem worse by forcing the same fiscal policy on all countries, regardless of whether they were in a balance sheet recession.

This is true with regards to what is emerging as “fiscal union” in the Eurozone, largely a commitment to strict fiscal targets.  This, however, is not how I would define a fiscal union.  When I use the term fiscal union, I am thinking of a centralized budget authority capable of making automatic internal transfers.

Paul Krugman has provided some very good examples of the importance of such internal transfers in the United States.  For example, see his discussion of Texas and the Savings and Loan crisis:

The cleanup from that crisis cost taxpayers about $125 billion (pdf), back when that was real money. As best I can tell, around 60 percent of the losses were in Texas (pdf). So that’s around $75 billion in aid — not loans, outright transfer.

Texas GDP was about $300 billion in 1987. So this was equivalent to giving — not lending, not even taking an equity stake — Spain 25 percent of its GDP to bail out its banks.

And in the US it wasn’t even treated as an interstate political issue.

Also, see his Florida example:

So as I read it, between falling tax payments without any corresponding fall in federal benefits, plus safety-net aid — not counting Medicaid, which would make the number even bigger — Florida received what amounted to an annual transfer from Washington of $31 billion plus, or more than 4 percent of state GDP. That’s a transfer, not a loan. And it’s very big.

These are examples of how assymetric shocks are cushioned within a fiscal union.  Transfers, not loans.  For the Eurozone to be successful, they need this kind of fiscal infrastructure.  Unfortunately, I think they are light-years away from such a union, and what they think is a fiscal union – strict deficit limits – is something very different, a union that as Koo says will make conditions worse, not better.  One of the many reasons I remain a Euroskeptic.

This post originally appeared at Tim Duy’s Fed Watch and is posted with permission.

6 Responses to "What Fiscal Union Means"

  1. Slarty   June 22, 2012 at 11:03 am

    Think Canada's equalization program. That's what Europe needs.

    • b.nimble   June 22, 2012 at 11:21 pm

      Just imagine how difficult that would be to manage – 17 countries with different cultures, different languages, different histories, different parliaments. Canada which has 2 major cultural groups (English and French) with several very important ethnic population included still find it tricky at times to manage its public finance.

  2. bubblesandbusts   June 22, 2012 at 12:43 pm

    Remember, Germany recently passed a constitutional balanced budget amendment. Does anyone think they will accept transfers or any type of fiscal union that doesn't require other nations to follow suit?

  3. WEAYL   June 23, 2012 at 3:19 pm

    A model for fiscal union

    1. Replace national VAT and corporation tax systems with single European system, with one European rate and one set of rules. All European companies will have single VAT declaration and corporation tax declaration for all Europe.

    2. Income from these taxes go directly to a central European fund.

    3. The European fund redistributes this income directly to member states according to pre-defined ratios. e.g. x% to Germany y% to Spain.

    4. The European fund guarantees all member state debts.

    5. In return for the guarantee, a "commission" is deducted, according to debt and/or defecit levels of member states. Higher debts=higher deducted commission.

    6. Pre-defined maximum debt levels are defined for all member states.

    7. Where member states exceed pre-defined debt levels, redistributed VAT and corporation tax revenue will be automatically "withheld" and used to neutralize debt until restored to agreed levels.