European Central Bank in Frankfurt. A new paper from IMF staff suggests a roadmap for fiscal union in the euro area (photo: J. Hildebrandt/Newscom)
Euro Area Fiscal Union
A new paper from International Monetary Fund staff argues that advancing fiscal integration would help address a number of gaps in the euro area’s architecture. Alongside the banking union, a fiscal union would reduce the incidence and severity of future crises by strengthening fiscal discipline and providing a minimum amount of insurance against deep recessions. While putting in place a fiscal union will take time, providing a roadmap for implementation is viewed as essential to anchor confidence in the euro area’s viability, thereby also supporting current crisis management efforts.
European policymakers have taken important steps to strengthen fiscal and economic governance frameworks. However, vigorous implementation and robust enforcement mechanisms are a prerequisite for greater fiscal integration. With these safeguards in place, according to the paper, a clearer ex ante approach to fiscal discipline and cross-country insurance mechanisms—as opposed to a strategy that relies exclusively on support when crises have already occurred—would further strengthen the architecture and ensure stability of the Economic and Monetary Union.
Gaps in euro area architecture
Contrary to expectations, the launch of the common currency did not make euro area economies more similar over time or more resilient to shocks. Real convergence lagged expectations, and country-specific shocks—home-grown or not—remained significant and more frequent than anticipated. For example, falling borrowing costs contributed to localized credit booms in some countries. At the same time, the high degree of trade and, more importantly, financial integration created the potential for problems in one country to be transmitted to others. This was particularly evident at the height of the current crisis when problems arising in banks raised doubts about sovereign creditworthiness, and in turn sovereign stress aggravated the pressure on banks’ balance sheets. Financial stress then travelled between interconnected banks across the euro area.
The paper also notes that weak national policies compounded the effects of adverse economic shocks and that European governance frameworks were too loosely implemented. As a result, when the crisis hit, countries had not built sufficient national buffers to provide protection against the economic downturn.
Meanwhile, there were few market forces to prevent and correct growing imbalances: once a negative economic shock hit, prices and wages did not adjust downwards to compensate for the losses in competitiveness, and labor mobility remains limited within the currency area. Likewise, capital markets—optimistic about the region’s growth prospects and unconvinced of the no-bailout clause—failed to differentiate between sound and unsound fiscal policies.
These interactions set the stage for the crisis that hit the euro area in 2010: with limited fiscal buffers, no area-wide support instrument, and no circuit-breaker to address bank sovereign feedback loops, imbalances that had accumulated in some countries soon evolved into generalized financial stress and economic shocks affecting individual countries turned into systemic ones, threatening the union itself.
The approach taken so far—dealing with crises after they occur—has been costly, not only in terms of direct financial assistance, but also in terms of lost output and increased unemployment.
Essential elements of a fiscal union
The paper sees fiscal integration providing a framework of fiscal discipline and insurance mechanisms that would help contain economic and financial shocks while ensuring better national policies before crises occur. Clearly, social and political preferences will determine the ultimate scope and shape of further fiscal integration in the euro area. But lessons from the crisis and the practice in other fiscal unions suggest the following four elements are essential:
• Better oversight of national policies and enforcement of rules. With more emphasis on structural fiscal targets and ongoing reforms to the governance framework, the design of fiscal policy has improved. However, going forward, reinstating fiscal discipline and reviving market discipline may require stronger involvement of the center in national fiscal decisions and clarification of bailout rules.
• Increasing risk sharing. Ex ante risk sharing reduces the need for costly support afterwards. So, provided there is better disciplining of national fiscal policies, all euro area countries would benefit from cross-country fiscal insurance mechanisms. There are a number of options available, including setting up a euro area-wide rainy day fund, a common unemployment insurance scheme, or a budget for the euro area. In any case, a minimum of fiscal risk sharing is a prerequisite to be able to rely on market discipline, because it adds to the credibility of no bailout arrangements.
• Borrowing at the center. In the long term, when the appropriate governance structures are in place, borrowing by the center—backed by its own revenues—could help finance risk-sharing vehicles, and reduce the potential for large portfolio shifts between sovereigns by providing a safe asset.
• A fiscal backstop for euro area banks. European policymakers have made important progress towards a banking union. Current steps to establish a Single Supervisory Mechanism and a Single Resolution Mechanism should be complemented by a firm and early commitment to establish an adequate backstop to anchor confidence in the banking system. While some of the insurance against banking accidents should be funded by the industry, a common backstop for the recapitalization, resolution, and deposit insurance would contribute to reducing the risk of contagion.
While the first three of these elements would help build a more stable union in the medium to long term, the final one is time sensitive, and thereby requires immediate attention.
Political backing for a clear roadmap that outlines the contours of a fiscal union is critical. While advancing fiscal integration will naturally take time, historical experience shows that effective crisis management has often gone hand in hand with far-reaching long-term reforms, including transferring some fiscal responsibilities to the central level.
