The Euro Area Falls Short on Fiscal Reform

If Europe’s recent economic travails have delivered one lesson, it is that there is a need for a coordinated fiscal and monetary counterattack in the face of the next downturn.  It was thus disappointing that the euro area decisions regarding the new Budgetary Instrument for Convergence and Competitiveness (BICC) fell short of achieving further fiscal integration. Waiting for a “crisis response” to put this capacity in place means that the response will come too late.

According to latest documents, the BICC will be designed explicitly without a countercyclical stabilization function and without its own sources of funding, cannibalizing the EU budget for resources. Funds are intended to be disbursed only among member states “within an acceptable range” of the money they contribute. The BICC is not in any meaningful sense a euro area budget capacity.

One might heroically argue that the BICC is merely a “crucial first step” that can be expanded in the next crisis. But by then it will be too late. Attempts in recent years to “fix the roof while the sun is shining” have failed.

As is well understood, monetary policy will not be able to provide the bulk of the stimulus in the next downturn (European Central Bank President Mario Draghi’s new commitment to more stimulus notwithstanding).  In addition, the euro area labor force is now (like Japan’s after 1995) shrinking, raising the risk of a deflationary accident.  Fiscal stimulus undertaken at the member state level will be uneven and almost certainly too small, and the euro area as a whole has in the last decade run a net public investment deficit. These facts add up to a significant economic handicap for the euro area, big enough to have contributed to the recent dramatic decline in long-term inflation expectations.  This is gross negligence of current euro area political leaders.

The BICC fiasco raises a strategic question of where the EU and euro area go next? The progress also announced by Eurogroup finance ministers recently on the banking union and tweaking of the European Stability Mechanism Treaty is nice, but the euro area needs a countercyclical fiscal capacity to avoid the risk of secular stagnation following the inevitable next economic downturn.

If “deepening the euro area” doesn’t work, the second-best option for Europe will be to try to “broaden the euro area” and make the already existing supranational budget in Europe, i.e., the EU budget, more of a euro area budget. Even if this will likely be impossible to achieve in time for the next euro area downturn, this could, for instance, involve the EU budget to backstop public investment spending with loans financed at concessionary rates with long maturities and the possibility of eventual debt forgiveness.

Such a process would take time and require that Brexit take place. No British government would agree to such a step.

Following Brexit, the euro area would encompass 19 out of 27 EU member states, about 85 percent of EU GDP and just over 75 percent of EU population. While this would easily provide the euro area with a qualified majority[1] in the EU Council, the EU budget must be decided unanimously.

For such a budget to be adopted, the euro area would thus probably have to be expanded to include more, perhaps all, of the EU member states.  The failure to create an integrated fiscal approach in the euro area alone reduces the incentive for noneuro countries, such as those in Eastern Europe, which are net recipients of EU budget spending, to eventually join the common currency.

The “vanguard argument” of integration led by only some member states has lost its potency in the euro area. Instead, as its best option for sustainable euro area fiscal institutions now lies in a reformed EU budget, the euro area will have to offer more carrots to non–euro area members to go along and preferably join the common currency.

As illustrated by Greece after 2001, euro membership is not without long-term economic risks for unprepared member states. Eastern member states wisely resisted rushing to join immediately after 2004, while the euro area crisis of course dampened the appetite for expanding the euro area among both existing and would-be members. But the two remaining (post-Brexit) “old” EU-15 members and sizable net EU budget contributors outside the euro, Denmark and Sweden, could join the euro in a few years without any material associated macroeconomic risk. If all the EU-15 members were to join the euro, it would pressure Poland, as the largest remaining nonmember, to join, after which the rest of the eastern nonmembers would likely follow.

Denmark, with its currency already pegged to the euro, would seem the obvious first expansionary choice for the euro. Yet Denmark has also voted against the euro in two referenda. With its probable application to join the banking union later in 2019, Denmark is removing one major political argument previously used against joining the euro, namely the risk of having to pay for failing banks in other European countries.[2] And there can be little doubt that naming Margrethe Vestager as the next European Commission president would boost the chances of a Danish euro rethink in the short term.

Ironically, therefore, for a euro area no longer capable of the necessary deepening but reliant on broadening its appeal, Vestager’s origin in a noneuro area member is a strength, not a weakness.

Notes

1. A qualified majority in the EU Council requires 55 percent of member states (15 out of 27) and 65 percent of the EU’s population.