In response to several inquiries1, I offer a few more comments on Europe in 2013, in particular why I do not view a delay in euro area fiscal integration as a disaster, why the United Kingdom will not leave the European Union and what I view as the major downside risk in 2013. (Hint: It is a large French speaking country in the heart of the continent.)
The Current Pace of Euro Area Fiscal Integration May Prove Sufficient
European Union leaders, following the example of Chancellor Angela Merkel of Germany at their recent EU Council session, blocked further rapid fiscal integration in the euro area for both narrow German domestic reasons and larger concerns about political feasibility. Merkel does not want this discussion during the upcoming German election campaign. But in a broader sense, further meaningful fiscal integration without political integration would not be democratic. As a practical matter, the required far-reaching changes to the EU Treaties are unlikely to be approved by voters in the current political and economic climate. Disappointing as their stance was, it made pragmatic sense.
Yes, delays in fiscal integration feed the perception that Merkel and her colleagues fail to understand that monetary unions require a financial and banking union to be successful. Such unions work better with extensive risk-sharing throughout the currency zone, as well as a fiscal union enabling asymmetric shocks to be cushioned by a centralized fiscal capacity. The widely cited example of this truism is of course the United States. The argument is that unless the euro area develops into something like the United States, complete with an operational Federal Deposit Insurance Corporation (FDIC) and a large federal budget, the euro is doomed.
No doubt such features, including a budget of perhaps 15 to 20 percent of the currency area's GDP, would make the euro area more robust. Indeed, if the euro area possessed many other political and economic governance institutions like those of the United States, it would be more stable, safe, and able to make fast decisions. But the euro area will not develop into a copy of the United States.
President George W. Bush once talked about the "soft bigotry of low expectations." In some ways, the euro area suffers from that problem, held to an American standard for success. Many proponents of this judgment point to the standard optimal currency area theory (OCAT) of Mundell, McKinnon and Kenen. The OCAT argument for fiscal transfers to mitigate the economic effects of asymmetric shocks is intuitively persuasive. Yet a currency area need not be "optimal" to be functional, especially if other permissive circumstances exist. Among these are the high political and economic costs of unraveling a currency area once it has been established. These high costs foster political acceptance of the status quo, even at the cost of economic volatility and social welfare losses. Inmates typically learn to cope with life on the inside if they know they cannot escape. This is the situation in the euro area. The forward-looking prescriptions of OCAT are thus irrelevant. Instead of becoming like the United States, the euro area can rely on history to safeguard its future. Since early 2010, it has created the European Financial Stability Facility (EFSF), the European Stability Mechanism (ESM), the Single Supervisory Mechanism (SSM), and a host of other innovations. These offer no reason to justify "low expectations." The euro area does not have to resemble the United States to survive and prosper.
Ironically, the idea that the euro area has to move rapidly to develop a sizable centralized fiscal capacity is contradicted by the fiscal history of the United States. It was only after the New Deal of the 1930s—almost 150 years after the US Constitution was adopted—that the US federal government acquired a fiscal transfer capacity anything like what is envisioned under OCAT. This is illustrated in figure 1.
It wasn't the genius of America's founding fathers that secured the fiscal capacity of the US federal government. That capacity grew out of much later political imperatives, hastened by Franklin Roosevelt's New Deal and Lyndon B. Johnson's Great Society guarantees of economic security for the elderly and the poor. Government budgets and redistributive structures are shaped slowly over the long term, though the trend has been inexorable. No large government entity can undertake revolutionary changes overnight.
Today most US federal government spending comes in the form of social benefits in all US states, except those with large federal government workforces. This is illustrated in figure 2.
Once the US federal government assumed most of the social safety net functions from the states, its expenditures became both geographically redistributive and countercyclical—well-suited for macroeconomic stabilization. But the US federal budget hardly developed with this objective in mind. It grew for various idiosyncratic political reasons over time. The growth of US federal social expenditures happened largely in a vacuum. Few large-scale state-level social programs existed before the New Deal. The US federal government was thus free to take on most of the social functions of the modern state. Indeed the entire theory of fiscal federalism (see for instance Oates 19682), which stipulates that macro stabilization tools should reside with the central government, assumes that sovereignty is principally located at the central level.
By contrast, in the euro area, central government primacy does not automatically apply. Unlike the continental-scale conquest by a single sovereign government in the United States, the euro area's history is replete with failed attempts to unify the continent by conquest. Sovereignty and political identities in the euro area reside at the decentralized member state level. The allocation of tasks between governmental layers thus takes place bottom-up, not top-down.
This political landscape, where all euro area member states possess all functions of the modern state, opens only a narrow path for budgetary unity. Unlike the United States, Europe is not expanding the social safety net in a vacuum, able to win public support because these functions had not existed before. Instead, meaningful new euro area fiscal capacity has to compete with existing government services at the member state level. This is a struggle that the "European level" cannot hope to win. Member states will not want to let go of their core social insurance functions. Hence it is unrealistic to expect the euro area to develop a sizable budgetary capacity beyond the existing EU-27 budget—let alone anything like the US federal budget.
It is realistic, however, for the euro area to develop a latent central budgetary capacity to address potential asymmetric shocks, though not by 2013. The euro area could provide occasional "accident insurance," for example, rather than a constant "social insurance" by the US federal government, as a way to overcome political constraints.
A euro area accident insurance against asymmetric shocks would not need to be as big as the US federal budget. As described in Wolff (2012), probably 1 to 2 percent of euro area GDP would suffice to provide such adequate macroeconomic stabilization.
Moreover, access to accident insurance funds could hinge on the recipient member state adopting policy reforms, just as reforms were required in return for the European Central Bank's Outright Monetary Transactions (OMT) program or other similar IMF-type conditional support mechanisms. With such programs, moral hazard concerns can be addressed just as they arise in other euro area bailouts. Assuming that member states' reform needs are known in advance to euro area authorities, conditions for financial aid could be announced ahead of time. Individual member states might then prequalify for automatic disbursements. The asymmetric shock would thus not have been caused by domestic policy failure. Viewed in this manner, the access to such transfers in the case of an asymmetric shock is functionally close to the euro area "solidarity mechanisms" attached to the "mutually agreed contracts for competitiveness and growth" approved by EU leaders at the recent EU Council.
The particular economic developments triggering a member state's access to euro area "accident insurance" would also be specified in advance. Such developments could include cumulative economic contraction, unemployment level, or the cost of government financing (measured by interest spreads). In principle, these could be whatever euro area leaders decide. Absent a US template, the euro area thus has plenty of latitude to innovate its way towards a sufficient fiscal capacity.
Why the United Kingdom Will Stay in the European Union
The new agreement in the EU-27 to launch the SSM for the euro area members and other willing member states—while setting banking rules through the European Banking Authority (EBA)—provides the City of London with a politically acceptable place inside the European Union. As discussed previously here on RealTime, with the most important British industry comfortably residing inside the European Union, the United Kingdom is not likely to take the momentous political decision to bolt. Absent backing from the financial services sector in Britain, the votes will not be there to quit.
Of course, Tory backbenchers may be slow to understand that the United Kingdom is not in an economic or political position to turn its back on Europe. Yet it is perhaps ironic that the most "pro-Britain " Tory politicians, while promoting the indispensability of Albion in the world, disparage their own ability to persuade the European Union to their point of view. They overlook the fact that this very ability to influence is what underpins the special relationship with the United States.
But the political deal on the SSM and EBA contains another innovative element that will be more and more important as the European Union strives to reconcile a "multi-speed union" of deepening euro area integration with the aspirations of non-euro area EU members, particularly the United Kingdom. This is the so-called "double majority rule" contained in the new EBA regulation . Its Article 44 now states that the "[EBA] Board of Supervisors shall take decisions on the basis of a qualified majority of its members..., which shall include at least a simple majority from members of [SSM] participating Member States,... and a simple majority from members of [SSM] non-participating Member States." In other words, EU member states outside the SSM will have a disproportional weight in the decisions of the EBA Board of Supervisors. Article 81 stipulates further that these double majority rules will be reviewed by the EU Parliament and EU Council if the number of non-SSM members reaches four, limiting the influence of a country like the United Kingdom in the EBA.
This is a classical minority-protection type clause. Short of reinstating the national veto, it provides the United Kingdom with assurances that it can affect European financial sector/banking rules in the EBA, even if it stays outside the SSM. Moreover, this type of minority-protection of member states not joining the euro or new euro area institutions can apply to other policy areas related to further integration in the euro area.
Similar rules should facilitate the United Kingdom's acceptance of further euro area-only integration in other policy areas as well. This modus operandi enabling more euro area integration, while accommodating the political needs of non-euro area members, will greatly facilitate the ability of the EU-27 (soon 28) to function amid deepening euro area integration.
Franc Poses the Principal Downside Risk for Europe in 2013
Across the euro area, severe economic hardships in many peripheral countries will continue in 2013, not least in Greece, Portugal, and Spain. This is part of the euro area baseline scenario. So is the political uncertainty surrounding the Italian elections. The real potential negative surprise for Europe is the evidence that President Francois Hollande is a captive of the French labor unions and hence is failing to implement structural reforms. His political strategy is unclear. On the one hand, his government's embrace of heavily symbolic increases in the tax rate for high income earners suggests an attempt to embrace "social justice" with an eye to undertaking reforms. But France's paleo-socialist labor unions, which count only a single digit share of private sector workers as their members, will not likely be placated. They seem determined to maintain current leisure levels for their few members and oppose labor market change in France. Reform should include more flexibility for French firms to adjust wages, working hours, and work organization in line with the competitive situation they face. Hollande is not likely to escape a confrontation with this part of his political base. The real risk is that—despite having a full term ahead of him and a parliamentary majority—he ends up shying away from it.
But just as the markets punished former Prime Minister Jose Luis Rodriguez Zapatero in Spain after he denied these problems until mid-2010, market pressure might focus minds in Paris. True, recent declines of French bond yields might have been precipitated by the Swiss National Bank (SNB) purchasing French bonds under its currency peg scheme (as the bank tried to avoid the super-low yields of German bonds). But unfortunately that gambit has given Hollande the opportunity to procrastinate.
1. I also need to add a correction. Several people have noted that the term I used in my previous RealTime piece, "NAMA promissory notes," is misleading. These securities used to recapitalize Irish banks (especially Anglo-Irish) are not in fact directly related to NAMA (National Asset Management Agency) in Ireland.
2. Oates, Wallace. 1968. The Theory of Public Finance in a Federal System. Canadian Journal of Economics 1 no. 1: 37–54