Options for Europe – Part 72

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Part III – Options for Europe

Chapter 22 Establishing a European fiscal capacity to save the Eurozone



There are a number of hybrid proposals, which acknowledge that transition towards a full fiscal union is desirable but unlikely in the time frame necessary to militate against the ravages of the crisis. These schemes are broadly organised in terms of proposals that seek to add cyclical responsiveness and hence, support at the European level to regions in crisis (increasing the ‘automatic stabilisers’) and proposals that seek to reorganise and reclassify government debt to reduce the vulnerability of the EMU to private bond markets. They are all what might be called ‘austerity’ proposals in that they offer palliative care solutions (‘bandaids’) to stop the breach. In that sense, they fail to address the cause of the breach itself – the lack of a fully-functioning fiscal authority and the bias towards pro-cyclical fiscal policy as a result of the SGP rules.

Boosting the automatic stabilisers within the European tax and transfer system

The so-called ‘asymmetric shocks’ (spending contractions not evenly spread across the monetary union) are particularly damaging to a monetary union, which is comprised of relatively disparate economies. When a particular state or region succumbs to a major downturn in economic activity, investment declines as sales plummet and unemployment rises, and new capital is hard to attract, finding profitable opportunities elsewhere. The asymmetry of economic performance across a monetary union also highlight one of the major shortcomings of monetary policy – it cannot be spatially targetted. The main policy tool at the central bank’s command – the capacity to set the interest rate – is a one-size-fits-all tool. The experience of the EMU prior to the crisis illustrates this problem. Given the fiscal policy settings, the ECB interest rates were too low for economies such as Spain and Ireland, which were undergoing unsustainable, and ultimately, destructive property booms, whereas other economies such as Germany and the Netherlands were experiencing modest growth, which would have been undermined by higher interest rates.

In these instances, only a stimulus from fiscal policy can provide the overall spending boost necessary to counteract the fall in private demand. The question then turns to what mix of fiscal policy tools are appropriate? There are two sources of stimulus that fiscal policy can provide: (a) discretionary changes to the spending and/or taxation settings; and (b) the operation of the in-built automatic stabilisers, which refer to the inherent sensitivity of taxation revenue and spending to changes in economic activity. Thus when economic activity falls and employment declines, the government automatically receives less taxation revenue and increases spending by way of welfare benefits. No discretionary changes to the policy settings are needed for this second effect to work. The upshot is that the automatic stabilisers will push the fiscal deficit up and provide a modicum of spending support to the local economy. In recessions, both sources of stimulus will typically be needed to ensure unemployment doesn’t escalate. Reliance on the automatic stabilisers only puts a floor into the contraction – that is, attenuates how far the economy will deteriorate, but will usually not provide sufficient stimulus to prevent a recession from occurring. Müller (2013) notes that a major advantage of these automatic spending buffers “is that they come into action reliably due to rules established in advance and without the necessity for further political decisions”.

The design of the EMU deliberately reduces the potency of these automatic stabilisers. As Müller (2013) notes “the EU budget is too small and its transfer mechanisms (such as the structural and regional funds) are too rigid to enable a short term adjustment of different cyclical development”. In 2013, there was a proposal coming from the German Young European Federalists to establish a European unemployment benefit system to “partly replace the national insurance systems” (Müller, 2013). The logic of the proposal is sound – to bolster the so-called ‘automatic stabilisers’ at the European-level, which would provide some offset against ‘asymmetric shocks’. The scheme would be “funded through non-wage labour costs” (for example, a small level on all payrolls) and provide support for workers for 12 months at half-pay (Müller, 2013). While the devil would be in the detail, the proponents claim that there “would not be much of a change through this measure” for the unemployed. This raises the question as to how the scheme actually would generate a higher level of total income in crisis regions, especially when it is acknowledged that “the national insurance systems are already higher than the ones the European Unemployment Insurance would provide” (Müller, 2013).

Further, the proposal is essentially political rather than economic given that the support would evaporate after 12 months thus ensuring that there would not be a “permanent financial redistribution among the member states” (Müller, 2013). However, as the current crisis has demonstrated, severe downturns, especially those related to private balance sheet imbalances, take many years to resolve and require long-term fiscal support while the private sector reduces its debt levels. Successful federations, such as Australia, allow for on-going redistributions of tax revenue, for example from states with strong growth to those with weaker performance. But the limits on the transfers proposed here reveal the conservative, neo-liberal nature of the proposal. The aim is to ensure that over “whole economic cycle, the fiscal net balance would … be almost evened out” (Müller, 2013). Why is that a desirable goal? What the desirable federal fiscal balance should be depends on the circumstances. At times, a balance might be desirable. At other times, a deficit or a surplus might be desirable and these circumstances may or may not coincide with a complete economic cycle.

Another automatic ‘cyclical response’ approach is suggested by Enderlein et al. (2012). Their reasoning is symptomatic of the Groupthink among European economists, that led to the problem in the first place. Many of the authors of this report were involved in various studies that gave rise to the design of the EMU. Their approach now, once the system has failed, is to patch it up with various ad hoc measures, all of which are ring-fenced by the austerity mentality. They refused to “even consider the option to abandon the euro” (p.3) and are, instead, guided by the principle: “As much political and economic union as necessary, but as little as possible” (p.3) They consider the “principle of subsidiarity”, which we examined in detail earlier in this book justifies this minimalist approach to fiscal union. They advocate what they call a “sui generis form of fiscal federalism”, which is driven by an implicit assumption that the national economies to be involved in this union are not remotely interested in surrendering their fiscal autonomy to the centre. Of-course, the SGP and the austerity packages forced onto many of the Eurozone economies during this crisis have already severely compromised the so-called fiscal autonomy of these nations. It seems that democracy and autonomy can be violated in some circumstances especially when the Troika is imposing the terms, but, then in other cases, is upheld as a sacrosanct principle that cannot be compromised. This sort of hypocrisy has woven its way through the entire debate about economic and monetary integration in Europe and will continue to deliver sub-par outcomes. Enderlein et al. (2012: 7) propose a simple rule for the limits of democracy – “sovereignty ends when solvency ends”, which is astounding if you think about it. The application of this rule inevitably leads to a violation of democracy because of the flawed design of the monetary system. The design forces the Member States to issue debt in a currency they have no control over and the ECB is formally precluded from giving any guarantees (although of-course it has violated that prohibition via programs such as the Security Markets Programme). Default risk and insolvency is always lurking – waiting for the next major economic downturn to arrive. Thus as soon as a nation falls into crisis, its citizens lose the capacity to influence their own destiny and are, instead, at the behest of unelected officials in the European Commission, the ECB and the IMF. That doesn’t appear to be a road map for a sustainable and prosperous Europe.

Their preferred approach to “cyclical divergences” (p.26) is “enhance the real exchange rate channel” (p.28), which is code for making internal devaluation more responsive through increased labour mobility and wage cuts in declining regions. The authors thus invoke the standard neo-liberal approach – workers from recessed regions should move to growing regions and those who stay should worker harder for less. There is no primacy given the the virtues of stable social communities built on family structures and community spirit. The economy rules and workers are considered meagre pawns in the decisions by management on where to locate industry. Should an industry suffer during a major downturn, then the social fabric of the region is of little importance. One would think that a durable solution to the European crisis is to keep regions viable, especially as the authors recognise that “(l)inguistic and cultural barriers are certainly important” (p.8) in Europe. Labour mobility is also unlikely to be of sufficient magnitude to provide any semblance of equalisation in unemployment rates within the Eurozone. A recent OECD study found that between 2009 and 2011 there was no discernible movement among citizens who were already resident within the Eurozone. The major “labour market adjustment in Europe during the crisis was driven primarily by citizens from outside the Eurozone, such as the recent EU accession countries or non-EU-27/EFTA countries.” (Jauer et al., 2014: 23). While the study found some net in-migration to Germany from Italy, Portugal and Spain between the middle of 2012 to the middle of 2013, Greek migration to Germany declined.

To supplement their ‘structural’ emphasis, which they admit would be “unlikely to solve the inherent difficulties” (p.30), Enderlein et al. (2012) propose ‘a cyclical adjustment insurance fund’. This fund would be managed by Eurozone finance ministers and build its kitty from contributions from nations experiencing above the Eurozone growth rates and pay out to nations in crisis, to “reduce pressure on public finances” (p.31). The scheme would thus force nations to reduce their domestic spending in times of buoyant economic growth and provide some relief in bad times. Significantly, the authors stress the “the system cannot become a hidden instrument for permanent transfers” (p.31) and nations might only be permitted to “take out what they once paid in” (p.32). Once again the presumption is that the ‘federal’ redistribution would be neutral across the economic cycle and across space, a proposition for which there is no rationale other than fiscal conservatism.

Pisani-Ferry et all (2013) propose a similar type of transfer system such that in times of recession, nations would enjoy increased ‘federal’ income and be forced to pay it back in better times. Their “relatively simple rule” would again exploit the “current fiscal framework” and require income support payments to flow whenever there are absolute and large output gaps (p.5). The authority administering the scheme would borrow funds during a recession. It is unclear how the debt would be serviced or relinquished. The proponents claim that a “natural way to pay the debt incurred in recessions would be to extract payments from countries with output above potential in good times” (p.5). But, an examination of the historical record suggests that nations finding themselves in that position are rare both in incidence and duration. The scheme also depends on how one measures the output gap. As we have explained in the discussion relating to the SGP, the estimates of the output gap provided by multilateral organisations such as the OECD and the IMF are biased downwards because they adopt their estimates of full employment unemployment are too high (that is, unemployment could be reduced substantially below the levels assumed by the neo-liberals to constitute full capacity). In this environment, the income support scheme proposed will provide inadequate spending support to nations in recession and would be of limited duration. The economies would be deemed to be back at full employment, while in reality they would still be enduring persistently high unemployment and private spending gaps.



Additional references

This list will be progressively compiled.

Borensztein, E. and Mauro, P. (2002) ‘Reviving the case for GDP-indexed bonds’, IMF Policy Discussion Paper, 02/10, September 2002. http://www.imf.org/external/pubs/ft/pdp/2002/pdp10.pdf

De Grauwe, P. (2013) ‘Debt Without Drowning’, May 9, 2013. http://www.project-syndicate.org/commentary/the-debt-pooling-scheme-that-the-eurozone-needs-by-paul-de-grauwe

Enderlein, H., Bofinger, P., Boone, L., de Grauwe, P., Piris, J-C., Pisani-Ferry, J., Rodrigues, M.J., Sapir, A. and Vitorino, A (2012) ‘Completing the Euro. A road map towards fiscal union in Europe’, Notre Europe. http://www.notre-europe.eu/media/pdf.php?file=completingtheeuroreportpadoa-schioppagroupnejune2012.pdf

Soros, G. (2013) ‘How to save the EU from the euro crisis’, UK Guardian, April 10, 2013. http://www.theguardian.com/business/2013/apr/09/george-soros-save-eu-from-euro-crisis-speech

Varoufakis, Y., Holland, S. and Galbraith, J.K. (2013) ‘A Modest Proposal for Resolving the Eurozone Crisis, Version 4.0′, July 2013. http://varoufakis.files.wordpress.com/2013/07/a-modest-proposal-for-resolving-the-eurozone-crisis-version-4-0-final1.pdf

Müller, M. (2013) ‘EU Unemployment Insurance: Getting the Eurozone back on track’, thenewfederalist.eu. July 5, 2013. http://www.thenewfederalist.eu/EU-Unemployment-Insurance-Getting-the-Eurozone-back-on-track,05865

Jauer, J., Liebig, T., Martin, J.P. and Puhani, P. (2014) ‘Migration as an adjustment mechanism in the crisis? A comparison of Europe and the United States’, Organisation for Economic Co-operation and Development, January. http://www.oecd.org/migration/mig/Adjustment-mechanism.pdf

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

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    2 Responses to Options for Europe – Part 72

    1. Jan Milch says:

      Nice blog post as allways!THis maybe interet you?? Hav a real nice weekend Bill!!
      Krugman’s misleading trivialization of the capital controversy-Lars Pålsson Syll

    2. Aidan says:

      Bill -
      Conspicuously absent from Chapter 22 (and indeed the rest of your book so far) is any mention of concessional loans. I hope you will rectify this oversight, as IMO this option has more potential to save the Eurozone than any other. It makes sense for the ECB because when the point of setting interest rates is to control inflation, it doesn’t make sense to charge the same rate for a project known to have a low inflationary impact and lending to a bank with a random inflationary impact.

      Such a system also has great potential for funding other non sovereign entities such as Australian states.

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