This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
The CEPR Policy Insight by 14 French and German economists (Bénassy-Quéré et al. 2018) marks a crucial stage in a long-lasting debate on how to reform the euro area. It offers a convincing synthesis in a discussion which until then had been held hostage by diametrically opposed camps: the advocates of risk reduction led by Germany and the apologists for risk sharing led by France. Bénassy-Quéré et al. (2018) convincingly underscore that the debate can be won neither on the battleground of the first best nor on the moral high ground. Progress requires movement on both fronts – risk sharing and risk reduction are complements, not substitutes.
We share this view. In this column we focus on fiscal policy dimensions and argue that finding the appropriate balance between risk sharing and risk reduction will be of crucial importance. We are convinced that fiscal risk reduction must be part and parcel of any viable reform proposal. In essence, establishing new arrangements of fiscal risk sharing such as a central fiscal capacity will only be politically feasible and economically effective if accompanied by a serious effort to strengthen existing elements of fiscal risk reduction.
Completing EMU or defending the status quo?
The euro crisis of 2011-2012 was a particularly drastic reminder of how incomplete the architecture of the single currency area has been. However, the insight of how important a central fiscal capacity (CFC) would be for the smooth functioning of a monetary union pre-dates the euro crisis by quite a bit. In particular, the theory of optimum currency areas and fiscal federalism pre-date the crisis by around 50 years. Yet, these early insights are more relevant than ever before.
Therefore, the underlying question is not whether a CFC is needed to complete the EMU; rather, how much additional integration do citizens and their political representatives really want. In some euro area countries, more integration has become a euphemism for footing more bills of policy mistakes made by others. They are not at all convinced that the benefits of further integration outweigh its costs, especially fiscal ones. Other countries in contrast underscore the benefits of more fiscal integration for the overall stability of the EMU and bemoan the moral intransigence of the other camp.
The current impasse can only be overcome if we accept the reservations of both camps and take them into account when putting forward reform proposals. Clearly, this key message of Bénassy-Quéré et al. (2018) applies to all policy areas of economic and monetary integration. We would add that it carries particular weight in relation to fiscal integration, because that's where citizens see the most direct impact in the form of taxes and transfers.
Two sides of the same coin
To be clear, we are strongly in favour of a CFC; we believe it is a crucial element of a complete EMU. And indeed, the call for a CFC aimed at dealing with major adverse shocks, is becoming louder: the IMF (Berger et al. 2018, Arnold et al. 2018) has recently confirmed its strong support for a CFC, a support that is shared by many others, including earlier contributions such as Beblavý et al. (2015), Dolls et al. (2015), Carnot et al. (2017), Abraham et al. (2017), and Beetsma et al. (2018). The design of a CFC raises many questions: What should it target – unemployment or investment? How should it be triggered – automatically or with expert judgement? Which shocks should it address – symmetric or asymmetric? How should it be funded – transfers, borrowing, a budget? And how should the moral hazard problem be tackled? The last one features particularly prominently in the policy debate. How can we ensure a CFC does not make governments less attentive towards prudent fiscal policymaking? There are several ways to address the underlying concern, but one stands out: making access to the CFC conditional on compliance with commonly agreed fiscal rules. Hence, strengthening the EU fiscal framework and setting up a CFC must be seen as one package. Trying to push ahead with a CFC without improving the common fiscal rules will not work.
The assessment of how the SGP has worked exhibits a clear cyclical pattern. The post-2007 crisis illustrates this nicely. After the crisis had broken out and until recently, the consensus was that the SGP had failed, and valiant attempts were made to amend shortcomings. Right now, after several years of solid economic growth, the assessment by EU institutions has become more sanguine: the SGP is again considered to have worked. A typical argument to substantiate the rosier appraisal is to say that public finances in other jurisdictions such as the US, Japan, or the UK are in a worse shape. What this view overlooks is that complete economic and monetary unions, which include a central fiscal instrument and one single sovereign bond market, can afford higher deficits and debt.
If we adjust for the cycle in the shifting assessment, the impact of the SGP has not been impressive. It did not push member states to take advantage of economic good times. Whenever a downturn arrived, some countries had not accumulated sufficient buffers to let automatic stabilisers dampen the decline in aggregate demand. Painful and pro-cyclical consolidation measures had to be implemented, giving rise to misgivings. Initially, the predicament was blamed on the 'stupidity' of the rules, but things did not improve as rules became more 'intelligent'. The outcome is an excessively complex set of rules that few understand and where the many elements of discretion are less used to tackle economic contingencies, but to solve problems that lie outside the realm of fiscal policy making.
There has been a surprising convergence of views on how to overhaul the SGP. Since the complexity of the current system has put off almost everyone simplification is the magic word. Almost all proposals put forward in the recent past, including by the European Fiscal Board (EFB),1 are organised around the same basic elements: one main objective (reducing government debt), one operational rule (capping expenditure growth, for example), and a parsimonious use of escape clauses (to account for unforeseen contingencies). Some observers doubt simplification will work; they think simplification is an illusion, because there are too many details and special circumstances (the cycle, one-off measures, and much more) that need to be taken into account in order to produce sensible results and ensure strict cross-country consistency (Bini-Smaghi 2018). The problem with this view is that it is stuck in the fallacious paradigm of the complete contract.
Expert judgement is inevitable in the application of fiscal rules, as it is in all areas of economic policymaking; the key question is who should exercise it. Bénassy-Quéré et al. (2018) raise this fundamental question and advance a proposal that is in line with our thinking and the thinking of the EFB (EFB 2017). The proposal is to separate the assessment of fiscal policy developments vis-à-vis commonly agreed rules and the political decision on whether steps are to be taken under the rules. Bénassy-Quéré et al. (2018) refer to the role of the 'prosecutor' and the 'judge'. While we share the idea of separating roles, we find the expressions 'prosecutor' and 'judge' misleading. The 'judge' is generally meant to impartially interpret the law in light of the available evidence. In EU fiscal surveillance the 'judge' is the decision maker endowed with the necessary democratic legitimacy, and its decision will and should follow prevailing political majorities. It is the 'watchdog' rather than the ‘prosecutor’ who should provide an impartial assessment, and by making the assessment public it enhances the accountability of the decision maker. With further economic and political integration the European executive will inevitably move from its original role of the guardian of the Treaty to a more conventional executive branch that takes political decisions. As a result, an independent assessment will gain in importance.2
The role of market discipline
Although the disciplining effect of the financial markets on fiscal policymaking has proved erratic, recent commentaries, including Bénassy-Quéré et al. (2018), have emphasised the potentially increased role of financial markets. Since institutions have failed, the underlying argument goes, it is time for markets to step in. Bénassy-Quéré et al. (2018) put forward a novel idea whereby euro area countries should finance new debt in excess of limits imposed by the SGP's expenditure benchmark with junior debt. The higher yield on junior than on senior debt would encourage fiscal discipline.
Junior debt may indeed fulfil a useful role in this regard. However, we also see risks to its issuance. First, one needs to be able to unambiguously establish that the threshold activating its issuance has been exceeded – assessing compliance with the expenditure benchmark involves judgement. Second, placement of junior debt may be risky if the existing senior debt stock is very high – markets may be disrupted if they are reluctant to accept the junior debt (realise that financial markets do not react in a smooth way). Third, how can one legally enforce the issuance of junior debt?
An alternative to the issuance of junior debt could be a 'budgetary charge' levied at the EU level for non-compliance with commonly agreed rules. The charge would not be imposed by the markets, which have a track record for not being consistent, but by the supranational institution. Different designs are imaginable in practice, but the underlying mechanism could be as follows. For as long as a member state is found to run afoul of key elements of commonly agreed rules, a given percentage of EU expenditure allocated to that member state would be transferred – subject to a decision of the Council with reversed qualified majority – to a rainy-day fund to be used – again based on a Council decision – the next time the country is in economic bad times. Conditionality on EU expenditure is not new and has slowly grown over the years. The recent Commission proposal for the 2021-2027 Multiannual Financial Framework even aims at extending it to areas such as the rule of law. For the reasons mentioned above, the budgetary charge would unlikely be effective with the current set of fiscal rules. It would have to be introduced with the overhaul of the fiscal framework.
Progress with EMU deepening has been hampered by diametrically opposed views on the need for risk reduction versus risk sharing. There is increasing doubt in the policy debate about whether further steps of integration should actually be taken. The contribution by Bénassy-Quéré et al. (2018) contains welcome suggestions for finding common ground to break the deadlock. We agree with this approach and view an exchange of risk reduction and risk sharing as a prerequisite to make progress with the fiscal architecture of EMU. In fact, as we have argued, political support for a properly designed central fiscal capacity will only emerge if access to the CFC is made conditional on an effective fiscal framework. Consequently, fiscal rules need to receive more attention.
Abraham, A, J Brogueira de Sousa, R Marimon and L Mayr (2017), “On the Design of a European Unemployment Insurance Mechanism”, mimeo, EUI and UPF.
Arnold, N, B Barkbu, E Ture, H Wang and J Yao (2018), “A central fiscal stabilization capacity for the Euro Area”, IMF Staff Discussion Note, 18/03.
Beblavý, M, D Gros and I Maselli (2015), “Reinsurance of national unemployment benefit schemes”, CEPS Working Document No. 401.
Beetsma, R, S Cima and J Cimadomo (2018), “A minimal moral hazard central stabilisation capacity for the EMU based on world trade”, ECB Working PaperNo. 2137.
Bénassy-Quéré, A, M Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani- Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro and J Zettelmeyer (2018), “Reconciling risk sharing with market discipline: A constructive approach to euro area reform”, CEPR Policy Insight No. 91.
Berger, H, G Dell'Ariccia and M Obstfeld (2018), “Revisiting the Economic Case for Fiscal Union in the Euro Area”, IMF Research Department Policy Paper.
Bini-Smaghi, L (2018), “A stronger euro area through stronger institutions”, VoxEU.org, 9 April.
Carnot, N, M Kizior and G Mourre (2017), “Fiscal stabilisation in the Euro-Area: A simulation exercise”, CEB Working Paper, No. 17/025, Solvay Brussels School of Economics and Management.
Claeys, G, Z Darvas and A Leandro (2016), “A proposal to revive the European fiscal framework”, Bruegel Policy Contribution, No. 2016/07.
Dolls, M, C Fuest, D Neumann and A. Peichl (2014), “An unemployment insurance scheme for the Euro Area? A comparison of different alternatives using micro data”, CESifo Working Paper, No. 5581.
European Fiscal Board (2017), Annual Report 2017.
Eyraud, L and T Wu (2015), “Playing by the rules: Reforming fiscal governance in Europe”, IMF Working Paper, No. 15/67.
Eyraud, L, X Debrun, A Hodge, V Duarte Lledo and C A Pattillo (2018), “Second-generation fiscal rules: balancing simplicity, flexibility, and enforceability, IMF Staff Discussion NotesNo. 18/04.
 The EFB has outlined its proposals for simplification in its first Annual Report 2017. Other prominent proposals, in addition to those included in CEPR Policy Insight No. 91, include Eyraud and Wu (2015), Claeys et al. (2016) and Eyraud et al. (2018).
 Interestingly, not all advocates of a radical simplification of the SGP thematise the separation of roles, which we believe is essential to make a simplification work in practice.