Wednesday, September 21, 2011

A fiscal union for the euro: Some lessons from history

by Michael Bordo, Lars Jonung & Agnieszka Markiewicz

Vox

September 21, 2011

The single European currency is the first of its kind – a union where monetary policy is decided centrally and fiscal policy decided nationally – something that many argue is the root cause of its troubles. This column looks to history to find examples of federal states with a common currency but without the frailties currently being exposed in the Eurozone. The main lesson: No bailouts.


The current sovereign debt crisis in Europe, now threatening the existence of the euro, has revealed major faults in the design of the fiscal framework of the Eurozone. It has inspired a heated debate reflected in a steady flow of proposals concerning the proper rules and institutions for fiscal policymaking in the EU. The debate shows no sign of an emerging consensus (see for instance Gual 2011 and Wyplosz 2011 on this site).

One reason for this lack of unanimity is that the Eurozone represents a new type of monetary union. It is the first monetary union where monetary policy is decided at the central (European) level while fiscal policy is carried out at the sub-central (member state) level. Thus, the economics profession lacks historical cases to use as guidance for theoretical, empirical, and policy-oriented work. The debate also reflects different country perspectives. Economists and policymakers in EU member states like Germany with strong fiscal positions and current-account surpluses tend to have other views than economists and policymakers in debtor countries like Greece and Italy with weak fiscal records.

In a recent working paper (Bordo et al 2011), we add to the current debate by turning to the history of fiscal federalism for an answer to the question: What are the lessons from the past for the fiscal arrangements in the Eurozone? In short, we ask, which fiscal arrangements in the federal states that we study would help to avoid the centripetal forces that threaten the stability of the Eurozone? This is done by exploring the record of five federal states: Argentina, Brazil, Canada, Germany, and the US.

The five federal states studied by us are monetary unions as well as fiscal unions based on fiscal federalism. They are monetary unions in the sense that they have all one common currency and one central bank managing monetary policy for the union. They are fiscal unions in the sense that one central authority is in charge of union-wide fiscal policy. However, these fiscal unions are organised as federations, where sub-central (regional or state) political entities enjoy significant independence to decide legislation, including taxes and government expenditures, at a level below the national (central) one. Within the fiscal union, there is a common market characterised by free trade and mobility of labour and capital.

The governance structure of the Eurozone has important similarities with that of a federal state. It is set up as a monetary union with the ECB as the central bank of the Eurozone. However, the central budget, the EU budget, is much smaller than the size of the budget of the central government of a typical federal country reflecting the fact that the political power of the centre (‘Brussels’ for short) is also much weaker in the Eurozone.

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