Fiscal policy and economic policy coordination more generally are becoming ever more important in the Economic and Monetary Union (EMU) of the EU, as we are witnessing the possible end of low interest rates on government bonds. There are signs in the bond markets that the investors are pricing in a permanent shift in the expectations concerning inflation dynamics. This is possibly due to the high levels of government debt, given 50 years of fiat-currency after the collapse of the Bretton Woods system. Moreover, the recent surge of defence spending is in the cards to add more stress to government finances in EU Member States, stemming from justified geopolitical concerns. Furthermore, ageing is a heavy factor here eroding fiscal sustainability as well. Debt levels are indeed on the rise, and EU is economically weak, politically weak. Even individual Member States are experiencing chronic fiscal degeneration, and credit ratings are evaporating, even in the US.

At the same time, there is no clear shared European identity, vision or view, nor the will to move forward to joint spending and large scale, permanent eurobond issuance. This is because Member States, at least some of us, want to stay as independent, sovereign nation-states – EU suffers from a de facto democratic legitimacy gap. The current turmoil in international relations provides the perfect opportunity, however, for the EU elites to move forward towards a fiscal federation. As the international role of the dollar as the reserve currency, primus inter pares, is eroding, central bankers in the EU are eager to boost the role of the euro as well. The elite wants to move forward, but the people resist. At least to a sufficient degree, as major decisions require unanimity.

We will see whether the new coalition in Germany will pivot. I have my doubts. The EU cannot and should not become a federal superstate without a Treaty change. Functional integration is perverse and wicked.

All this will likely have an impact on perceived debt sustainability for all Member States of EU, and fiscal rules will not save us.

Fiscal rules and the ghost of Delors are the other side of the issue

The fundamental rules governing public debt and deficits in EU are laid down in the primary legislation of the EU. The Treaty on Functioning of the European Union (TFEU) provides that Member States’ public debt ratios shall not exceed 60 % of GDP and public deficits shall not exceed 3 % of GDP. Article 126 of TFEU and the reference values in the protocols of the TFEU are the basis on which relevant secondary legislation provides further legally binding regulations. Various complex set of codes of conduct give further guidance on how to interpret and operationalize the complex set of rules. The rules have been modified recently, and the MTO has been replaced etc. The essence of the rules still remains.

Given that the historical record concerning the effectiveness of fiscal rules in the EU is debatable at best, one might argue whether fiscal rules are needed in the first place. There is, however, some evidence that fiscal rules have had some effect in terms of steering national budgetary developments. Due to impediments concerning orderly sovereign debt restructuring however, fiscal rules or at least policy incentives in some form will likely be needed in the future as well, as sovereign debt restructurings might prove to be difficult and cause unexpected consequences for the Euro area as a whole. On the other hand, a full convergence process where one-size-fits all monetary policy would actually work in the Euro area ideally is hard to imagine any time soon. This would be the ideal state of affairs. One price of money and monetary policy across the Euro area means currently too low interest rates for some, and too low risk premia for others. Ultimately, the divergences in competitiveness, differences in productivity together with weak mobility of labour and capital across Member states are the fundamental roots of economic challenges in EMU. It should be remembered nevertheless that the Euro area and EMU are essentially politically motivated constructions.

In terms of fiscal policy coordination and economic governance, the question of expert rules vs. democratic accountability is another important issue when considering what kind of centralized economic governance is politically sustainable in the long run in EU. One of the problems with fiscal rules is indeed that fiscal policy is at the core of coercive power of national politics. The national parliaments in Member states hold the power to tax, borrow and to spend.  Budgetary power is the crown jewel of national parliaments in Member states. Democratic legitimacy for any fiscal policy must ultimately come from the accountability of the relevant political decision-makers. This is the essence of the principle of subsidiarity in terms of political accountability and democratic legitimacy. On the other hand, if fiscal policy powers are taken away de facto from national governments and national parliaments, then accountability, economic or political, should not reside at the national level either. This problem is at the heart of EMU.

If one wants to restore fiscal powers and political accountability back to national parliaments, then one should have some credible mechanism to restructure sovereign debt in times of crisis without having to resort to excessively intrusive EU-wide financial assistance programs like for example in Greece in 2010-2015. This approach goes hand in hand with the reasoning of market discipline, in which bond markets would discipline the Member states from spending recklessly. As democratic accountability cannot be easily extended to the Council of the EU or to the Eurogroup or the European Commission or even to the European Parliament, one can argue that the de jure and de facto fiscal powers of these institutions should be rather constrained.

In spite of theoretical feasibility of any fiscal rule, it can be argued that national fiscal policies cannot be guided perfectly with some exogenous technical rules based on theoretical inter-temporal solvency considerations. On top of this challenge, the real problem is political in nature: coercive fiscal rules dictated by the European Commission and Council of the EU can be divisive, as the Council for example as a whole is not accountable to a given electorate in a  given Member State. This democratic legitimacy gap cannot be solved with any particular technical solution as regards the design of fiscal rules. That is why compliance could be more fruitfully be linked to positive incentives instead.

The lack of legally binding fiscal rules would require substantial increase of market discipline in order to limit moral hazard and to prevent excessive deficits, which could be supported for example by constraining the powers of the ECB/Eurosystem to conduct idiosyncratic bond buyings directed towards any single Member state. In practice, the Treaty could be amended in such a way that there would be clear provisions on the limits of the Asset Purchase Programme (APP) and Outright Monetary Transactions (OMT). Perhaps the ESM could play a role here with its ECCL program, at least in terms of conditionality.

In the Euro area, impediments to orderly sovereign debt restructuring can make market discipline incredible. If there is no credible alternative to bailouts, investors will assume that ultimately sovereign debt is bought or refinanced by the local central bank or other official party. This will in turn make it possible for Member States to take on more debt, as the credit risk premia are kept low due to the impression that sovereigns will be rescued financially. This potential moral hazard could lead to loss of monetary independence, inflation and other disruptions in the Euro area.

Banking, Saving and Investments Union

In order to foster orderly debt restructuring and credibility of market discipline, prudential regulation of banks should be improved with provisions to require banks hold sufficient amount of capital against sovereign credit risk. One of the main challenges for financial stability and orderly sovereign debt restructuring in the Euro area is the so-called vicious loop between banks and sovereigns. One key feature of this vicious loop is that domestic banks in the Member States are heavily exposed to credit risk of their domestic government. This can mean that while the perceived credit risk of a Member State is increased due to for example excessive government debt or deficits, the solvency of the banks within the Member State is deteriorated as a result, which in turn means more risk for the government. The additional risk comes from the perception that the financial market assumes that the balance sheet of the sovereign is used at least partly to bail-out the banks. Partly due to this, Banking Union was established in the Euro area in 2013 with its common supervision (ECB) and common resolution fund (Single Resolution Fund), although a common deposit insurance scheme is still missing. Debt restructurings become very difficult when the domestic banking sector cannot sustain the write-off of its sovereign exposures. Finance ministers of the EU (Eurogroup in extended format) are still discussing on how to mitigate the vicious loop by considering amending prudential regulation in terms of capital requirements for sovereign bonds. Currently, the EU legislation does not generally require banks to hold capital against credit risk from EU sovereigns. Contractual terms in EU sovereign bonds should be further optimized as well so that collective action clauses would mitigate the so-called creditor coordination problem. One major impediment in terms of orderly sovereign debt restructuring could be contagion to other vulnerable Member States.

..And joint EU spending and debt issuance is the other side

The way things are evolving, it surely seems that new incentives are being created. For example, the European Commission might be thinking that joint EU -level lending or spending might benefit from a permanent carve-out in terms of deficit book-keeping. As the fiscal sustainability of the US is eroding, there are clearly signs that there is a gathering will and momentum to boost the international role of the euro (to make it a credible reserve currency/safe asset). Creating a reserve currency means that one needs deep and liquid capital markets, lots of AAA -rated bonds with regular issuance, and so forth. This boils down to the 1960’s, when Robert Triffin proposed that a reserve currency needs debt and thus deficits. Joint spending at the EU level allows the Commission to issue Eurobonds, so that is why we can expect further proposals along the lines of the NGEU.

For example, the European Commission might be tempted to propose and establish a joint macroeconomic stabilization function within the Multiannual Financial Framework of EU and thus within the EU budget itself. Labeling it as defence spending would surely alleviate the political concerns of many. Marketing is important in politics as well. For example, a pimped Next Generation EU II (NGEU II) could be launched to cater for this more permanent possibility. Due to the Corona crisis, an EU-wide recovery fund Next Generation EU was decided by the Heads of State or Government in the European Council in July 2020. NGEU allows the European Commission to issue bonds on the capital markets to fund recovery in the EU with a total face value of around 800 billion euros. As part of the agreement, it was agreed also that the Commission would propose new Own Resources for the EU to pay back the bonds issued. Such new Own Resources could be based on Emission Trading Scheme revenues, Carbon Border Adjustment Mechanism or on a digital tax on companies. The vehicle was a functional and a political failure, but it will not prevent the Commission to propose another such arrangement in the near future. The problem is, that any joint spending should be theoretically smart, and this means that any joint spending should mean something like European public goods. What are these without provisions in the primary legislation on common defence etc?

From a purely legalistic point of view, the limits of the Treaties have been already breached and extending the current volume of the EU budget substantially, and allowing the EU to permanently borrow from capital markets would be a substantial change in the competencies of the EU, and thus would require a Treaty change. At the very minimum, access to such a macroeconomic stabilization /joint spending tool/function should require confirmed compliance with the fiscal targets as set out for example via the present approach. Participation should be completely voluntary, so that annual contributions to finance the scheme through Own Resources /payback would need to be strictly voluntary as well. These functional changes in the financial architecture of EU would likely require substantial changes in the Treaty. Another option for the Commission is to go via the intergovernmental route, but sticking with the EU remit is preferred by EU institutions.

https://www.politico.eu/article/europe-russia-donald-trump-vladimir-putin-war-and-joint-bonds-united-europe

Hit the road, Jack

The debate on a fiscal union of EU, i.e. the future of economic policy and fiscal policy coordination and the possible need to establish a central fiscal capacity in EMU, has been on-going for many years. Especially relevant question is whether a fiscal stabilization function could be established to smoothen idiosyncratic shocks in individual Member States. Symmetric shocks can be handled using monetary policy.

Current secondary legislation includes provisions to sanction Member States if there is severe non-compliance. However, these sanctions have never been used. Indeed, for political reasons it is unlikely that direct sanctions could be credibly instated in the first place. Politically, it could be easier to establish criteria to have an access to a macroeconomic stabilization function based on compliance, than to try to penalize Member States directly using deposited fines or other penalties. Such an incentive scheme could be based on the principles of a fair insurance – the pay-off from the insurance scheme should depend on the past behaviour of the policy holder. In various insurance policies it is common that the first-loss cost depends on the past behaviour of the policy holder. From the perspective of smaller ”frugal” Member States it is clear that for any joint macroeconomic stabilization criteria to become reality, strict conditionality will likely be needed . I doubt that even with the new coalition in Berlin things will be easy, when it comes to Eurobonds and joint spending on defence. The recently adopted SAFE instrument is tiny, and it is providing loans for Member States, not grants.

The Economic and Monetary Union will remain incomplete for the foreseeable future. This does not however mean that improvements cannot be agreed on. The key balancing act is how to balance risk sharing, good incentives and market discipline. On the other hand, risk sharing must be constitutional in terms of national parliaments and democratically legitimate. If fiscal rules are more flexible, non-binding and differentiated across Member States, likely from a political point of view, market discipline needs strengthening. Ultimately, the future of any sort of fiscal union is a compromise between all Member States, and therefore it needs to strike the right balance. There is no general will towards a proper federal EU.

One option to support market discipline would be to amend the competencies of the ECB in such a way that the Eurosystem could not buy government bonds without a limit. Currently, the yield curve reflects predominantly the unconventional monetary policy stance of the ECB. If the actors and investors in the capital markets assume that the central bank will ultimately buy bonds of Member States with solvency risks, the functioning of market discipline could be impaired. Moreover, it has been documented that the large scale buying activity of Eurosystem might also increase the imbalances in the TARGET2-settlement system in the Eurosystem (Bundesbank 2018). These imbalances might cause large budgetary risks for Member States in case that the dissolution of the Euro area cannot be ruled out (Bundesbank 2018). Risks stemming from monetary policy operations – direct or indirect – are substantially more opaque compared to for example liabilities stemming from the NGEU. Therefore, from the point of view of the Commission, it could be tempting to try to contain the risks in monetary policy operations via establishing a joint macroeconomic stabilization function instead within the EU legislative framework. If Germany and France among with perhaps Italy and Spain find a common tune, things might go forward as soon as July this year, when the new MFF proposal is adopted by the Commission.

All and all, it seems that the fiscal union architecture would need preferably amendments in the primary legislation of the union. The present daydream model of the EU elite for a soft, incentivizing fiscal rule combined with a macroeconomic stabilization function within the EU budget would be hardly compatible with the current provisions of the Treaties. Similarly, the European Stability Mechanism and the  NGEU would be better anchored via explicit provisions in the TFEU, and also any changes to the competence of the ECB or the ESCB would likely require a Treaty change as well.

I do not think that any new joint spending scheme is useful without a Treaty change. To launch an intergovernmental process, on amending the Treaties would give every Member State a fair possibility to set the limits to fiscal integration of the EU. Those Member States who want further fiscal integration and a proper federation of EU states, can go forward, and others can stay out. The system of Own Resources is key, as it is a precursor of taxing powers for the EU, and taxing powers are essential, if the EU wants to become a superstate, like the US. The Multiannual Financial Framework is the other side of the coin. Given the geopolitical weather, most likely the route that the EC will take, is to propose a large defence spending fund, to fund joint procurement. As the NGEU had its piloting phase, SURE, the future joint defence financing vehicle has a precursor in SAFE. The key moment in terms of political decision making is in 2027, when the MFF must be agreed by the European Council. Let’s see what the summer brings.

SOME REFERENCES

(Benassy-Quere et al 2018) Benassy-Quere, A., M. Brunnermeier, H. Enderlein, E. Fahri, M. Fratzscher, C. Fuest, P.-O. Gourinchas, P. Martin, F. Pisani, H. Rey, I. Schnabel, N. Veron, B. Weder Di Mauro. 2018. Reconciling Risk Sharing and Market Discipline: A Constructive Approach to Euro Area Reform. CEPR Policy Insight 91.

(Blanchard 2019) Blanchard, Olivier. 2019. Public debt and low interest rates. American Economic Review 109: 1197–229. [Google Scholar] [CrossRef]

(Bhatt and Kishor 2017) Bhatt, Vipul, N. Kundan Kishor, and Jun Ma. 2017. The impact of EMU on bond yield convergence: Evidence from a time-varying dynamic factor model. Journal of Economic Dynamics and Control 82: 206–22. [Google Scholar] [CrossRef]

(Bucheit et al 2019) Bucheit, Lee, Guillaume Chabert, Chanda DeLong, and Jeromin Zettelmeyer. 2019. How to Restructure Sovereign Debt: Lessons from Four Decades. Working Paper19-8. Washington, DC: Peterson Institute for International Economics. [Google Scholar]

(Bucheit et al 2018) Buchheit, Lee C., and Mitu. G. Gulati. 2018. Sovereign debt restructuring in Europe. Global Policy 9: 65–69. [Google Scholar] [CrossRef]

(Bundesbank 2018) Bundesbank 2018, Asset purchases have significant impact on TARGET2 balance, https://www.bundesbank.de/en/tasks/topics/asset-purchases-have-significant-impact-on-target2-balance-762952

(Checherita-Westphal and Domingues Semeano 2020) Checherita-Westphal, Cristina, and João Domingues Semeano. 2020. Interest Rate-Growth Differentials on Government Debt: An Empirical Investigation for the Euro Area. Working Paper Series; Frankfurt am Main: European Central Bank. [Google Scholar]

(Dawson and Maricut-Akbik 2021) Dawson, Mark & Adina Maricut-Akbik (2021) Procedural vs substantive accountability in EMU governance: between payoffs and trade-offs, Journal of European Public Policy, 28:11,1707-1726,DOI: 10.1080/13501763.2020.1797145

(Debrun and Jonung 2019) Debrun, X and L Jonung. 2019. Under threat: Rules-based fiscal policy and how to preserve it, European Journal of Political Economy 57(C): 142-157.

(De Grauwe 2013) De Grauwe, P. The European Central Bank as lender of last resort in the government bond markets.CESifo Econ. Stud. 59 (2013): 520–535. [Google Scholar] [CrossRef]

(De Jong and Gilbert 2020) De Jong, Jasper F.M., Niels D. Gilbert. 2020. Fiscal discipline in EMU? Testing the effectiveness of the Excessive Deficit Procedure. European Journal of Political Economy 61, https://doi.org/10.1016/j.ejpoleco.2019.101822

(Ehrmann and Fratzscher 2017) Ehrmann, Michael, and Marcel Fratzscher. 2017. Euro area government bonds–Fragmentation and contagion during the sovereign debt crisis. Journal of International Money and Finance 70: 26–44. [Google Scholar] [CrossRef]

(European Fiscal Board 2021) European Fiscal Board. 2021. 2021 Annual report of the European Fiscal Board.  https://ec.europa.eu/info/publications/2021-annual-report-european-fiscal-board_en

(Jonung and Drea 2010) Jonung, L. and  Drea, E. 2010. It can’t happen, it’s a bad idea, it won’t last: US economists on the EMU and the Euro, 1989–2002. Econ J. Watch 7 : 4–52. [Google Scholar]

(Kamps and Leiner-Killinger 2019) Kamps, Christophe and Leiner-Killinger, Nadine. 2019. Taking Stock of the EU Fiscal Rules over the Past 20 Years and Options for Reform, JahrbücherfürNationalökonomie und Statistik, vol. 239, no. 5-6, 2019, pp. 861-894. https://doi.org/10.1515/jbnst-2018-0090

(Leiner-Killinger and Nerlich 2019) Leiner-Killinger, Nadine and Nerlich, Carolin. 2019. Fiscal rules in the euro area and lessons from other monetary unions, Economic Bulletin Articles, European Central Bank, vol. 3.

(Mundell 1961) Mundell, R. 1961. A theory of optimum currency areas. AmericanEconomic Review 51: 657–665. [Google Scholar]

(Sargent and Wallace 1981) Sargent, Thomas J., and Neil Wallace. 1981. Some unpleasant monetarist arithmetic. Quarterly Review 5: 1–17. [Google Scholar] [CrossRef]

(Schoeller 2021) Schoeller, Magnus G. 2021. Preventing the eurozone budget: issue replacement and small state influence in EMU, Journal of European Public Policy,28:11,1727-1747,DOI: 10.1080/13501763.2020.1795226