Europe’s Future Is Federal

July 17, 2015 Finance

Numerous Europeans view Europe as a one-way street: they appreciate its advantages but are little inclined to accept common rules. An increasing number throughout the Union are handing their vote to populist parties – Front National, Syriza, Podemos – that surf on this Eurosceptic wave and rise up against “foreign”- imported constraints.

Embroiled with the Greek crisis, European policymakers will soon have to step back and reflect on the broader issue of the Eurozone’s future. Before envisaging an exit or, on the contrary, more sustained integration, it’s right to reflect upon the consequences of each option.

Oversimplifying, there are three strategies for the Eurozone: a minimalist approach that would see a return to national currencies, while keeping Europe perhaps as a free trade area and retaining a few institutions that have made a real difference such as common competition laws; the current approach based on the Maastricht Treaty of 1992 and its fiscal compact update in 2012; and, finally, the more ambitious version of federalism. My own clear preference is for the federalist version but I’m not at all convinced that Europeans are ready to make it work successfully.
Baneful Fall-out

The Maastricht approach infringes member states’ sovereignty by monitoring public debt and deficits. Its founding fathers rightly feared that the imminent default of one country might trigger a bailout: so the Maastricht Treaty enshrined a debt limit and a “no bail-out” clause. Solidarity towards a member state in trouble is driven by the fear of negative spillovers onto the same countries making good the default of the over-indebted country. These negative effects arising from the default may be economic – exposures for subsidiaries and banks and fear of banking and sovereign panic reactions (as in Greece in 2011), reduced trade – or other types as in Greece in 2015: empathy, the will to prevent damage to the construction of Europe, the nuisance power of the distressed country.

The prospect of a bailout may in turn generate moral hazard: up to 2009, very low borrowing costs brought about by the perspective of a European guarantee for debts (despite the no bailout clause) probably prompted the periphery to enter paths towards debt that were all the more unsustainable because of lax supervision of banks in certain countries.
As If There Were A Magical Number

The Maastricht approach has failed up to now. To understand why, let’s consider the four obstacles in its way: uniformity, complexity, implementability and limited solidarity.

Fearful of accusations of discrimination, Europe chose the same constraints on debt and budget deficit for all countries – the famous 60% and 3% of GDP in a nutshell – as if there were a magical number to guarantee the viability of sovereign debt. But this uniformity has no theoretical underpinning part from its transparency in the eyes of Europe’s citizens: a debt of 40% might be intolerable for one country while another might sustain one of 120%. The ability to take on debt rests on several factors: the country’s capacity for collecting and, eventually, increasing taxes, the rate of growth, the political balance between those who benefit from debt and those who would lose out in any default, or the share of sovereign debt in domestic hands (countries don’t like to default on their own citizens or banks.)

Complexity refers to the difficulty of measuring the real indebtedness of a country. Until the recent reform of the Stability & Growth Pact and changes to Eurostat rules, statistics on debt only embraced debts that are owed for sure. Contingent debts – off-balance-sheet exposures – may, however, be substantial: unfunded pensions, guarantees given to state enterprises or social security, eventual losses incurred through ECB guarantees or the European Stability Mechanism (the latter now being reported but not included in the debt.) Some of the most brilliant minds have become specialists in securitising future public revenues, in using derivatives or other devices to conceal debt levels.

As for implementability, European finance ministers have been unable to penalise the various breaches of the Stability & Growth Pact starting with those by Germany and France around 2003. This should come as no surprise.

First of all, finance ministers are afraid to expose themselves to the wrath of a country that’s made the breach by making any intervention that will doubtless fail to change the collective decision.

Second, the otherwise very legitimate goal of European construction has often been raised in order to close ones eyes to dubious accounting practices or an inadequate preparation for joining the Eurozone.

Third, everybody expects these little quids pro quo. Given that the political process has little or no chance of delivering the desired result, it would appear that the Maastricht approach needs a highly qualified and independent budget council. Unlike existing ones, all of them national, this budget council would be European – reflecting the possibility that a member state might cause negative spill-overs for the rest of Europe – and capable of imposing swiftly the necessary corrective measures.

What’s more, as financial penalties are ineffective when a country is broke and in a recession, it’s better to take alternative measures – compounding worries about legitimacy and sovereignty.

Finally, solidarity among neighbours has its limits, especially when a house is on fire and one has to pay for its rebuild. Current debate centres around finding out who would be the winners and losers of any fiscal stimulus undertaken by economically robust countries – or how much ECB interventions would cost and who would bear the costs. All of this underlines the limits of ex-post solidarity. And it brings me to the federalist approach.

Federalism implies a much higher sharing of risks. With euro-bonds, European countries would become jointly liable for each other’s debts. One budget, a shared deposit insurance and a common unemployment insurance would act as automatic stabilisers, offering more protection to countries – a country in trouble receiving automatic transfers (fewer taxes, more social transfers and use of the deposit insurance fund) – making the “no bail-out” policy more credible (stabilisers reducing the excuses one can make for a weak economic performance. On this last point, we should recall that the federal US government has not bailed out any of its states since 1840.

The federalist vision requires two pre-conditions. First, any insurance contract must be signed behind a veil of ignorance: you wouldn’t include solidarity in a buildings insurance plan if my house were already on fire. It would eventually be possible to resolve the current asymmetry between northern and southern countries by identifying and isolating problems inherited from the past in order to confront them; this is complex but can be done.

Then, and in the main, countries sharing the same roof must have common laws in order to limit moral hazard. It goes without saying that legal uniformity must apply to laws which may create collateral damage for other European countries and not, shall we say, the “pasteurisation” of supplies consumed in the member state: subsidiarity must apply in areas where it creates no costs for the rest of Europe.

The ECB’s centralised supervision within a banking union raises a sliver of hope and might pave the way for common deposits insurance since centralised supervision reduces the chances that countries supervising their banks prudentially end up paying for lax ones.
A Necessary Loss Of Sovereignty

But mutualisation cannot be achieved regarding unemployment insurance. Effectively, the unemployment rate in Eurozone countries is only partly determined by the economic cycle and is very much linked to choices regarding employment protection, active labour market policies, contributions to social security, professional training bodies, the type of redistribution (minimum wage or fiscal allowances), etc.

Clearly, countries electing institutions that enable them to obtain a 5% unemployment rate won’t want to “co-insure” countries that, de facto, opt for 20% joblessness. The same holds for pensions and the mutual sharing of debts. Against all this evidence, Europeans still cannot bring themselves to think of giving up their sovereignty.

We Europeans must accept the loss of sovereignty that’s necessary to live under one roof. And, to do so, we should rehabilitate the European ideal and unite to defend it against populist nationalism – and this is not easy these days…

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