Loss of fiscal sovereignty inevitable if euro to survive
OPINION:After the failure of the softly-softly approach, ‘interference’ looks set to become a permanent feature
THE IMMEDIATE liquidity and banking crisis facing the euro area is still very much with us, to judge by the unfolding situation for Portugal. In parallel, the debate about the future of the area has continued, even intensified, in recent weeks.
Top of the agenda is the possible issuance of euro bonds and closely tied to it the degree to which the budgetary policies of individual members, even those not being bailed out as Greece and Ireland are, may become increasingly subject to centralised “surveillance” – if not outright control.
The problem facing a currency union such as the euro area is one of the oldest in economics. The issue is how to ensure that wayward budgetary – or indeed banking – policies pursued by one country do not end up imposing costs on those following more prudent policies. As we have seen only too clearly, these costs – especially the loss of confidence in the common currency – can end up leading to a need for the resentful “good performers” to subsidise, through some sort of bailout, those who have failed to follow the path of righteousness.
The more homogenous the economic and financial development of the individual members, the lower the risk of this. But it is always there, as the designers of the euro area project were well aware. For that reason, the provisions of the Maastricht Treaty, which was supposed to keep everyone’s fiscal policies “in line”, were a key component of the euro area architecture from the outset.
Maastricht was intended to ensure that the budget deficits of individual countries did not exceed 3 per cent of GDP – a far cry from Ireland’s current 12 per cent (32 per cent including the bank bailout). Nearly all the other 16 are currently above the limit; over half of them by more than two percent of GDP. Thus, Maastricht would appear to have been an abysmal failure.
THE FIRST DEFICIENCY was that the largest members, Germany and France, exceeded the limit themselves and managed to get away with it at the EU political level. Small wonder that after this, others, both large and small, did not feel too intimidated by a possible breach. And they increasingly surpassed the limit, even before the crisis exploded. No fines were ever proposed or levied, on France and Germany or on anyone else.
The second, perhaps most fundamental, problem was that Maastricht basically looked only at the overall budgetary outcome and in practice paid little attention to what lay beneath. Although in theory there were procedures to assess the underlying sustainability of revenues and expenditures – including the issuance of “early warnings” – these were not invoked in any serious way. The best example is the virtually unprecedented shift in Ireland’s budgetary deficit from approximately zero in 2007 to 7 per cent of GDP in 2008 and 14 per cent in 2009. Indeed, as late as 2007 we were being congratulated by one and all for the soundness of our fiscal policies.
It is instructive to look at how other currency unions have coped with this problem. Perhaps the best example is that of the dozen or so francophone west and central African states who share a common currency, the CFA franc, which was tied to the French franc (now to the euro). French government representatives sit on the boards of the African central banks involved, to help dissuade them from adopting foolish policies that would eventually rebound to the cost of the French taxpayer.
But that was not enough to address the risk of fiscal profligacy. It would not have been acceptable for France to have been seen as “approving” the budgets of their former colonies. Instead, a quite clever solution was found. In practice, nearly all of these countries have – or try to have – semi-permanent “arrangements” with the IMF. Aid from France (and others) – a very important component in these countries’ budgets – is contingent upon the IMF giving a good housekeeping “seal of approval”.
The approach of the current IMF-EU bailout for Greece and Ireland seems rather similar to the arrangement for the CFA countries. But it would be inconceivable that IMF-type tutelage would become a permanent feature of the landscape after the current crisis eventually passes.
The fundamental requirement is to have a “preventative” mechanism in place that reduces the risk of other countries down the road falling into the same trap. Moreover, memories can be quite short and the possibility of “repeat offenders” can by no means be ruled out.
The current discussion about the possible issuance of euro bonds can be seen as an attempt to try to force the issue. The idea is that an individual country would issue its bonds “backed” or co-signed by all the other members. This of course means that if that country were to become unable to meet its obligations, the burden would automatically fall on everyone else. Not surprisingly, several of the strong performers have responded to the idea by saying, in effect, “fine, but the quid pro quo is that we must have a much larger say in your financial and fiscal affairs”.
WHAT MIGHT THIS mean? There will be talk of mechanisms involving “close/prior” “consultation” between the commission and the EU Council on members’ budgetary plans, with the issuance of “opinions” and “recommendations” becoming more the norm. So as not to offend national sensitivities unduly, the word “approval” will be avoided, at least for a while. Changes will be introduced incrementally, as is the EU way. At some point, when the political climate seems ripe, changes to the Lisbon Treaty will probably be mooted.
How far could this go? Clearly, close and explicit attention will start to be paid to the more detailed aspects of expenditure and (especially) revenue policies. The question of the “sustainability of revenues” will be on the table and there will be renewed talk of tax harmonisation. In Ireland’s case the corporation tax rate will likely come under major pressure. And we may not be in a good position to resist.
In sum, whether one likes it or not, significant and growing “interference” in individual countries’ fiscal policies is likely to become a permanent feature.
The “gentlemen’s agreement” approach embodied in Maastricht was tried and has failed. As in the case of other currency unions, if the euro area is to be a viable entity in the long run a considerable loss of fiscal sovereignty appears inevitable. It is important for the public policy debate to recognise this and discuss it openly.
Donal Donovan was a staff member of the IMF during 1977-2005 before retiring as a deputy director. He is currently adjunct professor at the University of Limerick and a visiting lecturer at Trinity College Dublin.