Europe’s federalism debate revived

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As eurozone ministers reflect on how to rebuild economic governance in the wake of the Greek crisis, Jean Pisani-Ferry explores the debate on fiscal federalism and urges policymakers to clearly define options for better coordination.

The following contribution was written by Jean Pisani-Ferry, director of Brussels-based think-tank Bruegel.

"It is an old debate, but tensions within the euro area have revived it: can a monetary union survive without some form of fiscal federalism?

This issue is of persistent concern for investors worldwide. Holders of European government bonds believed that they knew what they had bought. Sure, there was no such thing as a eurozone sovereign security. But German, French, Spanish, and even Greek bonds all carried roughly the same interest rate, so they were deemed equivalent.

Investors now recognise that they did not really understand what these bonds represented – that is, the institutional construct behind the European currency. And if the global financial crisis has taught us anything, it is this: when you do not understand a financial product, you should not buy it. But if investors actually take that lesson to heart, the European crisis will be far from over.

So, should Europe embrace fiscal federalism in order to strengthen the euro zone and restore investor confidence? The problem is that fiscal federalism means different things to different people.

Americans think they know what it is: a central government with a large budget (about 20% of GDP), whose macro-economic role is to carry out counter-cyclical spending and taxation, as most US states are constitutionally committed to some sort of balanced budget.

This was clearly true in the case of the stimulus programme launched in 2009, which included federal transfers to the states to sustain state-level fiscal spending. Similarly, when a state such as Michigan is hit by recession in its key economic sector (the auto industry), Washington collects less federal tax but maintains – if not increases – local spending, which partially offsets the shock to state income.

Economically, therefore, the federal budget cushions regional shocks automatically through discretionary action and stabilising transfers to the states. Politically, it embodies solidarity and thus helps cement the union.

If this is what is meant by federalism, it is better for the European Union to forget about it. The EU budget amounts to about 1% of GDP, just one-fortieth of total public expenditure. No-one, not even die-hard European integrationists, imagines that it can reach 5% of GDP (it is more likely to decrease). But even a 5%-of-GDP budget would be insufficient to play a meaningful macro-economic role.

To read the op-ed in full, please click here.

(Published in partnership with Project Syndicate.)

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