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Of the EU Budget and Fiscal Rules

November 26, 2012 Leave a comment Go to comments

Last Friday the negotiations on the 2014-2020 EU budget were put on hold because of  fundamental disagreements among Member States. Surprise, Surprise… I do not think it is a big deal anyway. There is not doubt that at the next meeting a last-minute- low-key compromise will materialize. A compromise that will most likely save the most controversial items of the EU budget, like agricultural policy, and  cut the very few investment programs that had made it into the budget in the past. But who cares, after all; our leaders will be able to show the usual self complacency, and the rest of us will be left with the all-too familiar sentiment of yet another missed opportunity.

Most commentators blamed David Cameron, but his position was not new, and hardly surprising. The UK has always tried to extract as much as it could from the European process, while giving as little as possible; others did it, are doing it, and will do it. But rarely with the consistency and the single-mindedness of the UK. This was true with EFTA in the 1960s, then again with the infamous UK rebate negotiated by Margaret Thatcher in 1984. If England never played for the common good in the past, how could we expect it to do so at a times of crisis?

No, the real surprise of the failed budget negotiation was not England, but Germany, and the coalition of the fiscal hawks.

Germany went to the negotiating table with the objective to extend its austerity recipe to the EU level. At a time when all Members tighten their belt, it argued, why would the EU do otherwise? Well, I do believe that there indeed is a number of reasons why the EU budget should be significantly expanded, precisely because EU Member countries are all more or less willingly embracing austerity.

Why is it so?  Let’s have a little context. The Fiscal Compact is inexorably marching towards entering into force (as of today, it has been ratified by 8 eurozone countries and by 4 out of the 8 other EU signatories). Thus, in the near future Member countries will definitely lose the instrument of countercyclical fiscal policy. But if local governments are constrained, then, it is worth pointing out, as I did some time ago, that the federal government has an important role to play:

The point I want to make is how disruptive the balanced budget rule has been for American states that were forced to cut spending and lay off public employees at the very moment in which the opposite were needed, thus exacerbating the crisis. It is true that most American states have stricter rules than the fiscal compact just approved in Brussels (notably, the budget must be balanced every year); but  it is also true that the federal government in the US retains the possibility to conduct discretionary policy, that it used massively also to (partially, as Krugman shows) contrast the procyclical expenditure cuts at the state level. European countries have no supranational entity of that sort. (emphasis added)

The following chart shows federal and local total expenditure in volume, together with a part of it, gross investment. The black line is overall (State and Local plus Federal) expenditure. It is also worth pointing out that Federal investment is net of defense spending. To ease comparison of changes, all items are made equal to 100 in the first quarter of 2007.

The figure leaves no space to ambiguity: Local governments saw a brutal reduction of their expenditure during the crisis, due to the balanced budget rules. But this was compensated by federal spending, so that overall expenditure increased at least until the end of 2009, and then went back towards the initial level. Krugman argued that the reversal was too hasty. One may or may not agree (I do).  What is certain is that were it not for the federal layer of government, the drop would have been far sharper and contractionary. It is also worth noticing that the balanced budget requirement was felt on state and local investment (and hence on the expenditure that impacts the future capacity of the economy to grow) significantly more than on current expenditure. On the other hand, the federal government, unconstrained, was able to channel into investment most of the stimulus money. An educated guess is that the effect of this on productivity in the coming years will be positive and significant…

So, here is the link between last week’s negotiation and the fiscal compact. One could have imagined that while tying their hands with strict fiscal rules, EU countries would think of a way to recover at least part of the lost capacity to react to macroeconomic shocks. And that, like in the US, this could be done by strengthening the spending capacity of the Union as a whole, obviously less subject than individual countries to the risk (if any) of opportunistic behaviour.

The discussion on the new multiannual budget could have been an occasion to discuss the articulation between the Union and Member states in contrasting business cycle fluctuations. It could have been the occasion to discuss how to set up a fair and incentive compatible transfer union, or a meaningful EU wide investment program. Instead, the logic of austerity prevailed, a logic that is even more unwarranted at the “federal” level than it is at the level of Member countries.  It is a pity…

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