Surrogates of Fiscal Federalism

We have been distracted by many events in the past few days, and an important document by the Commission did not have the attention it deserves.  In a Communication on the social dimension of the Economic and Monetary Union, sent to the Council on October 2nd, there are a number of very interesting elements. In general, what I find remarkable is the association of deeper social integration with the more general objective of macroeconomic rebalancing. It is never said explicitly, but the Commission stance is that stopping macroeconomic divergence requires more social cohesion and, ultimately, solidarity among Member States. It goes without saying that I find this important and welcome news.

A more specific point on which I want to raise the readers’ attention can be found at page 11  (pdf). It is long, but worth reporting in its entirety:

Finally, in the long term, based on progressive pooling of sovereignty and thus responsibility and solidarity competencies at European level, it should become possible to establish an autonomous euro area budget providing the euro area with a fiscal capacity to support Member States absorb shocks. The central budget would provide for an EMU-level stabilisation tool to support adjustment to asymmetric shocks, increase economic integration and convergence and avoid setting-up long-term transfer flows. Overall, a shared instrument could deliver net gains in stabilising power, compared with current arrangements. The size of this fiscal capacity would ultimately depend on the depth of integration desired and on the willingness to enact accompanying political changes. A common instrument for macroeconomic stabilisation could provide an insurance system to pool the risks of economic shocks across Member States, thereby reducing the fluctuations in national incomes.
In its simplest formulation, a stabilisation scheme to absorb asymmetric shocks could require monetary net payments that are negative in good times and positive in bad times. For example, a simple scheme could determine net contributions/payments by countries as a function of their output gap (relative to the average). Such a system would need to be financially neutral in the medium term for each country, and it would also depend on country size.
Alternatively, the scheme could be based on earmarking payments from the fund for a defined purpose, with counter-cyclical effects (similar to the US unemployment benefit system, where a federal fund  reimburses 50% of unemployment benefits exceeding a standard duration, up to a given maximum, conditional on unemployment being at a certain level and rising). The scheme could operate in such a way to avoid permanent transfers’ across countries. In other words, they should be designed to avoid that, over a long period of time, any country is a net loser or gainer from the scheme.

The Commission proposes the establishment of a federal budget in the only way that has a chance of being at least considered: a fund to be used for countercyclical expenditure; in particular, and this is what I find interesting, for unemployment benefits. Unemployment benefits in the United States are a powerful countercyclical instrument, that dampens asymmetric shocks. This is where we need to start if we want to introduce some sort of automatic transfer of resources from booming regions (today Germany; tomorrow, maybe, Greece?) to slumping regions (today Greece; tomorrow, maybe, Germany?).

The proposal has a couple of problematic aspects:

• The first is linking contributions and subsidies to the output gap, a measure that is highly controversial both theoretically and empirically (one of the many reasons why I find the current fiscal framework of the EMU completely absurd; but this is another story).
• The second is that it seems to suggest that the subsidies would only go to long term unemployed. This would of course create a huge moral hazard problem, reducing the incentive for countries, that remain in charge of labour market policies, to fight long term unemployment. I would actually prefer the opposite strategy: the first few months of unemployment are taken care of by the common pool, and beyond a certain duration the witness is taken by the Member State (such a framework should be coupled with uniform duration of benefits across Europe). Countries would therefore have the incentive to take care of the unemployed, among other things to reduce the burden on public finances.

The proposal, in other words, would need to be designed to be effective in sustaining the unemployed and dampening asymmetric shocks and divergence. If and when it will make it into some negotiating table, there will be room for discussion on the technicalities.

Most probably it will remain the n-th Commission document to never make it into actual norms. The Germans have already made it known that it is premature. It is a pity, Lacking federal budget and taxes, such a mechanism would be a centerpiece of a surrogate federal Europe. And without a federal Europe, the monetary union is doomed.