Notesale: Turn your study into money

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Fiscal Union
The Maastricht Treaty signed in 1991 established the creation of a monetary union in Europe without a common
budgetary and fiscal policy
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The costs of monetary union occur in the face of asymmetric shocks, as evidenced by the sovereign debt crisis,
where heterogeneity and structural differences could not be reconciled by one-size—fits-all monetary policy
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Obstfeld and Peri (1998) find there is little migration in response to asymmetric shocks within European countries,
relative to the US, implying labour is not mobile enough in Europe to compensate for shocks
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Capital markets can provide a private insurance mechanism if agents hold an internationally diversified stock
portfolio, however, financial markets aren’t fully integrated and the average citizen does not hold foreign shares
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OCA theory thus recommends either that national policies should be used in a flexible way or that a system of fiscal
transfers is used
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Countries that systematically use fiscal policies run into the problem of unsustainable debt dynamics, which imposes
negative spillovers on other members
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The accumulation of deficits can lead to unsustainable debt dynamics, however, as future generations of French
people will have to repay debt to future generation Germans
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This in itself limits the ability of national governments to respond to asymmetric shocks
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g, France/ Germany in
2003 disregarded the SGP)
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These credibility issues suggest the EU is unsustainable in its current form
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The
implication of this is a Fiscal Union on the basis of political unification
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The Solidarity criterion: When a common MP gives rise to conflicts of national interest, the countries that form a
Currency area need to accept the costs in the name of a common destiny
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This exists at the national level in Germany (Länderfinanzausgleich), but is absent at the European level, as the
budget is only 1% of EU-GDP, instead of the 5-7% which the MacDougall Report recommends
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An asymmetric shock occurs as European consumers shift demand in favour of German products at
the expense of French products
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In a MU the ECB is powerless, and so France will have to increase its borrowing, meaning unsustainable debt
dynamics may arise
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The centralised budget works as a shock absorber
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Exactly the opposite occurs in
Germany, where output increases and unemployment declines
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This acts to
smooth the shock, shifting (Df) and (Dg) back to their original positions and reducing the social costs of MU
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This depends on von Hagen and Hammond’s (1998) assumption that shocks are serially uncorrelated and randomly
distributed with zero conditional expectation, so you contribute as much as you receive in the long run
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This may lead to fiscal transfers not being temporary, as designed, but permanent
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However, if a preference shock is permanent, then transfers might need to be permanent, which risks reducing the
pressure on France to adjust wages so as to eliminate the disequilibrium - the moral hazard problem
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This is known as the ‘Mezzogiorno problem’, and is also attributed by Hughes et al
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Thus, one way to reduce moral hazard is to guarantee that transfers are transitory despite the shock persistence
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They also claim that any transfer system would throw up serious equity issues because Eurozone member countries
differ greatly in size and per capita incomes, therefore the contribution as a percentage of GDP across countries will not
be equal
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There are further benefits to fiscal union too over and above a simple transfer system: national fiscal policy is an
important source of asymmetric shocks
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The fact that fiscal policy has remained in national hands is a source of asymmetric shocks due to a ‘beggar-thyneighbour policy’
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Carlino and Inman (2013) note that fiscal spending has externality on other members, which implies a return to
coordinating fiscal policy
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This policy
stance is unlikely to have occurred under a more central EU fiscal oversight where the effects of German wage
moderation on other nations would have been internalized
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Increased need for political integration
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The McDougall Report (1977) notes that consolidating govt debt issues, reduces the fragility of a MU
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Eurobonds would be seen as a safe investment to rival US Treasuries, bringing down borrowing costs further
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Competitiveness of some countries who depend on low tax rates may be adversely affected (Ireland)
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The suitability of voter ideologies varies (French prefer higher taxes)
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Maybe if a one-size taxation scheme was taken on, different countries will be taxed different amounts as a % of GDP
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Bordo and James (2008) note that all past Fiscal Unions have been preceded by a Political Union, so it is considered a
pre-requisite
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Since such problems could jeopardise national unity at a national level, European nations will have to consider them
when conjecturing about the centralization of its national budgets
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De Grauwe (2008) has identified an 'Omitted deep variable’
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The lack of a deep variable also explains why Europe started with monetary union
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But at the same time it puts the whole process at risk
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And as we have argued, without these steps towards political union the monetary union will remain a fragile
construction
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