On the decentralisation of euro risks

2015-12-23

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In a December 15 article for the Brookings Institution titled “Mr. Schäuble’s ultimate weapon: The restructuring of European public debts” Carlo Bastasin describes the current situation around the initiatives on the European fiscal policy front. He notes thus:

The 18 countries sharing the euro are still struggling to recover from seven years of financial troubles that have jeopardised the very survival of the common currency. Since 2010, a slew of different proposals have been put forward for improving either the centralisation of the area’s economic governance or, alternatively, for decentralising the risks and limiting the amount of risk-sharing. The German government seems to have lost faith in any form of centralised governance, and it would rather try to shield German taxpayers from sharing the potential costs of a sovereign debt crisis in other countries.

The tone of the article is much less alarmist and more cogent in its analytical qualities than what its “clickbait” title would suggest. Mr. Bastasin’s thesis is that the decentralised approach to risk sharing entails a possibility of exacerbating the fragmentation of the euro area by reinforcing the divergent trajectories of its constituent national economies. What is not clear is whether that possibility is greater than the potential gains from the decentralised approach.

The willingness of the German government to protect its taxpayers from exogenous risks may indeed be the driving force behind its efforts to decentralise risk sharing in the euro area. An independent observer has, nonetheless, to acknowledge the fact that their mistrust for the centralised approach is predicated on a pragmatic understanding that is three-fold:

1. The European Commission has become a politicised entity that purports to be purely technocratic in nature: to act as the “guardian of the Treaties”. Every EU Member State gets to have its own Commissioner following a grand bargain that is meant to satisfy all national governments involved. In being political it also is subject to political pressures and, hence, prone to make judgements that introduce arbitrary exceptions from the rules for Member States that are influential enough to get things their way (e.g. France). The rules that the Commission is supposed to enforce must have universal application, rather than have force only for countries in a weaker bargaining position.
2. A centralised approach in an otherwise heterogeneous system creates a certain tension between the actual conditions and the stated ends. For the euro area to have a genuine fiscal policy of its own, governed by federalist principles, it needs to be fitted with all the necessary state structures, including a directly legitimised executive and a parliament that has full powers over fiscal and budgetary matters. There can be no efficient centralised management if all other things remain constant. As the system currently stands, the Commission or some other entity in “Brussels” would be ill suited to enforce a “one-size-fits-all” approach. It would lack the necessary instruments of raising and distributing funds, while it would not enjoy the required democratic legitimacy and accountability for handling such sensitive issues as taxation and social policy.
3. The presumption that sovereign bonds bear virtually zero risk has been part of the euro crisis in the first place. When the single currency was introduced, a set of incentives were put in place that saw countries with vastly diverse economic structures be treated as if they were equal in terms of their risk profile. Thus prior to the 2008 financial shock there was a considerable influx of capital from the “centre” to the “periphery” of the euro area that, inter alia, created inflationary bubbles while enabling certain governments to borrow money well beyond their capacity to repay. Furthermore, financial institutions were given a golden opportunity to make profit from sovereign bonds with the understanding that they would eventually enjoy implicit guarantees, otherwise the whole edifice would have collapsed under the weight of its own contradictions and illusions.

Against this backdrop, one need not be a supporter of the German government to recognise both the flaws in the present European architecture and the gaps in the various ideas for debt mutualisation or a Europeanised way to fiscal policy. For a centralised approach to indeed be plausible, a more holistic plan is needed; one that will transform the EU from the current model into an outright federation. My understanding is that while federalism may in theory be an excellent choice for the future EU, it is way too demanding a goal to be realised within the context of the present political realities.

European integration has hitherto been a gradualist exercise of proceeding little-by-little to the harmonisation of individual areas of policy. It would be highly unlikely for this to change in favour of a root-and-branch reconfiguration of the European Union into a sovereign nation state that is federal in its constitutional design. What is more feasible is a continuation along the current path, meaning that first there will be more efforts to improve the quality—and expand the scope—of a rules-based system, and only then use that as a firm foundation on which to establish new institutional arrangements.

Given that the ideal should be the guide rather than the enemy of the good, we may indeed admit that even within the present constraints there still exists a range of possible outcomes, where some tend to approximate our ultimate end more than others. Put in less abstract terms, we can think of ways to decouple the European Commission’s purely technocratic functions from its political actuality, much like we can conceive of rules-based frameworks that lay the foundations for a future EU-level fiscal capacity, such as a consolidated corporate tax base or a European tax on financial transactions. Also, we already have drastic changes in the monetary function of the euro area, namely in the capacity of the European Central Bank to exercise prudential control over the banking system, courtesy of the Single Supervisory Mechanism and the Single Resolution Mechanism. More secondary legislation along those lines can further expand the scope of concerted action at the European level, such as the long-discussed common deposit guarantee scheme.

The gist is that while the step-by-step method may not be the most effective, direct, or desirable one, there still are kinds of gradualism that are better than others. The greatest threat to the EU/euro system is its own shortcomings. Whatever makes the present order more robust to shocks, including those that are endogenous and systemic in nature, has to prima facie be treated positively.

To this end, the idea of decentralising risk sharing may, perhaps counter-intuitively, be a first step in forwarding the European integration process. That is so because it can help address and eventually correct existing flaws, while establishing a new framework for relative stability. It is then that a renewed impetus for further improvements to the EU edifice will be provided, meant to configure the emerging inadequacies of the gradualist method.

This is not the most rational approach one may think of, yet it is the kind of supranational politics that has more or less worked for Europe all these decades. If the history of European integration is a good measure, then the eventuality of a European fiscal union commensurate with a political union of sorts will first go through a protracted period of quasi-automatic, rules-based arrangements such as the current order of economic governance, only to render readily apparent to all policy-makers involved the necessary steps forward, those being a democratic executive with a fully fledged fiscal capacity and a euro-area-specific legislative function with budgetary powers.

The German government aims to promote the interests of the Germans. While we voice our concerns for what may be a rather “parochial” approach, we cannot ignore the fact that in the current EU set-up all national governments put their own interests before the general European good. Instead of blaming the German government for engaging in politics that may hamper the interests of its partners, we need to adopt a content-focused view of things, to discern between the items that are worth considering and adopting, and those that are only meant for internal consumption and narrow party politics.

The three items noted in the list above, namely (1) the politicisation of the European Commission, (2) the asymmetries and heterogeneity of the euro area, and (3) the misguided effort to harmonise sovereign risk profiles and produce perverse incentives, are real issues that need to be dealt with. Whether this happens the “German way” or not depends on what other national governments have to propound as an alternative. Whatever the case, the euro crisis has shown to those willing to distance themselves from their own position that wishful thinking and shorter-term politically-motivated illusions of convergence must not take precedence over tough choices that tackle the underlying problems.