Euro crisis: the dangers of fiscal integration

European leaders are advocating greater fiscal integration in response to the ongoing euro crisis. Despite their professed euroscepticism, David Cameron and George Osborne have offered their support for this approach. Yet such a policy would probably be ineffective at preventing future crises and could further damage European economies in the long-term.

One option being considered is stricter EU supervision of national governments’ borrowing levels – a rigorously enforced version of the failed Stability and Growth Pact. If this policy had been imposed during the last decade it might conceivably have moderated some aspects of the Greek crisis (although for many years the Greek government hid the true level of its debts and several other governments ‘cheated’ to meet the Maastricht rules). Strict fiscal controls would not however have addressed the effects of a one-size-fits-all monetary policy applied across diverse eurozone economies. Indeed, Ireland and Spain were among the most prudent eurozone governments during the recent boom period, with low budget deficits and low national debts. The problems in these countries largely resulted from inflationary bubbles which eventually collapsed.

A key question is how EU fiscal authorities would behave towards countries where credit booms had collapsed leading to a large fall in tax revenues. A strictly enforced fiscal stability rule would force national governments to cut expenditure immediately, even if this meant breaking commitments to electorates. In economic terms this could be a welcome development in that would preclude counter-productive Keynesian fiscal stimulus measures. However, the political incentives created by such economic shocks are a cause for serious concern.

National politicians would have strong incentives to blame the EU for severe depressions (and indeed the eurozone clearly does magnify boom-bust credit cycles in some countries). Accordingly, EU institutions, with their agenda of increasing integration, would have strong incentives to attempt to counteract economic and political instability with large fiscal transfers from the centre. In other words, counter-cyclical public spending by national governments could be replaced by fiscal bailouts/stimuli at EU level.

More and more vested interests would become dependent on such spending, making it difficult to roll back and leading to an enlarged role for the central EU authorities. There is therefore a strong likelihood that fiscal integration would eventually lead to the creation of a ‘transfer union’, with stronger countries subsidising weaker ones. The stronger economies would be damaged by higher taxes, while the transfers would crowd-out private-sector activity in the weaker economies, preventing their recovery – as we see in peripheral regions of the UK that are heavily dependent on subsidies from the South-East. An additional danger is that fiscal integration would eventually lead to tax harmonisation – destroying the benefits of tax competition. In conclusion, fiscal integration threatens to undermine the competitiveness of the EU’s more successful member states and thereby speed up the region’s already rapid relative economic decline.

27 October 2011, IEA Blog

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