The announcement by credit ratings agency Standard & Poor’s overnight that it could downgrade the triple-A rating of Europe’s debt rescue fund has battered market confidence, which had been buoyed by a new package of austerity measures by the Italian government.
The Italian stock market made gains on Monday before entering a phase of volatility and instability on Tuesday, after S&P announced that France, Germany, and 13 other Eurozone countries were put on review for credit downgrades.
A lot still needs to be done by the government of Prime Minister Mario Monti to redress the Italian situation and halt the debt crisis, particularly in terms of launching reforms to stimulate growth. Yet, in a week that most observers regard as decisive for the destiny of the euro, with a key policy meeting of the European Central Bank scheduled for Thursday and a meeting of the European Council the day after, the easing of the pressure on the debt of the third-largest economy of the Eurozone is certainly good news.
The (moderate) good news coming from Italy were coupled by equally (moderate) good news from Paris, where Nicolas Sarkozy and Angela Merkel met on Monday to discuss major changes to the European Treaties as well as measures to tackle the crisis.
In the past few months, Sarkozy and Merkel have maintained rather different stances on a number of issues, including the possibility to issue Eurobonds. But, and this is probably the good news, they were able to find some common ground in their Monday meeting. Their proposals, which will be detailed in a letter to the President of the European Council today, and presumably debated at the meeting of the Council later this week, seem to revolve around two main points.
First, automatic and immediate sanctions will be established for countries that breach a deficit limit of 3% of GDP. The sanctions will be suspended for a given country only if a weighted majority of the other countries votes against their application. Second, countries will have to write into their constitutions or national laws a “golden rule” to balance their budgets.
The European Court of Justice will not have the power to prosecute the countries in breach of the deficit rule or to rule national budget void, but it will have the mandate to review whether the balanced budget rules in the national constitutions and laws comply with the spirit of the new treaties.
In addition, the leaders of France and Germany propose to bring forward to 2012 the introduction of the permanent Eurozone bailout fund and to exclude the private sector from any future bailout agreements. This will help calm the markets, as a significant amount of bailout money will become available sooner than expected, while the likelihood of losses for private bond investors will significantly decrease.
All in all, Sarkozy and Merkel are pushing for stronger fiscal integration and discipline in the Eurozone, and possibly in the whole of the European Union. This is a step forward that needs to be taken if the Euro and the entire project of European economic integration are to survive the crisis.
A fiscal union, or something close to it, would minimise the risk of individual countries undermining the stability of the common currency with their fiscal profligacy. It would also allow Europe to issue “federal bonds”, similarly to what the US government does, which the European Central Bank could then buy in large quantities if needed. That is, the ECB could act as the lender of last resort not for individual states, but for the union in its entirety.
Fiscal integration is a big step forward and therefore also a very difficult one. Countries would have to give up a considerable portion of their sovereignty. National authorities would still be in control of the mix of expenditures and taxes, but the supranational authority would control the aggregates – that is, the deficit and the debt.
One can anticipate that citizens and several political parties in every country would strongly dislike the idea of giving more power to Brussels. In this regard, fiscal integration would require greater political integration, but this is not easy to achieve in times when resentment rather than trust is the prevailing feeling towards Brussels.
But there is a second, perhaps more subtle (and often neglected) difficulty in progressing towards greater fiscal integration along the lines set by Sarkozy and Merkel. Enshrining in law a rule to balance the budget and establishing automatic sanctions for excess deficit might severely harm the ability of national governments to use fiscal policy to stabilise the cyclical volatility of their economies.
The welfare of individuals, especially those towards the bottom of income distribution, can be severely affected by cyclical volatility. With monetary policy entirely delegated to the European Central Bank, and hence almost exclusively devoted to maintaining price stability in the Eurozone, fiscal policy is the main tool for stabilisation at national level.
Stabilisation requires fiscal policy to be used counter-cyclically: expenditures should be increased and/or tax decreased in an economic downturn and the opposite should happen in an upturn. So, in times of recession countries should be able to run a budget deficit, which would be then compensated by a budget surplus once the economy recovers.
A rigid fiscal rule of 3% on the deficit and/or a constitutional provision to balance the budget would likely deprive national governments of the flexibility necessary to do all that. In fact, the risk is that countries would end up using fiscal policy pro-cyclically, which in turn would cause even greater cyclical volatility.
For this reason, the rules ought to be written in such a way to provide countries with enough policy space to run fiscal policy counter-cyclically. For instance, the “golden rule” might establish that what needs to be kept in equilibrium is not the overall fiscal balance, but the fiscal balance adjusted for the cycle.
Alternatively, the rule might state that the budget must be balanced not in every single year, but on average over a period of a few years (say three or four).
The problem might be even more acute in a fiscal union where the federal fiscal policy is run by a supranational authority, be it a federal government or commission. This is because the business cycles of Eurozone countries are still somewhat a-synchronised. In other words, not all countries are in the same cyclical phase at the same time.
If this a-synchronisation were to persist once the fiscal union is formed, then the supranational fiscal authority would face a dilemma. Even if willing to operate fiscal policy counter-cyclically, the authority would not know which national business cycle to take as reference.
In fact, whichever cycle were used as reference (Germany?), there would be some countries for which the federal fiscal policy is counter-cyclical and others for which it is pro-cyclical. This in turn would cause an unequal distribution of the costs and benefits of integration across countries, with obvious grimaces and grievances.
The road to a stronger Eurozone passes through more, rather than less, fiscal integration. But this passage is certainly a very difficult and risky one to navigate, especially in the present storm. The captains of the Euro-boat need courage and vision. The same courage and vision which animated the leaders of the European nations in the aftermath of World War II. Are they up to the task?