Sunday, November 23, 2014
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The Birth of Fiscal Unions

PRINCETON – Fiscal unification is often an effective way to enhance creditworthiness, and it may also create a new sense of solidarity among diverse peoples living within a large geographic area. For this reason, Europeans have often looked toward the model of the United States. But they have never been able to emulate it, because their motivations for union have been so varied.

Desperate countries often consider such unions to be the best way out of an emergency. In 1940, Charles de Gaulle proposed, and Winston Churchill accepted, the idea of a Franco-British union in the face of the Nazi challenge, which had already overwhelmed France.

In 1950, five years after the war, Germany’s first postwar chancellor, Konrad Adenauer, also proposed a union – this time between France and Germany – as a way out of his defeated country’s existential crisis. Political unification was rejected; but economic association has had a brilliant career for more than six decades – until now.

The fundamental idea behind a fiscal union is that poorer, less creditworthy countries can gain from joint debt liability with richer countries. Indeed, one of the most fascinating proposals to this effect came at the beginning of World War I, when the Russian Empire found that its limited capacity to borrow on international capital markets and its low foreign-currency reserves left it unable to create an effective military force.

So the Russian government proposed what would have amounted to a full fiscal union with Britain and France for war-related finances. France latched onto the idea, because its borrowing capacity was also weaker than Britain’s. The British wanted to win the war – but not so much that they were prepared to accept unlimited liability for debt incurred by the French and Russian governments.

In reality, a fiscal union between such diverse political systems would have been unworkable. An autocratic or corrupt regime has a strong incentive to spend in a way that benefits the elite. That incentive increases if it can command the resources of a more democratically governed state, where citizens agree to pay taxes (and pay off future debt) because they also control the government.

The only circumstance in which democracies sign up to such a deal is when a clear security interest is at stake. It was that predicament that gave pre-1914 Russia unique access to the French financial market. Yet, in 1915, the British, even in the face of an ongoing war, were unwilling to assume Russia’s liabilities. Perhaps the sheer degree of uncertainty in pre-war Europe, or the more amorphous nature of the threat, made security concerns trump financial risk.

Russia’s World War I credit arrangements anticipated some of the political maneuvering about debt and its relation to security that occurred in late-twentieth-century Europe. Post-1945 West Germany was vulnerable for a long time, because it sat on the Cold War’s fault line. As a result, West German governments offered neighboring countries financial help in exchange for security and political solidarity, especially at moments when they were uncertain about the reliability and continuity of US support.

But there were limits. In 1979, when West Germany adopted a fixed exchange-rate regime with a support mechanism for its partners (the European Monetary System), the Bundesbank ensured that it was not committed to unlimited currency interventions and that it might stop when the stability of the Deutsche Mark was endangered.

The logic was repeated on an even larger scale at the beginning of the 1990’s, but this time without any pre-determined limits. The European Union’s commitment to monetary union enabled the eurozone’s Mediterranean countries to improve their debt dynamics and public finances dramatically. Their borrowing costs fell as they locked their currencies into a union with countries – Germany, in particular – with a stronger reputation for stability.

At that point, the problem of how to divide the eventual bill when things became costly was not addressed, and the problem of excessive debt was wished away by the establishment of convergence criteria (which were not fully implemented anyway). But, since 2009, when financial distress in the eurozone’s periphery brought such problems to the fore, Europeans have faced the same question as the WWI Allies. Are security and political interests so overwhelming that they justify assuming large and unlimited liabilities incurred by political systems over which they have no control?

Because Europe is at peace, with no singular, overriding security threat, it is likely that when the extent of the bargain becomes clear, voters and politicians in the rich creditor countries will reject it. But the more uncertain security challenges that Europe faces may just demand the kind of strong fiscal link that the French and Russians were willing to forge before 1914, and that the Germans and French embraced in 1950.

The implications for the present are important: the only palatable way in which the necessary balance between liability and security can be achieved is through a process of political reform that dissolves corrupt oligarchies and weakens incentives for fiscal imprudence. One approach might be to ask citizens in all European countries whether they are prepared to accept some sort of fiscal compact involving a hard limit on debt.

Germans refer to this solution as a Schuldenbremse (debt brake). It presupposes a profound process through which institutions and the assumptions underlying them come to be widely shared. But that takes time, as the history of the US – the world’s most successful union born of emergency – amply demonstrates.

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    1. CommentedLuigi Barretta

      The article is missing the key point: once you have a Country running a structural and cumulating trade surplus vs other Countries sharing the same currency (i.e. the rebalancing function performed by the exchange rate is disactivated), the fiscal union is not an option, it's a logical necessity. A Country can have a trade deficit if the Country in surplus lend the money to finance it. The debt position of PIIGS is balanced by a German credit. Therefore, or Germany asks for a fiscal and political Union in order to have the legal power to impose a long term change of laws that are making the PIIGS inefficient and funds the transition via tax collected also in Germany, otherwise Germany will go bankrupt together with its debtors.

    2. CommentedJose araujo

      Distress factors in EU periphery were not due to the debt level of countries (Portugal debt level was less then the european average, Spanish public debt was never a problem) but to the evident lack of solidarity between countries.

      Comparison between euro member with similar situations (Spain and the UK) made it very clear that distress problems were due to the lack of the figure of lender of last resort. The problems with countries issuing debt in a foreign currency is well known to us.

      The author also forgets issuing money is a funding decision by a country, and it should be used as an instrument. European Central Bank, and the Euro being stripped of that function made it an abomination.

    3. CommentedWalter Gingery

      Another iteration of the "German solution" to the European debt crisis: everyone will behave properly if we just give them more rules to follow. Dream on. Europeans always love the IDEA of the USA, until you ask them for a commitment to a common, inter-state fiscal and tax regime, as exists on the federal level, and the federal political bodies to legislate, adjudicate and administer it. At present Europe is stuck between a USA and a NAFTA-style union, and can't make up its mind which it wants.

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