Wednesday, November 26, 2014

The False Promise of a Eurozone Budget

BRUSSELS – A key question confronts the four presidents of Europe’s major institutions (the European Commission, the European Council, the European Central Bank, and the Eurogroup) as they prepare their report on how to reform the common currency: Does the eurozone need its own budget?

They are facing the argument that the United States’ monetary union works much better because there is a large federal budget to smooth the impact of asymmetric shocks – that is, shocks to individual states. The eurozone, it is claimed, should have its own budget to provide similarly automatic insurance to its members.

This argument, however, misreads the US experience.

True, in the US, as in most existing federal states, the federal budget redistributes income across regions, thus offsetting at least part of the interregional differences in income. But, while this has been repeatedly documented in many cases, the inference that redistribution is equivalent to a shock absorber is wrong.

For example, in the US, the federal budget offsets a substantial part (estimated at 30-40%) of the differences in per capita income levels across states, because poorer states contribute less income tax, on average, and receive higher transfer payments. But this does not imply that these mechanisms also provide insurance against shocks (sudden changes in income for individual states). Many of the transfers from the federal government – especially basic social support like food stamps – vary little with the local business cycle.

On the revenue side, the degree to which federal taxation absorbs shocks at the state level cannot be very large for the simple reason that the main source of federal revenues that does react to the business cycle, the federal income tax, accounts for less than 10% of GDP.

The low sensitivity of both federal expenditure and federal revenues to local business-cycle conditions explains why only a small fraction (estimated at about 10-15 %) of any shock to the GDP of any individual state is absorbed via automatic transfers to and from the US federal budget.

One idea that has been mooted repeatedly in Europe is to create some European, or at least eurozone, unemployment insurance fund. This idea is attractive at first sight. But here, too, the reference to the US experience is misleading.

In the US, unemployment insurance is organized at the state level. The federal government intervenes only in the case of major nationwide recessions and provides some supplementary benefits for the long-term unemployed. But this support is given to all states and thus does not provide those most affected with much more support than the others receive.

Moreover, unemployment benefits are not as important as is often assumed. In most countries, they amount to only about 2-3% of GDP, even during a major recession. In the US, the annual supplementary federal expenditure has amounted to only about 1% of GDP in recent years. It is thus clear that a eurozone unemployment insurance system would never be able to offset major shocks, such as those hitting Ireland or Greece, where GDP has shrunk by more than 10%.

The case of Spain illustrates another feature of European economies that makes it difficult to argue for a federal unemployment scheme. Spanish unemployment is now close to 30%, which a priori should be a good justification for some form of shock absorber. But Spanish unemployment has typically been consistently higher than the eurozone average, and fell to single-digit levels only as a result of an unsustainable building boom. Any common eurozone unemployment scheme would thus risk financing the long-term unemployment created by rigid national labor-market institutions, which for decades have proved impervious to reforms.

All in all, it is difficult to base the argument for some eurozone shock absorber on the US experience. But how can one explain the fact that the global financial crisis led to no regional banking crises in the US, whereas several eurozone countries’ banking systems are under such stress that their governments have had to rescue them (and then be rescued in turn by the eurozone’s bailout fund)?

This reflects another aspect of US arrangements that, again, is not widely appreciated. The US “banking union” provides tangible insurance against local financial shocks. For example, the local real-estate boom and bust in Nevada was as severe as that in Spain or Ireland. But, in Nevada, which is similar in size to Ireland, the local banking system’s losses were absorbed to a large extent by US “banking union” institutions, particularly the Federal Deposit Insurance Corporation (FDIC) and the federal mortgage-refinancing agencies, Fannie Mae and Freddie Mac.

For Nevada, such support can be estimated at 10-20% of its “national” income. Ireland would certainly be in much better shape if it had received a similar transfer.

This leads to a simple conclusion: The euro’s long-term stability depends far more on completing plans for a European banking union than it does on creating some new budget for the eurozone.

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    1. Commentedandrea naldini

      who has said that a EU budget should reduce asymmetric shocks? Can not it redistribute income? Can not increase demand, employment and living conditions? can not reinforce green economy?
      Other instruments target asymmetric shocks (coordination of iscal policy, monetary policy)-
      What strict thinking!

        CommentedJose araujo

        Its because of people like Daniel Gros, that we are in the situation we are, they are so blind with their Dogmas that they refuse to see even the simple things.

        If unemployment and health benefits comes from a "federal Budget" how can Daniel Gros claim that federal expenditure has low sensitivity to business cycles.... ABSURD and a LIE

        For sure if, like in the US unemployment and health is private, the federal budget won't react, but that because US economy lacks automatic stabilizers.

    2. CommentedJose araujo

      Yes the New Deal and the auto industry bail-out were big fat liberal lies, and yes what causes structural unemployment in Spain are rigid labor laws.....

      Its because of people that think like this that we are in the situation we are.

      Yes expansionary austerity was the way to go, with some luck maybe Santa Claus will help us Europeans, well Daniel Gross probably doesn't believe in Santa, but for sure he believes in magical creatures like confidence fairies and full employment

    3. CommentedJose araujo

      So lets see if I got this right, an Pan European unemployment fund, wouldn't work because it doesn't work in the US?

      And it doesn't work in the US because its at federal level, or because US don't have unemployment benefits just like we do?

      The author forgets US economy lacks most of the "shock" absorvers we Europeans have in place, and that's why federal budgets have lower impact, yet they do impact, specially in historical episodes like the new deal and others.

      Off-course for supply sidders and neoclassics, the Eurozone Budget ould have no impact, but for Keynesians, this would be a major tool not only to get us out of this crisis, but to ensure sustainable Europe.

      Unfortunatly we have been living, and are a product of this dogmatic doctrines, who although having been proved wrong ad nausea still are the major doctrine in European policy.

      Just a final note so say the natural adjusters in US economy and by design much more of a private nature then in Europe. In the US health plans and retirement plans are mostly private, while here they are public, so before saying this model is of no good because it doesn't work in the US, I would want to see how did the insurance companies and banks behaved from state to state.

    4. CommentedCarlos Trujillo

      I do not know enough about the American system for interstate compensation regarding revenue / expenditure, or federal unemployment aid. However it seems clear that a compensation system has the great advantage of uncoupling expenditures (high or low, it is not the biggest matter) in crisis areas, from revenues from these same areas, which are obviously very deteriorated. Although no increase was done, just the fact of maintaining and securing them is already a great help for a crisis area.
      Regarding the risk of compensating guilty high unemployment areas, for which Spain is given as an example, two remarks must be made. The first is that it is in fact true that the Spanish labor market is inflexible, and that this is probably hurting productivity. The second is that there is no evidence that this lack of flexibility has the responsibility for the chronically high unemployment.
      Between 2000 and 2007, the Spanish population increased by 11.5%, and its active population by 23.3%. Between those years unemployment went from 13.9 to 8.3% of the active population. Spain suffered two parallel phenomena, massive immigration, and a very significant and simultaneous increase of its active population ratio. It is also clear that the rate of job creation was far superior to these increases, as evidenced by the decline in unemployment. So, we are facing a structural phenomena, but that has nothing to do with labor rigidity, and is probably due to the late arrival of Spain to the usual rates of immigration, and of active population, in Western Europe.
      Regarding the regional banking crises, situation is also clear, at least for the Spanish case. The European authorities are trying by all means that what should have been a private bank failure with European implications, be assumed by Spanish taxpayers.
      Who was risking his money in the Spanish real estate stupid adventure? Clearly the Spanish “Cajas” (and partially also banks), but do not forget that they were funded by their German colleagues. What would have happened if we left things to go by its natural way? Of course the Spanish government would have had to respond for the Spanish bank deposits, but German banks would have had to take also their share of losses (fully justified, business is business), and perhaps also need the help of the German government. Instead we are seeing how the debts are transferred to Spanish taxpayers, and also, although to a lesser extent, to the Europeans taxpayers.
      I fully believe that if we are to build a strong Europe we need a common banking system. But what is most needed nowadays is to stop the great manipulation of the public opinion that is taking place at European level, and whose sole purpose is to maintain an unfair situation that also will prove unsustainable.

    5. CommentedCarol Maczinsky

      The impression I get depite the cry and hue is that the market bets that Merkel wins, and she is willing to sustain the Euro. So we will see a shift to ordoliberalism in the Union.

      "But how can one explain the fact that the global financial crisis led to no regional banking crises in the US"
      Lehmann? Actually the governments' countermeasiures are like cortison. Not really healthy. We will see how the ship is going to burn down.

    6. CommentedJoshua Ioji Konov

      A comprehensive article indeed. The EU 's problems are deeply incremented into a beaurocratical system whereas the governments are these that run the economy... the transmissionability of the EU economy is very limited too - in some countries bottom down. Programs and subsidies are politicized yielding to corruption by the officials. Large corporations are given immense powers by in some EU states intentional lack of consumer protection and labor protection, that basically open the gates for predatory and corruption practices. One word, the EU some governments are managing large parts of their economies that was given by the EU government, whereas the labor market was crashed by the recessionary forces and income has fallen. To suggest that farther EU centralization and power consolidations by Brussel that would allow more liquidity into the system to promote economic growth is incomprehensible... the EU needs some fundamental may say ideological changes to make the system work and lower interest liquidity is just one of them. What about the centralization, it may have a positive effect only if consumer and labor protection apply equally to all parts of EU and local governments are discharged from running the show by using neutral agents such as commercial banks e.g.

    7. CommentedJohn Brian Shannon

      Hi Daniel,

      I enjoyed reading this article and agree almost completely.

      Your question in paragraph 12 has an easy answer;

      The reason there were no parallel banking crises in the U.S. is that no serious real-estate bubble burst (when expressed as a percentage of GDP) here in North America, while in Spain, the huge real-estate bubble burst in a spectacular fashion!

      This is just a matter of bad timing for Spain and of good timing for the U.S. Also, profoundly, Spain could not print more currency and the U.S. could.

      The amount of exposure by Spanish banks on account of unemployed's is very low, even while the unemployment rate is approaching 30% -- not all that far from normal levels in recent years, by the way.

      At the same time, the amount of exposure on account of a drastic fall in real-estate prices there, is extremely high. (Higher than Spain could afford to cover -- as it turned out, which required a voluntary Eurozone bailout)

      If it ever occurs on a macro-scale, the mother of all depressions will be caused by a burst real-estate bubble -- as the exposure by banks to all mortgages (consumer, commercial & industrial) exceed their assets and could conceivably exceed the ability of governments to cover, in order to prevent default.

      Yale University economist Robert Shiller warned us in August, 2007, "The examples we have of past cycles indicate that major declines in real home prices - even 50 per cent declines in some places - are entirely possible going forward from today or from the not-too-distant future."

      That amounts to a lot of money, anywhere. Not many nations could survive that.

      If this occurred on a global scale, some nations would be able to print their way out of it, or at least print enough money to solve the today problem. But other countries without that ability would require bailout or default -- neither are good choices.

      The end of the story is, there is more exposure than assets when a real-estate bubble bursts.

      Cheers! JBS