Euro Area Policies: Selected Issues

The European Union’s (EU) financial stability framework is being markedly strengthened. This is taking place on the heels of a severe financial crisis owing to weaknesses in the banking system interrelated with sovereign difficulties in the euro area periphery. Important progress has been made in designing an institutional framework to secure microeconomic and macroprudential supervision at the EU level, but this new set-up faces a number of challenges. Developments regarding the financial stability may assist in the continuing evolution of the European financial stability architecture.


The European Union’s (EU) financial stability framework is being markedly strengthened. This is taking place on the heels of a severe financial crisis owing to weaknesses in the banking system interrelated with sovereign difficulties in the euro area periphery. Important progress has been made in designing an institutional framework to secure microeconomic and macroprudential supervision at the EU level, but this new set-up faces a number of challenges. Developments regarding the financial stability may assist in the continuing evolution of the European financial stability architecture.

IV. Strengthening Governance in the Euro Area32

A. introduction

85. The crisis has questioned the viability of the euro area in its current shape. Skeptics stressing its fragility because of the lack of fiscal union, inadequate market flexibility, and low level of labor mobility, now feel vindicated. There is no doubt that a fully-fledged federal system as in the U.S. would have helped to prevent some distinctive features of the crisis in the euro area (e.g. disproportionate state-level debts), allow smoother resolution of financial-system problems, and more generally, offer less scope for policymakers to confuse markets with conflicting commentaries. Yet, is this a definitive proof that the euro is not viable without a federalist fiscal architecture?

86. To address this question, this paper frames the various aspects of crisis prevention and management in the light of fiscal federalism. Strictly speaking fiscal federalism refers to the conduct of fiscal operations at federal and regional levels with a three-fold function: redistribution (permanent transfers from richer to poorer regions), stabilization (counter-cyclical federal fiscal policy when all regions are hit by a common shock), and risk-sharing (temporary transfers when selected regions are hit by a region-specific shock). The U.S. is the quintessential example of a fiscal union, while the EU, where certain functions such as agricultural and cohesion policy, can only be regarded as a soft form of fiscal federalism, which in any case does not coincide with the currency union. Differences between the two regions are even larger if the notion of fiscal federalism is extended to reflect the degree of cross-border economic activity and resolution mechanisms.

87. European economic governance is currently under debate but the large number of proposals on the table simply seek strengthened coordination. Is this a problem? We argue that this need not be a problem provided that solutions put forward work in practice. But a major overhaul is clearly needed.

88. The paper is structured as follows. Section B compares the euro area and the U.S. economic systems, with a focus on fiscal aspects. Section C assesses current crisis prevention and management proposed reforms. Section D concludes.

B. Economic Systems in the EU and the U.S.: A Brief Comparison33

89. This section compares the EU and U.S. fiscal and economic salient features, with a focus on fiscal federalism. One way to compare fiscal capacity in the two regions is to quantify the centralization of revenues and the distribution of expenditures by the U.S. federal government and the EU budget (Figure IV.1). Note that this is not an entirely fair comparison as the EU is distinct from the euro area, so the fiscal transfer space does not coincide with the monetary union and there are no specific transfer provisions for members of the euro area. Nonetheless, it is instructive to look at the differences between the EU and the U.S. In the U.S., federal taxes collected from the states range from 12 to 20 percent of state GDP, and federal transfers received by states range from 9 to 31 percent of state GDP. In contrast, most EU countries contribute to the common budget by about 0.8 to 0.9 percent of their GDP, and receive EU funds amounting to 0.5 to 3.5 percent of their GDP. As a result, fiscal redistribution is much more sizable in the U.S. and the relationship between redistribution and the level of development (as measured by GDP per capita) is also much stronger in the U.S.

Figure IV.1.
Figure IV.1.

EU and the U.S.: Fiscal Centralization and Redistribution

Citation: IMF Staff Country Reports 2011, 186; 10.5089/9781462338542.002.A005

Sources: OECD; Haver Analytics; Harvard Kennedy School, Taubman Center for State and Local Government; and European Commission, DG Budget.

90. While important, differences in fiscal centralization alone cannot explain why only the continuity of the euro area has been challenged so far. Institutional features, such as fiscal rules, the scope for local debt, the conduct of fiscal stabilization, the strength of the banking system and the extent of market flexibility also matter. We compare the two regions in those areas that can help prevent and manage crises in regions/states participating in a supranational entity:

  • Fiscal rules in the U.S. tend to be more stringent than in the euro area leaving less potential for irresponsible behavior. Most U.S. states have Balanced Budget Requirements (BBRs) in their constitutions, which can be interpreted as a response of the states to a credibly established no bailout by the federal government of defaulting states (Laubach, 2005). Snell (2004) concluded that 36 states have rigorous BBRs (effectively disciplining local fiscal policies), 4 have weak requirements, and the other 10 fall in between those categories.

  • The scope for local debt is less in the U.S.: given the higher share of centralization of revenues and expenditures and the fact that state fiscal rules are generally strict, state spending does not have the potential to lead to massive debt/GDP ratios. To illustrate, the combined debt of US states and local governments amounted to about 22 percent of U.S. GDP in 2010, with limited cross-state divergence (ranging from 9.3 percent in Wyoming to 33 percent in Rhode Island). In contrast, the euro area debt-to-GDP ratio amounted to 85 percent of GDP in 2010 (ranging from 18 percent in Luxembourg to 142 percent in Greece).

  • The superiority of fiscal stabilization in the U.S. cannot be established: During the crisis the US federal government allowed automatic stabilizers to run and adopted a major discretionary stimulus including direct help to state budgets. In the EU, counter-cyclical policies were left to each member state with some attempt of coordination from the center. However, both in the euro area and the U.S. there are states that had to deal with pro-cyclical fiscal policy at some point during the crisis and states that could benefit from counter-cyclical fiscal policy (Darvas, 2010). Focusing on the pre-EMU period, Fatas (1998) also concluded that the benefits in terms of fiscal stabilization were not sizable enough to compensate the costs of creating a fully-fledged European fiscal federation.

  • Strength of the banking system: measures implemented to date to reinforce the banking system seem to have been more effective in the U.S. Alongside with fiscal functions, banking regulation and supervision are also centralized in the U.S., and fixing the financial system is easier because cross-(state-)border banking is not inhibited. The fragmentation and fragility of the euro-area banking industry is a major reason why the crises in current program countries threaten the EMU project.

  • Labor and product market flexibility: the empirical literature proving the U.S. much closer to an Optimum Currency Area (OCA) than the EU is voluminous. Cross-border mobility of companies and labor is clearly superior in the U.S.

  • Significant similarities exist between the two areas as to the formal crisis resolution mechanisms: Prior to the crisis, there were no bail-out or short-term financial mechanisms in the euro area or the U.S. Neither an orderly default mechanism was previewed.

Overall, although the two regions have some similarities in terms of the damage potential of the state-level problems, the comparison with the U.S. suggests that a more federalist fiscal and economic union would most likely have reduced the vulnerability of the euro area to crises, accelerated the strengthening of the banking system, increased the political coherence of the euro area and boosted confidence.

C. Bolstering Economic Integration in the Euro Area

91. Solutions to euro area problems can be tailored to its needs. Since the euro area has a different political setup than the U.S., the level of government debt is very diverse across countries, and the establishment of fiscal transfers as sizable as in the U.S. would surely generate further tensions and antagonism between creditor and debtor countries, European solutions need not follow the U.S. model. How can the euro area governance be put on a solid footing? To what extent do the current governance proposals give the euro area some attributes of a political union? How do they contribute to enhance stabilization, redistribution and risk sharing?

Macroeconomic stabilization and discipline: enhancing the scrutiny of imbalances

92. With the monetary instrument lost, fiscal policy becomes the main countercyclical instrument in the euro area. However, fiscal polices have been mostly pro-cyclical before and during the EMU years (Fatas and Mihov, 2009). More responsible fiscal policies would have reduced the scope for crises by limiting pre-crisis debt levels. But this does not necessarily require a fiscal federation: a larger role for fiscal stabilization in the euro area can be achieved through counter-cyclical country-level fiscal rules. Most U.S. states have constitutional fiscal rules—and the same approach has also been adopted recently by Germany. Other euro-area members may also choose this approach, possibly augmented by the introduction of independent fiscal councils (Calmfors and others, 2010).

93. By capping the expenditure-to-GDP ratio, the revamped SGP (Tables IV.1 and IV.2) aims to contain pro-cyclical fiscal policies. Fiscal discipline will also be improved by strengthening enforcement (including quicker and semi-automatic sanctions) and making the debt criterion operational (placing under Excessive Deficit Procedure, or EDP, countries with debt levels above the 60 percent limit and reducing indebtedness at a yearly pace lower than 1/20th of the distance from that benchmark). Taking into account implicit liabilities will require a country with an oversized banking sector to factor in potential rescue costs. All this is encouraging. However, the effectiveness of fiscal surveillance could be substantially improved by introducing legal provisions requiring the correction of past upward drifts in public expenditure; calibrating more ambitious and country differentiated medium term objectives (MTOs) to realistically face sustainability challenges posed by the crisis and aging populations; initiating EDPs by reverse qualified majority whereby Commission’s recommendation prevails unless the Council decides otherwise by QM; restricting sanction waivers; and tightening legal deadlines for corrective action.

Table IV.1.

Main Changes to the Stability and Growth Pact following the 2011 Reform--Preventive Arm

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Source: Staff summary of current legislative proposals.
Table IV.2.

Main Changes to the Stability and Growth Pact following the 2011 Reform—Corrective Arm

article image
Source: Staff summary of current legislative proposals.

94. But macroeconomic stabilization is not only about fiscal policy and not all crises are rooted in a lack of budgetary discipline. As fiscal excesses may be neither the only nor the most important source of macroeconomic imbalances, the new Excessive Imbalances Procedure (EIP) is a necessary complement to the revised SGP. Imbalances can be of two kinds, internal (if prompted by irresponsible fiscal behavior, credit excesses in the private sector and asset bubbles) and external (if rooted in competitiveness deficiencies), both affecting the current account balance and international investment positions. The EIP comprises a preventive arm, identifying imbalances and triggering, as needed, in-depth analyses about their underlying causes. For countries suffering from excessive imbalances and put under the EIP, the corrective arm will require the adoption of adequate fiscal, structural and macro-prudential remedies. Current proposals helpfully identify general objectives, but to be effective, EIP regulations will have to define limit thresholds for key indicators, introduce more binding deadlines, and use reverse qualified majority voting in all relevant steps. The list of minimum amendments to make the new procedure work includes:

  • Establishing well-defined benchmarks in the EIP regulation. The absence of indicators and reference thresholds in the regulation introduces legal uncertainty especially at the initiation of the EIP. Such legal vacuum is at odds with SGP regulations, which specify benchmarks the deviation from which makes a strong case for activating EDPs. At the very minimum, EIP rules should clearly spell out thresholds for current account balances and international investment positions, given their comprehensive character. The remaining indicators (e.g. competitiveness, credit indicators) could play a complementary role and be the object of a separate Code of Conduct.

  • Facilitating decision making. Relevant EIP decisions (other than the imposition of sanctions) should be taken by reverse qualified majority, most importantly the initiation of EIPs.

  • Tightening deadlines. As the EIP involves many steps, the process is likely to be lengthy and uncertain unless binding deadlines are foreseen. Maximum spells within consecutive steps should be specified along the procedure and an overall time length of one year (starting from the initiation of the EIP until the final closure/imposition of sanctions) could be set.

Higher public and private risk-sharing

95. One important advantage of federal systems is that they create risk-sharing opportunities by pooling the debt of participating states. A euro area bond would play a similar role in the euro area. There would be common issuance to which countries have conditional access (either up to a level, or under some other strict, measurable conditions). Safeguards should produce the right incentives to prevent countries from massively issuing bonds and promote fiscal discipline more powerfully than the SGP or any other fiscal coordination proposal.

96. Euro area bonds would reduce the cost of debt of most member states (and eventually of all of them) through a much larger market size, depth, liquidity and diversification. This would place them on a par with the U.S. Treasury bonds, reinforcing the euro as a major reserve currency. Lower cost of debt and the attractiveness of this market for large investors would also help achieve more sustainable debt levels and higher economic growth potential.

97. Another important gap to fill between the euro area and a federal system as the U.S. is financial supervision and crisis resolution. By neglecting the problem of systemic risk, micro-prudential regulation has failed to maintain financial stability. As a result, many European countries have had to provide bailouts. Government interventions have in turn reduced cross-border lending, limiting the scope for risk diversification and financial stability. Both a macro-prudential approach to regulation and a euro area wide burden-sharing mechanism are needed to foster private risk-sharing, as is the removal of financial protectionism. And all these institutional changes should be feasible without creating a U.S.-style federal fiscal system.

Making the most of current redistribution efforts

98. Although modest compared with the U.S., Europe’s redistribution policy, embodied in the Common Agricultural Policy and the Cohesion Policy, features the highest degree of fiscal federalism at the EU level. Rather than discussing the optimal level of redistribution, a very contentious issue, it is important to note that the low level of intra-EU redistribution has not caused the current crisis: it is ironic that precisely Greece was the highest net beneficiary prior to the crisis, receiving much more than what the relationship between net balance with the EU and GDP per capita would suggest.

99. The EU earmarks a total of about 348 billion euros under the heading Structural and Cohesion Funds (SCF) over 2007–13. This is equal to 2.8 of the EU GDP or 0.4 percent of per year on average. It is usually claimed that EU funds are not as powerful an instrument for resource allocation as in the U.S. Yet, EU support for cohesion represents a significant amount when compared, for example, with the size of the rescue packages to Greece (110 billion euros) and to Ireland (85 billion euros). And Marshall Plan aid from 1948-51 was only about 2 percent of the GDP of all recipient countries, but made a substantial contribution to western European growth.

100. Moreover, some EU countries have large amounts of usable SCF. As a matter of fact, funds are only partially slowly absorbed and countries lose the funds that are still unused two years after they have been allocated. For instance, in Portugal and Greece unused funds respectively amount to 9.3 and 7 percent of GDP (Marzinotto, 2010). Accelerating the absorption rate of EU funds and further exploiting synergies between EU grants and EIB loans are two commendable objectives of adjustment programs in crisis-hit countries.

Enhancing market adjustment

101. Measures to move the whole euro area, including its labor market, towards an OCA, are of the utmost importance. It is now 20 years since the Single Market Program was launched with the goal of eliminating barriers to the movement of goods, services, capital and workers. Despite substantial progress over this period, especially in financial markets, the integration of product markets appears to have stalled, and labor remains largely fragmented.

102. Labor mobility in the EU remains relatively low, despite the legal right to work anywhere in the EU. One longstanding reason inhibiting mobility is the large differences in tax, social insurance and pension systems across the EU. There is ample evidence that differences in implicit tax rates on income substantially distort mobility (Fenge and Von Weizsacker, 2008, Wasmer and Janiak, 2008). Further reducing mobility distortions—not only for pensions but also for other parts of European welfare states—would be desirable.

103. Completing the agenda of the Single Market initiated in the mid-1980s, the Services Directive called for the removal of unjustified obstacles to market entry in the provision of services. However, given the abstract nature of its principles and its broad coverage, countries have practically kept a broad scope of freedom for its implementation and its impact has been generally disappointing. Moreover, the need to analyze regulations on an individual basis in order to verify their compatibility with the directive (“screening of legislation”) has made the transposition a very lengthy process and delayed its economic benefits.

Higher intrusion in domestic policies: who oversees non-compliance?

104. One common feature of the manifold processes described so far is that they keep intact national sovereignty. As such, the proposed governance package continues to belong to the category of inter-governmental projects subject to inter-governmental coordination. In essence, the de jure institutional structure of the region will be left broadly unchanged after these reforms and the control of fiscal, macro-prudential and structural policies will remain in the hands of national governments. The only hope for the reforms to make a difference with the status quo is that, this time, coordination and peer pressure will work. But will they really?

105. An attempt to complement coordination procedures with a certain dose of political commitment is represented by the Euro Plus Pact. Meant to bolster economic integration over and above Treaty commitments, the Pact (agreed upon by euro area leaders in March) was initially perceived as a valuable political addition to the governance package. However, in reality, the Pact contains a list of desirable cross-cutting goals for tighter coordination on the competitiveness, employment, fiscal and financial fronts, but no tangible means to implement them beyond current procedures. To help the euro area grow out of the crisis, the Pact should take a decisive turn towards commitments which are time-bound, ambitious in terms of objectives and concrete regarding their design.

106. The alternative to more governmental coordination is to transfer some national sovereignty to a supranational entity. This would mean that although national authorities would retain in principle the control over fiscal, macro-prudential and structural policies, some delegation of political power to the center is also allowed if a country fails to comply with euro area rules. A first step towards increasing the degree of supra-nationality would be to vest euro area authorities with powers to override national policies if those conflict with the common interest (Trichet, 2011). This would imply shared competence over economic matters, but only for sovereigns failing to abide by the region’s rules. In any case, in a highly interconnected region as the euro area national sovereignty is de facto more of an illusion than a reality.

D. Conclusion

107. Euro area governance needs to go through an ambitious reform. While the origin of the euro-area fiscal crisis is not the lack of a federal institutional setup with higher redistribution, stabilization and risk-sharing roles, a more federal approach would likely have dampened the contagion of state-level problems within the region, accelerated its resolution and enhanced political coherence overall.

108. While improvements compared to the status quo, current government proposals fall short of what is needed to support the integrity of the euro area. The new policy framework looks somewhat unclear, with no less than three different, partially overlapping, European procedures—for budgets, macroeconomic imbalances and macro-financial stability. This not only calls for a substantial coordination effort across policy areas, but more fundamentally, between the national and supranational authorities. If past is prologue, it is far from certain that inter-governmental agreements will succeed in this huge coordination task, and the Euro Plus Pact seems to be no exception in this respect.

109. For this reason it is expected that the governance model will be in need of reform soon. And euro area members will again be confronted with the uncomfortable, though unavoidable, decision on how much national sovereignty to delegate. No doubt curtailing the powers of governments breaking the rules requires a fundamental political move, possibly expanding the notion of national sovereignty with economic considerations, and requiring legal changes both to the Treaty and the Constitutional laws. Enabling the prevalence of European authority over national institutions (where circumstances so advice) needs, above all, a change in mentality, though some progress has to be acknowledged in the area of regulation and supervision. National authorities need to delegate some power to the center for the sake of the common interest. This is quite different from creating coordination institutions at the EU level that overlap, duplicate but that can hardly supersede national authorities.


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Prepared by Esther Perez Ruiz.


This section heavily relies on Darvas (2010).