As German Chancellor Angela Merkel announced yesterday, the only way forward for the Euro is for a full political and fiscal union of the member countries. With small peripheral Euro economies, the need for political and fiscal integration was apparent from the start. However, lacking political will, it was impossible to implement. Now with anti-EU sentiment on the rise in countries that are the focus of the debt crisis, it is too late to hope that this union will succeed.
The Mundell-Fleming model for small open economies, taught throughout undergraduate economics courses, demonstrated the need for fiscal and political integration from the start. One of the conclusions of the model is that under a fixed exchange rate a country gives up its ability to stimulate the economy through monetary policy. However, it gains the ability to stimulate the economy through government spending (see the Wikipedia article for more detail).
But the Mundell-Fleming model is a static model. In the context of a dynamic, politically charged world, the Mundell-Fleming model points to inevitable disaster. Clearly, with the ability to stimulate the economy, the government will start spending to curry favour with voters by buying economic votes through higher spending or lower taxes. Time and time again, incumbent governments win or lose elections based on the current state of the economy rather than the effect of long-run government policy. As long as the government can maintain a facade of fiscal sustainability (with a little help from major investment banks), government bonds will continue to be issued at low rates and the government will continue to spend prodigiously. In the case of Greece, although government spending as a share of GDP was stable, tax receipts as a percentage of GDP fell even as the economy expanded rapidly. This made an already wide deficit totally unsustainable. Panic over Greek debt might have taken longer to surface if the Greek government hadn’t already been running deficits beyond the Maastricht Treaty limits before entry into the EU.
The Maastricht Treaty sets a limit on member countries’ debts and deficits, but it provides no real level of enforcement. The online fact sheet on the Framework for Fiscal Policies says it all – ‘No financial penalties are used for enforcing the limit set as regards general government debt’. Eurozone governments are effectively incentivized to spend because they face no repercussions. Of course, negotiating stronger fiscal integration from the outset would have been nearly impossible. No citizen of Athens would vote for a political party that would allow someone in Brussels to tell them how to spend. And why would any elected government surrender its ability to boost the economy? In fact, the ability for effective fiscal economic stimulation may be a motivating factor for Euro entry.
The EU may finally be starting to implement stronger fiscal and political integration, beginning with the appointment of two former European Central Bank commissioners as the heads of state in Italy and Greece. But what now? Surely, the citizens in Italy and Greece won’t stand for this arrangement for very long. Their citizens will likely want a political leader to steer them away from further economic pain. Now, Anti-EU sentiment is rising in the peripheral economies. For those countries, they now feel that entry into the Euro has damaged their economy and they loathe the deficit and debt targets that are being imposed upon them. They feel as though they have lost their voice in the EU. So, why would citizens in Greece or Italy agree to more fiscal and political integration, when the amount they have already accepted has, in their eyes, been so disastrous?
Envelope Economics 