Jean-Claude Trichet, president of the European Central Bank, has created a buzz by proposing to appoint a finance minister for Europe. In fact, he comes close to the idea of a fiscal policy committee, which has been advocated for a long time and with increasing frequency since the onset of the sovereign-debt crisis.
As befits a central banker, the proposal is couched in careful hypothetical terms. Maybe, in the future, when a country once again does not live up to its commitments,
would it go too far if we envisaged giving euro area authorities a much deeper and authoritative say in the formation of the country’s economic policies? […] Would it be too bold, in the economic field, with a single market, a single currency and a single central bank, to envisage a ministry of finance of the Union? Not necessarily a ministry of finance that administers a large federal budget. But a ministry of finance that would exert direct responsibilities in at least three domains.
The first of his domains is fiscal policy oversight, the second is vaguely defined but concerns financial integration, and the third is external representation in international financial institutions, presumably a single Executive Director at the IMF.
It is of course of great significance that a departing ECB President – one who was in charge during the deepest crisis since the 1930s – has come to such a conclusion. Because the proposal is highly imprecise, it can be interpreted in a myriad of ways. The idea, it seems, is to let policymakers react as they see fit, to propose their own interpretations of a deliberately vague pronouncement, until something that is agreeable emerges.
Trichet’s text includes countless references to great European philosophers of previous centuries and to Jean Monnet and other Founding Fathers of the EU, but not a single one to the academic literature, which has obviously considered many options. It may help, therefore, to consider what the literature has to say about the issues at stake.
Academic literature on centralising finance ministry functions
Trichet’s call for institutional reform seems to be directly related to the current situation of Greece, so it is worth outlining how his thinking flows from Greece’s problems before turning the scholarship on this.
We are dealing here with a country that has been bailed out by the other Eurozone countries and the IMF under strict conditions, but also a country that fails to deliver. In such cases, the IMF normally suspends payments, letting the country deal with the consequences. This is, in fact, what the IMF recently threatened to do.
A consequence would have been default. In the current circumstances, the strategy of “teaching a good lesson” would directly hurt the other Eurozone countries whose governments and banks are creditors, as is the ECB whose losses would have to be covered by member countries. Indirectly, it could trigger a contagion of further defaults. For these reasons, the ECB is vehemently opposed to any default and pressure has been applied to keep the lending going.
Similar tactics have been applied in the past and, more than once, prompted the US to heavily weigh on the IMF to keep lending because the delinquent country was important, either economically (Mexico, Argentina) or politically (Egypt, Russia). This time it has led the Eurozone countries to quickly put together a new programme with more public money, and to start thinking of a bailing-in of private creditors, i.e. some form of default, causing enormous chagrin at the ECB.
Trichet’s idea aims at avoiding such a situation in the future. Shunning the incentive approach of the IMF – threatening to punish in order to elicit the desired response – he proposes to assume control of the delinquent country in this “second stage” of bailout. The IMF clearly has no authority to do so, hence the idea to give control to the EU. “In the new concept, it would be not only possible, but in some cases compulsory, in a second stage for the European authorities – namely the Council on the basis of a proposal by the Commission, in liaison with the ECB – to take themselves decisions applicable in the economy concerned. One way this could be imagined is for European authorities to have the right to veto some national economic policy decisions. The remit could include in particular major fiscal spending items and elements essential for the country’s competitiveness”. The proposal intersects three issues:
- the link between monetary and political union;
- the need for fiscal policy coordination; and
- the need for fiscal discipline.
The first issue has long been debated. The empirical evidence is that currency and nationhood normally come together but with countless counterexamples, mostly small states.
Beyond symbolism, the main reason is that the “optimal currency area” criteria stands to be better satisfied within unitary states.1 But then Frankel and Rose (1998) observed that the mere existence of a monetary union stands to make a clearly suboptimal monetary union “more optimal” as time passes by. So we knew all along that bad things could happen because the Eurozone is not (yet) an optimal currency area, and that they could be mishandled because we don’t have the instruments of a unitary state.
It is logical, at this stage, to see the emergence of proposals that aim at giving the Eurozone some attributes of a political union. Alongside Trichet’s proposal, we have seen suggestions that Eurobonds be collectively issued, which is partly what the European System of Financial Supervisors has been doing. The largely unnoticed, but historically significant presence of the Eurozone in IMF negotiations means that, in what Trichet calls the “first stage” of rescue operations, a country can find itself accepting conditions imposed by other. Because the first stage can fail, as is now happening with Greece, thinking about a second stage is unavoidable.
The second issue – the need for fiscal-policy coordination – harks back to the Delors Report (see here):
In order to create an economic and monetary union the single market would have to be complemented with action in three interrelated areas: competition policy and other measures aimed at strengthening market mechanisms; common policies to enhance the process of resource allocation in those economic sectors and geographical areas where the working of market forces needed to be reinforced or complemented; macroeconomic coordination, including binding rules in the budgetary field; and other arrangements both to limit the scope for divergences between member countries and to design an overall economic policy framework for the Community as a whole.
The voluminous literature that followed the Delors Report in the late 1990s made two points.
- First, it would be desirable to have a way of achieving the right fiscal-monetary policy mix at the Eurozone level.
This question has been set aside in academic work, perhaps because of theoretical uncertainties about the role and effects of fiscal policy, or because the problem had not yet materialised. The question, however, is very much alive at the political level where we hear periodic calls for “an economic government of Europe”.
- Second, with the monetary instrument lost, fiscal would have to become the main countercyclical instrument (Melitz and Zummer 1999).
It then transpired that fiscal policies were mostly procyclical before the adoption of the euro and that they have become, at best, mildly procyclical afterwards (Fatas and Mihov 2010). The idea that some centralised benevolent dictator could direct national governments to do a better job is attractive and justified, but is it realistic? Now that the president of the ECB has formulated the proposal, at least, we can hope to have a debate.
The third issue, the need for fiscal discipline, is the heart of current preoccupations. We all know the long debate about the Stability and Growth Pact. The very fact that Trichet wants something new is comforting; it is in line with my long-held view that the Pact could not work as intended, and that it mostly focuses policymakers on the wrong criteria (Eichengreen and Wyplosz 1997).
Over recent years, following von Hagen and Harden (1995), a large literature has developed the view that fiscal discipline is a matter of adequate institutions and that different countries require different institutions. This has recently turned into a rich debate about the use of rule and of institutions, with increasing interest on independent fiscal councils (see for instance Besley and Scott 2010). Within the monetary union, national councils may not be enough because of the externality that arises when one country fails to deliver fiscal discipline. The current crisis is a potent reminder of the importance of this externality. It is therefore entirely reasonable that the president of the ECB goes in this direction.
President Trichet’s proposal is original, it is remarkable, perhaps even historic, but not very clear. He envisions not a council but an individual. Yet, the decision to take over responsibility for fiscal discipline would come from “the Council on the basis of a proposal by the Commission, in liaison with the ECB”. A number of questions arise:
- Would this “minister” just be the Commissioner for Economic and Monetary Affairs, like Baroness Ashton?
- Would this be a new position, like that of Herman van Rompuy?
- Would (s)he just be the head of an independent fiscal council?
The experience so far with a High Representative for Foreign Affairs and Security Policy and with a permanent President of the European Council is not very encouraging. It shows that member states are most unwilling to give up national sovereignty for the common collective good. Things change over time, however, and the EU’s six decades are full of examples.
The idea of imposing fiscal policies on national governments and their respective parliaments, even in the “second stage” of a bailout programme is radical and sure to meet stiff resistance. It would require a very strong personality to carry out such a task, perhaps a former President of the ECB? Member countries have shown no inclination for having strong personalities in Brussels, however. Perhaps, then, they might start with a European advisory fiscal council that would oversee national advisory fiscal councils, a proposal recently made by the Commission. That would be a useful step.
Eichengreen, Barry and Charles Wyplosz (1997), “The Stability Pact: Minor Nuisance, Major Diversion?”, Economic Policy, 26:65-114.
Fatas, Antonio and Ilian Mihov (2010), “The Euro and Fiscal Policy”, in Alberto Alesina and Francesco Giavazzi (eds.), The First Ten Years of the Euro, University of Chicago Press.
Frankel, Jeffrey A and Andrew K Rose (1998), “The Endogeneity of the Optimum Currency Area Criteria”, Economic Journal, 108(449):1009-1025.
von Hagen, Jurgen and Ian J Harden (1995), “Budget Processes and Commitment to Fiscal Discipline”, European Economic Review, 39(3-4):771-779.
Melitz, Jacques and Frederic Zumer (1999), "Interregional and international risk-sharing and lessons for EMU", Carnegie-Rochester Conference Series on Public Policy, 51(1):149-188.
1 Optimal currency criteria are a list of economic features that make it likely that a group of countries would be better off sharing a common currency, e.g. labour mobility among the nations, similarity of industrial structures, etc.