Friday 17 September 2010

European Fiscal Federalism (Part 4): Institutional Framework and Credible commitments

Until now, this analysis has completely ignored who should be in charge of this redistributive policy. We have agreed that it should be the EU running the show, but which institution should be responsible for this?

The ideal institution is the one that can most credibly commit to following the redistributive fiscal policy necessary to ensure social stability and that no country grows at the detriment of another. In this sense we'd like to have the institution whose preference depends most positively and directly on the implementation of these policies. Unfortunately we can't peek into any institutions brain or heart. Thus, I believe the best method is to determine and settle for the least imperfect choice. In so doing, it becomes apparent to me, following Majone’s Functionalist approach, that the European Commission is the best institution, particularly for it's ability to lock itself into a given policy path, for its bureaucratic and technocratic expertise and for its innate self interest in increasing its influence. Ecofin, eurostat and budget commissions, in consultation with others departments and the member states ought to be the best drivers of this process.

This choice is also informed by considerations about the characteristics of cooperative arrangements in which voluntary intergovernmental commitments between Member states are not credible. This discussion is based on the conclusions from two-level games, veto player theory, game theory (prisoners’ dilemma), and the alternative of delegation as a strategy for unlocking policy making. Here the point is that there are too many EU Member States, who have to negotiate too much with both domestic and EU neighbours, facing rational, but non-efficient, non-cooperative incentives and who as a result come to prefer to pass on the burden of policy making to a specialised and well monitored agent, the European Commission. The logic I follow is that Monetary Union creates the externalities that require fiscal union. Therefore, my argument is coherent with the view of Alesina, Angeloni and Etro, that the Member states should delegate policy making powers to the European Commission when it comes to policy areas exposed to spillovers and ensuing negative externalities. Thus this logic is compatible with both Majone and Moravsick.

Here my concern is not so much with the amount of time necessary for the players to reach this conclusion, but rather that eventually they will reach a conclusion along the line of the above. The total learning period (where all the players find the “truth”) will depend on the preferences of players, on their numbers and on their exposure to signals. Finally, as Acemoglu points out it will also depend on whether the interpretation of signals is certain or uncertain. This total learning period is the time it will take players to go from insisting on cooperation towards delegation. In the Long Run we can see that as the process of going from stabilizing exchange rate arrangements towards the said fiscal union. In the really Long Run, we can consider this as the process of going from the Dark ages into the 22nd century (I'm optimistic, but even I realise this fiscal union will take long).

Notwithstanding, this process of learning can be illustrated by the grossly inadequate reaction of EU intergovernmental fiscal policy to the financial crisis and ensuing fiscal crisis. Three examples can be highlighted, one witnessing to the inability of member states to voluntarily and credibly cooperate in times of crisis in expenditure, the other in revenues and the latter in a plan for what is appropriate for the future (add the van Rompuy articles here!).

Regarding the first it is telling that when the financial crisis hit, countries restricted their financial bail out within national boundaries. Thus if a Swedish bank owned an Estonian bank or if an Austria bank owned a Hungarian or Slovenian bank, the government bail out could only be applied to cover liabilities in Sweden or Austria, leaving the most exposed counterparts to fend for themselves (obviously with the help of their own overstretched national governments). For all the talk of strength in numbers, the will and the tools weren't there to take advantage of the available economies of scale. In the absence of this federalist expenditure tool talks about bail outs will always suffer from some kind of ad hoc commitment incredulity, which could cause Markets to become bearish very quickly.

The other example relates to the ad hoc European fund set up to deal with potential sovereign insolvency. This is a problem on the EU's revenue side of the budget. There is a commitment to financing the fund but no hard guarantee of their actual implementation, because the fund is financed through voluntary donations. On top of this, these aren't even the type of donations typical and dominant in the budget process. These are literally voluntary, with no legal obligations for the member states to actually fulfil them once they are promised. It's all very pretty and it all makes sense but whether it actually happens depends on the volatile whiff of each investing member state. This is not just a theoretical concern about time inconsistency. Slovakia's withdrawal from the agreement could not illustrate this problem any better.

Such opportunistic behaviour of national governments will undermine cooperation if the opportunity of free riding presents itself and it is consequently a factor for concern. Once the failures to cooperate reach a certain cost, countries learn that the path they have been following is not viable and therefore decide to delegate policy making in that area to an International Organisation ( the EU), in order to minimise transaction costs related with ensuring the credibility of commitment.

The problem is that this learning process may take to long and this type of inconsistencies caused by political considerations and political instability, can have serious implications if there is a risk of contagion. Just imagine how the markets would have reacted if there had been a domino effect!

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