European Fiscal Federalism (Part 3): Pigouvian taxation, and redistribution - Externalities, mobile assets, and euro interest rates

So far, I’ve been describing the economic logic for fiscal federalism. However I have not qualified it. It's all nice and easy to argue that we need to tax the richest and subsidise the poorest, but how do you do this? Which pockets should the EU reach into and what should it pay for?

In the next lines I propose the following Euro-level fiscal tools : (1)Taxes on mobile factors that cause negative externalities, (2)an Income tax, and the maintenance of a (3)common education policy as well as a (4)common defence policy, with a tendency for expansionary military R&D expenditure during recessions. Finally I also argue in favour of (5)the establishment of an European Monetary Fund (EMF) to switch from cooperation to coordination of euro-area fiscal policies. This would be the best tool to keep and improve the theoretically good monitoring devices created by the SGP, while replacing its very ineffective legalistic procedures, in order to improve fiscal stability across the board.

I believe these are the necessary tools for the EU to minimise its risks of suffering from asymmetric shocks, while endowing it with the policy tools to deal with them, should they arise, as they inevitably will. They may however not be sufficient...

European Fiscal Federalism (Part 1): Introduction to the “irrefutable”

It seems that weekends are only reserved for Lady Ashton. On Sunday 8 August, Mr Janusz Lewandowski, the (Polish) EU budget commissioner started floating around the idea of a European tax to be levied by the European Commission on banks, financial transactions, carbon emissions (permits) and air traffic. Berlin, Paris and Westminster were not amused, but Poland, Austria, Belgium and Spain seemed to not dislike the idea too much. Anyway, this is part of the ongoing process of preparation for the 2014-2019 budget which will be presented by the afore mentioned Commissioner at the end of September 2010. Most interestingly of all for me was the response that the proposal received from the Financial Times. I believe that unless you've subscribed to the ft, even if only for free, you can't read this article. It's not complicated but I assume not everybody can be bothered to do it. As such I feel compelled to report some of the comments which are rather strong:

Upcoming EU Debates and Reforms

I'm going to do something everyone loves and no one is good at. I'm going to try to predict what the next big debates in the EU will be given what little information we have now. My logic is that future reform will follow the same path as previously and as such will be economic and intergovernmental crisis driven, with a bit of a functional institutionalist steering. I propose that two main policy areas will be discussed and that one major institutional issue will be raised. The first two refer to economic governance and to defence. The latter reffers to the possibility of a dual presidency of EU institutions under the same president.

1) POLICIES

a)Economic Governance: This is the perennial EU reform, caused by some ongoing crisis, and typically is path dependent, in that it is the latest step in European economic integration. Looking back at the Greek crisis which has spawned it, one is faced with the fact that this was almost inevitable. The geographical proximity of European countries and the transaction and transportation costs of the mid 20th century tie European countries to each other through trade, despite Political and security fears. These in turn motivate the ECSC(1951) and the CAP(1960), which then lead to the Common market. This increased level of integration increases intra-European trade, which leaves national producers more exposed to competition.unable to restrict access, national governments turn to artificially increasing competitiveness through exchange rate manipulation. This then causes a number of attempts from high productivity countries to control the others. Alternatively in order to avoid a race to the bottom in exchange rates countries decide to cooperate and coordinate their exchange rates. Independently of the mechanism, increased trade brings the need to coordinate exchange rates and so in 1979 is born the Exchange Rate Mechanism (ERM). Incidentally the main lines of EMU are first proposed a decade earlier in the Werner Report of 1969. From this and the subsequent imperfect agreements it is only a matter of time before those imperfections are made evident by speculative attacks. This, supported by enlargement, the profits that it brings and the impetus it gives to further integration and the countries adapt their interactive institutional framework, perfect the common market into the Single Market and inevitably implement the Euro. However this is still an imperfect setting and requires fiscal integration and delegation to give the monetary union more credibility and shield the member states from speculative attacks.

b)Defence: This is the latest in a number of articles which seem to me as though they indicate a certain willingness to move towards a much more integrated defence system for the EU. First I noticed Italy had been pushing for this (here's some more info), then obviously so did France, (and France again), as well as Germany (and again here). It seems natural. The USA is repositioning itself in light of the emergent powers in the East, looking at India and China as the next big partners/opponents in the geopolitical scene. It is also in decadence (not the one that makes your country disappear, but the one that makes it close a couple of military bases around the world and rethink cowboying around the world in the future.). So it must make some savings. Russia wont invade Europe, despite CEECs fears. Energetic disputes are mostly regional beyond the interest and influence of the USA. At the same the EU is very stable within itself, so the USA don't need to worry about developments here. It's not just that we are too many to deal with. Obama does not come to Europe because he doesn't need to.Thus the USA start pushing for a NATO which is less dependent on their own expenditure and ask us Europeans to share the bill. I don't like war and war-related business but this is an argument I have some difficulty arguing against.

However there is a more fundamental reason for the EU to integrate it's military organisations better, Economies of scale. Basically, as this article argues, and as should be apparent to anyone aware of the EU's non super power role, we spend almost 9 times as much as the Chinese in the military yet we get absolutely no value for money. The extent to which there must be duplication of efforts must be ridiculous for a block of countries who will never fight against each other again. Plus if we all get together, we are bigger, and as economics tells us, bigger markets bring higher levels of specialization which in turn creates higher efficiencies. This is a typical case of being able to get much much more for the same amount of money. Plus if integration in the defence sector takes place, the European defence market becomes a monopsony of procurement with all the advantages that creates for bargaining power for the EU and for all the specialization it creates in the supply side. The obvious downside to this is that we'll create a bigger and newer interest group with more nefarious interests. I mean the last thing we want is a militaristic Europe 100 years after the first world war. So maybe it should be so that this further step in defence integration should follow fiscal integration thus allowing the EU to buy a veto in the administration of war related businesses. In this sense the Germans and the French could sell their shares in the EADS to the EU. Either way something ought to be done to at least try to prevent this sort of development from taking place. After all, it would be a pity to have to continue to follow the USA's initiative. Wouldn't it be amazing if the next internet-like invention came from Europe rather than the USA? (and yes I know the first version of the web came from CERN...).

I don't know how long all of this will take, but it shouldn't be much longer. How long will largely depend on the UK and on the next period of persistent economic growth. The UK is the EU's largest spender on defence. Without it France would have to prop Germany up more than what it might like to. The UK would provide the necessary tie breaker. Finally in order to go through this process it is necessary to have two things: Democratic support and the economic resources to pay for it, so getting out of the crisis would help. It seems to me that the momentum is there. All that's missing is an opportunity.

2)Dual Presidency

Here and here are some discussions of the possibility and implications of merging the roles of the Council and of the Commission presidents. On the face of it, it is not a particularly bad idea. It would decrease the number of Mr/Mme Europe, which seems to have become a major embarrassment for post-Lisbon EU. But is it really such a good idea?

I am on the fence on this. I think that there's that argument in favour of it, but are the roles really compatible? The only example of this is the present situation of Lady Ashton. She's a servant to two masters: The commission of which she is a vice president and commissioner for foreign affairs, and the Council of which she is the president of the committee for foreign affairs and defence and security. How is she handling it? Well it's still a bit early to tell, but she's struggling. The problem to me seems to be that the Commission is an executive body, who is fairly political, and follows or leads the parliament, which is also political. The council however is intergovernmental. Might there be some conflict of interests? Not forcefully and actually this position could actually help put an end to the rivalry between the two institutions. But it would have to be well done... Whoever would be in charge would have to have a lot of staff. Though I would add that in good truth it seems to me as though the best arrangement would be the one where all council "committees" are modeled after the Commissariates and the European Parliament's committees so that the council's meetings are all presided over by the relavant comissioner. Finally, I do agree that at one point or another, the concentration of power will be such that the president of the EU position should either be made to be directly elected or so that the relevant politician must be a member of the lists of the majority party in the European parliament. Both would have political legitimacy, but the latter would do so with added simplicity. It would only require the addition of a small number of articles redefining the role of the president of the commission as closer to the role of the prime minister of a federation (say Merkel or the Prime minister of Canada, India or Australia), to ensure that the candidates would be apparent to everyone, thus forcing him/her to actively campaign. The fear here is that if there is no such transparency incentive, then we may end up with no apparent leader during the campaign, leading to the president being chosen ex-post in the corridors rather than ex-ante or during the voting, as is supposed to be the case.

So what do you think?

Greece will be bailed out before it defaults or restructures

So it seems that Greece will actually need to be bailed out. Wolfgang Munchau offers a good explanation of the underlying dynamics and mechanisms, while Jean Quatremer provides a more accessible version, for those who speak French. Its particularly relevant in terms of the accounting and maths of it all. Please read them if you have a chance. I must say I identify more with the optimistic perspective of M. Quatremer, in that Greece will be bailed out. I'm not saying it won't default. I'm just saying it will be bailed out and if that's not enough, then it will default. My hope for the bailout is that it will save Greece from falling further into a debt deflation dynamic such as the one described by Jacques Depla, which would then create real lasting problems. If this proves true, then we end up in Wolfgang Munchau's scenario number two, where the EU and the IMF bail out Greece. Contrarily to him I assume that member states can bail each other out, within the limits of some set out by article 103a of the Maastricht Treaty(in page 13), which reads as follows:

"ARTICLE 103 a 1. Without prejudice to any other procedures provided for in this Treaty, the Council may, acting unanimously on a proposal from the Commission, decide upon the measures appropriate to the economic situation, in particular if severe difficulties arise in the supply of certain products. 2. Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by exceptional occurrences beyond its control, the Council may, acting unanimously on a proposal from the Commission, grant, under certain conditions, Community financial assistance to the Member State concerned. Where the severe difficulties are caused by natural disasters, the Council shall act by qualified majority. The President of the Council shall inform the European Parliament of the decision taken."

Granted that all of Greece's problems are not motivated by "difficulties caused by exceptional occurences beyond it control", but they are partially. As long as it is possible to determine that an economic shock is not purely endogenous, this article allows for the intervention of the Council upon a unanimous decision of its members. Given that economics is not an exact science, and that we are unlikely to create a European Court of Macroeconomic Justice, it is fair to say that as long as an economic shock is symmetrical(meaning as long as everyone else is also experiencing a recession), those who are suffering less will always be able to bail out those suffering more, even if everyone is suffering.

I also disagree with Munchau on his last comment that "the message from the EU, and from Germany in particular, is that member states are not ready to co-ordinate economic policy in the short run, and move towards a minimally sufficient fiscal union in the long run, and that as a result EMU is doomed". To me this is a syllogism. I think that the EU is more than the sum of its parts, particularly in terms of institutional reform, which is what is relevant from the point of view of fiscal

Also, if common sense is not a good enough explanation for German self interest in dealing with its neighbours, here is a fairly comprehensive review of all the possible reasons why Germany does not want to offer Greece any outrageous bailout.

This is why we need European independent revenue, ie EU taxes. This way there will be another level of government whose preferences are the result of an aggregation of the preferences of the populations of all EU member states, weighted by the machanics of the European parliament's electoral system.

This way, the greeks won't complain about Germany. They'll complain about Europe. And if Europe does not help them with structural funds, they'll burn EU flags or vote for more leftist representatives in the EP, who will be more generous with how they spend EU funds.

On a final note, this issue of the bail out from the EU has been a controversial topic since the beginning of the financial crisis, before it expanded to the rest of the economy. There's an interesting distinction that must be made. States can, under some circumstances bail each other out, the ECB cannot. Both the member states and the ECB can bail out the private sector. The explanation for this can be found in Article 104 of the Maastricht Treaty:

"ARTICLE 104

1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’)in favour of Community institutions or bodies, central governments, regional, local orother public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

2. Paragraph 1 shall not apply to publicly-owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions."

So if you are wondering why people talk about the help that the ECB gave to businesses during the financial crisis, it did so through paragraph 2. It provided credid facilities to "private and publicly owned credit institutions." In conclusion, member states can bail eachother and their private sector out. The ECB can also bail out the private sector but not country. The ECB can increase its credit lines to private institutions all over the Euro-zone, which may then buy credit from the state. So in principle, the ECB could bail a state out. However, it is rather unlikely that the ECB will provide a credit line exclusively to one bank of a specific country, which would serve as a proxy of the state, as this would be highly frowned upon. Alternatively, it could provide that credit line to everybody, but it seems very unlikely that all those banks would then flock to a troubled country and just hand that money to it.

EMF, German economy and EU procurement reform

In the following article, Tony barber of the FT asks Two questions. First, whether it is possible for Germany to

: 1) "no longer to be, in the broadest sense of the term, the EU’s paymaster", 2) "impose strict budget deficits in the Eurozone" 3)"remain the EU’s champion exporter and a model of business competitiveness, piling up vast current surpluses as a result"

and secondly, whether this is compatible with European (Economic, I assume) Stability.

Regarding the first question, I believe that this is a coherently proposed set of goals. Again, I go back to the basic open economics: Y=C+I+G+NX, and Y=C+S+T implies that I-S + X-M = T-G. Therefore it is not just possible, but in the absence of a short term disequilibrium between Investment and Savings, if Germany wants to be a big exporter it needs to have a low deficit. What better way to do that than to stop being the EU "paymaster". But is it really the pay master?

Now, the second question is much more tricky. As I said, I'm assuming that he is referring to economic stability. Now the thing one needs to keep in mind is the EU's procurement system. At the moment EU revenue has 4 main sources: VAT, customs and agricultural duties and direct country contributions, based on some GNP proportionality formula. Then there are some other smaller adhoc contributions, but nothing more tha 5-10%. This means that whoever consumes more, whoever participates in more external trade, and whoever has the largest GNP, will always be the EU's paymaster. So Germany is stuck. Even if the EU was to levy some income tax, it would still be germans paying the largest piece of the cake.

Ultimately the point is still that the whole story is a bit inflated. There is no problem with Germany not wanting to pay for greek debt. Moreover, just because it decides that the idea of a EMF is good because it spreads the monetary cost of rescue to everyone, it does not mean that suddenly Germany wants to decrease the bill it pays. I guess it only means it does not want it to increase! Germany is the biggest payer of EU but it is not the majority. It's not worth making a fuss