The Centralization-Decentralization Issue

The Importance of Fiscal Discipline

The preference for limited explicit transfers calls for attention for implicit or involuntary transfers. The obvious concern is that sub-central governments run budget deficits and accumulate debts that they eventually can no longer honor. This could force the central government or the central bank to step in and provide indirect transfers. Such a process – known as the soft budget constraint – represents potentially a large-scale externality; it is well understood as a case of moral hazard.

A large literature is devoted to this question. It has identified a number of factors that encourage sub central governments to run up their indebtedness. Unsurprisingly, they emphasize political and economic institutions. The list includes the nature of the relationship between government levels, the influence of regional interests in the central government, the pre-eminence of the Finance Minister in the budgetary process, political stability and length of time in office, and the ability of markets to impose discipline. The literature has also shown the importance of fiscal discipline at the central level and the existence of vertical transfers and the role of borrowing restrictions at the sub central level.

The Specific Case of the Eurozone

The creation of the Eurozone has brought these issues to the fore. The Delors Report (1989) explicitly recognized the necessity for member states to be fiscally disciplined. This requirement was written in the Maastricht Treaty in the form of the Excessive Deficit Procedure (Art.126 of the TFEU). The Stability and Growth Pact (SGP) is an evolving set of guidelines set according to Art. 121 of the TFEU. The SGP is that it entrusts the Commission with the task of monitoring member states budgets and it allows the Council of Finance Ministers to take action, including imposing policy actions and imposing a fine, upon recommendations from the Commission.

This arrangement is surprising. Indeed, the EU has few attributes of a federal state, the Commission's budget is minimal and its revenues are provided by member states, not raised by centralized taxes, and yet it is formally authorized to censor national fiscal policies. According to an official survey of OECD countries, Sutherland et al. (2006) report that "the most common fiscal rule is the budget balance requirement [...] Most sub-central governments also face a restriction on borrowing. There has been a move in a number of countries away from micro-management through a prior approval system on a case-by-case basis towards aggregate and numerical targets. [...] Borrowing is rarely explicitly guaranteed by a higher level of government, but implicit guarantees may be more widespread. [...] Few countries apply fiscal rules directly to sub-central government spending". A summary of the findings is presented in Table 2 below. It appears that the SGP is both more encompassing and intrusive than what is found in federal and unitary states.

Table 2 Centralization of budget restrictions and sanctions

Note: The survey seldom distinguishes between regional (states, provinces, regions, etc.) and local (municipalities) authorities. When the distinction is available, mostly for Canada, Germany and Spain), the table only reports on regional authorities.

Arguing for the SGP is the presence of the strong externality that has been evident during the sovereign debt crisis, confirming the conclusions of the Delors Report. In addition, fiscal policy coordination is justified by another externality, the fact that one country's cycle affects others. Yet, the fact that the sovereign debt crisis occurred is enough to establish that the SGP has failed to deliver. Is this prima facie evidence of failure a violation of the principles of fiscal federalism? Not necessarily, since the fiscal discipline set-up is subject to the classic tradeoffs.

Indeed, as long as prices and wages are mainly driven by domestic factors, business cycles will not be synchronized. Purely domestic factors such as labor and product market institutions as well as trade specialization, which significantly differ from one country to another, explain the lack of a high degree of synchronization. Since, within the Eurozone where a single monetary policy, fiscal policy is the only remaining macroeconomic instrument left at national level.

In addition, strong asymmetric information and preference divergences must be factored in. Fiscal policy is an intensely political instrument and therefore a key prerogative of national governments. It lies at the heart of domestic politics, hence the information asymmetry. Furthermore, budget imbalances imply redistribution across generations, which involves deep preferences. Preferences are shaped by a host of national factors including demography, the structure of family ties, traditions and taxation of bequests, and more, all of which are the outcome of history. Even though these preferences are combined with unhealthy myopia – the common pool problem at the heart of fiscal indiscipline – the solution must come from within. It calls for formal or informal rules and institutions. Von Hagen et al. (2009) convincingly argue that, to be effective, fiscal discipline rules must be tailored to national specificities and must therefore differ across countries.

The tradeoff is clear. Each Eurozone member country needs to recognize that fiscal discipline at home is a matter of utmost importance to all other members. This is explicitly stated in Art. 121 of the TFEU. At the same time the design and enforcement of appropriate rules cannot be uniform, as required by Art. 126. The authority conferred by this article to the "Center", the combination of the Council and of the Commission, is in direct contradiction with the fact that fiscal policy is a national competence. This contradiction was always bound to lead to serious difficulties when conflicts would arise between the SGP requirements and national intentions. The experience so far is that national sovereignty prevailed in such instances.

The question is how to escape this contradiction. The approach adopted in the wake of the crisis has been to strengthen the power of the Center. This has been achieved with the Six Pack-Two Pack legislation and the Treaty on Stability, Coordination and Governance (TSCG) also known as the Fiscal Compact. The obligations of Eurozone member states have been extended to detailed ex ante reporting (the European Semester and submission of budget laws before they are presented to national parliaments), to new obligations to reduce public debts when they exceed the 60% threshold and to new sanctions. In addition, key decisions are to be taken by reverse qualified majority voting: a Commission proposal is accepted unless a qualified majority votes again. This last feature intends to tilt the balance from the Council to the Commission. These revisions raise the stakes of the conflict between mutually agreed obligations and sovereignty. It can be argued that, by agreeing to these changes, member governments have willingly given up some sovereignty. It is not clear at all that this indeed was the case, nor that national parliament and citizens were aware that it could be the case. As a result, the matter is becoming highly political, a promise of politicization of the SGP.

This evolution implies that the externality argument is believed to overweigh the two other arguments against centralization, information asymmetries and preference divergences. This, of course, is a matter of judgment. But do we need to face this sharp trade-off? Wyplosz (2013) argues that the relevant example is the case of states in the United States. Table 2 shows that few countries operate centrally imposed rules. Sanctions are quite widespread but they mostly concern the municipality level. Yet, in most countries in the sample, sub central governments are subject to fiscal rules. This points to the importance of self-imposed incentives. With one exception, all US states have adopted balanced budget rules, varying in details from state to state. Inman (2003) reports that this only happened after Congress rejected one more bailout request in the 1840s. This conforms to the indication in Table 2 that most countries do not guarantee sub-central government borrowings.

This is not the route taken in the Eurozone. Although Art. 125 of the TFEU strictly forbids bailouts, bailouts were repeatedly decided by the European Council. The EFSF, and its permanent successor, the ESM, are bailout institutions, de facto if not de jure. Paradoxically, this is in line with the US experience. As is well known, the first US Treasury Secretary, after independence Alexander Hamilton was eager to expand the realm of the federal government. One of his means was to bail states out when they met their budget constraints. Repeated defaults were averted that way, allowing the Treasury to acquire power, until Congress relented. The Eurozone bailouts and the creation of the EMS similarly expand the power of the Commission. They served as the motivation for the reforms of the SGP.

A crucial difference is that the US Treasury was able to grow, raising more taxes and expanding its budget, which the Commission cannot do. Moral hazard ensued as the states embarked on expensive infrastructure projects (chiefly building canals) that were not necessarily justified given that the Federal Treasury would eventually pick up the costs. The Kentucky decision was followed by a wave of defaults, affecting nine of the 28 existing states. In the Eurozone, the bailouts took the from of additional debts, leaving the affected countries with a burden that, at best, will weigh on economic conditions for decades to come.

This means that the Eurozone has even more reasons than the USA to let every member country design and enforce its own fiscal discipline rules and institutions. Crucially, the no-bailout rule must be somewhat reinstated. Indeed, if the same causes produce the same effects, the certainty that bailouts are a thing of the past should lead member governments to become fiscally disciplined. The Fiscal Compact already requires each member country to operate a solid fiscal rule under the supervision of an independent fiscal council. The implementation so far seems uneven, with few countries having made written it in their constitutions or having adopted rigorous and enforceable rules.

Implications for Monetary Policy

A difficult aspect concerns the role of the ECB. It is also bound by a no-bailout rule (Art. 123) and yet it has been part of the bailouts of 2010-2011. If the no-bailout rule is to be restored, this should also concern the ECB. In the US model, the central bank is strictly prohibited from purchasing state (and lower level of government) debts, including in its routine money market operations. The reason is that states are presumed to be allowed to default if their debts become excessive. The Federal Reserve therefore should not be in a position to suffer the corresponding losses, which would be a form of federal bailout. As a result, US Treasury bills and bonds are the monetary policy instruments of the Federal Reserve. In the Eurozone, there are no corresponding instruments, which necessarily exposes the ECB to country default risk.

This point simply means that there can be no single monetary policy without a single instrument to carry money market operations. The amount of securities held by the ECB for monetary operations is of the order of € 600 billion, but it previously reached a peak of almost € 1300 billion in mid 2012. The total of gross public debts of Eurozone countries is about € 9540 billion. If 20% of this amount were converted into a joint-liability of all Eurozone countries, with seniority over the rest of public debts, that would be more than enough for the most extreme cases experienced during the crisis. This would constitute of pool of very safe bonds available to the ECB for its monetary operations. Debt mutualization is often, and rightly criticized for its adverse moral hazard effect. On the other hand, the ECB is taking risks with the instruments that it deals with – not just public but also private debts. This is obvious for purchases, which are the raison d'être of OMT even though no purchases have yet happened. It is also the case for repurchase agreement even though it applies significant haircuts, but these haircuts may prove to be insufficient. In a way, the ECB effectively mutualizes these instruments, simply because there is no substitute. It is illogical to criticize the ECB for that while rejecting any proposal to provide the ECB with a European debt instrument.