BUS614: International Finance

European integration has reached a low point. Two major crises since 2007 – first the global financial crisis, then the sovereign debt crisis – have exposed deep governance problems and construction flaws in the Eurozone. Unprecedented economic hardship has dented citizens' support for European integration to the point where euroskepticism is a popular vote-getter in virtually all EU countries. As always, economic hardship breeds political populism, but this time populism takes the form of anti-Europe agitation. The previously-thought impossibility that countries could leave the EU is becoming a plausible scenario. European integration is no longer a one-way street.

A common response, popular amongst European and national elites, is that now is the time to go to the next integration step. Important changes decided since 2008 go in this direction: the Treaty on Stability, Coordination and Governance (TSCG) and the Banking Union both amount to further transfer of sovereignty away from member states. This is in line with the Jean-Monnet method, which foresees quantum integration steps in response to crises. It is a natural consequence of the treaty-sanctioned quest for "an ever-closer union".

Yet, another long-identified issue is the "democratic deficit". The decision structure of the EU confers considerable policy-making powers to bureaucratic institutions, that is institutions whose power does not come from elections, such as the European Commission or the European Central Bank. Even the Council, which brings together elected leaders, can be seen as a bureaucratic power because the leaders make collective decisions which go beyond the national mandates that legitimize their authority. For decades, we have paid lip service to the democratic deficit, but it now seems that the bird has come back to the nest to roost. One response has been to grant the European Parliament co-decision powers, but this institution operates more as a second chamber than like a real parliament elected on the basis of a European-wide debate on key issues faced by the EU. The creation of European political parties does not conceal the fact that MEP are elected as members of national parties, which typically campaign on national issues. Even when they advance truly European proposals, these ideas can differ considerably from one country to another, and they are even sometimes incompatible with one another. Paradoxically, co-decision may end up muddling policy decisions and deepen the democratic deficit.

The issues at stake fall in the much-studied area of fiscal federalism. Of course the European Union is not a federation, even though it has some federal features. Member countries have given up a number of previously sovereign functions, mostly in the areas linked to the Single Market, including trade and competition. In addition, a number of countries share a common currency and have given up monetary policy sovereignty; indeed, the Eurosystem is a federal arrangement. It would be desirable, therefore, that fiscal federalism principles underpin the EU architecture. Symptomatically, however, the word "federal" is considered as politically incorrect so that fiscal federalism are rarely invoked in policy discussions. For instance, the recent "Five-President Report", a catalogue of proposals to deal with the EU's malaise, does not mention at all fiscal federalism principles. Could it be, though, that these principles implicitly shape the EU architecture, either through spontaneous re-discovery or through silent application? This is the question addressed in the present paper. To that effect, it applies federalism principles to a few crucial questions, mainly fiscal policy, fiscal discipline and structural reforms, using where possible lessons from existing federations.

The next section briefly reviews the key message from the fiscal federalism literature. The following sections use these principles to examine a number of areas where centralization may be insufficient or excessive in the EU. Section 3 looks at public spending, both in the aggregate and my main functions. Taxes are examined in Section 4. The following section looks at the issue of fiscal discipline, a critically weak spot of the Eurozone. The allocation of policy competencies, a key characteristic of the UE, is the object of Section 6. The last section concludes.

Source: Charles Wyplosz, https://ec.europa.eu/info/sites/info/files/dp014_en.pdf