Daniel Abreu Costa // 18 July 2019

The 2008 crisis exposed the grave flaws of the EU’s Economic and Monetary Union (EMU). Most economists were not able to predict such economic turmoil, but many did raise red flags on the construction of the EMU. Now, it is clear that its flaws boosted the velocity and destructive power of the crisis across the continent. It is also clear that Europe needs reforms to complement and reinforce the EMU beyond the progress that occurred during the crisis. Creating a Fiscal Union should be the one of the top economic priorities of the new Commission as a new crisis might be approaching.

When the EMU and its exponent, the Euro, came into existence in the late 1990s, the EMU was effectively a political project. And as a political project without economic theory backing it, it has many flaws, many entrenched in the basis of the economics of currency areas. Robert Mundell’s Optimum Currency Area (OCA) theory clearly shows that the EMU is not an OCA, for instance. It also shows how deeply vulnerable non-OCAs are to asymmetric shocks. Besides, the EMU has a minimalist economic structure due to a shift in economic doctrine. One that believed that monetary policy alone would be enough to make the economy work and address inflation. An active fiscal policy was thought to be counterproductive, thus, there was little pressure to give the EMU institutional capabilities for a real synchronisation of fiscal policy.

Today, the Eurozone experiences a strong recovery from the 2008 crisis, but its architecture leaves the region vulnerable to future financial crises. Now that the Eurozone is stable, it is time that governments complete the EMU after the significant progress during the Eurozone crisis itself. Creating a fiscal union should be at the top of these priorities.

Nowadays, governments are solely focused on completing the banking union. Though there is a need to complete the banking union, this alone won’t be enough. The EMU requires fiscal risk-sharing to edge-off country-specific macroeconomic shocks. There are many ways to share fiscal risk without a lasting transfer of funds which is one of the major concerns of wealthy countries in the Union. For example, there are proposals for an EMU-wide unemployment insurance system to directly stabilize private incomes. Such a system would mean that fiscal sharing would occur through the country’s payments into the system, as these would drop during a crisis whilst benefits increase- the opposite would occur during an upswing. These benefits would, therefore, be funded by other countries.

Furthermore, another problem is that private markets don’t offer enough insurance against consumption declines during economic turmoil as we saw during the 2008 crisis. Maybe this is due to a crowding out effect on private spending. Of course, governmental deficit spending could be an alternative- but this of course comes with higher taxes which would hurt the pockets of consumers and producers. The alternative to this is to install a system where EU members mutually insure the others by sharing fiscal risk.

Additionally, the creation of a fiscal union could also enhance the credibility of the no-bailout clause. With further credibility, financial markets would be more likely to enforce fiscal discipline on member states. Previous experiences showed that many Eurozone area countries didn’t create enough buffers during the boom. This was reflected in, for instance, the higher revenues created by domestic demand booms which were erroneously predicted to be permanent.

Consequently, the creation of such a central fiscal stabilisation capacity in the Eurozone would then enhance the policy mix for the EMU as a whole. The space required to prevent a pro-cyclical fiscal adjustment in the future would be finally eliminated.

Still, such fiscal union needs to be backed with legitimacy and political consensus. This legitimacy might have to come through a pragmatic demonstration of why such fiscal union would largely benefit Europeans in terms of financial stabilisation and monetary security. It is fundamental that Europeans are informed of the clear flaws of the Eurozone. Maybe referendums could create such legitimacy and allow Europeans to receive enough information about the issues of the EMU. However, currently, there is no political will to move forward with any further reforms on the EMU. Only France and Spain seem to be the drivers of further reform at Euro level supporting a full-fleshed Euro budget and the finalisation of the banking union, specifically the European Deposit Insurance Scheme.

It is clear that the EMU has major flaws. It is an area that has a monetary union, a one-size-fits-all monetary policy but not a single fiscal union. There’s a need to build the required consensus on the view that it is better to rely on a central capacity and build a majority in favour of the view that fiscal stabilisation is a collective responsibility. Without significant progress to foster risk-sharing, the EMU will continue to be in dangerous waters.