Euro crisis: the dangers of fiscal integration

European leaders are advocating greater fiscal integration in response to the ongoing euro crisis. Despite their professed euroscepticism, David Cameron and George Osborne have offered their support for this approach. Yet such a policy would probably be ineffective at preventing future crises and could further damage European economies in the long-term.

One option being considered is stricter EU supervision of national governments’ borrowing levels – a rigorously enforced version of the failed Stability and Growth Pact. If this policy had been imposed during the last decade it might conceivably have moderated some aspects of the Greek crisis (although for many years the Greek government hid the true level of its debts and several other governments ‘cheated’ to meet the Maastricht rules). Strict fiscal controls would not however have addressed the effects of a one-size-fits-all monetary policy applied across diverse eurozone economies. Indeed, Ireland and Spain were among the most prudent eurozone governments during the recent boom period, with low budget deficits and low national debts. The problems in these countries largely resulted from inflationary bubbles which eventually collapsed.

A key question is how EU fiscal authorities would behave towards countries where credit booms had collapsed leading to a large fall in tax revenues. A strictly enforced fiscal stability rule would force national governments to cut expenditure immediately, even if this meant breaking commitments to electorates. In economic terms this could be a welcome development in that would preclude counter-productive Keynesian fiscal stimulus measures. However, the political incentives created by such economic shocks are a cause for serious concern.

National politicians would have strong incentives to blame the EU for severe depressions (and indeed the eurozone clearly does magnify boom-bust credit cycles in some countries). Accordingly, EU institutions, with their agenda of increasing integration, would have strong incentives to attempt to counteract economic and political instability with large fiscal transfers from the centre. In other words, counter-cyclical public spending by national governments could be replaced by fiscal bailouts/stimuli at EU level.

More and more vested interests would become dependent on such spending, making it difficult to roll back and leading to an enlarged role for the central EU authorities. There is therefore a strong likelihood that fiscal integration would eventually lead to the creation of a ‘transfer union’, with stronger countries subsidising weaker ones. The stronger economies would be damaged by higher taxes, while the transfers would crowd-out private-sector activity in the weaker economies, preventing their recovery – as we see in peripheral regions of the UK that are heavily dependent on subsidies from the South-East. An additional danger is that fiscal integration would eventually lead to tax harmonisation – destroying the benefits of tax competition. In conclusion, fiscal integration threatens to undermine the competitiveness of the EU’s more successful member states and thereby speed up the region’s already rapid relative economic decline.

Richard Wellings was formerly Deputy Research Director at the Institute of Economic Affairs. He was educated at Oxford and the London School of Economics, completing a PhD on transport and environmental policy at the latter in 2004. He joined the Institute in 2006 as Deputy Editorial Director. Richard is the author, co-author or editor of several papers, books and reports, including Towards Better Transport (Policy Exchange, 2008), A Beginner’s Guide to Liberty (Adam Smith Institute, 2009), High Speed 2: The Next Government Project Disaster? (IEA , 2011) and Which Road Ahead - Government or Market? (IEA, 2012). He is a Senior Fellow of the Cobden Centre and the Economic Policy Centre.

3 thoughts on “Euro crisis: the dangers of fiscal integration”

  1. Posted 27/10/2011 at 10:38 | Permalink

    And you would have permanent mutual resentment between the net payers and the net recipients, the exact opposite of what Euromantics promised.

  2. Posted 27/10/2011 at 13:21 | Permalink

    So-called fiscal integration would do nothing to help competitiveness. And it seems unlikely it would be acceptable to the populations either of transferor regions (like Germany) or of transferee regions (like Greece). That ought to give pause even to the anti-democratic European Union. Moreover would there not be a serious moral hazard in transferee countries? If the plan is for them to be subsidised year after year by better-run economies, where is the incentive for them ever to get their economic house in order?

  3. Posted 29/10/2011 at 13:55 | Permalink

    I agree with all the economic negative effects such as undermining competitiveness and benefits of tax competition (after all, equally high taxes in the entire eurozone will force businesses to move more and more of their business outside the EU), and especially with the fiscal transfer argument and the dependency on a more powerful EU central authority, which inevitably leads to more socialism.

    I would like to add the political dangers of fiscal integration. A push for greater integration will comprise of the eurozone countries only at first, as it could arise as a response to the Greek debt problem. This could lead to negative consequences in the outside-euro countries and yield negative reactions from them (some even call for a united front of non-euro countries against the euro countries). Euro skepticism will rise among the voters and we might experience even bigger rebellions in Parliaments of these countries than the one at the beginning of last week in the UK. Eventually, before the final step to fiscally integrate all the EU countries, the levels of euro skepticism among the people will simply be to high and a break up will arise as the only possible outcome. People tend to loose their confidence in things pretty easily, as is obvious during the current recession and recovery. The UK has already lost its euro-optimism (if there ever was any). A path to a fiscal union is not the way to restore this optimism, it is unfortunately a way to crush it all together.

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