Fiscal Freedom in the Eurozone?

Lucrezia Reichlin *

Italy's draft budget is the latest evidence that the EU fiscal framework, according to which national budgets are supposed to comply with common rules, is broken. To prevent an eventual disorderly breakup of the eurozone, a new framework must be devised.

LONDON – Italy’s government has approved a draft budget that would fund its expensive election promises by violating European Union fiscal rules for at least the next three years. With that, the populist coalition – comprising the anti-establishment Five Star Movement (M5S) and the far-right League party – has seemingly confirmed fears of populist-fueled instability in Europe.

The budget represents the victory of Italy’s two deputy prime ministers – M5S’s Luigi Di Maio and the League’s Matteo Salvini – over the country’s independent, technocratic finance minister, Giovanni Tria, who had presented a more conservative proposal. Any illusion that the populist coalition could be kept in check by moderate cabinet members has now been destroyed. Italy’s new “government of change,” which has been in power less than four months, is clearly both willing and able to challenge the EU.

Unsurprisingly, the market has reacted badly to the draft budget. But a full-blown speculative attack on the government-bond market is unlikely. After all, the key to debt sustainability is economic growth. And while a large fiscal deficit, fueled by tax cuts and increased current spending, is unlikely to help much on this front, it is not as if Italy’s attempts at fiscal consolidation were fueling a strong recovery.

Given this, investors seem likely to adopt a wait-and-see approach, at least in the near term. In the meantime, it is worth considering the implications of Italy’s new budget for the future of the EU and, in particular, the euro.

Italy is not the first country to flout EU fiscal rules. French President Emmanuel Macron just announced a draft 2019 budget that could result in a fiscal deficit above the EU limit of 3% of GDP. Others, including Germany, have done the same in the past. And there is no reason to think that more countries will not do the same in the future.

The EU fiscal framework, according to which national budgets are supposed to comply with common rules, is clearly broken. Given that framework’s place as a pillar of the Maastricht Treaty – the other being a shared monetary policy – the result could be the destruction of the euro. The only way to avoid such an outcome, it seems increasingly clear, is to devise an alternative framework. What form could this take?

One option is to abandon fiscal rules and let the market enforce discipline. Such a choice would likely produce a very unstable outcome. This is why recent proposals, such as the Franco-German Meseberg Declaration on eurozone reform, are based on a compromise: combining some degree of risk-sharing with measures to reduce risk and induce greater market discipline by, for example, restructuring debts.

Implementing such reforms, however, looks increasingly unrealistic. For it to work, members would have to be able to trust that everyone would adhere to common rules. After the latest fiscal violations that is simply not possible. Moreover, the appetite for risk-sharing is vanishing in Northern Europe, where pro-reform political parties have been increasingly weakened. A better approach, therefore, would be to focus on limiting the externalities of fiscal decisions taken by fragile member states, rather than trying to circumscribe the decisions themselves.

For example, the EU could impose a ceiling not on total debt, but on the portion of debt held by foreigners. That way, each country could increase its indebtedness if it so chose, so long as its creditors were its own nationals.

Under this approach, the decision to spend one’s way out of debt – using debt-financed expenditure to generate growth, thereby achieving sustainability – would come at the cost of some form of financial repression. Its viability would depend on citizens’ willingness to finance their government by investing their savings in its sovereign bonds, rather than pursuing more diversified and profitable portfolios. Such a model already exists in Japan, and Italy, with its large share of domestically-held public debt and substantial net private wealth, is not that far from the same situation.

The big advantage of this approach is that it would force politicians to take full responsibility for their actions, rather than merely pointing the finger at Europe when something goes wrong – a habit that has fueled the rise of populism in many countries. If they chose to forego the advantages of European financial integration, they would have to explain that decision to voters, who could then express their approval or disapproval at the ballot box and, of course, through their investment decisions.

Of course, this approach would limit financial integration, as banks would have to buy their own governments’ bonds, strengthening the link between financial and sovereign risk and crowding out lending to the private sector. Given this, adopting such a regime would make sense only if the option to use spending to escape debt were rarely and temporarily exercised.

The big question is whether the euro could survive under such a set of rules. The common currency’s purpose is to ensure monetary stability in markets that are financially integrated – a situation that, it is assumed, is good for growth. To the extent that financial integration is reduced, the economic motivation for maintaining the euro would fade. Protecting the euro, therefore, would necessitate ensuring that the fiscal freedom offered by this new type of rule – discriminating between national and non-national investors – could be exercised only in extremis.

One might say that establishing new rules regulating when and how the old rules may be broken smacks of desperation. But at a time when countries are flouting the fiscal rules anyway, a framework to define and provide for exceptional circumstances could help to avoid a disorderly breakdown of the euro or a paralyzing political crisis. /project-syndicate

* Lucrezia Reichlin, a former director of research at the European Central Bank, is Professor of Economics at the London Business School.