Economists look to United States for fiscal inspiration

Date: 08/10/1998

By Tim Jones

MANY economists are convinced that a single currency area cannot function at its best without a big federal budget, and one of them is a member of the European Central Bank's executive board.

Eleven years ago - ancient history in the life of the euro - Tommaso Padoa-Schioppa co-wrote a book questioning the whole notion that Europe could ignore the example of the US and try monetary union without fiscal union.

The idea that the corridors of ECB power are crawling with plotting federalists might appeal to members of the British Conservative Party prone to conspiracy theories, but misses the point.

Padoa-Schioppa is far from alone. Even economists who are sceptical about the euro altogether believe it will stumble unless it is accompanied by a US-style system for raising and spending taxes federally.

The European model is the stability and growth pact. This allows each government within the monetary union to keep its own budgetary powers but subject them to tight scrutiny by its peers.

The US, on the other hand, has developed a true federal system under which taxes are raised by local and state authorities as well as Washington. The states redistribute part of their revenues to municipalities and the federal government does likewise to the states.

These are not simply for dealing with problems which require spending across borders: environmental protection or educational standards. Fiscal transfers between tiers of government are also regarded as a form of macroeconomic insurance.

In a union, resources can be transferred from areas where income is temporarily high to those where it has temporarily dropped.

If demand for one region's exports falls, its demand for imports from other areas will also tend to drop and its workers' real wages (salaries adjusted to take account of inflation) will have to fall to restore the competitiveness of its exports to other regions.

Pre-EMU, a country could devalue its currency to achieve these ends. In monetary union, it will have no currency to debase. Instead, the required 'adjustment' will have to be made in wages, prices and jobs.

In the US, states and regions feel the pain of such adjustments. The Eighties' ghost towns around Pittsburgh and Detroit bear witness to that. However, the US federal government makes automatic inward transfers to depressed regions to ease that pain.

Transfers known as federal grants-in-aid often have specific 'equalisation' schemes which allot a higher proportion of their available funds to low-income states or ensure that the federal government bears the lion's share of total programme costs in such areas.

Harvard University economist Jeffrey Sachs, who became famous as a 'shock therapy' adviser to the first post-Soviet Russian government, has calculated the effects of these transfers on depressed regions. He found that a one-dollar decline in income in an average US region led to a rise in federal transfers of up to 10 cents and a drop in that state's tax payments to the federal government of 30 cents.

Another American economist, Barry Eichengreen from the University of California Berkeley, has extended this analogy to the euro-zone. Imagining a severe recession - a decline in income of 10&percent; affecting half the Union - he claims that fiscal transfers worth 0.5&percent; of EU gross domestic product would be needed to emulate Sachs' calculations. “It is hard to imagine that existing programmes are able to respond on such a scale,” said Eichengreen.

Former Commission President Jacques Delors took the first steps towards large-scale switches during the 1988 budget reforms and under the future financing agreement reached at the Edinburgh summit in 1992.

Having agreed to establish a monetary union at Maastricht a year earlier, EU leaders, and particularly German paymaster Helmut Kohl, were more receptive to the idea of boosting spending on structural funds - regional transfers - to 176 billion ecu over the 1993-99 period compared with 67 billion ecu during the previous five-year plan.

They also set up the special 15-billion-ecu cohesion fund for four countries which were then known as the 'poor four' (Spain, Ireland, Portugal and Greece), three of which are about to join EMU.

Generous this may have been, but even with such amounts of money, the overall budget is nowhere near the scale needed to have a macroeconomic impact, given that it cannot exceed 1.27&percent; of GDP until after 2006 at the earliest.

“It is generally accepted that the budget will have to be worth 6-7&percent; of GDP if it is to take on a macroeconomic role. But it is not just the size that matters but its variability and its need to have a big presence in investment programmes,” said John Grahl, an economist at the University of North London who has long advocated a federal budget for Europe.

Handing over resources of that magnitude - around 500 billion ecu - to the European institutions is hard to imagine in the current political climate. That climate, however, will be very different in the first decade of the next century.

Padoa-Schioppa's minimalist suggestion that funding for education in low-income countries could be federalised may be a start, particularly since poorer countries tend to lose their expensively trained workers to richer ones.

Even some tight-budget advocates have a weakness for the idea that the EU's cash pile should be significantly increased, arguing that only when big money is at stake will problems of waste, excessive salaries and allowances, privileged tax breaks and fraud really be addressed.