Fiscal federalism reforms in the European Union and the Greek crisis

Abstract: Based upon existing fiscal federal arrangements, this article considers the options facing the European Union to reform its own framework. There are two plausible ways the EU can stabilize the finances of its member states over the longer term. The first is to take steps that complement the market discipline of individual member states.

For market discipline to play this positive role, three conditions need to be met: (1) markets need to have accurate information on member state finances; (2) the market valuation of a given state also has to be an accurate valuation of the sustainability of that state’s finances; and (3) populations need to interpret market discipline as a signal about their government’s competence and punish governments that face market pressure.

Such a system is possible under the current Stability and Growth Pact, and indeed it appears that all three conditions held in summer 2009. Any bailout of a member state, however, undermines this type of system. More political integration would be needed to prevent a state from getting into a situation where a bailout would be an option. The Brazilian model is a precedent that the European Union could emulate.