Why further integration is the wrong answer to the EMU’s problems: the case for a decentralised fiscal stimulus

Tuesday, 15 November, 2016

by Thomas Fazi and Guido Iodice

The global financial crisis exposed the euro’s original sin of depriving member states of their fiscal autonomy without transferring this spending power to a higher authority. This left member states utterly defenceless in the face of economic crises, as the 2008 booms-gone-bust would make amply clear. Yet, the crisis did not bring about, as one may have expected, a loosening of the budgetary constraints imposed on individual governments (thus allowing them to pursue counter-cyclical stimulus policies) or by moving towards a fully-fledged fiscal union (or at least a modicum of economic coordination between surplus and deficit countries). Instead, we got the worst of both worlds: further restrictions on the fiscal autonomy of member states and no increase in the fiscal capacity at the federal level in Europe. The result, predicted by many non-mainstream economists, has been a deeper and more prolonged crisis than that of the 1930s (resulting in all-out humanitarian crises in a number of countries). There are now a number of official proposals on the table – most notably the European Council’s 2012 Towards a Genuine EMU, the European Commission’s 2015 Completing Europe’s EMU and several reports by the European Parliament – that propose to address this structural flaw by creating a fiscal and (ultimately) a political union (European Council 2012; European Commission 2015).

This would be a welcome development, were it not for the fact that the ‘brave new eurozone’ envisioned by these proposals falls very short of the kind of fiscal and political union advocated by progressive federalists (see, for example, Arestis and Sawyer 2012), and raises a number of worrying issues from both political and economic standpoints. Politically, it raises serious problems of accountability and democratic scrutiny and participation, since this proposed transfer of sovereignty does not foresee an analogous and proportionate transfer of democratic legitimacy, accountability and participation from the national to the supranational level (Fazi 2014). Economically, it does not foresee any real spending powers for this new supranational authority (which would require the ability of EMU itself to run budget deficits with the support of the ECB, fiscal transfers from richer to poorer countries, etc.), and is likely to revolve first and foremost around the creation of a European budget commissioner with the power to reject national budgets (Schäuble and Lamers 2014; Villeroy de Galhau and Weidmann 2016). It is not hard to see why such a development would be politically unsustainable, further exacerbating the union’s centrifugal tendencies. At the same time, we have to acknowledge that the political conditions are not ripe for a move towards a fully-fledged fiscal and political union, along the lines advocated by progressive federalists. So – barring a break-up scenario – what options does that leave us within the context of the EMU?

A decentralised fiscal stimulus

The only sensible solution in the short-to-medium term is to allow individual member states to adopt a more expansionary fiscal stance. It has been argued that this could be realised within the current institutional framework – for example by making optimal use of the ‘flexibility’ contained in the SGP or by reconsidering the Commission’s method of cyclical adjustment – to obtain a eurozone-wide expansionary fiscal stance of two to three per cent of GDP (Truger 2015). While this would be a welcome improvement, we believe that for some countries it would be insufficient, given the extensive damage caused by years of fiscal austerity. We posit that a better way forward would be to adopt a balance sheet recession approach to the problem, as suggested most notably by Richard Koo (Koo 2012, 2014, 2016). This means understanding that a number of eurozone countries, especially those of the periphery, are in so-called balance sheet recession – a situation in which individuals and companies, following the burst of a debt-financed bubble, collectively focus on saving rather than spending, thus reducing aggregate demand – and should thus be allowed to pursue much more expansionary fiscal policies until private sector balance sheets are repaired. More specifically, it means that private-sector savings levels have to be taken into account when evaluating the ‘optimal’ fiscal stance of member states. According to 2015 flow of funds data, private-sector savings amounted to 10.8 per cent of GDP in Ireland, 7 per cent in Spain, 6.8 per cent in Portugal and 6.3 per cent in Italy (Koo 2016). This means that there are sufficient levels of excess (i.e., unborrowed) savings to support a fiscal expansion in the order of 6-8 per cent of GDP in most periphery countries. Unfortunately, the EMU’s current budgetary rules – which prohibit governments from running sustained budget deficits of more than three per cent of GDP regardless of the size of private-sector savings – make no provision for this type of recession.

It is often argued that German taxpayers would never sanction a fiscal stimulus in periphery countries, but the existence of huge pools of private savings in those countries means that if those savings were to return to the domestic government bond markets, the ultimate cost to the German taxpayers would be zero. That said, periphery countries need to ensure that idle savings in these nations do not flow abroad but are invested in local government bonds. As argued by Richard Koo, this could be achieved by ‘re-internalising’ fiscal policy in the EMU: that is, by limiting the sale of government bonds to the citizens of each country (Koo 2012). A softer version of this plan would involve the introduction of different risk weights for local and foreign bonds (Koo 2016). The proposed new rule would allow individual governments to pursue autonomous fiscal policies within its constraint. In effect, governments could run larger deficits as long as they could persuade citizens to hold their debt.

Having established the criteria with which to determine the optimal fiscal stance for each member state (the private-sector savings level), we can now turn our attention to the optimal composition of the fiscal stimulus. We believe that the fiscal expansion (i.e., the percentage increase in the budget deficit vis-à-vis the current fiscal stance) pursued in the context of Koo’s proposal should be entirely devoted to the financing of government investment. The reason for favouring government investment over social transfers is twofold: first, the former is associated with higher fiscal multiplier levels, to the point that ‘investment may be self-financing for some economies’, in the sense that the debt-to-GDP ratio may not rise as a result of investment (and may even decrease) (IMF 2014); second, government investment does not simply increase demand, but can also have positive supply-side effects. The IMF’s findings are quite conclusive in this respect. Furthermore, it is interesting to note that Koo’s criterion, precisely because it mobilises idle savings, does not run the risk of crowding out private investment but, on the contrary, has the potential to generate an opposite crowding in effect, by stimulating private investment, as even the IMF acknowledges. Another supply-side channel through which public investment can improve a country’s economic performance is the reduction of the external deficit through a strategy of import substitution, via the development of local industries. Finally, an investment-led recovery, by allowing corporates to reduce their debt exposure, will also improve the financial stability of those countries that currently face the risk of severe banking crises as a result of the huge volume of non-performing loans (NPLs) held by local banks.

The role of the ECB: the need for a new ‘whatever it takes’

As is well known, in 2010, following the eruption of the Greek sovereign debt crisis, the interest rate differential (the so-called ‘spread’) between Germany and the periphery countries of the EMU started growing dramatically. Interest rates had, in fact, started to diverge already in 2008, in the immediate aftermath of the financial crisis, but became an existential threat to the survival of the eurozone only in 2010. With the eruption of a periphery-wide sovereign debt crisis, capital started fleeing periphery countries, causing a sharp sell-off of periphery government bonds, even in countries that had not experienced a banking crisis, like Italy. Further, it has been noted that the ESM/EFSF bailout of periphery countries amounted effectively to ‘a back-door bailout’ of reckless German and French lending (Gore and Roy 2012). This begs the question: why has the eurozone not collapsed? Marc Lavoie explains the EMU’s resilience with the fact that in a monetary union such as the EMU no country will ever find itself short of reserves, due to the functioning of the TARGET2 interbank payment system (which calculates debts between the EMU’s central banks), which acted as an automatic stabiliser that prevented the implosion of the eurozone (Lavoie 2015). Yet, it did not – and could not – prevent the divergence in bond yields witnessed between 2011 and 2012. This is why, in mid-2012, the ECB announced its Outright Monetary Transactions (OMT) programme. By pledging to purchase government bonds on an unlimited basis, though under strong conditionality, effectively transforming the ECB into a quasi-lender of last resort, Draghi caused core/periphery bond yields to converge once again. Furthermore, following the activation of the ECB’s quantitative easing (QE) programme, peripheral government bonds, such as those issued by Italy and Spain, have been trading at record-low yields.

There is a significant exception to the (relative) calm on sovereign debt markets: Greece. Excluded from the QE programme and subject to a structural adjustment programme that is likely to fail (even on its own terms), the country is still judged by financial markets to be at risk of exiting the euro. This raises the doubt that the OMT and QE programmes, precisely because they are conceived as emergency programmes, may not be sufficient to guarantee the integrity of the EMU in case of a new shock. As Mario Draghi noted in a speech at the University of Helsinki, in 2014, the financial integrity of a monetary union rests on the equivalence of bank deposits in all member states. If a euro deposited in a Greek bank is judged less safe than that of a euro deposited in a German bank account, then monetary union ceases to exist in the eyes of the public. ‘This in turn would undermine the fungibility of money’, Draghi said (Draghi 2014). Thus, what is needed is an instrument that will conclusively and permanently reassure markets about the ‘fungibility’ of the euro. Government bonds play a crucial role in the EMU (as in any monetary system): they are both the ‘raw material’ through which the ECB issues the currency, as well as safe assets that banks require to function smoothly. Therefore, to ensure the stability of the financial system, the government bonds of the euro area require the unconditional backing of the ECB. Such backing is crucial also for the success of the decentralised fiscal stimulus proposed in this article, because member states need to be insulated from any doubts that financial markets may have concerning their solvency or euro membership. Ultimately, guaranteeing the sovereign debt of the euro area member states means guaranteeing the irrevocability of the euro itself.

In practical terms, the ECB would simply have to pledge to do ‘whatever it takes’ to keep the interest rate differential between member states below, say, 30 basis points. This would ensure that member states would be able to finance themselves at reasonable costs even after the tapering of the ECB’s QE programme. The ‘fiscal effect’ of such a decision would be no different from that of the QE programme, and thus should not raise concerns of ‘monetary financing’ of government deficits. It could be argued that the ECB would be taking on a big risk – and mutualising it – by buying the bonds of potentially insolvent governments. This is irrelevant for two reasons. First, as with the OMT programme, it is likely that the ECB will not have to directly intervene in secondary bond markets to keep the spread within the predetermined boundary. Second, the ECB, quite simply, cannot default; as noted in a recent ECB paper:

“Central banks are protected from insolvency due to their ability to create money and can therefore operate with negative equity” (Bunea et al. 2016).

Jaime Caruana, general manager of the Bank for International Settlements, was even more explicit:

“Central banks are not commercial banks. They do not seek profits. Nor do they face the same financial constraints as private institutions. In practical terms, this means that most central banks could lose enough money to drive their equity negative, and still continue to function completely successfully” (Caruana 2013).

Ultimately, there is only one scenario in which the ECB could go broke: a collapse of the monetary union. On the contrary, a decentralised fiscal stimulus would have a number of economic and political benefits: not only would it have an immediate macroeconomic impact (thus leading to increased debt sustainability), it would also engender a more positive attitude towards European institutions (which would no longer be seen simply as enforcers of watertight fiscal rules), thus slowly re-creating the conditions – in the longer run – for moving towards a true solidarity-based and democratic fiscal and political union.


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Bunea, D. et al. (2016). Profit distribution and loss coverage rules for central banks. ECB Occasional Paper No, 169.  

Caruana, J. (2013). Foreword to Central bank finances by David Archer and Paul Moser-Boehm. Bank for International Settlements, BIS Papers No. 71.  

Draghi, M. (2014). Speech at the University of Helsinki, Helsinki, 27 November. 

European Commission (2015). Completing Europe’s Economic and Monetary Union.  

European Council (2012). The European Council agrees on a Roadmap for the completion of Economic and Monetary Union.


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Gore, G. and Roy, S. (2012). Spanish bailout saves German pain. International Financing Review, 29 June.


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Koo, R. (2014). The Escape From Balance Sheet Recession and the QE Trap. New York, Wiley.


Koo, R. (2016). Government as Borrower and Innovator of Last Resort. CFA Institute.


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Lavoie, M. (2015). The Eurozone: Similitudes and differences with Keynes’s Plan. Institut für Makroökonomie und Konjunkturforschung (IMK) Working Paper No. 145.  


Truger, A. (2015). Austerity, cyclical adjustment and the remaining leeway for expansionary fiscal policies within the current EU fiscal framework. Paper prepared for the 2015 Progressive Economy 2015 call for papers.


Villeroy de Galhau, F. and Weidmann, J. (2016). Europa braucht mehr Investitionen. Süddeutsche Zeitung, 8 February.