Where and why do we need policy coordination in Europe?

The European Union was first and foremost a political project. It was meant to bring countries closer together in economic terms, and inspire a common drive by upholding common values such as rule of law, respect for cultural traditions and history. Europe believed that by fostering economic and institutional integration between its member countries, economic cycles would become more synchronized and the impact of asymmetric shocks reduced.

The euro was expected to be one step further along this path, encompassing or at least fostering deeper economic, social and political integration. Fiscal policy coordination, wage and price flexibility, together with factor mobility (or the so-called four freedoms mentioned recently in relation to Brexit negotiations between U.K. and the rest of the E.U.), were seen as essential to fully reap the benefits of an optimum currency area. However, as recent macroeconomic developments have clearly illustrated, these conditions were insufficient to guarantee economic stability, equitable growth and fairness.

Today, we have come to the crossroads: we might be heading towards a fully integrated Political Union or towards a Union of sovereign states. Both are viable options, but they need to be put on the table so that we can debate and understand what we want, what we can achieve and what we stand to lose. Today, sovereignty seems like the last thing to give up in the most important battle still to be fought in Europe. With long histories and diverse traditions to follow in the economic policy-making process, many countries and governments are keen on upholding their legitimacy. Yet, to some extent, this legitimacy importantly depends on the economic benefits that governments are able to deliver, unfortunately now a scarce produce in a global economy drown in stagnation and confusion. Europe is called in to fight battles on too many fronts: its economic governance and institutions need a complete overhauling after the recent crisis; its political class need to reconnect with the citizens; and, maybe most importantly, its people need a way out of the current predicament branded with dim economic prospects, especially for the young ones.

Today, we have come to the crossroads: we might be heading towards a fully integrated Political Union or towards a Union of sovereign states.

Who can do what in this context? Well, a simple way out would be through fiscal and public economic policy, but this is no easy fix. Europe’s problems have now become so pervasive, their scale so large and their socioeconomic consequences so scary, that only a strong European leadership can make a difference now. With a European Commission seen too weak to provide a common policy guidance, sovereign governments are called to step in, time and again. Unfortunately, this creates all sorts of problems, and in particular coordination problems. A heterogeneous environment in general leads to coordination problems due to differences in preferences and, in particular, differences in policy objectives and policy tools.

Take any Southern European country and think back a few decades ago; most probably, it would be facing higher inflation rates and follow loose budgetary guidelines, but would still be able to maintain fiscal solvency and enjoy inclusive economic growth. In early 80s, Greece and Spain for example had a debt-to-GDP ratio of well below 60%. Now if we look north, a different macroeconomic story would emerge, despite similar outcomes in terms of fiscal sustainability and economic inclusiveness. In fact, many European countries reached the bottom in their income inequality measures in the mid-80s (according to data available from the World Wealth and Income Database, see http://www.wid.world). That was the image of a diverse but flourishing Europe, with countries following different development paths according to their own preferences and traditional economic models.

With a European Commission seen too weak to provide a common policy guidance, sovereign governments are called to step in, time and again.

Over the last decades, the economic links between European countries, expressed mostly through trade and financial capital flows, have grown stronger. This is to say that economic integration has been imposing constraints on policy reactions, and sometimes even forcing countries into a difficult balancing act between responding to domestic versus foreign disturbances. Once countries were forced to accept one economic model, one set of policies and one set of guidelines, rules were added with the intention to limit their policy discretion in deviating from the true model. In the end, this only limited their policy manoeuvrability in smoothing business cycle fluctuations and asymmetric shocks. It is not surprising to see how imposing a 3% deficit threshold and a 60% debt brake have failed despite decades of progress in European policy-making. With no functioning European risk-sharing mechanisms in place when the crisis finally arrived, rules only worsen the situation. Europe was a playground for asymmetries and some countries were hit more than others. However, not everyone needs to follow the same adjustment path out of a crisis; policy reactions might be constrained, or policy preferences might prioritise one policy instrument over another.

Why were rules needed in the first place? True: fiscal policy remains one of the few policy levers available to policy-makers to exercise discretion. And so, in the best European tradition, numbers need to be specified as not to get lost in translation – and this means all 24 E.U. official languages. The many rules built-in the existing treaties – e.g. the new Two Pack, Six Pack and Fiscal Compact -, are now seen as a first step towards increased sharing and adherence to the same sound economic policies. But are these expectations reasonable?

Fortunately, numbers, by themselves, do not rule, do not strike bargains, and do not implement policies. Numbers do not bring policy coordination by default. Accordingly, there is now, more than ever, an intense need for consensus and coordination going beyond numbers, rules and formulas. The understanding is that if we want to solve coordination problems, we need to do more than just setting common targets and policy objectives; and, since we cannot simply equalise preferences across countries, we need to harmonize policy instruments or at least have a centralised way of deploying the most powerful instruments directly from the E.U. level.

To make it work, additional resources need to be made available also at the E.U. level for investment mediated through the European Investment Bank and especially the European Fund for Strategic Investments.

The theory of fiscal federalism advocates a clear tradeoff between centralisation and decentralisation: a centralized provision of public goods might not fully reflect local preferences and tastes, while a decentralized system might neglect spillovers between local constituencies, e.g. administrative regions or states. Achieving full employment in order to lift Europe out of this pervasive socioeconomic crisis, which is clouding the economic prospects for many unemployed or underemployed people (involuntary working part-time), would be the best example of a European public good we can all agree on today. Countries’ preferences are clearly converging in this area; the same goes for education, R&D and research, infrastructure and the green economy. Unfortunately, E.U. policy tools available are not up to the task so far, neither in terms of scale, nor efficiency.

More concrete, a coordinated plan among member states to increase public investment so as to crowd-in private investment (possibly via fiscal incentives) would achieve lower levels of unemployment and higher inclusive economic growth. To make it work, additional resources need to be made available also at the E.U. level for investment mediated through the European Investment Bank and especially the European Fund for Strategic Investments. Its firepower today is meagre when compared to total E.U. GDP for example, standing at about 0,5% on an annual basis; this needs a huge increase in scale to make a meaningful impact. Obviously, it would be a situation where spillovers and synergies between countries are positive. The eurozone has already achieved a remarkable architecture of formal policy coordination; sovereign debt issuance strategies are coordinated by the European Commission; moreover, all major economic policy reforms are discussed ex-ante and, where appropriate, coordinated among countries. Unfortunately, the outcomes are non-binding for member countries, and will probably never be in such a setting. Taking a path inspired by principles pertaining to fiscal federalism would insure that a more vertically coordinated action plan is put in place and better tools are relegated to some key E.U. institutions, which then become responsible for providing European public goods as the ones mentioned above. Where this policy option leaves us on the way towards a deeper Political Union or towards a Union of sovereign states might still remain an open question. Nevertheless, this policy framework outlined above could make a difference to the current predicament by solving coordination failures in those policy areas that are truly European.

This article was published in Spanish in the magazine Temas (Fundación Sistema)