Interrelations between monetary and fiscal union

In the debate on the current debt and financial crisis in the EMU, both supporters and opponents of the Euro project agree it must be accompanied by a fiscal and political union in order to survive. However, while the former (e.g. Wolff, 2012; De Grauwe,

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2013²) believe this is both possible and desirable, the latter (e.g.

Feldstein, 1997; 2012) doubt it will ever happen due to a long historical tradition of sovereign nation states in Europe.

Unfortunately, the arguments in favor of political and fiscal integration as the condition for the monetary union’s sustain-ability are rarely provided. More frequently, especially in the current crisis-dominated hot debate, they are taken as given. As a result, the claim for political and fiscal union sounds more like a creed rather than something based on well-founded academic arguments.³

Furthermore, a closer examination of the interlinks between monetary and fiscal union on both theoretical and empirical ground provides us with a more nuanced picture.

According to the OCA theory as developed by Mundell (1961) and McKinnon (1963), which serves as the key theoretical frame-work for analyzing the economic rationale of a monetary union, fiscal policy can cushion the consequences of asymmetric shocks in cases where free mobility of production factors (labor and capital) is not sufficient to do so.

However, this part of OCA theory may be interpreted in two ways: either as the retention of fiscal capacity and sufficient fiscal buffers in territories participating in CCA to enable them to respond to idiosyncratic shocks in a decentralized way (in the absence of monetary accommodation) or the necessity to arrange centralized fiscal transfers between respective territories. The first interpretation was behind the original design of the Maastricht Treaty and the Stability and Growth Pact (SGP) (see Mortensen, 2004; De Grauwe, 2006). The second one seems to dominate in the post-2010 debate (e.g., Wolff, 2012) and the official proposals of reforming the EMU’s governance architecture (e.g., European Commission, 2012).

2. De Grauwe (2013) presents himself as a skeptic of the common currency project in 1990s.

However, as dismantling the Eurozone now would mean …profound economic, social and political upheavals throughout Europe, he is in favor of building a fiscal union to supplement the lacking component of monetary integration.

3. De Grauwe (2006), who offers an in-depth discussion on interrelations between monetary and political/fiscal union, and Aizenman (2013), who underlines the importance of a banking union (with its fiscal implications) for the stability of a common currency, are prominent exceptions here.

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Empirical analysis of historical and contemporary cases of monetary unions also provides us with mixed results. It is true that most historically known CCAs have matched with the territory of sovereign states, either unitary or federal. Furthermore, most historical episodes of monetary unification followed political unification, which was in most cases involuntary, being the result of war, conquest, colonization, etc. Nevertheless, there are also examples of the voluntary monetary union of sovereign states, i.e.

when a common currency unit and common central bank are established, but are not accompanied by a meaningful delegation of political sovereignty in other areas (like fiscal policy) to a supra-national entity and building a political superstructure.⁴

For example, the West African Economic and Monetary Union (WAEMU) or Central African Economic and Monetary Community (CEMAC) have virtually no political or fiscal integration but they have used a common currency (the CFA franc) since 1945, i.e., for almost 70 years. Only at the end of the 1990s did member coun-tries of both monetary unions start to develop other segments of economic integration, i.e., custom unions, common markets and some soft forms of supranational macroeconomic policy coordina-tion and fiscal surveillance, following the EU/EMU experience.

However, the pace of those integration processes is rather slow, especially in the case of CEMAC. Nevertheless, both monetary unions have proved sustainable so far in spite of numerous asym-metric shocks (see IMF, 2013 for a contemporary analysis of the WAEMU challenges), divergent macroeconomic trends, violent political conflicts (both internal and regional), limited trade and financial integration, etc.

Other contemporary examples of monetary unions with no or weak political integration components include the Eastern Carib-bean Currency Union and the Common Monetary Area in Southern Africa.

If we broaden our definition of monetary union by including permanently fixed exchange rate regimes (against other currency

4. Please note that in the contemporary world, no country enjoys full sovereignty and each form of international cooperation (explicit or implicit) involves some limitations on national sovereignty.

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or common metallic standard), we obtain more cases in which monetary “federalism” has not been accompanied by the political and fiscal one. This concerns, in first instance, the period of the international gold standard in the second half of the 19^th century and the beginning of the 20^th century, when most independent (and sometimes politically antagonistic) countries shared the same monetary rules and, in fact, remained in a quasi-monetary union (see Eichengreen, 1998; Cesarano, 2009).

Summing up, monetary unions between sovereign states or within relatively loose political federations or confederations are not a new phenomenon and the EMU is not as unique a historical case as suggested by some authors.

For instance, Bordo, Markiewicz and Jonung (2011, p. 26) claim that “The euro area is the first case in the history of monetary unions where monetary policy-making is centralized under one central bank while fiscal policy-making is decentralized in the hands of the national governments of the member states. This institutional framework is new for economists and policy-makers alike.”

Somewhat surprisingly, the European Commission (2012, p. 2) presents a similar opinion: “The EMU is unique among modern mone-tary unions in that it combines a centralised monemone-tary policy with decentralised responsibility for most economic policies, albeit subject to constraints as regards national budgetary policies. Unlike other mone-tary unions, there is no centralised fiscal policy function and no centralised fiscal capacity (federal budget)”. Perhaps these are just examples of “Europe’s centrism” in the perception of economic history and contemporary experience.

What may be more important but is rarely explicitly discussed, the EMU seems to be unique in terms of the depth of its monetary, financial and trade integration and the sophistication of its finan-cial sector,⁵ which makes it different from monetary unions in Africa and the Caribbean region. Also, the scale of international capital flows has increased in recent decades as compared to the era of the international gold standard.

5. These arguments have been raised by Aizenman (2013). The European Commission (2012) also makes reference to the negative consequences of the “renationalization” of the financial sector and the financial market within the EMU as a result of the financial crisis.

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Even taking into account the potential EMU specifics, historical and contemporary lessons of other monetary integration projects cannot be ignored and can broaden perspective of the debate on the future of the EMU. Unfortunately, most of the available comparative analyses concentrate on comparing the EMU with the US, sometimes selectively and not always with due attention to the historical evolution of the US federation. Today’s United States of America represent a mature and quite centralized form of federa-tion but it took almost two centuries to get to this stage (Aizenman, 2013). Looking back, until the 1930s, the US was much less politically, fiscally and financially centralized.⁶

While the comparison of EMU with the US has some merit due to their similar sizes and development levels, the experiences of other federal states, sometimes less centralized fiscally than the US (for example, Canada or Switzerland – see Bordo, Markiewicz and Jonung, 2011; Wolff, 2012), may broaden the debate on the perspectives of EU/EMU fiscal integration, not to mention the experience of monetary unions of sovereign states, which seem to be the most relevant to this debate but which are largely ignored.