Eurozone Watch

We have just published an article in the German weekly DIE ZEIT calling for a reform of European budgetary rules in order to limit the national governments' pro-cyclical fiscal policies.

We start from the observation that fiscal policy once again is turning pro-cyclical in a number of European countries. Germany is cutting corporate taxes and increasing discretionary spending at a moment when the economy is growing with rates close to 3 percent (see our post here). France's new president Nicolas Sarkozy is cutting income taxes for home buyers and overtime payment in a boom, providing an ill-timed boost to the economy (see post here) and the Italian government has just increased their deficit target from 2.3 to 2.5 percent of GDP inspite of strong tax revenues (the money supposedly will go into more social spending).

We thus pretty much see a repetition of the mistakes made in the New-Economy-Boom 1999/2000 when governments increased spending and cut taxes so much that in the following downturn they were forced to then cut spending or increase social security contributions pro-cyclically.

As we have argued before, this pro-cyclical policy is harmful, not only in a downturn, but also in an upswing. First, fueling the boom increases the risk that the ECB overshoots with its interest rate hikes while trying to limit inflationary pressure. Second, according to recent economic research, stronger amplitudes in the business cycle might dampen long-run growth as it lowers the steady-state spending of companies on research & developments. The current fiscal policy in EMU is thus a real obstacle towards reaching the targets of the Lisbon agenda.

In the ZEIT article we therefore propose to use EU fiscal policy to limit the national excesses of fiscal policy. We therefore propose three major elements of reform:

1. Money from the EU budget should be disbursed in a more counter-cyclical manner. Over the past years, money from the structural funds have for example fuelled the Spanish construction boom at a moment when the sector was already bloated. A possibility would be to slow building projects in a boom and expedite them in an upswing.
2. The EU budget should be financed by a cyclically sensitive tax. We propose a European tax on corporate profits. With a tax rate half today's average in the EU, the whole European budget could be financed. In addition, each country could levy an additional tax, pretty much as it is the case in the US today. This tax would also introduce a minimum level to limit harmful tax competition.
3. A European unemployment insurance should be introduced. This insurance would drain purchasing power from booming regions and thus limits the overheating of a boom, while it would funnel money into regions in dire straits. This insurance could be organised as a basic insurance which could be topped up by additional national benefits.

These proposals would not only put some stabilization into the EU budget. It would also limit the leeway for harmful pro-cyclical national fiscal policies. By putting one of the most cyclical tax at the European level, the national governments will have less possibility to misinterpret cyclical revenue increases as structural. By pulling the unemployment insurance partly on the European level, there will be less possibility to cut contributions in an upswing or benefits in a downturn (as it has happened for example in Germany over the past years and is set to happen again in 2008).

Now would be the moment to move forward with sensible proposals like that especially as Sarkozy has already put the governance of the euro-area on the table. It would be a good idea for Germany to become an advocate of these reform proposals to provide a counter-weight for Sarkozy's proposals which might well move euro-zone governance in a harmful direction if left uncontested.

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