When Mario Draghi was President of the European Central Bank (ECB), this institution failed to meet its target of ensuring inflation remains below two per cent. This is because the central bank raised interest rates in between 2008-11, a decision which later contributed towards the eurozone crisis. This legacy the new ECB President Christine Lagarde has inherited from her predecessor will only increase pressure for her to fulfil one of her early promises: to review the ECB’s monetary strategy.
To sustain the eurozone, the ECB’s governors agreed in the 1990s that the central bank’s policy should have two layers- an economic and a monetary one, alongside an inflation target. But the eurozone crisis has jeopardised the relationship between output, interest rates and prices, and inflation cannot be curbed until there is a stable relationship between those factors.
In his farewell statement, Draghi argued that the eurozone needs a central fiscal capacity big enough to act as a macroeconomic stabiliser. The Financial Times’ Wolfgang Munchau said that a banking union alone will not make the eurozone more resistant to significant industrial and technological shocks, and that only a finance minister in charge of a deeply integrated fiscal union can do that.
Helge Berger, Giovanni Dell’Ariccia, and Maurice Obstfeld produced a blog for the IMF that supported a fiscal union. They suggested that if the European Monetary Union (EMU) was as integrated as the US’s large currency area, they could tackle economic or financial shocks together. Furthermore, they would have empowered a central government to tackle vulnerable financial entities, safeguard bank deposits, and provide fiscal aid to member states affected by a deep recession.
Berger et al added that the EMU could mutually insure member states by sharing financial risk. For example, a dedicated central fiscal capacity could collect annual contributions from members in exchange for transfers linked to local shocks when they happen. This would provide some of the same benefits without requiring the harmonisation of unemployment insurance. But participation in such a scheme could also be made on the condition that member states obey fiscal rules to help reduce the chances that risk-sharing would pave the way for long-term transfers.
However, the biggest obstacle to a fully integrated EMU is Germany. As CNBC’s Dr. Michael Ivanovitch said, Germany, who registered a government surplus of €58 billion (1.7% of GDP) in 2018, would never accept a fiscal union with nations like Spain, who had a public debt of 100 per cent of GDP in 2017 alone.
Italy also has a deficit worth 134.8 per cent of GDP as of 2018. This means countries with substantial structural problems would become part of a de-facto federal state with a fiscally sound Germany.
Angela Merkel has always been the staunchest opponent of a European fiscal union. Considering she is not resigning her position until 2021, the German Chancellor will make the next two years difficult for Lagarde if she proposes that the next step to solving the eurozone’s problems is a fully integrated EMU.
The European Alliance of Peoples and Nations group in the European Parliament, which consists of Italy’s Lega and other right-wing parties, may have fallen short of its expectations during this year’s European elections, due to a 51 per cent turnout throughout the Continent. But if calls for ‘more Europe’ grows among the EU’s leaders, this has the potential to increase their popularity and fracture the European project further.
A fiscal union may have been Draghi’s dream and it may be the answer to Lagarde’s woes, but the reality is a fiscal union will never happen. Germany is reluctant to integrate with member states presiding over massive deficits and the growing tide of populism threatens the EU’s existence. Either way, the EU is at a crossroads as to where it goes next.