Creation of a full fiscal and economic union

A critical assessment

Seminar Paper, 2013
16 Pages, Grade: 2.0


Table of content

1. Introduction

2. Theoretical Framework: Fiscal Federalism

3. Fissures in the structure of the EMU
3.1 Externalities in the EMU

4. Confederation or Federation - A fundamental question
4.1 The fiscal and economic union
4.1.1 Confederal Fiscal and Economic Union
4.1.2. Federal Fiscal and Economic Union

5. Critical assessment


1. Introduction

The sovereign debt crisis has kept the leaders of the European nations occupied with emergency sessions of the Euro group. The result of this often described “muddling through” has led to what Angela Merkel called the ’union method’: A polity approach of European intergovernmental cooperation that aims at strengthening the groundwork of the European monetary union (EMU), the rule-based Maastricht treaty. However, on their way to this new framework many sacred rules were sacrificed in order to prevent a collapse of the EMU due to its constructional flaws. But how exactly can one interpret the tight mesh of contracts that have been made by all parties? And what are the alternatives? What will be the impact? This seminar tries to deduct an answer to these questions by applying fiscal federalism theory to recent developments in Eurozone polity and will also attempt to employ the same criteria for a more Euro optimistic approach.

The following seminar will address these questions and try to give a framework of the pros and contras of the given alternatives. The framework used will be the fiscal federalism theory proposed by Oates. In the first part I will explain fiscal federalism and how an optimal level of centralisation and decentralisation can be derived. Furthermore I will explain how different preferences might affect this outcome. In the second part I will describe the shortcomings in the construction of the Eurozone that lead to the unfortunate situation at hand and explain how externalities are created. The next step will be a distinction between a federation and a confederation in order to explain on the basis of an example why the choice should be based on the preferences of voter in the country. Ultimately, I will discuss the ramifications of either choice on the Eurozone, how either choice can be implemented and which shortcomings are to be dealt with. In the end a short critical assessment of both choices will be given.

2. Theoretical Framework: Fiscal Federalism

The theory of fiscal federalism asks the question how an ideal public sector should be structured in order to maximise its efficiency in terms of the provision of public goods such as price stability, stabilization, redistribution or allocation. Generally there are two extreme forms the organisation of a government that can be realised: Firstly, there is a centralistic approach, arguing for a unitary government body, which is endowed with all power. Secondly, there is a decentralised solution, where each jurisdiction is given the same powers. Clearly, each approach has its own advantages and shortcomings so that the optimal solution lies in the mix. In the following I will lay the formal framework for an analysis necessary to approach the subject at hand. The source for the following theories, if not stated otherwise, is Oates (1972).

A government supplies public goods, of which every good i enters the utility function of all individuals in the group that consumes that good. The level of consumption is independent of the number of consumers; therefore output is always high enough to supply all individuals at a fixed level. The consumption of each good is defined by a specific subset of the whole population. Consequently both extremes are conceivable: On one side this would mean that a public good is consumed by the whole population, therefore the good is a national public good. On the other end a public good is only consumed by one individual. This extreme could be considered a private good, as this single individual determines the level of consumption subject to his own budget constraint. The simplest case on how to solve the aforementioned question of the structure of the public sector is a case with no mobility and subsets of a population that has homogenous preferences on the inside and heterogeneous preferences compared to other geographically different subsets. There is a strong incentive to decentralise as there would be federal government for every subset that can be defined by the same preferences concerning the level of consumption of a public good and the composition of supplied goods. Additionally, the structure of the federal government should exactly coincide with the set of individuals who consume the good. Given that the subset of the population is supplied exactly the amount and composition of public goods allows for ‘perfect correspondence’ or ‘fiscal equivalence’: This results due to the fact that the supply of public goods always implies a free-rider problem because public goods are non-rival and non-exclusive in consumption. Hence, there can be externalities if the receivers of a public good are not congenial with the subset of payers. Given complete information of the government about the preferences in their geographical subset a benevolent planner will choose the pareto-optimal level of output of public goods subject to the regional governments budget constrain.

Given different preferred levels of consumption in the different subsets of the population, it would always be better for a local government to supply the pareto-optimal level of public goods. A central government would face a population composed of subsets with different preferences concerning the level of output of public goods. When choosing a level of output the central government could only choose an average level and therefore had no possibility to choose a pareto-optimal supply for any given subset of the population; the incentive to decentralise increases with the heterogeneity of preferences which is known as the ‘decentralisation theorem’. However, this changes when a central government can realise economies of scale or scope when producing public goods. This is because the formation and implementation of public decisions is costly and associated with fixed cost as for example redundant administrations for every jurisdiction. The tendency to decentralise is therefore counteracted by the incentive to save cost and economise certain levels of government. Therefore, it becomes desirable to find the level of decentralisation on which the marginal benefit of a more congenial supply of public goods equals the marginal cost of another level of government.

In summary, federalism theory tries to resolve the issue of the most efficient setup of the public using three building blocks: Firstly, trying to match the externalities, which arise due to the supply of public goods with the subset of the population that carries the burden of financing the good. Secondly, given heterogeneous preferences of the subsets, the ‘decentralisation theorem’ states that every single public good would always be supplied for every individual subset with homogenous preferences. Thirdly, economies of scale and scope that a central government could realise when supplying a public good nationwide are counteracting this effect.

3. Fissures in the structure of the EMU

The cause of the sovereign debt crisis lies with the convergence of sovereign bond spreads that took place after the introduction of the Euro as currency. This can be interpreted as a fall in risk premium charged by the financial sector or a non-credibility of the no bail-out clause of the SGP (Fahrholz & Freytag, 2011, Spahn, 2012) and led to a marked fall in financing cost of not only the government but also the private sector of the periphery (Fahrholz & Freytag, 2011). This effect was strengthened by the fact that all bonds issued by EMU sovereigns were considered risk-free asset and could be used for refinancing with the ECB subject to the same haircut as there was no differentiation between the issuing sovereign (ibid). Additionally, the constraints of the SGP were soft and had little impact on member states of the EMU, therefore did not prevent the excessive deficits (Ioannou & Stracca, 2011). Consequently, as exchange rate risk and differences in the treatment of different sovereign bonds were nullified, cross-border holding of public debt and financial market integration increased (Mongelli, 2013). This has been accommodated by the structure of the financial system of the savings-rich northern countries of the Eurozone: Most of the assets are held in form of deposits with the banking system and in form of insurances or pension funds. These intermediaries have a strong ‘home bias’ and therefore tend to invest their funds in their home currency (Gros, 2012). Additionally, regulation imposes limits on investment in foreign currency and therefore increases the ‘home bias’ of financial intermediaries (ibid). The thereby abundantly available capital and the low interest environment not only induced an unforeseen increase in public debt but also fuelled a credit boom, as massive amounts of liquidity were channelled through the banking system from North to the south (Mongelli, 2013). The immense demand for goods triggered a massive inflow of goods and thereby a current account deficit, however excess demand was not saturated and inflationary pressures remained. This constituted an effect that was already implied in the famous ‘Walters’ critique’: Nationally different inflation with a given Eurozone wide uniform nominal interest rate have the effect of different real interest rates across countries. A country with very high inflation therefore faces lower interest rates then intended by the central bank, fuelling investment and consumption which in turn accelerate excess demand and thereby inflation, leading to an even lower real interest rate and so on. The opposite effect takes place in a country with lower inflation (Spahn, 2012). This constituted a situation of low demand in north accompanied by low inflation, inducing real depreciation vis-à-vis the south, and high inflation in the south, fuelled by second-round effects and high demand on the labour markets. This pressure on the price of labour led to increasing costs of tradable goods and decreased competitiveness through real appreciation vis-à-vis the north (Fahrholz & Freytag, 2011). However, this process counteracted the instability described by the Walters’ critique by reducing competitiveness and reducing external demand for domestically produced goods. Although the adjustment of the competitiveness channel has offset the effect of the real interest rate channel, the consequence was high current account deficits and increasing external debt (Spahn, 2012).

When the financial crisis hit the Eurozone, uncertainty and heightened risk aversion dried up liquidity in the interbank market, which was the main channel of intra-Eurozone liquidity equalisation. As liquidity ran scarce and the capital influx receded, growth slowed and interest rates in the Eurozone increased. The former comfortable growth-interest rate differential worsened which in turn accelerated capital flight and froze bond markets for southern periphery sovereigns (Gros, 2012). When bond markets tension rose and yields increased, banks in the southern periphery suffered heavy losses due to home bias and deterioration of the asset side of the balance sheet. Engaging in fire sales, banks increased turmoil on the bond markets and perpetuated capital flight even more. As growth was mainly induced by favourable financing environment and credit boom in most periphery countries, former booming economies plunged into recession and macroeconomic imbalances that were afore hidden by abundantly available credit were laid bare (Mongelli, 2013).


Excerpt out of 16 pages


Creation of a full fiscal and economic union
A critical assessment
University of Frankfurt (Main)  (Applied Econometrics and International Economic Policy)
Seminar: Towards a deep and genuine EMU: economic, financial and fiscal aspects
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BSc, Alexander Kuchta (Author), 2013, Creation of a full fiscal and economic union, Munich, GRIN Verlag,


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