Enhance the eurozone’s fiscal capacity

Economic opinion

Next Generation EU can play an important role in the recovery of European economies from the Covid-19 crisis, but it does not create the much-needed fiscal stabilisation function for the eurozone. At most, it is a stepping stone in that direction. Judicious implementation can further pave the way. Squandering the money threatens to make the structural strengthening of the currency union with a fiscal union and further political integration even more distantly utopian. But that is not an option. For those who deny the currency union budgetary power are ultimately giving it the kiss of death.

Currency union without a central budget

The euro area is the first currency union with a fully centralised monetary policy, while almost all budgetary functions are still carried out by the sovereign Member States, albeit within a European framework. Ultimately, the Member States themselves determine expenditure and revenue. That is a problem. After all, one of the specific budgetary functions, namely the stabilisation function  which ensures the absorption of economic shocks1, is carried out most effectively in a currency union via a central budget. This applies not only to the absorption of shocks affecting one or only a few Member States (asymmetric shocks), but also to shocks affecting the union as a whole (symmetric shocks). The Covid-19 pandemic is a shock that affects all Member States, but with uneven effects because the most severely affected sectors are not equally important in all Member States. 

A comparative study of thirteen federations (Cottarelli, C. & Guerguil, M. (ed.), 2015) shows that even in the most decentralised federations, around half of total public expenditures are spent by the federal government. Usually this amounts to 15 to 20% of GDP. In most cases, revenues are even more centralised than expenditures. In most federations, revenues mainly stem from federal taxes on income and consumption. The central government often transfers part of its revenues to the lower government levels.

Owing to the fact that neither the European Union nor the eurozone are real political unions, this typical budget model sharply contrasts with the EU budget. Until the current new budgetary framework, the EU budget represented only about 1% of European GDP and about 2% of all public spending in the EU. Member states spend by far the largest part of the expenditures. The EU’s fiscal capacity remains extremely limited. Over 80% of the EU budget is financed by transfers from the member states, thus the opposite direction of what is the case in typical federations. The small EU budget includes instruments to foster economic cohesion between countries. They aim to prevent asymmetric shocks but cannot absorb them. There is hardly any economic stabilisation via the EU budget.

The adoption in July 2020 of the new 2021-2027 budgetary framework for the EU and the Next Generation EU programme changed this somewhat. The EC’s initial budget proposal was in line with the previous budget as a percentage of EU gross national income. But the Covid-19 crisis prompted European government leaders for the first time to increase the budget by more than 60% with temporary additional resources under a catchy name, Next Generation EU. The EU can finance these resources with loans, which will only be redeemed (much) later, partly with own EU taxes. A large part of the additional resources will be transferred to member states in 2021-2023 through a new recovery fund on the base of reform plans to make the member states’ economies more resilient, greener and more digital. In this way, the EU budget can provide an important stimulus to economic recovery, especially in the poorer countries or countries severely affected by the Covid-19 crisis. Spent judiciously and timely, it will bring about stronger economies and greater convergence.

Yet, Next Generation EU does not create the stabilisation function that will make the currency union institutionally more stable2.  For it doesn’t provide a structural system of automatic fiscal stabilisers that would absorb an economic shock through public spending (e.g. on unemployment) or reduced tax revenues. Moreover, the fund is limited in time. The step backwards is written into the decision from the outset. But with the concept of European loans that are repaid with European taxes, a step has been taken towards a budget union.

Crippled fiscal policy

Without further steps forward, Europe will have to continue to make do with fiscal rules that have become hopelessly complex over the years. They need to reconcile public finance sustainability of the individual member states with economic shock absorption. The rules have become increasingly complex because the right balance between the two objectives at the level of the member states and of the union is difficult to find. As a result, an appropriate fiscal policy stance can hardly be found. The countries most in need of a more flexible policy are usually the ones that are forced into a tight budgetary straitjacket3.  A truly coordinated fiscal policy is hard to achieve.

The Covid-19 crisis has made this problem even more acute. While learning from the experience of the 2011 euro crisis, when premature fiscal consolidation exacerbated the economic downturn, the so-called escape clause of the fiscal framework was activated very soon after the outbreak of the crisis. This allowed member states to leave the predefined path to balanced budgets and debt reduction and, with the implicit support of ECB policy, to mobilise the necessary financial flows to protect public health and mitigate the economic impact of the pandemic on households and businesses as much as possible. In addition, some other measures were taken quickly. Today, the prospects for the European economies are much brighter than they were after the euro crisis a decade ago. But compared to the US, they remain more modest. The greater fiscal power of the US is an important explanation for this, even though fiscal policy is not a race for the most, and the needs of the US economy are not fully comparable with European needs4

Need for a quantum leap

The simplification of the European fiscal framework was on the political agenda before the outbreak of the Covid-19 pandemic and will return in full force once the escape clause will have to be deactivated. The need for a fiscal stabilisation function is also increasingly recognised. The European Fiscal Board, among others, discussed proposals to this end in its last annual report. They should, among other things, allow for a more gradual and differentiated debt reduction between the member states and create more room for government investments. The Board reiterated the need for permanent and fully-fledged fiscal clout for the currency union, a need also endorsed by the ECB, among others.

Although urgently needed, its creation in the short or medium term nevertheless seems utopian. After all, it touches upon taxation, which pre-eminently touches on national sovereignty and is linked to democratic legitimacy. The establishment of a fiscal stabilisation function thus requires some kind of fiscal union, which in turn requires a further developed political union. In other words, a quantum leap in European integration. As noted, a step in that direction has been taken with the Next Generation EU recovery fund. The future will show whether a stepping stone has been laid from which further steps towards a more stable (currency) union will follow. A judicious implementation of Next Generation EU can further pave the way. Squandering the money would push the utopia even further into the future. That is not an option. Because those who deny the eurozone budgetary power are ultimately giving it the kiss of death.

1 In addition to the stabilisation function, the central government is, in principle, also best placed for the policy of income redistribution, at least as far as there is sufficient consensus in the federation on the desired degree of redistribution. Collective goods that are useful to all citizens of the union or that entail clear economies of scale, such as defence, foreign policy or transport infrastructure, are preferably produced centrally from an efficiency point of view.

2  See KBC Economic Opinion of 24 September 2020.

3 See KBC Economic Opinion of 20 September 2018.

4 See KBC Economic Perspectives of May 2021 and KBC Economic Opinion of 1 April 2021.


Any opinion expressed in this KBC Economic Opinions represents the personal opinion by the author(s). Neither the degree to which the hypotheses, risks and forecasts contained in this report reflect market expectations, nor their effective chances of realisation can be guaranteed. Any forecasts are indicative. The information contained in this publication is general in nature and for information purposes only. It may not be considered as investment advice. Sustainability is part of the overall business strategy of KBC Group NV (see https://www.kbc.com/en/corporate-sustainability.html). We take this strategy into account when choosing topics for our publications, but a thorough analysis of economic and financial developments requires discussing a wider variety of topics. This publication cannot be considered as ‘investment research’ as described in the law and regulations concerning the markets for financial instruments. Any transfer, distribution or reproduction in any form or means of information is prohibited without the express prior written consent of KBC Group NV. KBC cannot be held responsible for the accuracy or completeness of this information.

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