Forget Italy: Fiscal union is unlikely to mend the euro’s defective heart

 
John Chown
WHEN the European Central Bank announced last year that it would do “whatever it takes” to save the euro, many assumed the crisis was over. This week’s Italian election has already shown that an unexpected event could easily throw off balance Europe’s preferred solution.

But there is a more important issue at stake. The Eurozone has yet to solve its original defective structure. A sustainable monetary union needs arrangements in place to ensure each country maintains fiscal discipline, with clear provisions that each state is responsible for its own debts, and adequate arrangements for emergency inter-state transfers. Consequently, it is now accepted that fiscal union is necessary.

But how does the Eurozone get there? It will require a renegotiated constitution, raising problems that must be analysed before they can be solved. Prospective members will have to read the small print before signing up. And it’s in the small print that danger lies.

The essential conditions for fiscal union to work are balanced budgets and labour market flexibility. Fiscal discipline implies central control to ensure that national budgets are balanced. It does not imply “tax harmonisation”, however, as this would leave its members – unable to exercise monetary policy – with expenditure changes as their only policy tool.

Importantly, fiscal union could also involve inter-member transfers. As such, those joining must compare real financial positions, watching for unintended consequences. And this analysis has to go beyond the current obsession with formal debts, projected budgetary cash flows and external assets. Future commitments are just as important.

The most dangerous potential long-term shock, without urgent policy changes, looks likely to be pensions. In a paper I presented to a Chatham House economics meeting in 2001, I analysed Eurostat figures on the subject. Then, before the sovereign debt crisis even happened, I pointed out that the Eurozone would inevitably collapse in about 2030 without changes to the pension policies of individual states. And as recent figures confirm, reform has really yet to happen.

Early this century, there were typically four people in work for every person in retirement and drawing a pension. By the middle of the century, the ratio will be down to two workers for every retiree. Importantly, the consequences for EU members will be very different.

Britain and France, for example, have similar broad economic statistics (they are about to exchange their positions as the second and third largest EU economies), and their citizens have similar expectations of earnings-related pensions. But there the difference ends: British pensions are backed by some €2 trillion (£1.7 trillion) (about 80 per cent of GDP) in independent fund assets. In France, however, pensions are nearly all “off balance sheet” liabilities of the state. The latest Eurostat figures show that, by 2060, on unchanged policies, the French government will be paying out 16.8 per cent of GDP to pensioners every year – double the UK figure of 8.4 per cent.

To some extent, French policies have changed – for the worse. One of the first actions of President Francois Hollande’s government was to reverse the modest increase in the pension age introduced by his predecessor Nicolas Sarkozy. My Chatham House paper warned against any UK involvement with a Eurozone project that might potentially lead to a raid on our funds.

The UK is not, and surely will never be, a member of the Eurozone. But this same divergence of long-term commitments exists across the Eurozone. Germany has a largely state-funded pension system, similar to France, but with a later retirement age. Will German taxpayers be willing to subsidise early retirement for the French?

And what of other countries? The Netherlands and Finland, which are expected to be part of an inner group of Eurozone members, have about 100 per cent and 60 per cent of GDP respectively in pension fund assets and should watch this situation very carefully indeed. Sweden and Denmark, with 36 per cent and 150 per cent respectively, will (like the UK) obviously keep well clear of the Eurozone.

There is no space to discuss the implications of a two-speed Europe (a potential disaster but possible opportunity). But the implications are clear. Without a serious resolution of the future commitments of potential members of a fiscal union, the Eurozone’s eventual collapse is inevitable.

John Chown is principal at Chown Dewhurst, and a co-founder of the Institute for Fiscal Studies.