Fiscal union has no place in EU Brexit plan

June 7, 2016

The European Union’s knee-jerk reaction if the UK votes to quit the club will be to integrate further – in particular, to charge full steam towards fiscal union. After all, “more Europe” is the EU’s typical response to a crisis.

But such a move would be politically foolish, provoking a populist backlash. Britain isn’t the only EU country where euroscepticism is running high. Think of France’s Marine Le Pen, Italy’s Beppe Grillo and Germany’s Alternative for Germany (AfD). A better response would be for the EU, especially the euro zone, to loosen fiscal policy while supercharging economic and market reforms.

The possibility of a Brexit cannot be ignored. With just over two weeks before the British people vote on June 23, a poll of polls compiled by NatCen Social Research has 51 percent for Leave and 49 percent for Remain. Ladbrokes on June 7 put the probability of Brexit at 29 percent.

If Britain votes to leave the EU, it’s not just the UK economy that would suffer. The divorce process and reduction in trade flows would harm the rest of the EU. Other countries, therefore, need a contingency plan – to cushion the impact. A possible plan B is fiscal union for the euro zone. After all, the conventional wisdom is that the absence of budgetary union was to blame for the euro crisis.

But while almost everybody who wants fiscal union agrees it should have a euro zone finance ministry, there’s little consensus beyond this. Germany and some northern countries would like to be able to tell profligate southern countries how to run their budgets. Southern countries would like northern ones to help them fund their budgets.

Even if the shock of a Brexit vote forced the elites to put aside their differences, they would struggle to sell fiscal union to their people because this would involve a transfer of sovereignty away from national parliaments to Brussels or Frankfurt. Some countries would have referendums to approve such plans. The process of seeking ratification could be so politically toxic that it might cause the EU to blow up.

The EU needs a better plan B. This would be a more ambitious version of the plan outlined by Mario Draghi, president of the European Central Bank, in his Jackson Hole speech in 2014: looser macroeconomic policy supported by structural reforms.

With interest rates in negative territory, the central bank is, using Keynes’ analogy, pushing on a piece of string. It would be sensible to change the ECB’s mandate so that its goal is to hit an inflation rate of 2 percent rather than keep it below but close to 2 percent – a target that hard-wires deflationary bias into the system. But given looser monetary policy would have limited effect at present, a higher priority is looser fiscal policy – in particular, more freedom for governments to borrow to invest.

Berlin has, in the past, been hostile to both monetary and fiscal laxity. However, its position could shift after a Brexit vote, particularly if other countries are prepared to embrace more reforms to boost their productivity. Such reforms are needed at a national level – to free up labour and product markets, stamp out tax evasion and corruption, and streamline bureaucracy. The euro crisis has already prompted Ireland, Greece, Spain, Italy and others to take such action, although more is needed.

Action to improve productivity is also needed at an EU level – mainly to complete its single market. Again, moves are already afoot – notably to create a digital single market, a capital markets union and an energy union. But these initiatives need to be brought to fruition.

Finally, the euro zone needs to complete its banking union. The euro crisis exposed a so-called doom loop connecting over-indebted banks and governments. When the banks got into trouble, their governments had to bail them out. And when states borrowed too much, banks that had lent them money also got in trouble.

Banking union has tried to sever the first part of this loop by requiring banks’ investors rather than taxpayers to support them if they need more capital. But it has failed to sever the second half of the loop – the exposure of banks to over-borrowed governments. Cutting this link without provoking a renewed crisis will be hard but needs to be part of the euro zone’s medium-term plan.

All these measures – more investment financed by borrowing, a symmetrical inflation target for the ECB, market reforms at a national level, completing the single market, and finishing banking union – would be desirable if Britain voted to stay in the EU. Indeed, the UK would itself benefit greatly from the completion of the single market. However, in the event of Brexit, the EU should push forward along these lines with extra energy rather than racing headlong into the blind alley of fiscal union.

(Hugo Dixon is chairman of InFacts, a journalistic enterprise arguing that Britain should stay in the EU.)

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