Starting in the 1950s, Europe’s leaders edged closer. First came the European coal and steel cartel. Then the Common Market. Then the European Union, which now includes 27 states. Then the disappearance of many border controls inside the EU. Finally, the euro. Each step of the way the nations of Europe gave up a little more sovereignty, deferring to EU officials in Brussels on regulatory issues, honoring the rulings of the top EU court, and — with some exceptions such as Britain — yielding the power to set interest rates to the European Central Bank.
One thing no one surrendered: power over the national budget. Fiscal union, where a central authority has final say over each country’s spending and taxing, was never a possibility. Politically at least, it was a move too far: To control the budget was to control the nation itself.
Now the idea is being debated like never before. The desperate rescue attempts launched in Europe in the last two years mark a step toward fiscal union, though Germany, the EU’s most important member, still opposes it. That opposition means that true fiscal union “is really, really still a long way off,” says Fabio Fois, an economist at Barclays Capital in London. Still, the Europeans seem to be headed in that direction.
Why? First, with the ECB buying Italian and Spanish bonds to stop the Greek contagion from spreading, the central bank and its president, Jean-Claude Trichet, are becoming de facto financial masters of the states they are rescuing: If Italy backslides on reforms, the ECB can stop buying its government securities and abandon it to the market wolves.
Long-term solution needed
So far the ECB’s buying binge has lowered yields on Spanish and Italian bonds by more than a point. “It’s not perfect, but this is sustainable,” says Steven Major, global head of fixed income research at HSBC. “The longer-term solution involves some kind of fiscal union, and we need time to get to that.” The Royal Bank of Scotland Group estimates that purchases of Italian and Spanish debt by the ECB and the EU’s bailout fund may eventually reach €850 billion ($1.2 trillion).
The European Financial Stability Facility, which the EU set up last year to prevent the Greek crisis from spreading, should soon be doing the bond buying the ECB has launched. The EFSF is getting expanded powers from euro zone members to buy all euro region bonds so that it can aid member states before a full-blown bailout is needed. Acting through the fund, the EU can impose austerity measures on euro zone states that eventually need help. Such authority resembles the power that a finance ministry of Europe would have.
The other factor that brings fiscal union in Europe closer is the way the EFSF is financed. To raise money for its bailout efforts the fund must issue bonds guaranteed by all the member states of the euro zone. The first bond issue of the EFSF, in February, for €3.6 billion was a big success because of that guarantee. Two other offerings have done well, too.
This funding method could be a prototype of how a European fiscal union would operate. In addition to member states issuing their own bonds backed by their separate governments, Eurobonds would be issued with the backing of all the member countries. It would be harder for bond vigilantes to attack these bonds, backed by 17 countries, than the bonds of Greece or Italy alone.
A European finance ministry?
Trichet, one of the architects of the Maastricht Treaty that established the euro, said in June that he favored a European finance ministry and veto powers for the EU over national budgets. “Would it be too bold, in the economic field, with a single market, a single currency, and a single central bank, to envisage a ministry of finance of the union?” he asked in a speech in Aachen, Germany.
For a number of officials, the answer is still yes. “This huge risk-pooling exercise will not come easily, and the risk of political fallout will be large,” Jacques Cailloux, chief European economist at RBS, wrote in a recent note.
The Germans, who have spent the most money bailing out their euro zone neighbors, are still leading the opposition. “We don’t need a fiscal union, and we should oppose it because that would mark a dissolution of responsibilities,” says Michael Meister, the finance spokesman for Chancellor Angela Merkel’s Christian Democrats. A Merkel coalition ally, the Christian Social Union, “will not support this,” Horst Seehofer, chairman of the party, said on Aug. 7. The plan “can’t seriously be desired by anyone.”
The situation in Italy also reveals a wish to preserve fiscal independence. The government in Rome has ceded power to financial markets and officials in “Brussels, Frankfurt, Berlin, London, and New York,” former EU Competition Commissioner Mario Monti wrote in an editorial in Milan’s Corriere della Sera newspaper on Aug. 7. The result is a “political downgrading” for Italy that will damage potential economic growth, Monti wrote. Yet the drubbing Italy has taken for its weak finances has inflicted a lot of damage, too.
The bottom line: By issuing bonds backed by all members of the euro zone, the EFSF shows how a central finance ministry might function.