Speech

Address by Dominique Strauss-Kahn, Managing Director of the IMF
At the Bruegel-IMF Conference “Sovereign Risk and Fiscal Policy in the Euro Area”
Bruegel Institute, September 14, 2010

As Prepared for Delivery

Good afternoon. I am delighted to take part in this important conference on fiscal policy in the euro area. The ideas presented today are sure to serve as valuable inputs to those working on how to strengthen the EMU’s fiscal framework.

Over the last sixty years, the nations of Europe have joined together to build a common road to prosperity, stability and peace. The integration of their markets has created tremendous opportunities for innovation and growth, delivering a remarkable rise in living standards.

This success has been anchored in an understanding that sharing the same road requires more than fair play and good will. To ensure that the journey proceeds smoothly, European nations have had to surrender some autonomy for the sake of the greater good. This has applied to trade and competition policy and monetary policy, and to some extent also to financial and fiscal policies.

But in the wake of the crisis, we have learned that some of EMU’s rules are not working as well as they should. Problems in the financial system revealed themselves first—though this was obviously not just a European issue. The weaknesses of EMU’s fiscal rules—which failed to prevent some countries from running unsustainable deficits—then triggered a severe crisis. And now, the legacy of insufficient structural reforms is weighing on the recovery.

Today, policymakers have a unique opportunity to tackle these problems decisively. Yes, the required reforms are likely to be politically challenging—no policymaker likes to give up autonomy. But in a closely integrated economic and monetary union, national policies must be set within the framework of that union. Unless leaders take bold action now to strengthen economic governance, I see a real danger that within a generation—or even sooner—member states will no longer be able to compete with the more dynamic nations of the world—with costly consequences for its citizens.

It is in this spirit that I want to offer some ideas for how to strengthen Europe’s macroeconomic policy framework—and specifically, how a more integrated and centralized fiscal framework could deliver higher and more stable economic growth for Europe.

Policy priorities for Europe

To provide some context, let me mention quickly the well-known policy challenges facing Europe today.

The most urgent task is to reignite growth and tackle unemployment—and to do so in a way that takes account of important social considerations. The successful ILO-IMF conference that took place yesterday in Oslo focused on precisely these issues.

As the recovery takes hold, countries with large fiscal and current account imbalances need policies that support growth and facilitate adjustment. Reducing high public debt is clearly a priority, though the pace of fiscal consolidation must depend on country-specific factors, including the strength of the recovery and the available fiscal space. But what is needed now in all European countries is the adoption of credible plans for medium-term fiscal consolidation. More rapid progress in healing the financial sector is also critical.

Focusing beyond the near term, the key challenge is boosting productivity and growth. There are many excellent ideas for how to bring vitality back to Europe, including those laid out in the EU2020 strategy. But these ideas must be put into practice as a matter of urgency. This calls for action in a very different way than was used to implement the Lisbon agenda.

But all this needs macroeconomic stability. This is where strengthening the EMU’s fiscal framework fits in.

Monetary union and fiscal coordination go hand in hand

At the outset, let me state my firm conviction that the full benefits of the single European market can only be reaped if based on a stable single currency. But an international currency union can only survive if it has strong fiscal coordination mechanisms that deliver the key macroeconomic benefits of a fiscal union. Why? Because in the absence of such mechanisms, two problems arise. First, the burden of country-specific shocks must be borne entirely by national fiscal policies. And second, when national fiscal policies go astray, all members of the union must bear some of the costs of such policies—in other words, independent national fiscal policies raise the risk of moral hazard. I am sorry to say that little has changed since I wrote “La Flamme et la Cendre” in 2002.

A fiscal federation deals with both of these problems.

First, it provides macroeconomic insurance against region-specific shocks through national social security and tax systems. In Canada and the US, for example, such transfers automatically offset about one fifth of the impact of regional shocks. More persistent shocks are addressed through other transfers—as is done, to a smaller extent, in the EU through structural funds.

Second, it reduces moral hazard risks by restricting spending and borrowing by subnational entities. This in turn bolsters the credibility of the center to deliver nationwide macroeconomic stability.

Within the European monetary union, the economic framework lacks both these elements.

So let’s look at what is working in EMU’s fiscal framework, and what needs fixing. In sum, while EMU has speed limits—the deficit and debt targets—and radars—the Commission—it lacks effective traffic police, traffic court, and emergency roadside assistance.

The Excessive Deficit Procedure—or EDP—introduced the speed limits: deficits no higher than 3 percent of GDP, and debt no higher than 60 percent of GDP (or, if debt is higher, rules that it must decline at a sufficiently fast pace). The SGP then clarified that the “deficit reference value” is truly a speed limit, and not a cruising speed. The SGP also explicitly established a structurally balanced budget or surplus over the medium term as a key target. By calling for greater build-up of fiscal buffers in good times, this strengthened the potential for fiscal policy to serve as a stabilization tool.

But the crisis laid bare three major gaps in EMU’s fiscal framework.

• First, the SGP was undermined by insufficient ownership of rules, deficient statistics, and excessive focus on formal compliance with the deficit ceiling. This undermined preventive instruments, such as “early warnings.” And enforcement of the EDP, which is ultimately the responsibility of the Council, was allowed to be swayed by political considerations.
• Second, the SGP lacked effective instruments to hold governments accountable for missing medium-term fiscal objectives, or for not making fast enough progress in reducing excessive public debt.
• Third, the absence of well-articulated crisis management and resolution capabilities exposed the euro area to the risk of a full-blown debt crisis and pressures for ad-hoc bailouts.

I’d like to explore the first two issues—EMU’s governance, or its traffic court; and EMU’s instruments, or its traffic police—in greater depth. Another issue I’d like to discuss—which has been evident for longer—is the absence of effective macroeconomic insurance. With the creation of the European Financial Stability Facility, the need for emergency roadside assistance has been temporarily filled. And while a permanent crisis management framework is still needed, its design will depend on how the rest of the fiscal framework is set up.

A greater role for the center is the answer

My main message is that the center must be given a greater role in national fiscal policies if EMU is to become a more effective—and more resilient—monetary union.

What is the best institutional approach to increase the role of the center? The most ambitious solution—extensively discussed in the academic literature—would be to create a centralized fiscal authority, with political independence comparable to that of the ECB. The authority would set each member’s fiscal stance and allocate resources from the central budget to best hit the dual targets of stability and growth.

In my view, it would be good to go in this direction. But, of course, such a leap towards European political integration appears unlikely in the foreseeable future. And I recognize that such a delegation of fiscal powers to the center could meet political resistance in some countries, where the appetite for ceding further control to Brussels is already weak.

Nevertheless we should explore other ways to reinforce the center. One idea is to shift the main responsibility for enforcement away from the Council. This would go a long way towards minimizing the risk that narrow national interests interfere with effective implementation of the common rules. In other words, EMU’s traffic court would become a more credible judge of fiscal behavior in the euro area.

Within the existing institutional context, the Commission, as guardian of Europe’s treaties, could play such a role. Alternatively, a separate, independent institution could be more effective. Even if it is important for the Council to retain a veto right at qualified majority or even unanimity, the process has to be in the hands of an independent entity.

Now, how would a stronger center help shape more responsible and growth-friendly fiscal policies in euro area members? I see two pillars on which this role would rest: smarter enforcement, and a larger central budget.

To make enforcement of common fiscal rules smarter, economic judgment should play a more important part in the assessment of fiscal performance. For example, the EDP should extend its focus beyond formal compliance with the deficit ceiling, and take into better account the overall economic context in which fiscal policy is being set.

One concrete and excellent idea being discussed by President van Rompuy’s Task Force is greater focus on troublesome debt dynamics. Accordingly, the EDP would be activated when the expected path of debt is deemed unsound—regardless of the actual deficit. This is particularly important, in light of the potentially large stock-flow discrepancies between deficits and debts, which in some cases could reflect worrisome accounting practices. Europe’s looming population-related spending pressures are another relevant factor.

Another idea would be to give some credit to members making one-off down payments on growth-enhancing reforms—for example by giving a temporary waiver when deficits exceed the reference level. Of course, this should not become a loophole in the SGP. To ensure that such waivers are deserved, they should be limited to cases where the upfront costs of reforms are unambiguous and large, and where the positive impact of the reforms on long-term debt sustainability is clear.

There are many other reforms that could help enforcement become more effective—including those being discussed by the Task Force. I support the adoption of a broader range of sanctions. In particular, EMU should move away from immediate fines, which can undermine adjustment efforts. Instead, fines could be “smoothed” over time—possibly in the form of temporary “discounts” on future EU transfers.

Of course, while sanctions can help deter weak fiscal policy, prevention is the best way to keep public finances in good health. Strengthening surveillance could help detect problems early, while augmenting the scope for peer pressure could discourage weak policies. The new initiative of the European semester, through which fiscal plans would be assessed before they are submitted to national parliaments, is a useful step.

The second pillar supporting a greater role for the center is a larger central budget.

A larger central budget would make more financing available to tackle structural weaknesses in areas like infrastructure, R&D investment, and education—which would in turn boost growth in the euro area. Common resources could also be used to incentivize favorable economic and structural policies, by giving strong performers enhanced access to EU funds. In terms of resources, the larger central budget could be financed by a European VAT, or by carbon taxation and pricing.

One final point: In creating new mechanisms for transfers within the euro area, it will be essential to minimize the risk of moral hazard inherent to any insurance scheme. This is another reason why enhanced macroeconomic surveillance and an increased role for the center are so important.

Concluding thoughts

Let me conclude:

European integration has been a remarkable success story. Over the last sixty years, it has raised the quality of life for hundreds of millions of Europeans. But the crisis has laid bare some fundamental gaps in economic governance that not only placed the euro area at great macroeconomic and financial risk, but may also hamper its long-term growth prospects.

Now, in the wake of a major economic crisis, the euro area faces a defining choice. Going back to business as usual is not an option.

The euro area could opt for the smoother road of governance reform—along which current institutions and mechanisms are adjusted mostly at the margin, but essentially remain in their current form. In my opinion, this road will lead to stagnation—with difficult debt dynamics, volatile risk premia, and persisting structural problems.

Alternatively, it could opt for the more ambitious, yet potentially bumpier road of governance reform—one that would lead to a new level of integration and policy coordination. I see this road leading to a far more dynamic euro area, with mutually reinforcing reforms that trigger a virtuous cycle of productivity and growth.

For EMU’s fiscal framework, the ambitious road is based on a greater role for the center. This change is clearly essential for the success of economic and monetary union, which relies ultimately on shared fiscal responsibility. It is also critical for restoring confidence in Europe, given how closely fiscal credibility and financial stability are intertwined.

To me, the choice is clear. The euro area must seize the moment to strengthen the coordination of economic policies and fortify its institutions. This is what will allow us to extend the benefits of prosperity to all the peoples of Europe, for many years to come.

Thank you for your attention.