European Union

The disastrous stealth federalisation of the EU

BY Tuomas Malinen & Peter Nyberg   /  6 August 2020

When the European Union was created in the mid-1990s it had bold aims: to unify Europe (erasing the risk of new wars), to create a common market for goods and services, to bring prosperity to all, and to enforce the rule of law across Europe. A vital part of this effort was to encourage sound finances among sovereign member states through mutually agreed rules and constraints.

Wars among member states have, fortunately, been avoided but mutual prosperity, the rule of law and economic and political sovereignty have gradually been lost. Increasingly, the union is one of bureaucracy only, run at the federal level. And the common currency, the euro, is at the very centre of these problems.

The latest and arguably most serious attempt effectively to undermine sound sovereign finances and to impose a federal-style mechanism on the EU is the “recovery fund”. Its economic rationale does not hold up, and it seems like a desperate effort to bribe the problematic southern economies – especially Italy – to stay in both the euro and the union.

Italy has massive sovereign debt (probably around 140% of GDP at present), and has declined funding from the European Stability Mechanism (ESM), most likely because its loans come with conditions which require economic reform. This could be too embarrassing for a G7 nation, and Italy could choose to opt out.

Most worryingly, the blueprint for the “recovery fund” seems, in many respects, to be contrary to several important principles of the Treaties as originally understood. It thus undermines the rule of law within the EU as well as its legitimacy. It also continues the failure to encourage member states to adapt their economies to the demands of a common currency and to take responsibility for their own economic policies and development.

The recovery fund is a significant step along the pathway towards federalisation. But how did we get this far?

From a debt crisis…

Everything starts with the introduction of the euro.

When it was introduced in 1999, the euro was intended to be a symbol of unity and a mechanism for supporting growth and welfare in the union. Though it was not recognised at the time, from the very beginning the eurozone started to exhibit problems common to all currency unions in history.

A successful currency union without a transfer union demands large and exacting economic and social adjustments by its members. Member states agree to adopt a common currency instead of national currencies through which historically, whenever necessary, they have been able to correct economic imbalances with the surrounding world.

If member states cannot become sufficiently nimble in managing their internal costs, economic disturbances inside and outside the EU will cause swings in competitiveness and consequently in growth, employment and welfare. In order to succeed economically, members of the European single currency thus required a degree of economic flexibility previously unheard of for most of them.

It is not difficult to understand why this flexibility did not arrive promptly as required. A national economy develops over time through a complex set of unique political, cultural and economic processes, norms and laws. Generally, the longer the history of a nation, the more complex and difficult it is to change the mix. This leads to significant diversity in how productivity and competitiveness develop and are managed across nations. This applies especially in Europe with its millennia-old national cultures.

The function of a foreign exchange rate is to encourage trade by reflecting and neutralising these differences between nations. Without it, economic differences tend to remain or even grow unless very strongly discouraged by economic and social policies.

When the euro was established, it seemed a political necessity to include economically weaker and less flexible economies. Many market participants tended to assume that the act of joining implied that there existed an informally agreed, credit risk reducing mechanism to compensate for the lack of a national currency. Therefore, the interest rates of all member states’ debt could relatively safely be arbitraged and allowed to decline.

This led to a convergence of interest rates across the union through the rapid growth of cross-border financing, making union proponents (particularly the European Commission) deliriously happy over the apparently rapid integration of banking, capital and money markets. But that was a mirage, and banking and capital markets remain divided across the Eurozone even today. At the same time, it became obvious that weaker member states had lost production to stronger ones, while it became cheaper for them and their firms and households to acquire debt.

When the global financial crisis of 2008 hit the eurozone, flows of capital (i.e. debt) turned away from the weaker nations. The weaker member states kept their economies from collapsing by increasing government expenditure, financed through debt issuance. Trust in the existence of the mysterious and unconfirmed compensation mechanism declined as a result, and in 2010 a debt crisis emerged.

…into the mutualisation of debt

During the early years of the euro, interest rate differences were arbitraged especially by French and German banks which lent aggressively to weaker nations, including Greece. In April 2010, as the extent of Greek government accounting malpractices became public knowledge, ratings agencies downgraded the debt of Greece to the lowest category – “junk”. The interest rates of Greece shot up to levels which were unserviceable for the public sector.

The German and French leaders panicked. If Greece would default and be forced to exit the euro, their banks would suffer crippling losses. Greece must be saved! But there was a problem. The Treaty on the Functioning of the EU (TFEU) Article 125 bans shared fiscal responsibility, including income transfers between nations. This was known as the “no bailout rule”.

This was bypassed by eurozone member states providing Greece with a bilaterally agreed bailout (outside the EU treaty) in 2010. The same year, a Luxembourg “dummy-corporation”, the European Financial Stability Facility (EFSF, also outside the EU treaty), was created to provide financial assistance to euro member states in economic difficulties. Its funding was guaranteed jointly and severally by the members of the eurozone. Eventually it provided Ireland and Portugal with parts of their bailouts in 2011. In the same year its lending capacity was almost doubled, which was opportune given that Greece needed a second bailout already in 2012.

The EFSF was superseded by the European Stability Mechanism in 2012, which is based on an international treaty separately from the EU treaty. Efforts have been made to make the two treaties compatible. It is capitalised by the euro member states. From its inauguration ESM was alone responsible for any new financial commitments to problem euro states. The ESM was also empowered to provide funds for directly recapitalising banking systems in trouble. Bailout programmes were concluded with Spain in 2012 and Cyprus in 2013. In 2015 Greece received its third bailout.

In addition to these specific organisations, the European Central Bank has in recent years through various monetary programmes acquired a great deal of financial assets on behalf of its shareholders, the national central banks. Any losses on the acquired assets are, in principle, shared between the member state central banks. They, in turn, are ultimately capitalised by their respective governments.

The “recovery fund”

The European leaders have now agreed on the €750 billion “recovery fund”. It would give the EU the power to issue debt guaranteed by the member states through the EU budget, the Multi-Annual Financial Framework (MFF). Leaders have agreed that €390 billion would be given out as grants and €360 billion in loans.

The narrative goes that the €750 billion fund would somehow, under the centralised money distribution scheme, miraculously save the €14 trillion economy of the EU. As we know from previous EU programmes, providing practically free money to governments is unlikely to result in an overall increase in productivity or better economic governance in general. The idea that giving money to less productive economies would yield a stronger stimulus than more productive economies using that money to stimulate themselves defies normal economic logic.

What makes the programme exceptional compared to previous schemes is that it works through the EU budget and gives out grants and loans. It thus creates a budget deficit for the EU, which will be financed through the issuance of debt and, possibly later, by new taxes levied by and rendered to the EU. The TFEU Article 310 requires that the EU must have a balanced budget.

The grants are income transfers which affect the fiscal situation of countries. This also means that they breach TFEU Article 125. This has been played down by referring to the emergency powers of the Commission and the European Council, deriving from TFEU Article 122, enabling temporary financial assistance in an “exceptional situation”.

Previously, Article 122 was seen as an actual emergency measure which could have been applied, during natural disasters such as earthquakes. Now, it suddenly concerns the whole union and the response of national governments to the pandemic. Distribution of grants also follows a completely different logic.

Around 70% of the amounts to be given out as grants are determined by population, GDP per capita (inverted), and the unemployment rate between 2015-2019. So, the grants are distributed, not based on the economic fallout of the pandemic (which would be appropriate for the purposes of Article 122), but on how countries have managed to grow and create jobs during the pre-Covid years. If this does not constitute an income transfer from richer to the poorer members of the EU, we don’t know what does.

As such, the fund is a major step towards a fiscal union. It introduces a practice of income transfers, where the agreed Treaties do not apply in case of broadly defined economic emergencies in the EU. As is generally known, there is no lack of such crises in the EU’s past, and more can be creatively defined when desired. Since the new support is unlikely to stimulate greater economic flexibility among less nimble economies, the mechanism will therefore most probably also be used in the future.

Increased use of this new philosophy – always possible in Commission proposals, and likely if a global crisis emerges as many predict – it also means that the size of the fund is likely to grow, possibly substantially. The fund, around 5% of the EU’s GDP, is way too small to handle a global economic crisis hitting Europe. For example, the recapitalisation needs of central and southern European banks are already now estimated to be in the range between €500 and €800 billion, which even may prove too low an estimate if (or when) the crisis deepens.

Moreover, since the new level of EU debt initially has no new income streams to service it, the cost of servicing it will ultimately fall on taxpayers. Indirectly it therefore increases the often already unsustainable sovereign debt pile of EU member states. As indebtedness continues to increase, EU debt will force member states either to let aggregate tax rates rise or to give the EU wider-ranging rights of taxation, which may force countries to reduce the tax rates over which they may decide nationally.

Politically, this seems like a clear case of providing national politicians with an easy way out. Rather than taking responsibility for ending popular domestic programmes, they are likely to give the EU taxation rights which can be (ineffectually) criticised prior to national elections: “We really would like to continue giving you all these public services, but we cannot by ourselves change EU taxes. It is the EU which forces you to choose between more taxes or less service than before.” This process will gradually take us into a federation-in-practice, step by step.

Alas, the “recovery fund” is the most recent Trojan horse in the federalisation of the EU.

Countries should be able to “opt-out”

The EU has long been on a stealthy trip towards federation. Some claim that is has been the aim all along – to create a European super state. We take no view on that, but the goal has been clear for many and now we finally are at the “gates” of a completely different union than the one we joined.

While arguments for the EFSF and ESM, of which the latter is still operational, providing funding to crisis-hit economies, have taken us to the limits of the current European Treaties, the “recovery fund” is pushing us over them. The politicised EU institutions (and some equally politicised commentators) do try to muddy the waters, but the fact is that the “recovery fund” is very likely to change the EU in a fundamental way.

Creation of a structural budget deficit, financed by EU borrowing, to finance fiscal transfers based on the economic situation before the pandemic, leaves no other interpretation. The “recovery fund” is created with a view towards establishing a transfer union and creating a path to full economic federalisation.

This is not the EU that sovereign member states originally joined. There are and have been those who support the development of a federal state and consider the suppression of national powers and policies a good thing. They do not wish to discuss or draw attention to federalist developments until either the transformation is irreversible or there is a clear majority of the population supporting the change.

The majority of the public in member states have therefore, until now, remained unaware of the gradual but substantial loss of national responsibility and independence. We therefore urge all concerned institutions, including national parliaments, finally to have an open discussion about how they would prefer the EU to develop in the coming years.

No doubt some will argue for the present trend towards a strongly centralised federation. Others may even prefer to leave the EU if that is necessary to safeguard their freedom and way of life. There must be room in Europe for both choices.

Open and wide debate, including the options of referenda, is the only way to keep the process and its ultimate end result legitimate and acceptable to all.

Until his retirement in 2010 Peter Nyberg worked at the Finnish Ministry of Finance as Director General of the Financial Markets Department. He joined the Ministry in 1998, having previously worked at the Bank of Finland in various capacities, finally as an Adviser to the Board. After his retirement he was retained for various tasks related to financial crises, among them work for the Irish government to evaluate the causes of the banking crisis there. He also worked for the IMF as a Senior Economist in the 1980s.

Tuomas Malinen is CEO of GnS Economics Ltd. and an Adjunct Professor of Economics at the University of Helsinki. He is also a Vice-Chairman of EuroThinkTank, a group of professional research group studying the future of the eurozone. His research interests include economic growth, economic crises, monetary unions and income inequality.


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