Making the case for a 'federation lite'

As part of ECFR’s ‘Reinvention of Europe’ project, Emma Bonino and Marco de Andreis make the case that a ‘lite’ version of federation may provide a viable and practical solution to the euro crisis. Other essays in this series will also be emailed directly to those who have subscribed to our weekly updates.

Making the case for a ‘federation lite’ 

The great contraction of the world economy that begun in 2008 and the European financial crisis have refocused debate on the nature of Europe’s political union. One proposed solution to the crisis is to increase the level of European integration towards a form of federalism. But what might a resulting ‘United States of Europe’ look like, in terms of government functions and budgetary resources, and would this necessarily be the “huge federal superstate” that eurosceptics are so alarmed at? One answer might be for a limited form of federalism that concentrates relatively small resources in relatively few areas: a ‘federation lite’.

The global economic crisis could not fail to have a huge impact on the process of European integration for the simple reason that the process was centred on the European economy since its beginning.

At first the impact was mainly a threat to the internal market, as governments dispensed state aid on domestic banks and manufacturers. The European Commission, however, did a good job in reining in these initial protectionist tendencies, helped perhaps by the timid recovery which began in the second half of 2009.

Then, in early 2010, the markets began to loose confidence in the sustainability of several Eurozone countries’ public debt, dramatically increased over the last couple of years in an attempt to counter the effects of the contraction. The spread between Greek bond yield and the Bund reached 400 basis points in late January 2010. From that point onwards the sovereign debt crisis snowballed and the yield gap yawned: first that of Greece, then Ireland, then Portugal. Greece requested EU and IMF aid in April 2010, Ireland the following November and Portugal in May 2011.

The European Financial Stability Facility (EFSF) was launched at the Ecofin Council of May 9^th, 2011, to provide loans to Eurozone governments in financial distress. However this proved unable to calm market fears and stem contagion. Large gaps in bond yields spread to Spain and Italy[1] by July (both considered too large to be rescued). This marked the beginning of a new, more dangerous phase that not only threatened European Monetary Union, but global financial stability and European integration itself.

Efforts by Eurozone leaders to deal with the crisis have continued. Meetings in July and October 2011 failed to produce a package of measures capable of calming the markets. A ‘fiscal compact’ was signed by all but two (Britain and the Czech Republic) of the 27 member states in March 2012 in an attempt to make EU governments’ fiscal policy more accountable and responsible.

Whether or not the fiscal compact is able to calm the markets, it is certainly meant to calm German fears of fellow Eurozone member states’ fiscal profligacy. It may, in other words, give Berlin enough confidence in the ability of its Eurozone partners to redress their fiscal imbalances, making German help temporary rather then open-ended. This, in turn, may – just may – eventually bring Germany to accept the mutualisation of Eurozone debt by issuing so-called Eurobonds, while it did contribute to remove its objections to provide more funds to the ESFS, its successor the European Stability Mechanism (ESM,) and the International Monetary Fund (IMF).

Between December 2011 and mid-April 2012, markets were also calmed by two waves of cheap ECB loans to banks, which dramatically reduced the interest rate paid on sovereign bonds, and a further bailout package for Greece in February 2012 that forced private creditors to accept a 70% loss.

Despite being no end in sight to this climate of emergency, however, the Eurozone – when taken as a whole – remains both wealthier and more economically sound than most other regions of the world. For instance, it has less public debt, half the fiscal deficit, less private debt relative to GDP and far better external accounts and income distribution than the United States. It also has no more internal imbalances on key indicators like inflation, growth and productivity.

Arguably, the main threat to the euro is the simple fact that the Eurozone (and the EU), lacking political unity, cannot be taken as whole. The few historical experiments of single currencies backed by several sovereigns all failed. A single currency needs the backing not only of a central bank and a single market where labour and capital move freely, but also of a Treasury empowered to redistribute resources via taxing and spending in order to avoid the creation of excessive domestic imbalances.

The bulk of US public debt is federal debt credibly guaranteed by the federal government. All Eurozone debt is national debt, guaranteed by national governments only: there is no federal government, and a German guarantee on the Greek debt, for example, is evidently not credible, in spite of all the ad hoc efforts to the contrary made so far. It is this that has led to a chorus of calls for European political union.

George Soros has written that “There is no alternative but to give birth to the missing ingredient: a European Treasury with the power to tax and therefore to borrow”.  The IMF has lamented the lack of “political union and ex ante fiscal risk sharing” in the Eurozone. Other eminent figures have called for a European ministry of finance, and in the US (where many have doubted the single currency from the beginning) leading economists have argued that greater integration is part of the solution.

Some current politicians have echoed these sentiments. Franco Frattini, then Italy’s Foreign Minister, declared on 14 September 2011 that “Italy is ready to give up all the sovereignty necessary to create a genuine European central government”. Later that month Alain Juppé, the French Foreign Minister, declared: “I am in favour of a true European federation because in the world in which we live we cannot tackle the challenges we face on our own”. In November Angela Merkel  told the delegates at her annual party Congress in Leipzig that “It is now the task of our generation to complete the economic and currency union in Europe and to create, step by step, a political union”.

Such ambitions would involve radical changes. The EU currently has no power to tax, and its budget is almost exclusively made up of transfers from member states. Its expenditures amount to only around 1% of the EU’s GDP, and serve almost no governmental functions (they are largely subsidies, with agricultural subsidies constituting almost half of the total).

Any move towards deeper European integration would thus have to involve rethinking an EU budget: how it raises taxes, how much it raises, and what it spends its revenues on. Some economic theories, particularly fiscal federalism, provide plenty of arguments for certain categories of spending to be centralised at the EU level: security and defence; diplomacy and foreign policy (including development and humanitarian aid); border control; infrastructure projects with Europe-wide network effects; large scale research and development (R&D) projects; and social and regional redistribution.

Of this list, defence and foreign policy – having to do with survival and identity - are the ultimate taboos of state sovereignty. Precisely for this reason, though, there cannot be any true European political union lacking these prerogatives. It is in a sense axiomatic: if one invokes political union in order to save the euro and possibly the EU, then one must be ready to transfer these functions of government to the federal level. Conversely, if one believes defence and foreign policy must be kept at national level, then proper political union is simply unachievable and thus useless as a remedy to the euro ills.

Although the current budget for scientific research is around €9 billion, only 3% of money spent on R&D in the EU comes from Brussels. In the US the federal government funds around half of all research and 17% of development.  This suggests room for more EU involvement that would allow truly pan-European scientific projects on a far greater scale than what member states could afford on their own. The parallel is with space programmes and national-security related research in the US, which is all run at federal level.

Social redistribution would consist in a federal programme of unemployment subsidies, and regional redistribution would allow newer EU members to close the gap in living standards with the rest of Europe (more than a third of the current EU budget is already used for this purpose).

The transfer of certain functions of government from the national to the European level should entail no net increase of public expenditures in the EU as a whole, and possibly a net decrease (thanks to economies of scale).

Take defence. As the NATO cold war experience shows, efforts to coordinate independent defence establishments have always produced disappointing results and free riding at the expense of the richest suppliers of the public good. ECFR’s Nick Witney, the former head of the European Defence Agency,wrote the most knowledgeable and persuasive indictment of Europe’s security and defence policy as it stands today:

“Nearly two decades after the end of the Cold War most European armies are still geared towards an all-out warfare on the inner German border rather than keeping the peace in Chad or supporting security and development in Afghanistan […] This failure to modernise means that much of the €200 billion that Europe spends on defence each year is simply wasted […] The EU’s individual Member States, even France and Britain, have lost and will never regain the ability to finance all the necessary new capabilities by themselves”.

If this is the diagnosis, and if several years spent improving coordination and cooperation among different national defence organisations have failed as a cure, wouldn’t the creation of an EU army be the most logical step to pursue? Note that precisely because the mission of Europe’s military force has so profoundly changed, it is in principle much easier to start a new army from scratch – manpower, equipment, doctrines and all – rather than persevering in the futile attempt to convert existing ones to new missions tryingat the same time to increase their cooperation. If it possible to create from scratch a new currency and a new central bank, as experience shows, the same applies to a new army.

If the EU spent 1% of its GDP on defence – almost €130 billion – it would have the second largest defence budget in the world after the United States, with 3 to 5 times the resources available to powers such as Russia, China or Japan. While this sum would certainly be enough to make of the EU armed forces an effective military organisation for the conceivable missions it has, it still would imply €60-70 billion of savings with respect to the current situation (more than 0.5% of Europe’s GDP).

Diplomacy, a relatively inexpensive item in the budgets of member states, would nonetheless cost a lot less if centralised at the European level. Thousands of member states’ embassies around the world and hundreds of intra-EU embassies would become redundant.

The EU is already the largest humanitarian aid donor, and a substantial development aid donor. Greater foreign policy capacity within the EU would allow greater coherence between this aid and the overall goals of an EU foreign policy.

Despite customs already being an exclusive EU competence [2], the EU still anachronistically carries out this function of government through 27 separate national customs organisations. Given also the growing importance of new security missions (anti-proliferation, anti-terrorism, health and food security etc...) at the expense of the traditional tax collecting mission, this could be effectively moved at an EU level and carried out by a single EU customs organisation.

Other public goods – for instance education, health and transport – should be left at member state level to account for differences in underlying preferences. The EU’s role would be to regulate and coordinate only when made necessary by its internal market mandate.

Agricultural policy currently involves subsidies that account for 43% of the EU budget: spending with negative impacts on resource allocation, domestic and international prices, world trade, food quality and the environment. National governments should be free to spend money on such subsidies - subject only to internal market rules - but there should be no place for them at the EU level.

A ballpark quantification of the cost of these competences could be of the order of 5% of Europe’s GDP broken down as follows[3]:

% of EU GDP

- Defence: 1.0

- Diplomacy (including Development and Humanitarian Aid): 1.0

- Research and Development: 1.0

- Social and Regional redistribution: 0.7

- Border Control: 0.5

- Trans-European Networks (TENs): 0.5

- Administration: 0.3

Total: 5.0

On the revenue side there are several options to finance a budget of this order of magnitude. However, direct taxation of EU citizens would reinforce democratic legitimacy and accountability, and do away with the transfers from member states that currently cover 87% of the budget. That taxation could involve a corporate income tax, levied at the federal level (such taxes accounted for 10% of total 2008 tax revenue in the Organization for Economic Cooperation and Development), and/or a single Value Added Tax on imports. One study on this subject reveals that a single VAT on EU imports would have raised 1.6% of EU GDP in 2006. A low-growth scenario projection to 2014 would bring this figure to almost 2%. Covering the suggested 5% of GDP through only two taxes would leave all the other levers completely in the hands of member states, whose public expenditures currently absorb on average around 50% of GDP, ten times as much as what we propose.

So, at least in terms of resources, who’s the superstate here?

In 1977, the report to the European commission on the role of Public Finance in European Integration by a Study Group chaired by Donald MacDougall (at that time the Chief Economic Adviser of the Confederation of the British Industry) concluded: “It is possible to conceive, presumably at some distant date, a Federation in Europe in which federal public expenditure is around 20-25% of gross product as in the USA and the Federal Republic of Germany. An earlier stage would be a federation with a much smaller federal expenditure of the order of 5-7% of gross product, or roughly 7½ -10% if defence were included. An essential characteristic of such a federation would be that the supply of social and welfare services would nearly all remain at the national level”.

This report and the idea for a ‘federation lite’ put forward in this paper suggest that the EU is not faced with a simple binary choice between a “huge federal superstate” and disintegration. The current financial crisis underlines the logic that lies behind further integration, as the Union reinvents itself in response to the challenges it has exposed in its system of incompletely shared sovereignty. A federation lite would involve a pragmatic approach to that further integration.

- by Emma Bonino and Marco de Andreis

You can read more about the ‘Reinvention of Europe’ on ECFR’s website. We are also publishing a series of papers examining the national debates in individual countries over the financial crisis and the future direction of Europe. Click here to read the papers on Poland and the Czech Republic, and here to read a paper explaining the debate over the Fiscal Compact, growth and austerity.

This paper, like all ECFR publications, represents the views of its author, not the collective position of ECFR or its Council Members.

[1] The spread between Italy’s ten-year bond, the BTP, and its German counterpart went over the 200 basis points mark in early July 2011 and this was taken as a clear sign of distress and contagion. It kept rising from that level, however, and went over the 500 mark in November 2011. It hovers around 330 in early March 2012 for both Italy and Spain. Greece, Ireland and Portugal requested aid when their yield gaps went over 400.

[2] See Art.3 of the “Treaty on the functioning of the European Union” (Lisbon Treaty).

[3] Eurostat 2011 forecast for EU 27 GDP is € 12.650 trillion, for the euro area is € 9.433 trillion. Thus, 1 % corresponds respectively to € 126 and 94 billion, 5% to € 630 and 470 billion.