A Model for a Fiscal Union? What Europe Can Learn from the German Experience

The euro has strengthened the economic differences between a more affluent north and a struggling south, which is the core problem of the current crisis in the euro zone. A potential solution to this problem could be to transform the monetary union into a fiscal union. This article sketches two different models for fiscal unions: a federal structure like that of Germany, where federal revenues and expenditures are controlled in significant part by federals laws, which has an extensive bailout system built in; and a confederal system like that of Switzerland, where Cantons are autonomous in their fiscal policies but clear bankruptcy rules are implemented. The article describes the reasons for which the German arrangement, one that strongly relies on income equalisation, have not proven successful in harmonising the financial position of the Lander and municipalities and why bailouts have become rather the rule than the exception. In consequence Germany has introduced a debt brake that does not allow expenditures to be structurally higher than revenues. Although it is too early to evaluate the sustainability of such a mechanism yet, the debt brake seems to be a promising means for preventing an unsustainable built-up of debt under normal economic conditions. This article concludes that as long as debt brakes are not fully implemented and further fiscal harmonisation cannot be expected, the European Union will still have to rely on market-based regulatory instruments and the disciplinary function of interest rates, possibly culminating in a bankruptcy procedure.

The German experience with the financial arrangement between the Federation, the Lander, and the Municipality suggests that frameworks that rely on income harmonization and the threat of intervention in case of severe budgetary imbalances easily fail in achieving a sustainable budgetary policy in each territorial authority.
A debt break that includes a strict expenditure rule is a promising approach to avoid the built-up of such imbalances in the first place.
Whether such a debt break can be lastingly enforced in Germany and in the countries that signed the Fiscal Compact remains yet to be seen - particularly in times when shocks outside the government sector (like banking crises) put pressure on government income and expenditures. Until the enforceability is proved, market-based instruments that rely on the disciplinary function of interest rates are still needed.