The Euro Zone Steps Toward Fiscal Union

Moody's

  • The European Commission has begun reviewing the 2014 budgets of each euro zone member state, hoping to avoid repeating past excesses.
  • Deficits are expected to decline next year, but debt will remain a substantial burden across the region.
  • Supranational control of fiscal policy is still some way off, but will be essential for the single-currency area to function efficiently.

Taking a first step toward fiscal union, euro zone member states this week were required to submit their 2014 national budget proposals to the European Commission for review.

The commission, the European Union's governing body, took the step in an effort to avoid a return to the problems that set off the euro zone sovereign debt crisis. With that crisis still not fully resolved, authorities are stepping up their economic and budgetary supervision of member states, particularly those in the single-currency area.

The 2012 fiscal compact

The latest move stems from the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, commonly known as the fiscal compact, which was signed in February 2012. The treaty aims to permanently enshrine balanced-budget rules into EU and national law, ruling out questionable future fiscal policies that could add to regional instability.

The fiscal compact specifically calls for national governments to maintain structurally balanced budgets, with deficits equal to no more than 0.5% of GDP over the medium term. The treaty also calls on nations with levels of national debt that exceed 60% of GDP to reduce that by an average of one-twentieth per year.

In May, the European Commission introduced a pair of regulations, dubbed the “two pack,” aimed at improving euro zone economic governance and coordination among member countries. The commission will weigh in on budget plans, highlighting and requiring revision of any policies it judges as risky.

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The commission will also consider the macroeconomic forecasts on which national governments base their budgets. Not all national budgets for the coming year have been released, but those that are show governments’ GDP forecasts for 2014 are generally in line with our expectations as well as those of the European Commission and the International Monetary Fund. Spain, Greece and Portugal are notable exceptions, reflecting the difficulty of forecasting in economies where banking problems and other uncertainties cloud the outlook.

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Most euro zone governments are working to shrink deficits and lower debt. Although demands for sharp fiscal consolidation are being tempered by the belief that austerity is hindering the return to economic growth, public finances still require improvement. Most euro zone members are a long way from achieving the balanced budgets required under the fiscal compact rules. Only Germany is anticipating such a situation next year. Spain is expected to report the highest deficit-to-GDP ratio in the euro zone in 2014, at 5.8%. No new tax increases have been announced in Spain, but public spending will continue to fall, with infrastructure investment set to decline almost 9%.

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Ireland looks set to reduce its deficit more than any other euro zone member next year, thanks to €2.5 billion in fiscal tightening measures, including a cut in unemployment benefits for young people and cost-saving measures in healthcare. Ireland plans to exit its bailout programme by the end of this year. Meanwhile, Portugal has outlined €3.2 billion in spending cuts for 2014, including public sector wage cuts of 2.5% to 12%. The Portuguese government is hoping to retire its bailout loans in June.

Meanwhile, Greece expects to keep its 2014 budget deficit at 2.4% of GDP. However, the country will still have Europe's highest debt-to-GDP ratio, nearly triple the fiscal compact maximum. With such a heavy debt burden, another write-down of Greek debt has not been ruled out and the need for another bailout is possible. Italy, Spain and France all project their public debt ratios to rise next year. Even Germany is expected to report a debt level that is well above that allowed under fiscal compact rules.

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The risks that GDP will grow more slowly than forecast and that deficit and debt targets will not be met are considerable. The euro zone economy will grow below potential in 2014 and there is a chance output may fall below expectations. Weaker growth in the U.S. and in major emerging markets would weigh on the euro zone via reduced trade and increased financial market uncertainty. Around 12% of the euro zone's goods and 15% of its services are destined for the U.S. Meanwhile, Germany, the region’s powerhouse, is exposed to a slowdown in emerging markets. Almost 6% of German exports are destined for China, and about a quarter of German exports go to emerging and developing countries.

Rising debt costs

Renewed financial market jitters would add to government finance burdens. Should investors move out of riskier assets such as the government bonds of the most troubled European countries repayment costs would rise. The Spanish government estimates it spends 3.5% of GDP on interest payments. The European Commission will also be looking carefully at the national budgets' financial market forecasts. Ireland’s budget projects long-term interest rates will average 4.1% in 2014, down from 4.3% in 2013. Moody's Analytics expect rates to average 4.6%.

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The European Commission has a difficult but important task ahead. Reviewing national budgets is just the first step in a shift of fiscal control from euro zone member states to a supranational body. The full shift is still some way off, and the commission is likely to face criticism and resistance in coming years. Nevertheless, preventing the implementation of harmful fiscal policies is essential for the efficient functioning of the currency union, and, ultimately, the continuation of the euro zone.


Melanie Bowler is a Economist at Moody's Analytics.


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