In early 2019, Mario Draghi, president of the European Central Bank, addressed a plenary of the European Parliament on the 20th anniversary of the euro. Parliamentarians had much to celebrate, Draghi opined, including the maintenance of price stability and the resumption of economic growth. But the ECB president also issued a warning: Europe’s economic and monetary union was dangerously incomplete.

What Draghi meant was no mystery. In contrast to other long-standing economic and monetary unions (such as the United States), the EU had no official treasury to stand alongside the European Central Bank. In 1999 the European Union had created a supranational central bank to implement a single monetary policy. But it stopped short of closing the circle: the EU, as distinct from its individual member states, possessed no “fiscal capacity” – that is, no ability to tax or borrow on its own. Instead, it relied entirely on contributions from its member states. And they were predictably reluctant to share.

Free Riders on Board

Because the plenary of the European Parliament was an occasion for celebration, Draghi didn’t belabor the details. But the contents of his warning were well known. Most obviously, the absence of an EU fiscal capacity resulted in an undersupply of stabilizing – that is, countercyclical – macroeconomic policy initiatives. When the European economy slowed or fell into recession, the ECB could be expected to cut interest rates, which, no question, was helpful. But there were circumstances in which monetary policy was not enough to counter a downturn.

Interest rates can’t be cut below zero, and they were at or near zero for seven years prior to the outbreak of the Russia-Ukraine War in 2022. To be sure, central banks could still resort to unconventional monetary policies such as quantitative easing in an effort to mimic the effects of negative interest rates. However, the effectiveness of such unconventional policies is disputed, including by not a few central bankers themselves.

It follows that in a serious downturn there is the need for fiscal stimulus to supplement monetary easing. But when fiscal policy is decentralized – when, as in Europe, its stance is decided by the individual member states rather than at the level of the economic union – this stabilizing function is bound to be undersupplied.

The reason is straightforward. To finance its own deficit spending, each European government has to issue additional debt. That debt will be serviced and eventually repaid by levying additional taxes on residents. But the benefits of the policy, unlike the costs, accrue to foreigners as well as nationals. Some of the additional spending will be on imports – and disproportionately, in the case of the economically integrated European Union, imports from other European countries. Some of the positive effects of fiscal stimulus will there- fore spill across national borders to benefit Europe as a whole.

Economists will recognize here a classic “free rider” problem. Each European country, bearing all of the costs but enjoying only some of the benefits of fiscal stimulus, will prefer that other countries do the deficit spending and incur the associated debt. Countercyclical fiscal support will thus be undersupplied.

Nor is this the only context in which this kind of free-rider problem arises. Public opinion polls suggest that Europeans feel more strongly than Americans about the urgency of the green transition. But left to their own devices, European national governments will underinvest in climate change abatement since greenhouse gas emissions travel across borders. Consequently, the residents of each country incur all the costs of those green investments but reap only some of the benefits.

The European Commission, the EU’s proto-executive branch, could encourage those national governments to coordinate their investments. The fact of the matter, however, is that EU governments are burdened by different levels of debt and therefore have different capacities to invest. Heavily indebted countries such as Greece and Italy are constrained, leaving more lightly indebted countries (notably Germany) to undertake a disproportionate share of the relevant investments while continuing to import CO2 from their neighbors. The result: not enough investment in the places with the highest payoff – not to mention political division.

Yet another example of this fiscal free-rider problem is Europe’s Common Foreign and Security Policy. Russia’s attack on Ukraine is a reminder of the need for the EU to invest in the capacity to defend its common external borders and enhance its security more generally. But European governments are notorious for underinvesting in defense. This is partly because they are accustomed to free riding on the United States, the largest NATO member, but it is also because spending on defense is decided at the national level, creating a temptation to hope that the burden will be taken up by other EU countries. Consequently, European countries as a group end up spending too little.

Been There, Done That

The historical development of a federal fiscal capacity in the United States illustrates how another collection of states responded to these same imperatives. It also shows, though, that the political economy of fiscal federalism is more complicated than suggested by this simple story of spillovers and free riding.

The founding fathers of the U.S. did not contemplate the rise of a powerful central government with extensive fiscal resources. To the contrary: they believed in what is known in today’s EU as “the principle of subsidiary.” They insisted that, aside from a handful of essential functions and instruments expressly assigned to the union, policy responsibility should devolve to the states.

To be sure, within three years of ratification of the Constitution, Congress had accepted Alexander Hamilton’s proposal for a Treasury Department to assume and manage debt incurred by the individual states during their war of independence, and to charter a central bank, the Bank of the United States, to issue banknotes and promote the development of financial markets. To overcome the opposition of states’ rights advocates such as Thomas Jefferson, Hamilton argued that only by creating these institutions to manage the debt inherited from the states could the new nation regain access to international financial markets, as was critical for its national defense and hence its survival.

The irony, from the perspective of 21st-century Europe, is that American opponents of expansive federal powers, such as President Andrew Jackson, saw the bank and not the Treasury as the bugbear. Jackson vetoed renewal of its charter in 1832. Thus, the U.S. was left with a federal treasury but no central bank – the opposite of the situation in Europe today. Jackson and his fellow critics assumed that because the dollar was anchored to gold, the financial system could function perfectly well without a central bank.

Time was not kind to their argument. The incomplete union experienced recurrent financial crises, which continued to plague the country until a new central bank, the Federal Reserve, was established eight decades later. U.S. history is consistent, in other words, with Mario Draghi’s argument that an economic union needs both a monetary and a fiscal capacity. But it also shows that it may take time – very considerable time – for the political system to deliver.

The United States Treasury was never the target of equally intense populist ire because the founders were careful to constrain its resources and operation. The Constitution limited the federal government’s revenues to customs duties and land sales, while creating high hurdles to establishment of a federal income tax. This limited ability to raise revenue and hence to issue debt explains why the federal government had to rely on the states for resources to wage the War of 1812. It is part of the story of why the U.S. military could not prevent the British from torching the Capitol in 1814.

For the remainder of the 19th century, fed- eral spending averaged less than 3 percent of GDP, with the sole exception of the Civil War when it shot up to as much as 15 percent of national income. Having learned the lessons of the War of 1812, Treasury Secretary Salmon P. Chase imposed new taxes on everything from gold watches to pool tables. And in 1862, Washington added a graduated income tax on high incomes (then, more than $1,000). The additional revenues facilitated additional borrowing, which helped the Union win the war.

This episode thus illustrates how an existential crisis can lead to an expansion of federal fiscal powers. But it also shows that expansion may prove temporary: the federal income tax was declared unconstitutional in 1872 once exceptional wartime circumstances had passed, after which federal spending ratcheted back to 3 percent of GDP. As we will see below, the onset of Covid-19 prompted EU member states to give their union additional fiscal powers. U.S. history is a reminder that we should not take for granted that such additional powers will be permanent.

Federal spending shot up again during World War I, financed in part by an income tax made possible by the 16th Amendment to the Constitution, but fell back once more following the war’s conclusion. The true breakpoint was the Great Depression of the 1930s.

The Depression was an economic crisis of the first order, whose consequences could not be adequately addressed by state and local governments alone. States were constrained by constitutional and legislative balanced-budget rules, while local governments numbering in the thousands had engaged in reckless public works spending in the 1920s and now defaulted on their debts. This left only the federal government, which stepped in with household income relief, income-generating public works projects and modest macroeconomic support. (Modest because President Roosevelt, not having been converted to nascent Keynesian doctrine, eschewed the idea of running large deficits.)

This transfer of fiscal powers to the federal government then persisted through the successive shocks of World War II and the Cold War with the Soviets. Individual and corporate income tax bases were broadened, and rates were raised. But since both businesses and households were mobile, those high rates were feasible only if taxes were levied at the national level.

Increasingly, Washington raised revenues and transferred a portion to the states for purposes earmarked by the federal authorities. Through the 1950s, earmarked purposes mainly meant infrastructure such as interstate highways. But over the next half century, social programs increasingly dominated. An example is Medicaid, publicly funded health insurance for those with limited incomes, which became law in 1965. Medicaid is administered by the states but mostly funded by Uncle Sam. Enrollment has more than quadrupled from some 20 million Americans in the 1970s to more than 90 million today.

How should we understand this increase in federal fiscal powers? Why, in other words, was the increase in federal taxes and transfers not rolled back after World War II, as it was after the Civil War and World War I?

One answer is that spillovers and free-rider problems had become increasingly visible as the economy integrated and developed. The interstate highway system illustrates the point; when deciding where to build roads and what sort to build, a state legislature was unlikely to take into account the implications for the efficiency of the national transportation grid. By the same token, the Cold War meant that spending on collective defense, which had to be a collective responsibility, remained elevated.

The logic of top-down spending continued to morph. In a technologically advanced economy, education and R&D were increasingly important for productivity growth – hence the need for federal grants to subsidize research at state universities, and the economic rationale for the post-World War II GI Bill. Similarly on the social-spending front, only Washington was in a position to provide health care coverage for old or low-income residents since asking individual states to do so would have turned the generous ones into magnets for the indigent of other jurisdictions.

But there was more to the expansion of federal spending than the need to prevent free riding. In fact, free riding was its root cause: state and local governments grew increasingly successful at exploiting the national Treasury. Paying only a fraction of the cost but enjoying all of the benefits, locally elected representatives lobby for the increased provision of federally financed local public goods. If Congress then becomes more polarized and fractionalized, it may be unable to form the united front needed to resist these local demands.

Institutional changes decentralizing congressional decision-making, as occurred in the U.S. in the 1970s along with the weakening of party discipline more recently, may further complicate efforts to build a united front. In this view, the level and composition of payments from federal to state and local governments are shaped by coalitions of self-interested local authorities and their congressional allies, not by an optimizing federal government seeking to solve free-rider problems.

This has not been lost on European policymakers. Indeed, some European politicians rightly worry that if the EU acquires expanded fiscal powers, impecunious member states and interest groups will follow the American example in exploiting access to the fisc for their own advantage.

Work in Progress

The architects of the euro were aware of arguments that monetary union should be accompanied by fiscal union. The theory of optimal currency areas, developed in the 1960s to identify when national economies might on balance benefit from a shared currency, focused initially on two conditions:

• Whether the economies in question experienced synchronized business cycles, rendering the same level of interest rates congenial.
• Whether labor was mobile among them, enabling workers to move from depressed to booming parts of the monetary union.

Peter Kenen of Princeton University then added a third criterion:

• Whether there existed a federal fiscal system capable of transferring budgetary resources from booming to depressed regions.

Over the next 30 years, a series of official reports – most famously one created by an EU committee chaired by Donald MacDougall, a British civil servant, and published in 1977 – reemphasized the need to flank a prospective monetary union with a federal fiscal system. But when the Maastricht Treaty creating the blueprint for the euro was finalized in 1992, no such flanking institution was included.

Going ahead with monetary union was seen as urgent. European officials had just been reminded by the European currency crisis of that year that exchange rates can be dangerously volatile – especially when politicians interfere with their management. This volatility threatened to incite a political backlash against the single, barrier-free market, the EU’s signal achievement. Better to make it a priority to delegate monetary policy to independent technocrats, officials concluded. Hence the case for a single currency managed by an independent EU central bank.

But transferring as much as a quarter of the tax revenues of member states to the European Union in order to fund the operation of a federal fiscal system, as recommended by the MacDougall Report, proved a bridge too far. Deciding on what and on whom to spend a country’s precious tax revenues was a political prerogative over which foreigners could not be trusted. The distributional consequences of national fiscal policies were simply too prominent and politically delicate for budgetary authority to be delegated to the European Commission, the majority of whose members were necessarily appointees from other countries.

Then there was the fact that proposals for fiscal integration were not negotiated in the absence of knowledge about who would gain and who would lose. Some member states were in stronger fiscal positions than others. The implication was that these stronger states would contribute disproportionately to the common EU budget, while the weaker ones would mainly draw on those pooled resources. In Germany, a country renowned (or perhaps notorious) for its fiscal discipline, critical commentators dismissed fiscal union as “transfer union.”

The most member states could agree on was that national fiscal policies were a matter of “common concern” because their effects spilled across borders and because excessive deficits might pressure the ECB to bail out profligate governments by running unacceptably high rates of inflation. This worry led to negotiation of the Stability and Growth Pact, in which countries could not run budget deficits in excess of 3 percent of GDP and could not accumulate debts in excess of 60 percent of GDP. Surveillance and oversight would be the job of the European Commission.

But enforcement proved easier said than done. Over the first decade of the euro, when the European economy had a relatively easy ride, member states went their own fiscal ways. The Stability and Growth Pact was honored in the breach. But the easy ride ended abruptly with the global financial crisis in 2008, the Greek debt crisis in 2010 and, subsequently, the crisis of confidence in the euro itself.

Policymakers feared a “diabolic loop” connecting banking and sovereign debt problems. In countries like Ireland experiencing banking crises, the costs of repairing the banking system threatened to bankrupt the government. In others such as Greece, sovereign debt default threatened to bankrupt banks holding government bonds. It appeared that the ECB would be forced to ride to the rescue, and that its actions would foment the high inflation that members of the public – especially the German public – held in such fear.

As similarly happened more than once in U.S. history, the European crisis bred a response in the form of fiscal integration. But the increase in fiscal powers was modest by U.S. standards, reflecting political sensitivities.

The members agreed to create a temporary European Financial Stability Facility, followed by a permanent European Stability Mechanism, to lend to troubled governments. In its first eight years (2010-18), however, the EFSF/ ESM disbursed an annual average of €37 billion, equivalent to just 0.25 percent of 2018 eurozone GDP.

It was further agreed to establish a Single Resolution Fund to help restructure troubled banks. The SRF was funded not by a transfer of tax revenues from governments, however, but by levies on credit institutions similar to how the Federal Deposit Insurance Corporation is funded in the United States. Still, by mid-2023, capitalization of the SRF had reached only €77 billion, or about 0.5 percent of eurozone GDP.

EU leaders saw the need to do more. Already in December 2012, European Council President Herman Van Rompuy had recommended adding a “fiscal capacity” (his words) to the eurozone. In June 2015 the presidents of five European institutions (commission president, council president, ECB president and two others) proposed commencing work on a proper “fiscal union” (their words) to flank the monetary union. “All mature monetary unions,” the five presidents observed, “have put in place a common macroeconomic stabilization function to better deal with shocks that cannot be managed at the national level alone.”

No sooner did the five presidents make their report, however, than the turbulence within the eurozone receded. And with it receded enthusiasm, such as it was, for fiscal union.

Europe’s Hamiltonian Moment?

Predictably, another crisis was needed to restore the momentum. But Covid-19 was no ordinary crisis. For the first time ever, the European Commission invoked the escape clause provision of the Stability and Growth Pact, suspending the operation of the EU’s fiscal rules. These would remain in abeyance through the end of 2023, reflecting not just the exceptional circumstances created by Covid but also economic fallout from Russia’s attack on Ukraine – specifically the sharp increase in European energy prices.

In March 2020, the commission proposed the creation of an EU facility to make loans to the governments of member states experiencing pandemic-related increases in unemployment insurance outlays. This facility, known as “Support to mitigate Unemployment Risks in an Emergency,” or SURE, was to be funded by allowing the commission to borrow €100 billion on financial markets and lend the proceeds to needy governments. As proposed, SURE would have been a small but significant step in the direction of fiscal federalism: small because €100 billion was less than 1 percent of the EU’s GDP, but significant because this was the first time the EU, as distinct from individual member states, would be permitted to tap financial markets.

However, reception of the proposal was mixed, revealing the EU’s longstanding fault lines. Nine member states, including Greece and Italy, endorsed the plan. But Germany and the Netherlands, seeing SURE as a first step down the slippery slope toward transfer union, opposed it. The eventual compromise authorized the facility to operate for less than a year.

By mid-May, the gravity of the pandemic crisis led to a softening of German opposition. Germany and France jointly advanced a proposal for a larger (now €500 billion) facility – once again to be financed by EU borrowing, but this time to fund grants rather than loans to member states worst affected by the crisis. This last provision resembled the kind of matching grants provided by the U.S. federal government to the states.

The European Commission elaborated on the Franco-German proposal, which it named NextGeneration EU (NGEU), upping its size to €750 billion while addressing concerns about the additional cost by recommending that a third of the funding should take the form of loans. Repayment would go toward eventually retiring the EU’s newly incurred debt.

The commission envisaged a multi-year program. Disbursements would extend through 2026, and the commission’s borrowing to fund grants would be repaid only starting in 2028 – presumably through the introduction of new EU taxes. Operating this program of fiscal transfers not for a few months but now for a period of years looked like a more significant step in the direction of fiscal federalism.

In addition, while three-quarters of funds disbursed would finance expenses incurred by governments in conjunction with Covid-19, the other quarter could go toward funding distressed businesses, underwriting research and financing other strategic investments including those associated with the green transition. This resembled the way that Washington earmarked grants to the states for specific purposes. In effect, this was another step in the direction of fiscal federalism.

Once more, however, this move toward fiscal federalism exposed political fault lines. German opposition to an expanded program may have softened, but not so that of other northern European countries including Austria, Denmark, the Netherlands and Sweden, which worried that they would give more than they got. To assuage their concerns, the commission proposed attaching rigorous conditions to the disbursement of funds.

Governments receiving grants would have to detail how they planned to spend them, while those receiving loans would have to provide a credible schedule for repayment. These measures antagonized several of the EU’s lower-income countries – Czechia, Hungary, Poland and Slovakia – which anticipated being on the receiving end of funds but did not see why they should have to explain themselves to richer member states.

The commission also included the political precondition that only countries abiding by EU standards for rule of law would be eligible. This was a shot at Hungary and Poland, which had taken steps to limit press freedom, judicial independence and human rights, in violation of European norms. Their representatives were understandably displeased.

Given their opposition, the EU’s unanimity rule prevented immediate implementation of the plan. Two months of deadlock followed, during which the Covid crisis deepened. The deadlock was finally broken, as EU deadlocks typically are, in four days of meetings extending well into the night that culminated in agreement to fudge the details

Northern European countries were bought off with a commitment to cap the size of the regular EU budget. More NGEU spending would thus be offset, at least in part, by less EU spending in the future. Central and Eastern European states were promised a bit of additional financial support, and the condition regarding rule of law was watered down.

The final provision read “the mere finding that a breach of the rule of law has taken place does not suffice to trigger the mechanism,” meaning that it does not prohibit the country at fault from receiving grants and loans. If you find this language confusing, you’re not alone. There followed an extended battle between the EU and the government of Hungary, resulting in high uncertainty about whether the latter’s limited reforms would unlock NGEU funding.

Critically, the commission was authorized to take on the function of an EU treasury by borrowing €750 billion, and the member states agreed on what was euphemistically called a “roadmap” for repayment, to be financed by dedicated EU taxes as opposed to the customary contributions to the EU budget from member states. To this end, the commission suggested a new tax on plastic products, a carbon adjustment tax, a tax on digital transactions and possibly a financial turnover tax.

It then took the better part of a year for national parliaments to ratify the agreement. At this point, the commission began issuing bonds on financial markets, national governments presented their proposals for spending and repayment (so-called National Recovery and Resilience Plans), and the EU began disbursing funds.

The contrast with the U.S. is revealing: large transfers to U.S. states were made already in late March 2020, and again in the late days of the Trump administration and the early days of the Biden administration. Evidently, when seeking to organize transfers of fiscal resources among its members, a full-fledged political federation like the U.S. can move faster, since only one legislature must agree. So while agreement on the new EU facility required unanimous agreement by the member states (as do most agreements in the European Union), passage of a supplementary budget bill in the U.S. requires only a congressional supermajority.

This is a reminder that a degree of political solidarity – including acceptance by a minority that its wishes can be overridden by a large majority at least on occasion – is a prerequisite for an extensive system of fiscal federalism. Political union is precondition for fiscal union, as the point is sometimes put.

One Off

This last point is telling, because NGEU increasingly looks like it can’t be repeated. Covid-19 was an exceptional crisis that set in motion an exceptional response. The pandemic put millions of lives at risk. A new fiscal transfer mechanism was justified on not just economic but also moral and humanitarian grounds. Moreover, unlike conventional interstate fiscal transfers that might encourage profligacy on the part of the recipients, no one believed that Covid-related transfers would encourage taking more Covid-related risks. In other words, what economists call moral hazard was not an issue.

Contrast the response to Russia’s invasion of Ukraine two years later. This required all EU member states to ramp up defense spending, despite possessing different amounts of fiscal space. And contrast the response to the dramatic increase in energy prices that followed, which imposed different costs on EU member states depending on their dependence on imported fuel and the energy intensity of their industry.

One might think that these crises would have prompted more EU borrowing to finance transfers to needy member states and the adoption of new EU taxes. In May 2022 Mario Draghi, having ascended to the office of Italian prime minister, made just that point. “With regard to long-term investments in areas such as defense, energy and food and industrial security, the [NGEU] program is the model to be used.”

But there was no new EU fiscal facility, no new authorization for the commission to issue bonds. Instead the member states agreed only to refrain from competing with one another for limited supplies of oil and gas, and thus to avoid unnecessarily driving up prices. The European Commission was not permitted to purchase energy on the members’ behalf.

On the defense front, member states agreed only to pool a fraction of their resources to finance the costs of joint military operations and provide weapons to the Ukrainian army. Even here, members were not obliged to finance operations to which they objected. Action at the level of the European Union would have required unanimity, and Hungary’s Viktor Orbán, friendly to Vladimir Putin, was prepared to exercise his veto.

Revealingly, the Treaty on European Union, the EU’s quasi constitution that dated from 1992, specified that expenditures arising in conjunction with military and defense operations could not be financed by the EU itself. The funds must come from national contributions. Evidently, the founders recognized that responsibility for defense was too sensitive a matter to be transferred from national governments to the EU. Hence joint action was financed from national budgets, from which dissenting member states could opt out.

The implication is that a fully elaborated system of fiscal federalism, what is commonly referred to as fiscal union, presupposes a prior move to political union. The United States, as a national federation with an elected president and congress, is just such a political union. But it took the better part of 150 years, punctuated by a devastating civil war, the Great Depression and World War II, for America to complete its fiscal and political union. Europe may be moving down the same path but, by any honest evaluation, remains far from the destination.