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Discussions about a euro-area budget are gaining momentum, not least because of the threat to veto any EU budget increase by David Cameron. The President of the European Commission has been calling for a democratic federation of nation states while the President of the European Central Bank believes that full federation may be too high a bar to be passed. Federations typically have sizeable federal budgets. In the US, federal spending accounts for 68% of total government spending, in Switzerland it is 32% and banking policy is almost completely federal. There is thus a fundamental question about whether the euro area needs a budget and what it should look like. Here are some key considerations.

Euro-area countries such as Spain and Ireland that strictly followed the fiscal rules in the run up to the crisis, responded to the downturn and the huge private sector deleveraging with a fiscal expansion. The rules of the Stability and Growth Pact foresaw that in such a situation the national automatic stabilisers would take care of the downturn. But the recession was so deep and the associated banking sector problems so large that debt-to-GDP ratios increased very rapidly. The mechanics of monetary union imply that markets are less and less willing to finance fiscal deficits. Country borrowing essentially leads to balance-of-payment crises with private sector financing drying up and bond yields rising for the government and the private sector. This further deepens the recession. The basic idea of Maastricht – that national stabilization policy would suffice – has proved wrong.

Fiscal federations therefore typically assign stabilisation functions to the federal level. The federal stabilisation policy fulfils two basic functions. First, it is aimed at stabilising large regional shocks. Second, it aims to provide a response to a recession in the federation as a whole. National stabilisation policy alone will not provide an adequate aggregate fiscal response due to free riding behaviour. In the euro area, no clear fiscal response to the drop in GDP of -0.5% next year has been formulated and the space for monetary policy to address this decline in GDP is limited. There is thus a strong case for a federal budget to be used for stabilisation policy but it would have to be well defined.

Federations also provide public goods such as defense and price and financial stability. While for the euro area, views on defense policy are certainly too different to provide this public good in the federation, the euro area is committed to price stability. As regards financial stability, steps towards a banking union have been agreed, but central parts of the banking union are still missing. One option would thus be to use a federal budget as a backstop to the banking union thereby breaking the vicious circle between banks and sovereigns that currently undermines financial stability. The fiscal backstop to the common resolution will mean that financial conditions stabilise across the euro area.

A well-defined banking union with a common fiscal backstop would be an important stabilisation tool as it would absorb the impact on the financial system of regional shocks. But federations typically use additional stabilisation tools, such as unemployment insurance, to mitigate regional shocks. Should the euro area contemplate such measures? In the short run, this appears to be difficult. Introducing common unemployment insurance while keeping labour market laws national could create significant incentives to free-ride on the common insurance provision. Yet in the long-run, more labour market harmonisation may be desirable. A more feasible approach now would consist of increasing and re-designing structural and cohesion funds in the euro area to target growth in the most affected countries. Additional euro-area funds could also be deployed for euro-area infrastructure projects.

How should the euro-area budget be financed? Ideally, the revenue source should be stable and have minimal distorting effects. Using taxes that have an already fairly harmonized base at the EU level, such as VAT or corporate taxes or the financial transaction tax, may be one option, but agreed contributions from national budgets would also be possible. The EU budget, however, may not be the best instrument because many of the functions outlined above would be exercised only at euro-area level. A separate budget from the EU budget, or a supplement to the current EU budget for the euro area, appears necessary. Clearly, separate euro-area resources to support the emerging banking union and growth in the most affected countries would be a key ingredient in making the euro area a more stable and monetary union more effective. The European Stability Mechanism, as a euro-area institution, is a step in this direction. Nevertheless, more tax-raising autonomy underpinned by greater democratic legitimacy may ultimately be needed.