Help for Poorer Neighbors Designing a Transfer Union to Save the Euro

Many economists argue that the euro zone needs to become a transfer union, where payments flow from richer to poorer states, if the single currency is going to survive. But a look at existing systems in different countries shows that the design of such a union is crucial -- otherwise some countries will become permanently dependent on handouts.
The Portuguese Finance Ministry in Lisbon. Experts say that the euro zone will have to become a transfer union if it is to survive.

The Portuguese Finance Ministry in Lisbon. Experts say that the euro zone will have to become a transfer union if it is to survive.


In the summer of 1990, the deutsche mark was declared the official currency of the German Democratic Republic, as communist East Germany was known. Three months later, the five East German states joined the Federal Republic of Germany.

All at once, the newly enlarged "deutsche mark zone" had what economists and politicians want for the euro zone today: a common economic and financial policy, largely uniform fiscal and social systems and an extensive redistribution of income among the regions. The agreements were an "expression of solidarity among the Germans," then-Chancellor Helmut Kohl said approvingly. He famously promised that there would soon be "blossoming landscapes" in the east.

His promise proved to be wishful thinking. Since then, more than €1.4 trillion ($1.98 trillion) in financial assistance and transfers have flowed from the former states of West Germany to the former East Germany. But Kohl's blossoming landscapes have yet to materialize.

To this day, incomes, exports and productivity rates in the eastern German states are only a fraction of what they are in the west. The eastern states have the highest rates of unemployment and the fastest-growing public debt. Statisticians characterize the situation as a "stagnating catch-up process."

Arguing for Central Control

The experiences in the former East Germany provide a counterpoint to the ongoing debate about the future of the euro zone. To lead the common currency out of the crisis, both politicians and economists want to finally create the political underpinnings the euro has lacked until now. European Central Bank (ECB) President Jean-Claude Trichet advocates creating the position of a European finance minister, Euro Group Chairman Jean-Claude Juncker wants to collectivize credit policy through European bonds, and German Chancellor Angela Merkel and French President Nicolas Sarkozy have announced their support for a European economic government.

The common message of all of these initiatives is that financial policy should no longer be left in national hands. The euro, they argue, needs central standards for taxes and government budgets, liability for national debts and a redistribution of income that offsets the differences between rich and poor regions. "A common currency without a common fiscal policy is not viable," says Thomas Straubhaar, director of the Hamburg Institute of International Economics.

The example of the states of the former East Germany, however, shows that a political union can sometimes even amplify existing economic imbalances. Instead of seeking a way out of their economic crisis, some poverty-stricken regions might prefer to become permanent subsidy recipients.

If we take a close look at the financial systems of industrialized nations, the conclusion is simple: The question of whether to have a transfer union  or not is less important than the question of how it is constructed. How large do regional transfers have to be? Must the central government be given control over national fiscal policy? And, most of all, does it make sense for the community to guarantee national debts in the future?

Sacrifices Required

At issue are the handling of economic imbalances, the difficult balance between fairness and efficiency, and the economic mechanics of a monetary union. If each country has its own currency, it has a proven instrument for shrinking balance-of-trade deficits or surpluses. Rising or falling exchange rates ensure that the flow of goods among nations is readjusted appropriately.

In contrast, if countries are members of a monetary union, the adjustment process must be achieved in other ways. Either substantial financial assistance flows from rich to poor, or the deficit country makes economic sacrifices -- in that its workers emigrate to countries with surpluses, or they remain at home and accept drastic pay cuts -- so that their country's own products can become competitive again.

Both approaches are usually found in functioning currency zones. If a region within one of these currency zones runs into trouble, the richer partners provide it with assistance. At the same time, the local population is willing to make sacrifices and accept losses. The problem is finding the right balance, because financial assistance is often easier to implement politically than austerity measures.

This has led to the development of many transfer systems in Europe that do not reduce economic imbalances but entrench them instead. Although plenty of money is being spent, the gap between rich and poor is not shrinking.

Frittered Away

In Italy, for example, the wealthy north has been sending financial assistance to the poor south since the end of World War II, most recently in the form of annual payments of €50 billion. The money is used to build roads, construct steel mills and promote small businesses. But this hasn't narrowed the economic divide. Instead, the money has trickled away into pointless large-scale projects. A not insignificant part of it has ended up in the pockets of the mafia. The assistance has not led to the economic upswing it was intended to produce. Today, the per-capita income in the southern region of Calabria is less than half as high as in the northern region of Lombardy.

In Belgium, annual payments of more than €10 billion flow from the affluent northern half of the country, Flanders, to the former coal and steel regions of the south, and yet the economic divide between the two regions remains unchanged. In Wallonia, the French-speaking south of the bilingual nation, unemployment is almost twice as high as in the north. In Charleroi, a run-down city in Wallonia, agencies now offer tours of "the ugliest city in the world."

Italy and Belgium were already divided economies when they had their own currencies. But the tensions have only increased since the euro was introduced. In Belgium, the struggle over the capital Brussels is the only thing preventing the two mutually antagonistic parts of the country from splitting apart. And in Italy, where the right-wing Northern League defends northern Italian interests, a party representing the south has also now been formed. It sees its main objective in liberating the poorer parts of the country from "northern Italian oppression."

An extensive system of financial redistribution also exists in Germany, where the individual states have hardly any sources of tax revenue of their own. Instead, the federal and state governments derive most of their funding from joint taxes. In addition, poor states, like Saxony-Anhalt, Saarland and the city-state of Berlin, are entitled to subsidies from the wealthy states of southern Germany. In Germany, about €7 billion in funds are redistributed among the states each year to offset economic imbalances within the republic.

The American System of Individual Responsibility

In the alternative model to a German-style transfer union, ordinary people have to shoulder most of the adjustment burden. In the United States, for example, workers are much more willing to move to other states for better-paying jobs than in Europe, although this is also greatly facilitated by the fact that the whole country speaks the same language.

As a result, economic imbalances are reduced relatively quickly within the US, thus limiting the need for intervention by the federal government. There are, of course, federal taxes and targeted regional aid programs coming from Washington. The large-scale social welfare programs for retired people (Medicare) and the poor (Medicaid) also help to soften economic tensions. But there is no such thing as a redistribution of wealth based on the German model of financial transfers among states. Oxford-based economist Clemens Fuest explains the system by referring to what he calls the typically American "aversion to government."

The notion that individual states could attempt to pass on their unsustainable mountains of debt to the community, as is the case in Europe, is also unthinkable in the United States. In the last 170 years, federal and state governments have only assumed the debts of cities and other municipalities in exceptional cases, as a study by US economist Robert Inman concludes. In 1997, the US government rescued the over-indebted capital Washington from bankruptcy, and since 2002, the New Jersey state government has been helping out the cash-strapped port city of Camden.

Otherwise, a strict ban on government being held liable for others' debt applies in the United States, not unlike the corresponding clause in the EU's Maastricht Treaty. In the United States, state and local governments that cannot manage their money effectively cannot expect financial support from Washington or a state capital. When the cash-strapped state of Minnesota became insolvent a few weeks ago, no bailout fund was established to save it. Instead, the state government closed many government agencies, shut down many public works projects and sent two-thirds of government workers on unpaid vacations.

This is the way it usually works in the United States: If a state runs into difficulties, it has to reduce spending, raise taxes or negotiate with banks to restructure its debt.

Low Debt Levels

The effects of the principle are beneficial, with prudence instead of inefficiency prevailing among those involved. Lenders pay close attention to whether the states to which they lend are solvent. And the states only take on debt that they assume they will be able to repay.

As a result, debt levels are relatively low among US states, at least compared with Europe. From Alaska to Texas, and from New York to California, the average debt ratio of US states is 17 percent of GDP, which is several times lower than levels in Ireland, Italy and Greece. This reduces the risk of states falling victim to turbulence in the financial markets. Even if interest rates rise drastically, the consequences for state budgets remain manageable. Furthermore, there is virtually no risk of a heavily indebted state tearing apart the entire monetary union.

Switzerland uses very similar methods to secure the stability of its currency. "The people in Bern don't feel particularly connected to those in the canton of Ticino," says the Swiss-born economist Charles Blankart. "That's why Switzerland has established strict rules for its financial constitution." The cantons enjoy financial autonomy, federal taxes are low, and the central government is not liable for the debts of its administrative divisions. Even more importantly, the fiscal principles are not just stated in the national constitution -- they are also adhered to, even in a crisis.

In the 1990s, for example, several cantons were in financial trouble after their regional banks had speculated badly on real estate. But none of the provincial governments even considered requesting assistance from the central government. Instead, the cantons had to raise taxes and use the additional revenues to rescue their ailing banks.

A few years later, the Alpine town of Leukerbad fell upon hard times after having amassed enormous debts relating to a number of tourism projects. But when the town council announced that it would no longer service the loans, the creditors tried to compel the canton of Valais, where Leukerbad is located, to step in. But the Federal Supreme Court of Switzerland dismissed the case. The judges ruled that the banks should have made the necessary provisions for the event that one of their borrowers failed.

The Temptation to Print Money

In Germany, there's an old saying to the effect that those who guarantee the debts of others run the risk of being suffocated. It's a principle that doesn't only apply in our personal lives, but also to the financial relationships between countries, especially in a monetary union. If it is all too easy for members to pass on their debts to the community, the very existence of the monetary union can be put at risk, as many examples show.

In the mid-19th century, for example, France, Belgium, Italy, Greece and Switzerland established the Latin Monetary Union, a precursor of the European Monetary Union. The exchange rates among the members were set, and all members were required to accept the currencies of their partner countries. But Italy and Greece, in particular, took advantage of the rules of this union to take out high government loans, which they paid for in part by printing money. The other countries resisted the southern countries' inflationary policy, but then the monetary union fell apart in the mid-1920s.

Argentina's debt crisis was also largely attributable to the irresponsible fiscal policies of the country's administrative units. In the 1980s and 1990s, the Argentine provinces borrowed large amounts of money from their regional banks. When the provincial governments found that they were unable to repay the loans, the central government and the central bank had to step in.

When Argentina finally declared bankruptcy in 2001, the country received emergency loans from the International Monetary Fund (IMF). It was forced to implement a brutal austerity program and plunged into a deep recession.

German System Is 'Not a Model'

What Europe can learn from the experiences of other currency areas is obvious. A viable transfer union for the euro zone cannot be modeled after the systems of centralist countries like France or Sweden, warns Berlin-based economist Henrik Enderlein. The right model for the continent, says Enderlein, is a "competitive federalism" resembling the systems in Switzerland and the United States. The individual states are largely autonomous in making decisions on income and expenditures, while low federal taxes and a central unemployment insurance provide for a minimum of financial equalization.

Most of all, however, the individual states remain responsible for their debts. Those that mismanage their finances must face the consequences, including higher taxes and the possibility of bankruptcy, by themselves.

Help from the community can only be provided if it is tied to strict conditions and is monitored by a nongovernmental organization like the IMF. Countries that can no longer service their loans must turn over their national sovereignty to a European austerity commissioner -- or file for bankruptcy. The German system of redistribution of income among federal, state and local governments is "not a model for Europe," says economist Enderlein.

Most experts seem to agree that the transfer union is important. Even more important, however, are its limits.

Translated from the German by Christopher Sultan
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