Representation and Redistribution in Federations:

Lessons for the EMU

Jonathan RoddenStanford University

No monetary union without fiscal union?

This is often presented as an empirical claim.Many scholars move quickly to the notion that the Euro cannot survive without “fiscal union,” and reform efforts focus on bringing it about. My main goal: Bring relevant facts from existing fiscal unions, especially the United States, to the debate. How likely is fiscal union in the EMU, and how would it work? What are the key challenges?

OverviewPolitical constraints:

What type of reform is possible?Rules versus discretion?

Fiscal Unions:Risk-sharing/stabilization

Grants versus fiscal flowsRedistributionEndogenous fiscal unions

The reform agenda

First round of 2016 Austrian Presidential Election

Brexit referendum

Italian Constitutional Referendum 2016

Italian Constitutional Referendum 2016

Population density and Democratic vote share, U.S. Counties, 2016

A new political cleavagePerceived winners and losers from:

Skill-biased technological changeGlobalizationThe European Union

Cosmopolitan, knowledge-economy core versus periphery

Across countries and within countries

Why does this matter?Certain forms of centralization are off the table

Sapir and Wolf (2015), Tabellini (2016): “…the fiscal institute should have the authority to veto national budgets.”

If something like a “fiscal institute” was possible, how would it work under these constraints?

Rules versus discretion? Blackmail?

Why fiscal union?Risk-sharing and stabilization in the absence of monetary policyThe assumption is that member states experiencing high levels of volatility cannot self-insure via their own fiscal policy. A common argument: The center must have the fiscal capacity to smooth asymmetric shocks:

Key question: rules versus discretion?

Otherwise, shocks are too likely to turn into debt crises.

Lessons from fiscal unionsRisk-sharing and stabilization

Fiscal flowsGrantsA case study of the Great Recession

RedistributionIncomeRepresentationEconomic geography

Endogenous fiscal unions

Stabilization and fiscal flows

A large literature:Sali-i-Martin & Sachs (1992), Bayoumi & Masson (1995), Brunila et al (2003), Von Hagen (1992, 2007), Melitz & Zumer (1998), Obstfeld & Peri (1998), Sorensen & Yosha (1997), van Wincoop (1995), Feyrer & Sacerdote (2013), Malkin & Wilson (2013).In the United States, a $1 decrease in a state’s real per capita income is associated with a decrease in net fiscal contributions in the range of $0.25 - $0.40.

An important result that has not been emphasized in the literature on EMU:

This is driven completely by the tax side. There is no disproportionate increase in federal receipts in states experiencing downturns.Federal expenditures are uncorrelated with state income, but tax payments are highly correlated. Implications for EMU?

Grants versus fiscal flows

A highly progressive tax system and a system of inter-personal expenditures seems highly unlikely in the EMU given political constraints and lack of administrative capacity. Most “fiscal union” proposals involve lump-sum grants to member states.So let’s take a closer look at grants.

Are grants counter-cyclical?

Source: Rodden and Wibbels (2010)See also Blöchlinger and Egert (2016), Foremny & Solé-Ollé (2016)

What about the great recession?

Common perception is that federal automatic stabilizers kicked in and prevented Euro-style fiscal crises from emerging in troubled states.In fact, American Recovery and Reinvestment Act was highly discretionary and highly unusual.

How did the stimulus work?

Following the approach of Gros & Belke (2015), let’s focus on some of the states that were hardest hit by the Great Recession:

ArizonaFloridaNevada

What happened to their tax revenues?Federal grants? Federal direct expenditures?

Real per capita income in the states hardest hit by the Great Recession

Real state-local tax revenue in the states hardest hit by the Great Recession

Real federal grants per capita in the states hardest hit by the Great Recession

Real direct federal expenditures per capita in the states hardest hit by the Great Recession

What happened in the states that continued to grow during the Great

Recession?

Let’s look at Alaska, North Dakota, and South Dakota

Real per capita income in the states that did well during the Great Recession

Real state-local tax revenue in the states that did well during the Great Recession

Real federal grants per capita in the states that did well during the Great Recession

Real direct federal expenditures per capita in states that did well during the Great Recession

Change in real per capita income and real per capita grants from 2008 to 2009

Were temporary increases in grants sufficient to help hard-hit states smooth out their expenditures over the recession?

Real state-local expenditures per capita in the states hardest hit by the Great Recession

How does this compare with the hard-hit member states in the EMU?

Real revenues and expenditures per capita in Spain and Ireland

How did credit markets react to U.S. states during the crisis?

Credit Default Swaps for U.S. States

Credit Default Swaps for Selected US States and EU Countries

To summarize:Grants typically fall during recessions, but direct expenditures increase and federal taxes decrease.The 2009 stimulus was different. Large, discretionary spike in grants in addition to direct expenditures.But the grants were not nearly enough to replace falling state revenues.Discretionary federal assistance was very poorly targeted.Expenditure cuts were very large, and undermined a large part of the stimulus.Member state fiscal policy in EU is more stabilizing than that of U.S. states, whose fiscal policy is extremely pro-cyclical.

The U.S. states are not unusual

Source: Rodden and Wibbels (2010)

RedistributionWhy can’t the federal government target states most effected by recessions?This raises a set of questions about the political economy of redistribution.

Average income and transfers (1990-2005)

Size of marker reflects relative per-capita representation

Income, representation, and federal transfers to Brazilian states, 2005-2013

Size of marker corresponds to seats per capita

Why are grants often not progressive?

In a legislative bargaining model, small states are attractive coalition partners.

Votes can be purchased for lower priceThis can easily undermine progressivity if small states are not also poor

Seats per capita and federal transfers in 9 federations

Voting weight and EU transfers per capita

Representation and Redistribution

Formulaic equalization does not undermine this effect.

It is often built into formulae that are difficult to renegotiate

Causality?Maybe over-represented states had more leverage at the moment of federation formationBut the relationship is still very strong among provinces that were not parties to the initial bargain

Including new EU member states

Endogenous fiscal unions

In a bargaining model of union formation or renegotiation, a member state’s outside options should shape its voting weight and future flow of transfers

See, e.g. Morelli

Over-representation and commitment to future transfers are often meant to assuage fears of exploitation by small and peripheral units at the stage of federation formation.Small provinces experiencing the most volatility are often over-represented and favored in the flow of transfers. The initial bargain is very sticky.No precedent for radical reorientation of voting weights in favor of low-volatility units.

Is it true that there are no monetary unions without fiscal union?

If the relevant definition of fiscal union means progressive taxation and counter-cyclical expenditures, yes.

Canada and the United States before World War II.

Under what conditions can “fiscal union” be achieved?

Is war a necessary condition?

WWI New DealWWIII Koreaa

Federal expenditures as a share of total (federal, state, municipal) expenditures in the United States, 1900 to

present

WWI

New DealWWII Korea

Federal expenditures as a share of total (federal, state, municipal) expenditures in Canada, 1930 to 1970

WWII Korea

European fiscal union?Many reform proposals call for unrealistic levels of peacetime fiscal centralization.Recognizing the moral hazard problem, many proposals also call for unrealistic (and unprecedented) loss of fiscal sovereignty for member states.Unrealistic expectations about delegation to “experts.”Is there strong evidence to suggest the Euro is doomed without American-style fiscal union?

Would Florida and Arizona have had a Greek-style crisis if they were solely responsible for Social Security, Medicare, and Medicaid?

A realist reform agendaThe U.S. experience reveals that banking union is crucial

Gros and Belke (2015)

Enhanced facility for fiscal stabilization by member states?Reduce debt overhang

Alexander Hamilton as an exampleDebt assumption first, fiscal union later

Orderly default processLoss of sovereignty as part of BankruptcyA role for the judiciary?