Mario Draghi on a Common Fiscal Policy for the Eurozone

Imagine that someone told you that a key issue will be determined by whether the countries of the European Union display “unity.”

Is that statement encouraging, or despairing? Mario Draghi suggests (with a degree of optimism, I think?) that European unity about a common fiscal policy is the next step to make the euro function well in “The Next Flight of the Bumblebee: The Path to Common Fiscal Policy in the Eurozone” (NBER Reporter, October 2023, delivered as the 15th Annual Martin Feldstein Lecture).

(Most readers of this blog, I expect, recognize Draghi’s name as head of the European Central Bank from 2011 to 2019. Indeed, during a time of eurozone financial crisis in 2012, Draghi is sometimes credited with having “saved the euro” by making a forthright “whatever it takes” promise, when he said during a press conference: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Not everyone knows, however, that Draghi has a PhD in economics from MIT and was a professor at several Italian universities before getting into the central banking business.)

Draghi’s reference to the “flight of the bumblebee” is a reminder of the old line that bumblebees seem ill-suited to flight–but they fly anyway. Similarly, economists have been arguing since the 1990s that the economies of Europe may be ill-suited to a common currency–but they adopted one anyway.

The concern has to do with the theory of “optimal currency areas.” When does it make sense for two geographic areas to share a common currency, and when does it not? Imagine that two economic areas experience different “shocks.” Perhaps one part is dependent on the price of oil, but another is dependent on the price of wheat. Perhaps one area depends more heavily on manufacturing, while another area depends more on computers and information technology.

If these two areas have different currencies, they can adjust to these shocks through shifts in the exchange rate. But if they are glued together with a single currency, then wages and prices in one area–measured by that common currency–will be shifting relative to the other. One area will feel “rich” and the other will feel “poor.”

If two areas are well-suited to be a common currency area, then there will be various adjustments to smooth out such differences over time. For example, workers will migrate from low-wage to high-wage areas; conversely, companies will shift their investment to take advantage of low-wage areas. Moreover, the central government will practice some degree of redistribution: the high-wage area will pay more in taxes, and the low-wage area will receive more in benefits.

But what happens if, because of various barriers (national boundaries, different regulations, culture and language barriers), workers and firms don’t move much between the high- and low-wage areas? What if the central government is relatively small and weak, so that it doesn’t practice a meaningful degree of redistribution? And what if, because of the common currency, no exchange rate adjustments are possible? In that setting, the lower-wage area may just be stuck in that position for a long time. This is arguably what happened in the US economy, where the southern states remained poor for decades from the late 19th century into the 20th century–until cross-region migration of workers and firms increased, along with an expanded fiscal role for the US government. It’s what is happening in modern Europe, as certain countries including Greece, Italy, and others seem stuck in a low-growth trap.

The bumblebee that is the euro continues to fly. As Draghi points out, the underlying assumption in adopting the euro was that even if the EU was not actually ready to be a common currency area in 2000, it would evolve in that direction. As he says:

But there was always another perspective, which was that the euro was the consequence of decades of past integration — notably the evolution of Europe’s single market — and that it was only one more step along a much longer road towards political union. And through the so-called “functionalist” logic of integration, where one step forward leads inexorably to the next as its shortcomings are revealed, the end goal of political union would drive the necessary macroeconomic changes. From this viewpoint, the key question was not whether the euro area was an optimal currency area from the start — evidently it was not — but whether European countries were prepared to make it converge towards one over time.

In some ways, this vision of greater economic mobility of workers, firms, and products across the countries of Europe has been coming true. Draghi notes:

Twenty-five years of economic integration have led to more integrated supply chains and more synchronized business cycles, making the single monetary policy more appropriate for all countries. Multiple studies find that business cycle synchronization in the euro area has risen since 1999 and the euro can explain at least half of the overall increase. At the same time, while labor mobility in the euro area remains some way short of US levels, studies have found a gradual convergence, reflecting both a fall in interstate migration in the US and a rise in the role of migration in Europe. And channels of risk sharing have improved further. For example, against the backdrop of banking sector integration — the so-called banking union — and generous official assistance, cross-border lending was notably more resilient during the pandemic than we had seen during previous large shocks. The further Europe can advance along this path — especially in terms of integrating its capital markets — the lower the need for permanent fiscal transfers will be.

But with all of these changes duly noted, it remains true that fiscal policy across the nations of Europe is dominated by individual countries, not by a centralized budget. US-style transfers from higher-wage to lower-wage areas are not possible. As Draghi points out, in the US states can be required to run balanced budgets, in part because the US federal government can run budget deficits when needed. But in a European context, every country can run budget deficits when it wishes to do so, which already led to one deep EU recession back in 2012-13.

Draghi’s vision for a common EU fiscal policy starts from a belief that EU countries have some shared goals: for example, a shared interest in higher defense spending in the aftermath of Russia’s invasion of Ukraine, and a shared interest in a transition to lower-carbon energy sources. As Draghi writes:

Whichever route we take, we cannot stand still or — like a bicycle — we will fall over. The strategies that had ensured our prosperity and security in the past — reliance on the USA for security, on China for exports, and on Russia for energy — are insufficient, uncertain, or unacceptable. The challenges of climate change and migration only add to the sense of urgency to enhance Europe’s capacity to act. We will not be able to build that capacity without reviewing Europe’s fiscal framework, and I have tried to outline the directions this change might take. But ultimately the war in Ukraine has redefined our Union more profoundly — not only in its membership, and not only in its shared goals, but also in the awareness it has created that our future is entirely in our hands, and in our unity.

I confess that for me, Draghi’s call for EU “unity” on these topics feels discouraging. Are the EU countries across eastern Europe, close to the Soviet border, going to agree on defense policy with countries in the rest of Europe? Is France, with its nuclear power plants, or Norway, with its North Sea oil reserves, going to agree on energy policy with, say, Portugal and Greece? Is Draghi correct that without such agreement, the bicycle will fall over and the eurozone will be subject to another round of financial crisis? Or perhaps this bumblebee can just keep flying, even if economists can’t quite grasp how it is doing so.