Fiscal Federalism and the Political Economy of Eurozone Integration

Abstract

The purpose of this thesis is to identify the political, institutional and economic obstacles to achieving economic integration and stability in the euro area while finding a solution to those obstacles by examining the economics and political dynamics of the currency union. The benchmarks of the Maastricht Treaty and the Stability and Growth Pact encouraged cosmetic reforms that did little to alter the structural problems of the Eurozone's economic periphery. Therefore, the best political and economic solution to the problem of integration is to allow for fiscal federalism within the union whereby Member States take full ownership of their economic policies. Although decentralizing fiscal policy is an essential part of fostering integration, harmonizing banking regulation throughout the Eurozone is also necessary course of action. The guarantee of emergency funds for Eurozone states at the precipice of default will only breed a moral hazard for more rule-breaking. The conditionality of tough austerity measures of the emergency programs also breeds popular animosity against the euro and outsources the moral and political responsibility of unpopular structural reform to forces outside of the country. Member States should allow heavily indebted states to default and allow banks that made investments in those countries' debts to incur losses. Through enforcement of the no-bailout clauses of Eurozone agreements, domestic political actors will be unable to issue more debt and thus have the political cover to impose the necessary structural reforms to improve the economic sustainability of their respective countries. Since an exit from the currency union would aggravate the debt problems of a peripheral Member State, the rest of the euro area is unlikely to suffer the loss of membership by refusing to transfer funds to its insolvent members.