Is the EU ready to truly apply the subsidiarity principle?

Roel Beetsma, George Kopits 15 June 2020

a

A

For anyone who cares about the European project, the fresh push by key EU member governments to establish a recovery fund is most welcome news. Moreover, the European Commission proposals that followed soon after so far have provoked relatively little resistance. Arguably, this represents a step back from the abyss of disintegration, as the coronavirus exposed a major fault line in the European architecture. 

In the management of the present crisis, member governments followed instinctively their immediate national interest in protecting the welfare of their own citizens, with little regard for the possible impact on neighbouring countries. The calls for solidarity from countries hardest hit by the pandemic were resisted by a few others with a familiar morality play, much like during the debt crisis a decade ago. Member states that have been profligate in their public finances should not expect to be bailed out by those who had practiced discipline. 

The concern about moral hazard has some validity and should not be minimised or rejected out of hand. The no-bailout provision in the Maastricht Treaty as well as the Stability and Growth Pact are in fact intended to prevent moral hazard.1 To be sure, laxity in fiscal policy and banking practices can be viewed as having contributed to the euro debt crisis. But, by contrast, the current pandemic, coupled with a devastating economic aftermath, is an exogenous shock suffered by some regions through no fault of their own. Thus, the current crisis warrants collective action to complement remedial action undertaken by individual member countries.2 The Treaty on the Functioning of the European Union (Article 222) allows for such solidarity.

Subsidiarity in principle and practice

Far more compelling than the spirit of solidarity is the principle of subsidiarity, enshrined prominently in the Maastricht Treaty. Under the subsidiarity principle, well known in federal and quasi-federal systems, each government function, along with the necessary resources, is assigned to the lowest level where it can be performed most efficiently. Tasks that are performed less efficiently at lower levels, because of significant externalities across jurisdictions, are usually delegated to the highest level.

In the EU, for example, while sanitation and police protection are under the authority of local governments, defence and foreign policy rest primarily with national jurisdictions, and monetary policy is to be centralised at the supranational union level – though during a transition period limited to the euro area. But several activities, such as banking supervision, social assistance, and environmental protection, are shared between the national and union authorities.3 

Following the logic of this approach, healthcare is a shared responsibility at various levels of government: whereas the national and local governments are clearly at the front line in managing the current crisis in real time, the EU authorities should be in principle responsible for strategic guidance as well as financial support commensurate with associated costs or losses incurred by national and local jurisdictions. Thus, given an unanticipated shock like the current one experienced by member countries both at national and local levels, reflected over time in a spike in their spending needs and a sharp fall in tax revenue, compensatory EU transfers and concessionary loans are entirely justified. Such support would not only be aimed at providing resources for healthcare spending, but also at overcoming a massive, albeit temporary, decline in economic activity, in particular in those regions that have been hit hardest. This acts de facto as an insurance mechanism that makes everyone better off from an ex ante perspective. It provides additional benefit by targeting the mitigation of the negative externalities from the economic fallout in the hard-hit regions, and it may be particularly effective if coupled with incentives for governments to implement growth-enhancing structural reforms and manage crisis-induced shifts in the economy. Resources for the support provided by the central EU level can come from direct taxation of firms or citizens, as well as from specialised sources such as pollution and financial transactions. If upfront borrowing is needed, such tax revenue can be earmarked to pay off the debt incurred.

Further implications for the novel coronavirus 

The subsidiarity principle is of obvious relevance in the case of cross-border spillovers, which have played a particularly important role in the current crisis at least for two reasons.4 First, countries have been imposing lockdowns in a staggered way. For example, Italy preceded the Netherlands, which in turn preceded the UK. Since it reduces spreading the disease to other countries, the lockdown is a public good. However, the economic cost of the lockdown is borne first and foremost by the country that imposes it, while the benefits (in terms of reduced contagion and casualties) are enjoyed more widely. So, there is an incentive ceteris paribus to postpone the lockdown for too long, thus producing excessive costs on the entire union. 

With proper coordination, the lockdowns would have been imposed in the very early stages of the outbreak and the damage could have been much smaller. The fact that the lockdowns were staggered may have caused additional damage by extending the overall length of underperformance of the EU economy. Since securing a coordination agreement may be time consuming, the response to the outbreak of an infectious disease should be spelled out ex ante. The lessons learnt from the experience so far may call for the following subsidiarity solution: suppose there is an outbreak of some unknown, potentially dangerous disease somewhere (Covid-19 may not be the last one!), then, optimally, the area where the outbreak is detected goes into an instantaneous lockdown and the EU immediately provides the funding to overcome the local/regional economic dip. The lockdown quells the disease spread in its early stages, while the support resources insulate the area where the detection first occurs from economic damage. Clearly, a type II error would occur in the case of a disease that turns out to be no more deadly than a seasonal flu, as was the case with the Swine flu of 2009. However, the damage from the type I error after the outbreak of the novel coronavirus is so much larger than that from the potentially more frequent type II errors that such a policy in ‘expected terms’ can produce huge savings in terms of lives and economic activity.

Second, combatting infectious diseases calls for centralising medicine/vaccine procurement and stockpiling at the EU level, as well as centralising the allocation of medicinal response as soon as a disease emerges somewhere else. Centralizing procurement gives the EU a negotiating advantage vis-à-vis pharmaceutical companies, while centralised stockpiling and allocation decisions (by experts) allow to target maximum firepower (more than an individual country can) at a disease hotspot when it breaks out. While spending on the procurement of medical countermeasures to infectious diseases is likely to be relatively small to overall spending on healthcare, maintained large central stockpiles to be readily deployed, can lead to a sizable reduction in casualties and economic cost.

Lessons from the United States

The resemblance of intergovernmental tensions in coping with the Covid-19 and its aftermath within the EU and the United States is remarkable in several respects. The latter, comprised of a mature federal structure, is admittedly a more advanced application of the subsidiarity principle, as evidenced by common monetary, defence, foreign policy, environment, as well as macro stabilisation fiscal policies. Although a rational allocation of governmental functions and resources has evolved over more than 200 years, the state and local governments are currently at loggerheads with the central government over the division of responsibilities in tackling the present crisis. 

The concern about moral hazard by US state governments dates back to the early 19th century. Following the so-called Hamilton moment – often incorrectly interpreted by European commentators as the final solution to the debt overhang inherited by the states from the revolutionary war – state governments abused periodic federal bailouts of their fiscal profligacy. But by the 1840s, the US Congress refused any further bailouts – in what became a strictly observed implicit no-bailout clause, whereby an increasing number of states adopted a constitutional current budget balance rule, to regain access to the bond market.5 Increasingly, however, some states had complied with their rule by granting to their employees future pension and healthcare benefits instead of wage increases. 

Against this backdrop, recently the majority leader of the US Senate (along with the US president) refused to consider a sizeable package intended to rescue states and municipalities proposed by the opposition-controlled House of Representatives. He argued that states and municipalities currently facing severe fiscal stress because of past profligacy should go bankrupt, an option that is not however available to the states by virtue of constitutional fiscal sovereignty.6 The counterargument, much like in the case of EU member states, in these circumstances – which, unlike during the self-inflicted euro debt crisis, occurred beyond their control – calls for application of the subsidiarity principle. 

Since the central government has been fitful and slow in providing financial and medical assistance to the states from contingency reserves and procurement channels, the Fed felt obliged to act in extending quantitative easing to purchases of state and municipal bonds, albeit through indirect channels, disregarding all precedent. A drawback is that the golden rule allows states to borrow only to finance investment expenditures, at the exclusion of current spending or to compensate for a shortfall in tax revenue. 

Despite the highly politicised approach to dealing with the coronavirus in the US, we can draw some lessons of potential relevance for the EU debacle. First and foremost, in the current extraordinary shock, application of the subsidiarity principle, with appropriate safeguards, overrides the no-bailout clause. Second, the subsidiarity principle should elevate the union-wide stabilization role to the highest level of government, given the externalities of shocks or cyclical swings among lower level jurisdictions. Third, fiscal transfers should be targeted preferably to lower-level governments in the form of grants rather than loans, insofar as those governments are subject to rules-based constraints and are prepared to reform their economies where necessary. Such transfers are to be financed mainly from (preferably progressive) direct taxes on households and firms. And fourth, as compared to fiscal policy, monetary policy is a dysfunctional stabilisation tool of limited effectiveness through lending to lower level governments.

Beyond the coronavirus 

As the present predicament has morphed from an extraordinary healthcare crisis into an EU-wide macroeconomic stabilisation problem, the European Central Bank has had to carry the brunt of the adjustment, absent a central fiscal authority. In the circumstances, given the cross-border spillovers of a shock of this magnitude and time horizon, it makes eminent sense for the highest EU institutions to step into the void.

Unlike the ECB’s large-scale lending operations, which exacerbate private and public indebtedness and tend to contribute to violating EU fiscal rules, grants financed from debt issued at low market interest rates would not add to the debt burden of member countries – while leaving aside any mutualisation of legacy liabilities. However, there exists strong political resistance against grants by some member states. Anyway, instead of making them widely available to countries, it may be more acceptable and more efficient from a risk-sharing perspective to target them at regions (well-defined for targeting Structural Funds) based on per capita indicators of morbidity and temporary income loss suffered by households and businesses. 

Beyond the current crisis, transfers from a newly created permanent facility (or the widely advocated ‘central fiscal capacity’),7 rather than an ad hoc fund, could be triggered in the event of recession, financed initially with the issuance of bonds with mutual guarantees and then replenished with dedicated EU tax revenue during a surge in activity. The facility would be operated quite apart from the European Stability Mechanism whose mandate is to provide financial assistance to member states subject to conditionality in the form of adjustment measures – much like under IMF stand-by arrangements. 

In all, there is a strong legal and economic case – that should be persuasive even for those who still resist it on moral hazard grounds – for a timely application of the subsidiarity principle in establishing a permanent EU-wide countercyclical facility. The alternative is an increasing risk of disintegration exploited by fringe nativist political forces from inside and geopolitical adversaries from outside the Union.

Authors’ note: The views expressed are those of the authors and do not necessarily coincide with those of any of the institutions they are affiliated with. We thank Charles Wyplosz for detailed comments on an earlier version. The usual disclaimer applies.

References 

Arnold, N, B Barkbu, E Ture, H Wang and J Yao (2018), “A Central Fiscal Stabilization Capacity for the Euro Area”, IMF Staff Discussion Note, 18/03.

Beetsma, R, B Burgoon, F Nicoli, A de Ruijter and F Vandenbroucke (2020), “Centralizing EU policy in fighting infectious diseases: status quo, citizen preferences and ways forward”, CESifo Forum (forthcoming).

European Fiscal Board (2017), Annual Report 2017, Brussels.

European Fiscal Board (2018), Assessment of the fiscal stance appropriate for the euro area in 2019, Brussels.

Henning, C R and M Kessler (2012), Fiscal Federalism: US History for Architects of Europe’s Fiscal Union, Bruegel.

Kopits, G (2017), “Toward a Closer Union in Europe: Elusive Mirage or Reality within Grasp?” in N Costa Cabral et al. (eds), The Euro and the Crisis: Future Perspectives for a Monetary and Budgetary Union, Springer.

Sinn, H-W (2018), “The ECB’s Fiscal Policy” NBER Working Paper 24613.

Wyplosz, C (2020), “So far, so good:  And now don’t be afraid of moral hazard”, in R Baldwin and B Weder di Mauro (eds), Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes, CEPR Press e-book.

Endnotes

1 Yet neither the clause nor the Pact were effective in preempting loose fiscal policy in some countries. See the critical assessment by Sinn (2018) who documents 121 violations of the deficit limit in member countries, not justified under the escape clause, through 2017, which were never sanctioned. 

2 Wyplosz (2020) recognises the moral hazard associated with such collective action, but views the emergency created by the pandemic as the more important consideration.

3 For an application of the subsidiarity principle in the EU, see Kopits (2017).

4 Beetsma et al. (2020) make a case for centralising procurement, stockpiling and allocating of medical resources under a specialized EU authority for the prevention and cure of an epidemic of infectious diseases within the Union.

5 See Henning and Kessler (2012) for a historical summary of the US federal system.

6 Under the Eleventh Amendment of the US Constitution, the states are immune from bankruptcy.  Only local governments (municipalities and counties) have access to Chapter 9 of the Bankruptcy Code. As Puerto Rico is neither a state nor a municipality, Congress had to enact special legislation to remedy its default.

7 This is tantamount to the central fiscal capacity advocated for example by the European Fiscal Board (2017, 2018), Kopits (2017), and Arnold and others (2018).

a

A

Topics:  Covid-19 EU institutions EU policies

Tags:  COVID-19, coronavirus, subsidiarity principle, Maastricht Treaty

MN Professor of Pension Economics and Vice-Dean of the Faculty of Economics and Business, University of Amsterdam, Member of the European Fiscal Board

Senior Scholar, Woodrow Wilson International Center for Scholars

CEPR Policy Research