How economic policy drives European (dis)integration

The Eurozone is (quietly) disintegrating as ‘core’ and ‘periphery’ countries continue on paths of economic divergence. That disintegration is reinforced by self-defeating policies shaped by a macroeconomic model that mimics and reinforces the divisions between ‘winners’ and ‘losers’

Debates on the economic future of Europe often focus on the role and usefulness of fiscal policies for spurring growth in post-crisis Europe. While it is assured that the question whether and how fiscal policy can help to overcome low growth in the euro area will stay with us for much longer, our recent research suggests that the currently imposed policy-stance not only stifles economic growth, but also contributes to a growing structural divergence across European economies and, hence, fosters European disintegration on a large scale.

While critics of austerity regularly point to the role of economic ideas in shaping political sentiments towards (self-defeating) fiscal consolidation, our recent research shows explicitly how pro-cyclical fiscal policies are hard-wired into the EU’s fiscal regulation framework. We thereby contribute to closing the analytical gap regarding the role of the European Commission’s potential output model in shaping European economic policy. The Commission’s model estimates of ‘potential output’ translate into judgments on how much of the fiscal deficit (or surplus) in a particular country is ‘structural’ in the sense that it is not due to the ups and downs of the business cycle. The ‘structural deficit’, in turn, is a central control indicator anchored in the Stability and Growth Pact and hence has a direct impact on fiscal policies in euro area countries.

By investigating how the potential output model has contributed to shaping policy-making and economic development in the euro area over the time period 1999-2014, we find two major performative aspects: first, the model has a pro-cyclical impact on fiscal policies, by increasing the leeway for fiscal policy in good times and by demanding more austerity in crisis times. Thereby, it promotes an inversion of the traditional ‘anti-cyclical’ use of fiscal policy to one that amplifies booms and busts.

Second, we show how the transmission of the model’s outcomes into economic policy-making reinforces path-dependent developments across European economies. Specifically, our results suggest that the model used by the European Commission to coordinate national fiscal policies contributes to structural and economic disintegration between ‘core’ and ‘periphery’ countries in Europe. Current policies amplify international divergences in unemployment and indebtedness: while those countries that are already losing ground are further restrained in their scope for fiscal and political maneuvering by the Commission’s pro-cyclical model estimates, the ‘winners’ (especially Germany) are rewarded and strengthened. Hence, divergence is being reinforced.

This feature of European policy coordination is especially peculiar as it contributed to the accumulation of financial and trade imbalances before the crisis. By focusing solely on public debt, it helped to sustain models of economic growth building on increasing private debt for purposes of housing and consumption. These growth models were, as we show, prevalent in a series of European countries and have been positively evaluated by the Commission’s potential output model, which is deployed as a policy coordination device. However, as the developmental trajectories of crisis-ridden countries changed from better to worse after the outbreak of the global financial crisis, so did the model evaluations and fiscal prescriptions. We show how the additional shocks imposed on those countries not only lead to a deepening of the economic downturn by preventing adequate government intervention, but also served to restrain their capabilities to break out of the vicious circle of increasing debt and unemployment.

These findings indicate that the combined regime of competitiveness and fiscal discipline currently prevailing in Europe is unsuitable for organizing sustainable forms of economic convergence in Europe – instead this regime further promotes a process of ever-increasing European stratification

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