Tax Analysts Blog

Taxes & Sovereignty: The Euro Experiment

Posted on Aug 18, 2011

Henry Kissinger predicted the demise of the euro many years ago. He and other euro-skeptics saw a fundamental flaw in the structure of the single currency.

The flaw -- which remains in place to this day -- is that countries adopting the euro must forfeit monetary policy to the European Central Bank but retain full political sovereignty over fiscal policy. The powers to tax and spend were deemed too vital a national interest to be transferred to a collective EU body. Thus the euro-zone wants to enjoy the practical benefits of a common currency without the hardship of giving up sovereignty where it matters most.

Pardon the poker analogy, but these governments were never genuinely "all-in" when it came to creating a solid foundation for the single currency.

That was Kissinger's point; such a system would inevitably prove unworkable. You can't have countries pursuing divergent fiscal policies while the ECB is locked into a single unified monetary policy. Something would need to give. Either the euro-zone would collapse due to lack of fiscal coordination, or the members countries will eventually be forced to relinquish sovereignty over taxing and spending. Because the latter is politically unthinkable, the former becomes all the more likely -- if not probable.

At best, membership in the euro-zone requires a superficial degree of fiscal sacrifice. This took the form of the EU Stability and Growth Pact, which encouraged governments to keep their annual budget deficits under 3% of GDP. The problem with the pact is that the prescribed deficit cap is nonbinding and was therefore routinely ignored. The pact never had real teeth because the euro-zone countries wanted it that way, as the alternative threatened their sovereignty.

Also note the EU maintains rules making it virtually impossible to harmonize tax policy. A mere qualified majority is sufficient to adopt an EU directive in other policy areas, but approval of a tax directive requires the unanimous consent of all 27 EU member states. That means a single holdout can effectively veto the advancement of tax policy. Why was taxation singled out for the unanimity requirement? You guessed it ... sovereignty. (Just imagine if the U.S. Congress couldn't pass a law unless all 50 states agreed to it. Sounds like a system designed to fail.)

Nevertheless, the great euro experiment marched on for more than a decade. Over that time the currency performed relatively well, better in fact than the U.S. dollar. Euro-skeptics were often called out on their dire predictions, but the rebuttal was quick: Just wait -- the euro hasn't experienced a crisis yet.

Well, we now have that crisis. Greece, Ireland, and Portugal are being bailed out by the EU and the IMF. Spain and Italy are receiving support from the ECB to keep their cost of borrowing down. Last week we heard France might be in trouble as well. Where will it end?

The design flaw is finally clear for all to see. The euro-zone is paying the price for refusing to coordinate their taxing and spending regimes. One gets the sense they're dragging the rest of the global economy down with them.

These countries will soon face a tough decision: Does the need to salvage the euro outweigh the primal instinct to retain political sovereignty over taxing and spending? If so, there is indeed hope for the euro's future. If not, then these guys still aren't all-in.

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