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Economic and monetary union and the European Community budget.

In 1977 the European Commission published the report of a Study Group which it had set up, under my Chairmanship, on 'The Role of Public Finance in European Integration'. This is sometimes called the 'MacDougall Report', which does scant justice to my six European colleagues, our two consultants from the United States and Australia, and our excellent Secretariat.

It was based to a considerable extent on a study of eight existing economic and monetary unions--five federations (the United States, Canada, West Germany, Switzerland, Australia) and three unitary states (France, Italy and the United Kingdom). Although it was most unlikely that the European Community would be anything like so fully integrated for many years to come, we believed that our analysis would help to throw light on how its public finance activities might be expanded and improved over a shorter period of time.

The Report is still quite frequently referred to, but there is sometimes a little confusion about what it actually said. It may therefore be useful, before going on to discuss its implications for the future of European integration, to summarise some of our relevant findings and conclusions (to which I shall add, in parentheses, a few comments by way of amplification or justification).

1. Public expenditure by the members of the Community (then nine in number) was about 45 per cent of the GDP of the area as a whole. Expenditure by the Community was 0.7 per cent. In the federal countries we studied, public expenditure by the Federal Government, as distinct from that at lower levels, was around 20-25 per cent of GDP.

2. Per capita incomes were at least as unequal(1) between the nine member states of the Community, and between the 72 regions we distinguished in the Community, as they were on average between the various regions of the countries we studied, even before allowing for the equalising effects of public expenditure and taxation. (The subsequent admission of Spain, Greece and Portugal will have tended to reinforce this conclusion.)

3. In the countries studied, public expenditure and taxation reduced regional inequalities in per capita incomes by, on average, about 40 per cent so that, after allowing for the effects of public finance--which helped poorer regions at the expense of richer ones--there was much less geographical inequality within the existing economic unions than there was within the Community, whose budget, besides being very small, had a weak redistributive effect per ECU spent and received.

4. In unitary states a large part of the total redistribution between regions arose automatically and was in a sense 'invisible'; high incomes went with high tax payments and low incomes with relatively high receipts of centrally provided services and transfer payments. In federal countries, inter-governmental grants and tax-sharing played a much more important part. These achieved relatively large redistributive results with relatively small amounts of federal expenditure, because the net inter-regional transfers were to a smaller extent than in the unitary countries the result of differences between large gross payments in opposite directions.

5. As well as redistributing income regionally on a continuing basis, public finance in existing EMUs played a major role in cushioning short-term fluctuations. For example, we reckoned that one-half to twothirds of a loss of income in a region due to a fall in its external sales was automatically offset through lower payments of taxes and insurance contributions to the centre and higher receipts of unemployment and other benefits. There was no such mechanism in operation on any significant scale between member countries of the Community.

6. Even with the powerful regional effects of public finance just described, several countries had only with difficulty been able to avoid intolerable tensions arising from regional disparities in levels of employment, living standards and rates of growth. (Such disparities can arise despite migration from the depressed to the more prosperous regions, which can itself cause further problems: congestion, and possibly resentment, in the latter regions; and, in the former, waste or under-utilisation of the capital stock, both public and private, including housing. A vicious downward spiral may also develop if the younger, more enterprising and more skilful people leave; and if this, coupled with lower demand in the areas, discourages private investment, while local public investment is reduced through loss of local revenue.)

On the basis of the above, and other much more detailed information, and taking account of what we assumed to be political realities, we suggested, as a first step, an increase in the Community Budget over, say, the following decade or so, from 0.7 per cent to around 2-2 1/2 per cent of GDP. This would begin to exploit the case for Community involvement where there were economies of scale, or 'spill-over' from one part of the Community to others, or indeed to all of it. An important example of the latter would be Community action, particularly in the areas of regional, unemployment and manpower policies, to ensure so far as possible that the benefits of closer integration were seen to accrue to all, that there was a narrowing--or at least not a widening--of the disparities between the economic performances and fortunes of member states. The aim of these measures would be mainly, but not only, to reduce inter-regional differences in capital endowment and productivity, and so help poorer areas to improve their economic performance, rather than to increase, by mere subsidisation, their levels of private and public consumption. We reckoned that our proposals would reduce inequalities in per capita incomes between members by about 10 per cent.

We were also aware that most governments were reluctant to see any significant increase in public expenditure at all levels--Community, national, state and local--as a percentage of GDP. We therefore looked for desirable transfers of expenditure from national to Community level, for example, external aid programmes, high technology research, and a suggested Community Unemployment Fund;(2) for savings in existing expenditure, notably agriculture; for the most cost-effective methods of achieving the objectives--there was much to be learned from the experience of existing federations; and avoidance of regulations, harmonisation, and so on, which were not worthwhile in terms of the extra bureaucratic and compliance costs involved (a matter to which I sometimes wonder whether the Community pays sufficient attention). We reckoned that Community expenditure would not be increased by more than 1 per cent of GDP, and hoped that this could be offset by the economies in national expenditures then being sought. We suggested that the additional Community revenue involved might be raised in part by a more progressive system.

We did not, however, believe that the relatively modest Community budget we were proposing would be nearly sufficient to sustain a monetary union. It need not be anything like as high as the average of around 45 per cent of GDP in the EC member states, or even the 20-25 per cent of federal expenditure in the federal states we studied. We judged that a Community budget of the order of 5-7 per cent might just suffice (or 7 1/2--10 per cent if defence were included), if, but only if, it concentrated much more than in existing federations on the cushioning of temporary fluctuations and the geographical equalisation of productivity and living standards.

The budget we proposed in this context would have reduced geographical inequalities by some 40 per cent, as, on average, in the countries we studied. We reckoned, it is true, in a purely hypothetical simulation, that using entirely a mechanism similar to the German Landerfinanzausgleicb, which involved direct transfers between the Lander, a 40 per cent reduction in inequalities between the nine member states in 1975 could have been achieved by unconditional transfers to the governments of the three poorer countries from those of the six richer ones of amounts equivalent to only 2 per cent of Community GDP. But we regarded a Community budget consisting entirely, or even mainly, of such a scheme as quite unrealistic. There are, quite rightly, bound to be objectives other than geographical equalisation, and gross Community revenues and expenditures are almost certain to be much larger than net transfers. (It is interesting that the 1992 Community budget is about five times as large as the total of the transfers from the net contributing countries to the net recipients. )

Since 1977 the budget has increased from 0.7 per cent of GDP in the Community to 1.2 per cent in 1992, and the Commission's proposals following Maastricht would increase it to around 1.35 per cent in 1997. But this would mean an increase of nearly one-third in Community expenditure and is, perhaps not surprisingly, strongly opposed by many member states. It would, however, still fall short of our modest 'interim' proposal of 2-2 1/2 per cent, and is of a different order of magnitude from what our Group felt, and I still feel, would be necessary to sustain monetary union. (I would not go to the stake for our precise figure of 5-7 per cent, but it seems not unreasonable to suggest that, if a budget of 2-2 1/2 per cent is required to reduce geographical inequality by 10 per cent, one of at least twice that size would be needed to achieve a 40 per cent reduction. Our suggested Community Budget would, moreover, be only about one-quarter of the federal budgets in existing federations, as a proportion of GDP.)

I also think that, in the context of a monetary union, a much larger Community Budget than is at present contemplated would be necessary to cushion the effects of short-term (and medium-term) fluctuations, as was done in existing EMUs. Even if the rate of inflation in a country was among the lowest in the Community, and even if its per capita income was similar to that in the Community as a whole, it might run into difficulties because, for example, its products lost out to substitutes, or it became over-dependent on declining industries. Without help from the Community, whether automatic or deliberate, it might then, having lost the power to vary its exchange rate, have to suffer a prolonged period of painful adjustment, with sluggish, or even negative, economic growth, high unemployment, and possibly outward migration with the associated problems described earlier.131 With a single currency, while national balance of payments problems as we have known them would no longer exist, they would be replaced by this kind of suffering. It could, and should, be mitigated by temporary Community assistance, including help with the structural changes that are required. These take time to be effective, and one cannot rely on rapid changes in relative costs and prices, which tend to be notoriously sticky in industrial countries.

Many, however, would challenge this argument on the ground that exchange-rate changes are of little value, so that the loss of the power to use them is no great sacrifice. I would dispute this, first of all by quoting from the Report of the Delors Committee on economic and monetary union141 (whose members included, in addition to the President of the European Commission, twelve Presidents or Governors of central banks and the Managing Director of the Bank for International Settlements). They said: 'The permanent fixing of exchange rates would deprive individual countries of an important instrument for the correction of economic imbalances'.(5)

I too believe that, in the medium term at least, exchange-rate changes can be a valuable weapon, when used in conjunction with appropriate fiscal and monetary policies. Whatever some economic models may now suggest, there are numerous historical experiences to support this view. One is what happened after the devaluation of sterling in November 1967, and the complementary measures taken during the following few months to restrain domestic demand. 1968 was a difficult year, partly because of the so-called 'J-curve', which means that devaluation tends to worsen the balance of payments before improving it. But by the summer of 1969 it was clear that there had been a sharp turnround in the balance of payments, and a classic shift of resources: a very large increase in exports coupled with a much smaller rise in imports, a large increase in manufacturing investment, hardly any rise in consumers' expenditure and a fail in public consumption. More recently, there was a close correlation in the 1980s, in the United States and Japan, between changes in their real effective exchange rates (measured by relative unit labour costs) and their current accounts; and between their nominal and real effective exchange rates.(6)

As the latter correlation suggests, it is wrong to think that the beneficial effects of devaluation will always be wiped out quite quickly by faster inflation. For example, after the devaluation of sterling against the dollar by about 30 per cent in 1949, the United Kingdom retained virtually all the competitive advantage gained vis-a-vis the United States for four to five years, and the bulk of it for considerably longer.(7)

It will also be argued that a much larger Community budget is not required to support monetary union since what really matters is 'convergence' in terms of rates of inflation, interest rates, exchange-rate stability, government borrowing and debt. The degrees of convergence required in these fields to qualify for membership of the monetary union are defined precisely in the Maastricht Treaty. Most may well be necessary conditions but they are not, in my view, sufficient. I would regard as equally important the achievement of economic and social 'cohesion', an objective referred to only in rather general terms in the Treaty.

Here again I would quote from the Delors Report(8) (italics mine): - 'If sufficient consideration were not given to regional imbalances, the economic union would be faced with grave economic and political risks'. 'The economic and monetary union would have to encourage and guide structural adjustment which would help poorer regions to catch up with the wealthief ones.' 'Policies should be geared to price stability, balanced growth, converging standards of living, bigb employment.' The Committee evidently recognised the danger of the Community becoming what I have heard described as a 'low growth, high unemployment club'.

The Delors Report, in my view, thus gave most of the arguments for a much larger Community budget to sustain monetary union. It implies clearly that the necessary cohesion will not occur of its own accord. The excellent report by the National Institute to the European Parliament on 'A new strategy for social and economic cohesion after 1992'(9) makes a powerful case for stronger policies to this end by the Community. It paints a worrying picture of the outlook for many of the less prosperous regions (and of areas, hitherto relatively prosperous, but likely to lose ground--and these could well include substantial parts of the United Kingdom); and of the possible adverse effects on them, relative to the rest of the Community, not only of the Single Internal Market and the transition to Economic and Monetary Union, but of a number of other unrelated developments likely to occur in the 1990s.

The Report, no doubt realistically, assumes that only a small increase in the Community budget, as a percentage of GDP, is likely to be politically acceptable over the next five years or so. But it also considers the possibility of more ambitious programmes, and discusses a number of possible measures that seem to the authors unlikely to be acceptable in the foreseeable future, either for political reasons or because they would involve excessive demands on Community funds. Some of these might become feasible at a later date, for political attitudes change--and may indeed need to change ,if the degree of integration hoped for by many, including a single currency, is to be achieved. The Report recognises too that its recommendations go only part of the way to achieving the necessary degree of cohesion, and proposes that later in the decade there should be a thorough examination of possible mechanisms for more substantial inter-regional redistribution, as explored in the 'MacDougall Report'. I sincerely hope that this will be done, because I fear that an attempt to introduce monetary union without a much larger Community budget than at present would run the risk of setting back, rather than promoting, progress towards closer integration in Europe.

Our Study Group considered that the experience of existing monetary unions provided a reasonably objective yardstick for the degree of regional equality required to support such a union in modern jargon, for what 'cohesion' would involve in quantitative terms. If it is argued that greater regional inequality, whether temporary or permanent, could be tolerated in a European monetary union, and that a much smaller Community budget would be required than the one we suggested, ! would once again point out that it was only about one-quarter the size of that in existing federations, as a percentage of GDP.

I am attracted by the possibility, discussed in the National Institute Report, that the European Investment Bank (EIB) might make a much greater contribution to the achievement of cohesion. EIB loans for regional development are already of the same order as grants from the structural funds for this purpose. The provision of 'soft' loans (subsidised by the Community), and possibly of venture capital, might make a substantial additional contribution, at relatively small cost to the Community budget, and thus reduce somewhat the total required.

A much larger budget would, however, still be required, but this need not increase total public expenditure at all levels to the extent that it resulted from a transfer of functions from national governments to the Community; and insolaf as favourably placed countries or regions paid more to the Community under redistributive schemes, they might, in the comrnunautaire climate assumed for a sustainable EMU, be prepared to cut back somewhat at least the growth of their public spending on things other than help to less favoured areas. It sometimes seems strange to me, if countries have the political will to have a single currency, a European Central Bank, with national central banks no more than its operational arms, having no autonomous monetary policy powers, and with the Community having authority over the financing of national budgets, that they do not also have a political will, and feeling of unity, as strong as that in existing economic and monetary unions, and so a readiness to have as powerful equalising and equilibrating mechanisms as they have.


(1) As measured by the Gini coefficient.

(2) The idea of a Community Unemployment Fund was first proposed in the 'Marjolin' Report of the Study Group (of which I was a member) on 'Economic and Monetary Union 1980', Brussels, March 1975. The Fund would pay a fiat money amount per day per unemployed person to national unemployment schemes which could, within certain constraints, remain quite different in accordance with national economic conditions and preferences. The payments would be financed by a uniform percentage levy on wages and salaries. Part of the contributions of individuals in work would be shown as being paid to the Community and part of the receipts of the unemployed as coming from the Community. Apart from the political attractions of bringing individual citizens into direct contact with the Community, the scheme would have significant redistributive ef/ects between richer and poorer countries and between countries with lower and higher unemployment. It would also help to cushion temporary setbacks in particular member countries. Experience in the United States, where the proceeds oi a Federal payroll tax--of a uniform percentage of wages, up to a fixed ceiling--were largely paid into State unemployment trust funds, suggested that a strong harmonisation oi member state schemes would not necessarily be a prerequisite of Community participation. (See pages 389 and 493 of Volume II of the 'MacDougall Report'.)

(3) The country would no longer have the power to stimulate domestic demand through lower interest rates; and its power to do so through fiscal policy would be limited by, among other things, the Maastricht rules on government borrowing, or by inability to borrow more than a certain amount on the markets on acceptable terms, or by unwillingness to impose further burdens on future taxpayers.

(4) Committee/or the Study of Economic and Monetary Union. Report on economic and monetary policy in the Community, 1989.

(5) Page 16.

(6) See articles by Edward Balls and Martin Wolf in The Financial Times, 20January and 24 February 1992.

(7) As measured by hourly earnings in manufacturing (see MacDougall, The World Dollar Problem, 1957, page 82); and the same is broadly true of wage costs per unit of output because productivity in manufacturing rose only marginally faster in the United States.

(8) Pages 18 and 13.

(9) Luxembourg: Office for Official Publications of the European Communities, 1991. The main authors, Iain Begg and David Mayes, have drawn on the report in their article on 'Social and economic cohesion among the regions of Europe in the 1990s', published in the National Institute Economic Review, November 1991.


Iain Begg and David Mayes 'Social and economic cohesion among the regions of Europe in the 1990s, National Institute Economic Review, no. 138, November 1991, pp. 63-74.

Some words were omitted from the second paragraph of page 66 which, as a result gave a misleading impression of the conclusions of the 'MacDougall Report' of 1977 which is discussed in the note by Sir Donald MacDougall in this Review. The second sentence should read:

The MacDougall Report concluded, for example, that it would be possible to reduce disparities in the Community of 9, for the most disadvantaged regions, by a similar 40 per cent with interregional transfers amounting to around 2 per cent of Community GDP. A 10 per cent reduction could have been achieved as part of a Community budget which amounted to some 2 1/2per cent of Community GDP, in what was described as a prefederal phase of integration, rising to perhaps 7 per cent in a fully federal European system. [omission shown in italics].
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Author:MacDougall, Donald
Publication:National Institute Economic Review
Date:May 1, 1992
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