Growth and the Single Currency: the Fiscal Policy Paradox

Growth and the Single Currency: the Fiscal Policy Paradox, by Jan A. Kregel Director of Research, Levy Economics Institute of Bard College Economic Adviser of the Minister for European Affairs 

The Single Currency and Exchange Rate Stability

The Single European Currency, originally proposed in the Werner Report issued in 1970, was finally introduced in 1999 in support of the Single European Act (1987).  The Werner proposals were formulated in the context of the Bretton Woods global fixed exchange rate system that was in the midst of disintegration by the time the Report was published. Despite the difficulties encountered with various serpentine tunnel systems of exchange rate management after the demise of Bretton Woods, the EEC persisted in its intention to introduce the equivalent of an irreversible fixed rate system via a single currency, issued by a supra-national monetary authority in a world of floating exchange rates. The Single Currency was thus novel in two respects, the adoption of an irreversible internal fixed exchange rate system in the presence of an international system of floating rates, thereby eliminating exchange rate adjustment for individual member states’ trading relations with the rest of the world1, and a currency issued by an institution without any direct linkage to a national government or government balance sheet,2 thereby eliminating direct coordination between creation of liquidity and government fiscal policy. Indeed, this problem was solved by making fiscal policy subservient to the single currency via the Protocol to Section 104 of the Maastricht Treaty.

However, the elimination of bilateral exchange rates for national currencies did not eliminate the impact of exchange rates on the performance of individual countries via variations in the rate of the single currency vis-a-vis the other, floating, currencies of international trading partners. Instead it made the impact of exchange rate variations of the single currency uniform across member states that were far from having achieved economic convergence, and thus variable in terms of the impact on domestic production conditions due to differences in the domestic production structure and the structure of external trade of the member states. Just as a uniform monetary policy had a differential impact cross countries depending on their particular economic conditions, uniform exchange rate changes had differential impact across countries that was largely independent of domestic economic conditions. Thus changes in investor preferences for US dollar denominated holdings, or changes in global capital flows, could produce positive or negative impacts on external balances independently of domestic policy requirements.

Internal Adjustment to External Imbalances

While the single currency eliminated national exchange rate adjustments as a remedy to correct trade imbalances among member states and non-EU trading partners, it shifted policy to internal adjustments via relative domestic wage and price adjustments with Eurozone and non-Eurozone trading partners. However, these adjustments would have a differential impact on relative competitiveness within and without the Eurozone, making their impact difficult to determine.

In addition, emphasis on adjustment in domestic wages and prices created the potential for a deflationary bias similar to that prevalent in the pre-war gold standard in which deficit countries were under greater pressure and incentive to adjust via measures to reduce relative prices and activity relative to the surplus countries and to their trading partners in the rest of the world. 

While variation in the external value of the single currency could provide aggregate adjustment of the Eurozone external balance as a whole, the impact of these changes would not have an equal impact across all members of the Eurozone, while the enabling Protocol provided no formal fiscal policy mechanism to redistribute or offset this impact on productive and social conditions in individual countries.

At the same time, the redenomination of the sovereign debt of national governments in a currency issued independently of national member governments’ budgets or national central bank policy, sharply constrained the ability to finance domestic adjustment policies to offset the differential impact of the exchange rate of the single currency. In essence, government financing of domestic fiscal policy expenditures became formally identical to that of any private institution. Financing of expenditures had to be covered by fiscal revenues or by borrowing from the domestic or foreign private sector or by sale of assets to the domestic private or external sector. If government used borrowing to finance a shortfall of fiscal revenues then to meet debt service on the sovereign debt thus created would require governments to generate tax receipts greater than expenditures, engage in additional borrowing (debt roll over), or sell public assets.

And just as different private borrowers have different credit risks and face different risk-adjusted borrowing rates, “sovereign” borrowers should have different credit risks determined by the ability of governments to raise revenue as determined by conditions of the domestic economy and institutions. However, after the introduction of the single currency the fact that government borrowing was denominated in the liability of an external central bank appears to have led private lenders to overlook these national risk differentials in the first 10 years of the euro’s existence. Thus countries with higher borrowing and debt stocks were little penalized by the market imposing higher borrowing rates leading to an allocation of private sector liquidity within the Eurozone which reinforced economic imbalances and contributed to the European financial crisis after the collapse of US financial markets.

This market anomaly allowed many individual governments to access private market financial support at attractive interest rates to implement domestic income support measures to avoid the implementation of wage/price adjustment mechanisms compatible with the new single currency system. However, when this private sector market anomaly disappeared after the 2008 financial crisis, and economic conditions made it difficult for governments to generate higher fiscal revenues to replace the withdrawal of private financing, maintaining the financial stability of government and private financial institutions required financial support at the EU level in the form of the creation of the ESFS, subsequently replaced by the ESM, the extension of IMF program support, and eventually the direct intervention in government securities markets by the ECB to “do what it takes” to prevent a destructive financial collapse of government bond markets and private financial institutions. The necessity of an EU level response to the crisis should have made it obvious that the existing framework of fiscal policy management at the national level was incompatible with the new system.

Early Recognition of Impact of Monetary Policy and Fiscal Constraints

Many commentators had already noted the difficulty created by a monetary policy managed by a central institution that was independent of fiscal policies managed at the national level and subject to aggregate constraints. Wynne Godley[1] had very early noted that the Maastricht Treaty explicitly outlined monetary arrangements, but provided no response to the question: “how is the rest of economic policy to be run? As the Treaty proposes no new institutions other than a European bank, its sponsors must suppose that nothing more is needed. But this could only be correct if modern economies were self-adjusting systems that didn’t need any management at all.” He also pointed out that “the Maastricht criteria for the establishment of ‘convergence’ were far too narrowly conceived. To fulfil the conditions necessary for a successful currency union it is not nearly enough that member countries agree to follow simple rules on budgetary policy … They need to reach a degree of structural homogeneity such that shocks to the system as a whole do not normally affect component regions in drastically different ways”[2] noting that “if Europe is not to have a full-scale budget of its own … you will still have, by default, a physical stance of its own made up of the individual budgets of component states. The danger, then, is that the budgetary restraint to which governments are individually committed will impart a dis-inflationary bias that locks Europe as a whole into a depression it is powerless to lift. The useful comparison can be made with the US. … The analogy is useful because United States does so obviously need a federal budget as well as a federal bank, and the activities of the two authorities have to be coordinated. If there is a recession remedial (expansionary) fiscal policy at the federal level is the only proper response; it is inconceivable that corrective action should be left to component states, which have neither the perspective nor the coordinating machinery to do the job. If there is a federal budget there must obviously be a legislative and executive apparatus that executes it, and is democratically accountable for it.”[3]

Prominent members of the Bundesbank had also noted this mismatch between monetary policy imposed on the level of the EU and fiscal policy left to decisions of member states within the constraints in support of the single currency. Otmar Issing, a member of the German Bundesbank and eventual chief economist of the ECB, noted in a review of the Maastricht process that “historical experience shows that national territories and monetary territories normally coincide. . . . the relevant legislation, as a rule, defines monetary sovereignty in relation to a national territory. . . . In contrast to the normal rule, the Maastricht Treaty implies a clear discrepancy between the intentionally rather modest political integration and monetary integration.”[4]

The 2009 Financial Crisis and Extraordinary Fiscal Policy

The experience of the 2009 financial crisis highlighted this difference between a EU level monetary policy and fiscal policy decisions left to the decisions of the member states, but independent of the differential conditions that the single currency and exchange rate produce in economic performance, differences that would normally be met by fiscal policy measures appropriate to individual conditions but which were constrained by the conditions to support the single currency. Even if the earlier critiques were ignored, the most recent experience should have suggested the need for an alternative mechanism of financial support for government policies to respond to macroeconomic imbalances that were compatible with the concern to avoid government default and maintain the integrity of the euro.

Instead the response was to strengthen the constraints on individual government’s domestic expenditure policies to the support the stability of their fiscal balance and thus to the stability of the Euro, rather than the stability of the macro economy. However, this simply reinforced the recessionary bias that was already implicit in the relation of the new single currency and its issuance by a central bank without a political/institutional base and made it more difficult to offset the impact on domestic economic conditions of international changes in exchange rates.

Reinforcing Fiscal Constraints Reduce Flexibility in Crisis Response

            While the formal specification of these constraints on government expenditure contained in the Protocol to section 104c(2) of the Maastricht Treaty and subsequent reinforcements in the Stability and Growth Pact in response to the crisis, e.g. the Six pack (2011), the two pack (2013), plus Title III of the Fiscal Stability Treaty (the Fiscal Compact) that are considered necessary conditions for the stability and success of the euro were introduced in order to improve coordination of national fiscal policies, they also reduced the flexibility of national governments in responding to financial crisis and intra-EU imbalances created by the single currency in a global floating exchange rate system. This mismatch in monetary and fiscal policy decisions, the former at the EU level, and the latter at the national level, and the mismatch in the flexibility of monetary policy management relative to the increasingly rigid fiscal policy objectives, create potential financial instability in the euro area and undermines the operation of monetary policy.

Fiscal Stability and Financial Fragility

Minsky’s analysis of financial fragility may provide a guide to the paradox of measures to support euro stability leading to national financial instability. The extensions of the prior fiscal constraints in the recently introduced Fiscal compact imply that most governments should always have financing profiles that generate fiscal balance or surplus. The fiscal compact is the equivalent of a policy of imposing what Minsky defined as hedge financing as a common EU policy. That is, always having more than sufficient resources to meet financial commitments without recourse to external financing. In Minsky’s approach this financial profile should provide extreme financial stability as governments will always have the resources to finance their expenditure commitments on current expenditures and on debt service.

However, this condition contains a paradox, and a virtual impossibility theorem for countries that currently have debt and deficit ratios above the SGP limits, as this requires not only budget balance, but a rising fiscal surplus that can only be achieved through a combination of higher growth and taxation. Since governments cannot produce this growth through appropriate demand management policies, it must come from either domestic consumption and investment or from net foreign demand. But increased domestic expenditures cannot be generated by reducing government expenditures or raising taxes to generate the required fiscal surplus, since this only reduces domestic demand. Improving the external account can not longer be achieved by exchange rate adjustment but must involve domestic wage and price adjustment, which also exerts a negative impact on domestic incomes and investment incentives. Further, these adjustments must be relative to major trading partners who may also be engaged in domestic price adjustments, making the required adjustments even greater.

Fiscal Stability, Financial Fragility: the Fiscal Policy Paradox

            As noted, for Minsky, financial stability is similar to the requirements of the SGP Fiscal Compact: hedge financing for the government. This requires that tax yields are greater than expenditure by a margin (T>>G) to provide for debt reduction. But as noted, higher tax yields in the absence of fiscal measures to produce higher growth require the private sector to increase tax payments, which can only be done by reducing private expenditure. Thus, the ability of the private sector to increase tax payments and repay debt requires the private sector to spend less than its income. Thus, if households net save (Y-C >> 0) and firms earn net profits > 0, this means that for the combined private sector, saving should exceed investment (S>I). But this contradicts the condition for macroeconomic equilibrium for a closed system to maintain output levels: 0 = (S-I) + (T-G).  So for the compact conditions to hold, S<I and the private sector must finance its deficit expenditure by increasing its indebtedness, increasing private sector financial fragility. In a closed system, the public and private sectors cannot both be engaged in hedge financing at the same time. Figure 1 shows the Minskyan financial profiles for the private sector compared to the government sector.

For a closed system figure 1 shows that it is not possible for both sectors to employ hedge finance as would be required for financial stability. One sector has to be in deficit if the other is in surplus. The only way that both can be in surplus is if the measures indicated line lines 2 or 3 are implemented, increasing indebtedness or divesting assets, neither of which are sustainable processes for the private sector and constrained by the Fiscal compact conditions.    These same relations can be shown in a graphic representation of the national accounts for a closed economic system.

         From the aggregate income identity we know that national income is determined by the aggregate of private and government expenditure. We also know that aggregate expenditure is determined by household decisions to consume, business sector investment, and government expenditures net of taxes. It is usually assumed that the household sector is a net saver, spending less than income (although the recent use of appreciating real estate values to finance consumption calls this in question), while the business sector is a net borrower, spending on investment more than it earns in profits (although this clearly has not been the case in the United States in the recent period!). But, irrespective of the balance between the expenditure decisions of households and firms, in a closed economy the combined private sector cannot save on net more than the net deficit of the government sector. While we all know (perhaps from personal experience?) that any individual economic unit can spend more than it earns, this is not true for the aggregate economy as a whole without some adjustment in another sector or in the level of income. This is the basis for the argument given above and is based on the national accounting definition of income and expenditure:

                                               Y = C + I + (G – T) where

Y is national income, C is consumption expenditure, I investment expenditure, G government expenditure and T taxation of income

Since C = Y – S so Y = (Y – S) + I + (G – T)

This means that the net position of any given sector will be conditioned on the behavior of the other if income is not to adjust to restore the balance, for example, (S – I) = (G – T).

In Graph 1 the private sector financial balance (S-I) is represented on the horizontal axis, positions on the right of the origin indicate that on balance household saving exceeds firms’ decisions to investment and households are acquiring financing assets with those savings. On the left of the origin firms are investing more than households are willing to save. The vertical axis represents the government balance, above the origin the government receives taxes in excess of its expenditure, while below it is in deficit and must be issuing liabilities to cover the gap between expenditures and tax yields.

Graph 1

         The dotted line shows all the possible combinations of government and private sector balances for a given level of income. For any combination not represented on this line, income will adjust. For example, in the first quadrant which shows combinations of fiscal surplus and private sector surplus expenditures are less than income and thus income will decline. On the other hand, in the third quadrant the opposite occurs and income will be increasing. For the second and fourth quadrants the behaviour of income depends on the relative balance of surpluses and deficit positions. When surplus positions exceed deficits income will decline and vice versa as indicated on the graph. Thus the above mentioned paradox. It is impossible for the government to run a hedge financing scheme without sacrificing growth unless the private sector increases its indebtedness. But it will only be willing to do this if it expects income and profits in the future to justify the higher expenditure. But, as was learned in the Great Depression of the 1930s and the 2000s, this is unlikely to occur without an exogenous boost to activity, which normally can only come from higher government expenditures via fiscal policy.  If the government must run a surplus that is sufficient to eliminate its excess debt over time, then the result will simply be to substitute private debt for government debt, or for national incomes to fall producing a permanent condition of stagnation. Both these conditions create fragility for households, who are forced to borrow to meet debt service and for firms, as lower growth means reduced revenues available to meet their financial commitments with a clear impact on non-performing loans of the financial system.

Is there a way out of this paradox and perpetual economic underperformance as the price for stability of government debts and the success of the euro? Yes, the answer is to be found in the external sector. For an open economy macroeconomic equilibrium in the level of income requires 0 = (S-I) + (T-G) – (X-M). It is possible for the private and public sectors to be in surplus (S>I and T>G) if and only if there is a current account surplus (X>M) sufficiently large to compensate. This means that the Fiscal Compact conditions can only be met with an external surplus sufficiently large to offset the savings of the government and the private sector. At the EU level this means that since some countries will only require fiscal balance, while excess debt countries will require surpluses, that the euro can only survive if the EU as a whole has an external surplus. But this means that the financial fragility, deficit spending, and increasing indebtedness are shifted to the rest of the world; in current conditions to the United States; but current US policy is to take active measures to eliminate its role as global debtor of last resort.

 Figure 2 summarizes these arguments.

These relations can be presented graphically by transforming Graph 1 above following  a suggestion of Robert Parenteau[5] to include the external account balance. In Graph 2 represents three balances, but only two dimensions so the graph is normalized on the basis of balance in one of the three sectors to show the compatible positions of the other two. To present the role of the Fiscal compact this graph is normalized around the 45 degree line through the origin which shows the combination of private sector and external sector positions compatible with government fiscal balance (T-G=0).

Graph 2

  The vertical axis shows the financial position of the combined private sector, with a saving surplus represented by a positive sign (above the horizontal line) and a deficit position of increasing debt a negative sign (below the horizontal line). The horizontal axis shows a current account surplus as a positive sign (to the right of the vertical line) and a deficit as a negative sign (to the left of the vertical line).  The graph is thus a handy way of identifying the private and external sector positions that are compatible with the Fiscal compact pledge of a balanced government budget.

Starting from the origin, both the private sector and the foreign sector are in balance S-I=0 and X-M=0 , so the government is also in balance: T-G= 0. As noted, on any point along the 45-degree line, the government budget is fully funded. However, the private sector can only net save and have a hedge profile along with the government in quadrant IA, in which the external surplus exceeds the private sector surplus. In quadrant IB, the current account is not sufficiently large to offset private saving, and the government is in deficit.

To represent the compact’s requirement for a fiscal surplus, or for a country with an excess debt position, the 45-degree line would be shifted downward to the right as in Graph 3.

Graph 3

It also shows the area in quadrant IV compatible with a fiscal surplus requires an increase in private sector indebtedness matched by a higher current account surplus. For positions in quadrant IA the external surplus must be sufficiently large to offset a private sector surplus. The shaded area in the graph provides a representation of the conditions that could be required for countries such as Italy and Greece, which have very large debt ratios, under say a 3% fiscal surplus target. For these countries, given the condition of household balance sheets it is unlikely that they can borrow to meet expenditure in excess of income, so that Quadrant IV is not a viable solution. 

The graph can also be normalized on private sector equilibrium as in Graph 4, with the 45-degree line showing the conditions in the other two sectors, given S=I balance. Unless the private sector is able to finance expenditure via deficit spending, the Fiscal compact viable positions lie in quadrant IA, with a current account surplus sufficient to offset the combined net saving of the government and the private sector. If uncertainty, or monetary restriction leads the private sector to increase saving, as shown along the green arrow, the current account balance must be even higher in order to allow a fiscal surplus. Of course, the crucial question is whether the external sector can be expanded by the amounts required to support equilibrium.

Graph 4

These diagrams suggest that the ability to obtain an external surplus is crucial to the ability of the private and government sectors to meet the fiscal targets. Since the external account is the mirror image of the net balance of the private and government sectors of its foreign trading partners, domestic adjustment to allow debtors to fully repay creditors can only occur with the cooperation of the debtors’ trading partners. However, the differential combination of the three sectoral balances will have an impact on country growth performance.

The Balance positions of major Eurozone countries

The positions of the major Eurozone economies are presented on Graph 5. Of the major countries represented in the diagram, all have growth rates above 2%, save Italy and France. Both countries are constrained by their ability to improve their growth performance, first because they cannot rely on exchange rate adjustment, second internal wage and price adjustment would just reduce their domestic demand performance, and third they are stymied by the fact that the other major Eurozone economies are practicing much higher current account surpluses. The remaining possibility is internal demand stimulus, but this is prevented by the limits on government expenditures. Thus, low growth creates increased financial stability as incomes are not sufficient to service financial liabilities and produce the growth of nonperforming loans in the financial system.

         Note that Germany and the Netherlands are the only countries in Quadrant IA, (indeed Germany maintains a surplus with all its EZ trading partners). France is the only country with an external deficit, while the remaining countries are situated in Quadrant IV with fiscal deficits within the 3% limits, offset by private sector surpluses, that is private sector expenditure that does not support domestic demand.

Graph 5

         The paradox is even stronger in Eurozone economies that do not show current account surpluses. This includes France and Belgium as well as most of the smaller member states. For these countries the constraint of the -3% fiscal constraint and an external deficit means that they can only achieve a position of private sector hedge financing by operating in the small green triangle in Graph 6. 

Graph 6

 The position facing small EU periphery countries that seek to expand by means of domestic demand and investment above domestic savings would produce conditions such as shaded area in Graph 7. Here increasing private sector deficits will be compatible with higher external deficits and an improved fiscal position. This again highlights the fact that government stability only comes with an increase in private sector indebtedness in the absence of the ability to access external demand by selling into external markets.

Graph 7

Can the Euro Survive without External Surpluses?

This leaves external demand as the only solution to survival of the euro, given the insistence on fiscal balance. But without the ability to improve external competitiveness through exchange rate adjustment, internal depreciation through wage reductions or productivity increases in advance of wage increases will be required. However, this is also a policy that reduces domestic demand, offsetting the benefits of higher foreign demand. And here is the paradox: all the policies proposed to increase growth of incomes and generate fiscal surpluses ultimately have a negative impact on income growth. Keynes called it the paradox of saving; here, it is the paradox of euro survival. Historically, deflations have produced financial crises just as easily as inflations. While Germany pleads for more political control and integration, the EU may disintegrate through political reaction to prolonged stagnation.

Is the Eurozone a Ponzi Scheme?

But is this solution financially stable? In the 1940s, the United States considered a policy of supporting domestic demand through a permanent current account surplus. Evsey Domar showed that a stable share of export surplus to GDP was feasible and stable on one condition: the rate of increase of the outstanding foreign lending was greater or equal to the interest rate charged on the loans. But on reflection, note that this is the definition of a Ponzi scheme! And the reduction in efficiency wages and/or currency depreciation required to keep the surplus would dampen domestic demand, producing stagnation. The survival of the euro based on a permanent export surplus seems to require the permanent maintenance of a Ponzi scheme or stagflation to keep imports from growing more rapidly than exports.

         Thus, given the inability to improve external competitiveness in the short term, it is impossible to have both the private and fiscal balances in surplus. If the public sector is to remain within the 3% deficit limit, the private sector will have to be in deficit. As shown clearly in the graph, this can only occur if a country has a current account surplus. It is thus clear that if a country has a debt to GDP position higher than 60% it can only comply with the convergence conditions if it manages to situate itself in Quadrant IA. But this is precisely the adjustment conundrum raised by the fiscal and debt constraints for this means that there must be other member states that are in Quadrants II and III within the deficit limit of 3%.

         Just as it is inappropriate to extend the analysis of the household budget constraint to the economy as a whole, it is also inappropriate to extend it to the analysis of national solvency in the international context. Indeed, it may be the case that the policies of foreign governments are a major determinant of domestic performance. This was the conclusion that Keynes came to in his work on German postwar reparations. Germany could repay the Allies only if the Allies were willing to boost their consumption of German goods. The solution that was eventually adopted—increasing short-term private lending to Germany rather than increasing imports of German goods—laid the basis for both the 1929 US stock market crash and the rise of fascism in Germany.

The Impact of Relative Wage and Price Adjustment in Place of Exchange rate Adjustments

         It is also important to note the limitations on wage and prices adjustments, they must to relative to those of a countries major trading partners. Consider the policies introduced by the German government after reunification in 1990. Wage growth was slowed below the growth in productivity and unit labor costs fell and inflation dropped below that in the rest of the eurozone. The impact was the same as if German had depreciated its currency, and is equivalent to an implicit subsidy for exporters, and a tax on imported consumption goods. Interest rates set by the ECB on the basis of average EU inflation rates in the presence of lower German inflation produced a higher relative real interest rate in Germany and thus an incentive to private saving. As a result of these policies, Germany’s government deficit fell and its external surplus rose, boosting the German savings rate. leading to a private sector surplus and an external surplus – a position in Quadrant IA.  With a lowered government deficit, the external position had to more than offset it, or the growth rate would have fallen—which is in fact what occurred. The result is growth in German GDP in excess of the growth of consumption and a rising German savings rate. It should be obvious that this result is independent of whether or not Germany was more parsimonious than Italians or Greeks, either ethnically or culturally. The German private sector was were simply responding to policy incentives introduced in order to pay for reunification.

         But within a monetary union such as the euro, this domestic policy means that Germany has to be a net lender to the rest of the world, and in particular to the rest of the European Union, to the extent that it has a positive external balance within the EU, which is in fact the case. And this is precisely what happened in the 2000s. German banks lent to private and government borrowers in the periphery in order to allow them to run deficits and buy imports, many of them from Germany. The result, Italian, Greek, Portuguese fiscal and external deficits, which produced a rate of growth of income below the rate of growth of consumption, a low savings ratio, and a rising debt ratio. It is thus not surprising that some of the largest exposures to peripheral borrowers such as Greece were German (and French) banks. But, if the borrowers are insolvent, then the loans on German and French bank balance sheets were impaired and could not be redeemed without the creation of the EFSF/EFS to purchase the loans.

         But this does not mean that those countries with weaker fiscal balances and external dabt are more profligate than Germans are parsimonious. It is the policy mix that makes them so, not any inherent cultural characteristic. The real cost of a potential default will be borne by the lending banks.

         As already noted, unless there is cooperation to increase flexibility in terms of domestic policy, there is nothing that the highly indebted EZ countries can do to change its behavior. Italy cannot adjust its exchange rate if it wants to remain in the eurozone. It could attempt to reduce real wage growth to below the rate of productivity growth, but this would have to be at a rate higher than that practiced in Germany and would cause a reduction not only in demand and employment but also in saving. It would also reduce saving in Germany, since its growth rate would also fall due to a declining net external surplus. Germany can only continue its behavior by finding export markets external to the eurozone, which is what occurred as Germany increased exports to China. But, given the new US policy, this is going to be more and more difficult. The bottom line is that highly indebted countries will not be able to repay outstanding debts through fiscal austerity, nor by expanding its external surplus — the solution lies in fiscal policy coordination in the EU and in the global economy, not in the Fiscal compact. Highly indebted countries can grow their way our of debt, they cannot export their way out of debt by domestic depreciation and raising exports. But to do this requires a reform of the conditions on fiscal policy in the EU to support and share domestic growth and employment.

Alberto Heimler

Scuola Nazionale dell’Amministrazione, Roma, Italy

Economic Adviser of the Minister for European Affairs, Italy

Regulatory reform and competition: Some challenges facing the European Union

1. Introduction

A competitive environment provides the incentives to respond to market signals (i.e. produce more/less, increase/reduce prices, create new products, adopt new processes, enter in/exit from the market, etc.) and, in the process, disciplines the creation and the strengthening of market power. The hope of achieving a strong market position is the best incentive for entrepreneurs to start an activity, while the signals that the market conveys are a source of information for buyers and sellers to react. In the process, existing profit margins are competed away and eventually new ones are created.

Contrary to what first year of college economic textbooks teach us, competition is rarely taken place between firms selling exactly the same product, i.e. gasoline, but operates mainly through differentiation. As Steve Jobs once said, “you can’t look at the competition and say you’re going to do it better; you have to look at the competition and say you’re going to do it differently1”. This is a universal truth not simply associated to high technology. Indeed two pizza parlors that sell exactly the same pizza do not exist in the world! By differentiating their offers, firms try to achieve the loyalty of their customers, creating in the process investment and employment opportunities. This is why the entry into the pizza market should not be blocked, unnecessarily limited or be subject to some sort of standardization. The same is true in almost all markets and for almost all products. So why is the economy full of regulations aimed at restricting competition, blocking entry or limiting the expansion of existing businesses?

Most of the times there are good general interest reasons for restricting competition by regulation, i.e information asymmetries, externalities, natural monopolies, non competitive markets. Sometimes such reasons are overstretched, protecting incumbents more than necessary. Some other times existing regulations may have been justified in the past (once they were introduced), but innovation or technical progress may have made them obsolete.

Regulatory reform is difficult. There are indeed quite powerful forces in the economy, both private and public, that pursue the objective of promoting unjustified restrictive regulations and maintaining them in place, the main reason being stopping new opportunities from even having a chance, so that the market power of incumbents is maintained high without much effort.

The market power resulting from protectionist regulation is not always reflected in high profits only. Sometimes market power is shared with employees, leading to high wages, some other times with suppliers, leading to high purchase prices for productive inputs. In other words protectionism is very often, if not always, associated with inefficiency. This is very negative for competition, because it expands the number of stakeholders of the protection. They all can join forces to maintain the regulations, lobbying and arguing in their favor. They can be opposed only by consumers that as a result pay higher prices or receive lower quality or by taxpayers burdened by extra taxes to cover up unjustified losses of State owned enterprises. The problem is that consumers or taxpayers are not aware of what is going on and in any case are not very vocal because they individually gain very little if protections are lifted, while beneficiaries lose quite substantially.

The problem with regulations, including regulations that restrict competition, is that they all respond to legitimate general interest concerns and it becomes very difficult to identify the fine line where a regulation becomes restrictive. In regulation the issue is always a matter of degree and it is very often the case that some sort of regulation is necessary even in fully liberalized markets. As a result in many jurisdictions, in order to make sure that regulations remain competition friendly, a system of controls have been developed to make sure that only unjustified restrictive regulations are eliminated so as not to block beneficial developments.

The European Union was able to tackle some of these issues quite effectively, promoting the single market, an area where the free movement of goods services, capital and people is assured and as a result all domestic regulations are banned from impeding market access, going much beyond non- discrimination principles. The creation of the EU single market was accompanied by antitrust rules, making sure that competition is not distorted by private practices aimed at artificially blocking market developments favorable to consumers, and by State Aid rules, blocking anticompetitive subsidies. 

The objective of the single market is to make sure that market access is not unjustifiably blocked or made more difficult. Introducing regulations only when they are strictly necessary and making sure that they are proportionate to the objectives pursued is the responsibility of Member States. In other words, while citizens welfare is the final objective of the Treaty, promoting the single market does not necessarily maximize citizens welfare by itself. Complementary domestic policies not only are required as well, but they are the most important. One of the exceptions is antitrust enforcement, which I will not address in this paper, where the influence of academic research (especially originated in the US) has led to the adoption of a standard of competition analogous to what it would be in a domestic economy, i.e. achieving productive and allocative efficiency.

Looking at European internal market rules in this perspective leads to a different understanding on their relevance and their capacity to be adapted to specific sectors and practices. In this paper after a brief description of the objectives pursued by the EU Treaties with respect of the creation of the single market, I will look, with a few examples, at how domestic policies should integrate the EU ones and how EU rules should be interpreted. Finally, I will address State aid control, a policy area where, because State aid control remains a Commission monopoly, there has been an effort to incorporate in the regulations and in the individual decisions the final objective of promoting productive and allocative efficiency. However optimality is far from being achieved.

2. The European Single Market

The European Union was set up in 1957 to guarantee the free movement of goods, services, capital and people within the Union. This meant that it dismantled not only all trade barriers that impeded free movement directly, but also all regulatory provisions and practices that achieved the same result indirectly. It did not happen by chance. It was the clear intention of the founding fathers of the Union to set up an efficient institutional structure that was meant to be effective and resist in time. All the features of the European system are necessary for the Union to work properly and continue to do so after Sixty years since its establishment. This is why all the regional agreements that have been created in recent years imitating the EU model2, having left out features wrongly considered marginal and not important, were usually unable to deliver similar results3.

The most important element of the European Treaties is that they originate from a visionary construction: economic integration as a solution to wars and destructions.  This idea was not a new one and was already flashed out a few years earlier when the French foreign (and prime) minister Robert Schuman suggested the creation of the Economic Community for Steel and Coal (ECSC) on May 9 1950 as a way to prevent further war between France and Germany. According to the Schuman Declaration of the time the aim of the ECSC was to “make war between France and Germany not only merely unthinkable but materially impossible”4.

The high profile objective of the European Community has influenced the type of instruments that were put in place in the Treaty – the creation of an area where the free movement of goods, services, capital and people was guaranteed – and the type of rights and obligations that the Treaty created. Indeed, unique among international Treaties, the provisions of the EU Treaty were not directed towards Member States only, but created rights for individuals and firms that could be affirmed in Court.  As a result, the respect of the Treaty was not left to the sole action of the European Commission and of the Member States governments (top down approach) that for example led to the liberalization of public utility markets in the EU, but also to the judicial initiatives of all European citizens and firms (bottom up approach) when their rights originating in the Treaty provisions were not fully recognized by other private parties and, more importantly, by Governments themselves. This meant that private citizens and firms, if they believed that a piece of legislation or an administrative decision by a Member State violated their rights under the Treaty, including of course the free movement provisions, could bring that Member State to Court and that rule or practice could be ignored as if it did not exist, i.e. allowing what it prohibited.

The results achieved in the Union go much beyond what is prescribed by the Treaty and/or by the action of the European institutions, because every Member State could add to it. For every European policy initiative there is an active role played by Member States that most of the times goes beyond the simple transposition into domestic legislation of EU rules. Very often Member States have to create new institutions, for example independent regulators, for implementing community rules. Sometimes, for benefitting the most from Community rules, an industry, at the initiative of a Member State, has to be restructured horizontally and/or vertically. For example Member States, even beyond what the EU prescribed, had to make sure that the former electricity incumbent monopolists divest generators and/or the electricity grid in order to create a competitive electricity market. Some other time the role of the European rules is limited to some aspects of more complex procedures, for example in public procurement the EU main concern is adjudication (so as to open up domestic procurement markets to foreign suppliers), while Member States are fully responsible for execution and sanctioning ad of course for the quality of what they purchase. 

All this means that the effectiveness of the European rules is very much dependent on the quality of the action Member States take at the national level. The role of Member States is even more important than simply being complementary to EU policy, considering that the regulation of many activities, especially in the service sector, remains domestic in character.

Free movement and the principle of mutual recognition

The aim of the European Treaties is to create an economically integrated Union where, among other objectives to be pursued, competition is not artificially distorted. As a result a number of instruments have been introduced that address different types of distortions. The core of the Treaty is represented by the rules that promote the free movement of goods, services, capital and people.  They make sure that Member States do not create even unwillingly artificial barriers to entry for goods, services, capital and people from other Member States and in this way do not restrict competition in an unjustified way. In addition the State aid provisions make sure, at least in principle, that Member States do not subsidize firms in the absence of some form of market failure. Finally the EU antitrust rules provide a check on the market power of firms and make sure that it is not artificially maintained or increased.

As for Single Market rules, not only the introduction of trade related instruments negatively affecting intra European trade is prohibited by the Treaty, but every public regulation that impedes the free movement of goods, services, capital and people is prohibited unless justified by the objective of attaining other general interests strictly defined. In this environment antitrust rules were originally introduced to make sure that firms would not reintroduce privately the restraints of trade that the European Treaty had eliminated. State Aid control was introduced to make sure that Member States do not favor their own firms through unjustified subsidies. As a result of the introduction of this rich portfolio of instruments in the European Treaties, direct and indirect protectionism within the EU was banned. For example, reserving public procurement to local companies only – i.e. banning suppliers from other Member States – is prohibited, irrespective of the objective pursued. Or even granting a legitimate aid only to local companies is prohibited when it would exclude non local companies that would qualify.  

Even more subtle forms of protectionism are made almost impossible. Indeed the European Commission, the guardian of the Treaty, and the European Courts have coherently and strategically promoted an application of the Treaty as extensive as possible, blocking all State measures at all levels of Government that negatively affected intra European trade directly and indirectly. This meant prohibiting legislative and regulatory provisions independently from their explicit intention to provide an obstacle to enter a market for firms from other Member States. It was sufficient that the provision had that effect. In particular, a regulatory restraint that blocked a product freely available in another Member State was prohibited if such a restraint was not properly justified by linking it to the attainment of general interests objectives strictly defined (safety, defense, health and security). As a result, the concept of discrimination that the European Courts developed through their case law was not simply that a regulatory provision be respected by everyone regardless of nationality, but that if the sale of a product/service is allowed in one Member State, it should be allowed in all, unless some general interests strictly defined are negatively affected.

This principle of mutual recognition, established by the Court of Justice back in 1979 with the Cassis de Dijon judgment5, clarifies that free movement should not be interpreted simply as prohibiting direct and indirect discrimination on the basis of nationality. Mutual recognition has a much wider definition and in particular it promotes competition among domestic regulations of different Member States. The rule states that if a product is authorized to be sold in one Member State it should not be blocked by some restrictive regulation existing in some other Member State, unless such a restriction can be justified in order to attain other general interest objectives strictly defined. Although mutual recognition was originally developed to promote the free movement of goods, it is now widely applied to services as well and, for example, is at the basis of the mutual recognition of university degrees within the EU so as to allow the free movement of professionals. In other words not only products or services of other Member States cannot be discriminated directly or indirectly, but also firms desiring to establish themselves anywhere in the Union cannot be blocked by discriminatory rules or practices.

The principle of free movement is quite powerful. For example in a case launched by the Commission against Greece in 1998, the Commission was concerned that a Greek law (that was in existence for decades) that imposed that an optician shop be owned by a qualified optician who in turn could operate only one shop was against the principle of allowing the free establishment of a company. The issue here is that the Greek law was not discriminatory, since domestic and out of State opticians were treated equally.  However the law was considered by the Court of Justice to be in contrast with the free movement provisions unless Greece was able to justify it with respect of the attainment of some safety or health considerations. And indeed the Greek government defended the provision by arguing that it was necessary for public health. Instead, according to the Court, “(P)public health could be protected by guaranteeing that certain actions will be carried out by qualified, salaried opticians or under their supervision” and, furthermore, that ownership of the shop by an optician was not necessary6.

Without any political decision or discussion, a domestic law was considered contrary to the Treaty simply as a result of a legal procedure. The same happened to thousands existing rules and regulations, making the regulatory structure of all Member States compliant with the Treaty. Furthermore all new regulations and regulations of every Member State are by necessity compliant so as not having them scrapped.

Based on a 60 years experience, an internal market case has to have a number of characteristics: 1) the regulation of a given market has to differ among Member States; 2) such differences have to be considered unjustified by a tribunal, often by the European Courts; 3) the free movement coherent solution is easy to identify and does not require the exercise of ex-post controls.

In other words it is clear from the EU experience that a Tribunal is not well equipped to exercise ex-post control (making sure that a judgment is properly interpreted) or to fine-tune a judgment that has been already taken (adapting it to changed circumstances). I will provide an example that shows the limitations associated with a judicial approach to the EU internal market.

The Italian code for disciplining traffic on public roads provides that only automobiles are allowed to tow trailers. Motorbikes cannot do so in Italy, while they are allowed to tow a trailer in most other EU Member States. The provision that did not allow motorbikes on Italian roads was allegedly thought to be an illegitimate quantitative restriction of imports (even if also Italian producers of tow trailers were affected by the ban7) and was brought in front of the Court of Justice.

The Italian provision is clearly non discriminatory in the sense that it affects equally all producers (both Italian and foreign) selling a motorbike in Italy and all consumers driving a motor bike in Italy. However the Court argued that “in the absence of harmonization of national legislation, obstacles to the free movement of goods which are the consequence of applying, to goods coming from other Member States where they are lawfully manufactured and marketed, rules that lay down requirements to be met by such goods constitute measures of equivalent effect to quantitative restrictions even if those rules apply to all products alike”.  Italy justified the restriction by saying that the prohibition originated from road safety considerations, considering the specific contour of its national territory. The Court agreed that road safety could indeed represent “an overriding reason relating to the public interest capable of justifying a hindrance to the free movement of goods”.

However the Court had also to ascertain that the measure was proportionate to the objective it meant to achieve. Here the Court suggested that in the absence of harmonization of traffic rules, “(A)although it is possible … to envisage that measures other than the prohibition (of motorbikes with trailers) could guarantee a certain level of road safety …., the fact remains that Member States cannot be denied the possibility of attaining an objective such as road safety by the introduction of general and simple rules which will be easily understood and applied by drivers and easily managed and supervised by the competent authorities”[6].

In other words by this judgment the Court stops short of becoming a traffic regulator and rightly so. The Court simply says that the prohibition of tow trailers for motorbikes in Italy may not be necessary, but that such a prohibition is easy to understand and to implement. A Court is not well positioned to change rules when the decision is a maybe, not a clear yes and no.

Indeed, judicial review is effective for ensuring some regulatory convergence in sectors where full harmonization through legislation is not considered appropriate. Nonetheless the role of Member States in devising and implementing rules that are not contrary to the Treaty provisions remains of the outmost importance. However, the internal market rules are to be applied by a judge only when there are differences between regulations existing in different Member States. Indeed a judge could never apply the internal market rules to eliminate unjustified regulation existing in all Member States.

For example, had tow trailers not be allowed to circulate in any Member State, there would be no discrimination in place and no violation of internal market rules, even though the rule may nonetheless be unjustified.

The internal market rules don’t lead to optimal policy choices. They just make sure that trade (defined in a very broad sense) is not restricted.

3. Free movement objectives and domestic policies

The European Commission very quickly understood that the Treaty provisions by themselves could not achieve full harmonization of regulation across the Union because in some areas the technicalities of regulation were quite complex and furthermore the domestic legal provisions over which to achieve convergence where quite numerous, not just yes or no, like in the case of motorbike tow trailers. The Commission had to identify the optimal rules over which to harmonize.

Take for example public procurement provisions, one of the first areas where the Commission initiated an action for achieving convergence of adjudication procedures in Member States. Here the issue is how to open up to competition from outsiders domestic public procurement markets. There are many ways by which a public administration could make successful entry by outsiders more difficult: 1) lack of proper advertisement of the bid to outsiders; 2) lack of transparency on the standard for adjudication; 3) narrow product definition; 4) widespread renegotiations after adjudication, limiting such an opportunity only to insiders, i.e. being much stricter when the bid was adjudicated to outsiders. On all these issues judicial review would be very ineffective in the absence of a best-practice benchmark to use as a common reference standard. In such a case, only explicit harmonization can achieve convergence. This is why the Commission intervened with harmonization directives already in the 1970s (the first directive for the procurement of public works was issued in 1971 and for the procurement of supplies in 1976).

Today public procurement Directives impose on Member States a common framework on how the bidding process, for contracts above a given threshold, should be advertised, organized and carried out. However the Directives are concerned only with the bidding and the adjudication process (above a given threshold), leaving the planning, the execution, the sanctioning and the ex-post controls to national governments to regulate (including adjudication below the threshold), unless for example there are excessive cost increases after adjudication. Renegotiations, although they may be justified in the case of unforeseen circumstances having occurred, may suggest that the process of adjudication was a screen to keep foreign players out (since only domestic suppliers knew that the price could be increased afterwards and so could make a very aggressive bid).

There are differences in objectives between the Community and national governments. While a domestic legislation on public procurement would have as its objectives the pursuit of value for money or, in other words, the effectiveness of the purchasing activities of public Administration in achieving the desired quality at minimum cost, the first recital of the new European directive on public procurement suggests that the objective to be achieved is simply the opening up of domestic procurement markets: “The award of public contracts by or on behalf of Member States authorities has to comply with the principles of the Treaty on the Functioning of the European Union, and in particular the free movement of goods, freedom of establishment and the freedom to provide services as well as the principles deriving therefrom, such as equal treatment, non-discrimination, mutual recognition, proportionality and transparency”[7].

While achieving value for money and the opening up of procurement markets are fully compatible objectives, simply opening up procurement markets to foreign competition is not sufficient for achieving value for money. A different instrument has to be used for that purpose. For example guaranteeing the quality in a service procurement throughout the contract period can be assured only by introducing a system of incentives compatible with that objective. Competition in the adjudication process does not achieve that objective. As Albano, Heimler and Ponti (2014)[8] discuss, one possibility is to introduce incentives for good quality provisions, for example extending the length of a service contract in response of a high quality performance. Of course the process is incentive compatible, only if the possibility is allowed for in the procurement contract, i..e. the possibility is well known ex-ante and, given an observed performance, there is no uncertainty in the way it is interpreted and rewarded.

Public procurement is an example for showing the interplay of different instruments in the proper regulation of a sector. Both EU and domestic legislations are necessary to address all the issues involved. One possibility for achieving value for money in public procurement is to superimpose an effect evaluation objective to the EU procurement rules[9]. This is fully compatible with the EU directives, but needs to be introduced domestically.

Some Member States do so on a regular basis, taking the EU initiatives as a starting point of a process of reform. Italy (including administrative judges reviewing government decisions) very seldom builds up from existing EU obligations and remains confined to the text of the EU rules without understanding their objectives fully nor trying to adapt them to domestic circumstances. Two examples may help explain these points, one on public procurement the other one on the service directive.

Public procurement

The new 2014 directives on public procurement innovate quite substantially on previous consolidated practices. In the past, for fear that member States would strategically exclude foreign firms, bad reputation (past performance) could be a criterion for exclusion from a bid only in very stringent circumstances. Recognizing that this limitation negatively affected the incentives for a quality performance after adjudication, the new Directive suggested in Recital 101 that a company can be excluded from a bid in the case of  “repeated cases of minor irregularities (which) can give rise to doubts about the reliability of an economic operator which might justify its exclusion”.  Italy, when transposing the new directive into national law chose a much more rigorous standard: having been found responsible in the past of “serious professional violations”[10]

For the Commission this more rigorous Italian approach is perfectly fine, given the objective the Community pursues, i.e. promoting the free movement (the probability that an outsider be wrongly considered a bad performer is reduced). On the other hand for Italy such a restriction on the possibilities of excluding low quality firms, may lead to widespread inefficiencies. Were they considered when the procurement law was enacted? My understanding is that the only concern of the drafters of the law was reducing administrative discretion. The costs involved, in terms of reduced quality of supply, for achieving it did not matter to them.

The service directive

Article 12 of the Directive suggests that “(W)where the number of authorisations available for a given activity is limited because of the scarcity of available natural resources or technical capacity, Member States shall apply a selection procedure to potential candidates which provides full guarantees of impartiality and transparency, including, in particular, adequate publicity about the launch, conduct and completion of the procedure”. The principle of introducing a bidding procedure in the case of scarcity was meant to be applied to situations of very tight and stable oligopoly, where demand is captive and the possibility to exercise that activity for a new entrant is impossible, once all possible authorizations had been granted.

There is a further condition that needs to be taken into account for the mandatory bidding to be incentive compatible, but this is an issue that unfortunately the Directive does not consider: the value of the activity to be authorized should not depend on the value added provided by the company who had been first authorized to start it. Otherwise the State risks expropriating through the subsequent biddings some of the benefits that should accrue to the company itself, discouraging the company for fear of expropriation from carrying out in the first place any investment or any effort for improvement, not a very good result in terms of public policy goals to be pursued.  For example what is the value of a TV transmitting frequency thirty years after it has been used by a successful TV company? How can you disentangle the value of the frequency from the value of the company itself (whose value would be scrap without the frequency)?

Furthermore it is clear from the text of article 12 that the bidding is necessary only in circumstances where an activity cannot be carried out by an outsider unless he participates in a bidding procedure. If, on the other hand, a company can enter the market by acquiring on the market an already authorized company, than introducing regular biddings should not be necessary. This is certainly the case in Italy for establishments providing beach services or for shopping stalls. Those should be issues of no community significance. Furthermore periodic bidding would create a disincentive for sunk investments, exactly the contrary of what a “good” public policy should pursue.

The EU should reconsider the way it interprets article 12 of the service directive.

4. State Aid control: recent developments

Article 107 of the EU Treaty which defines incompatible State Aid was very carefully drafted. It does not define aid, it only defines what an aid cannot do: “Save as otherwise provided in the Treaties, any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market”. Accordingly, there are five elements to an incompatible State Aid: (i) the use of state resources; (ii) the measure must confer an advantage to certain firms; (iii) the advantage must be selective; (iv) the measure must distort competition; and (v) affect trade between member states.

What is an aid?

Without going into the operational details of European State aid policy, it is important to underline that the Commission and the European Courts, similarly to what happened in the field of antitrust, have provided a wide definition of what is an advantage to firms, defining as state aid not just a financial transfer from the State, but any advantage that directly affects the budget charges of a firm. Furthermore, given the fact the government ownership was widespread in Europe (at least until the late 1990s), the notion of State aid was expanded in order to identify the circumstances when investment decisions in government-owned firms were incompatible with state aid legislation. The main instrument developed was the private-investor principle, introduced already in 1981, according to which no State aid is involved if it can be shown that the capital investment by the state would also have been made by a private investor at market conditions, an easy standard to declare, but a difficult one to enforce in a rigorous way.

For example, it is not clear what is the standard of reference to be applied—the profitability of the additional investment or the overall returns that the firm achieves otherwise. As von Weiszacker (2002) argued, the problem with the private-investor test adopted by the Commission is that the profitability is calculated with respect to the addition of capital to an existing firm as if it were a stand-alone investment. This is not the right test for a company that the government already owns. Indeed, if new capital increases the value of the old capital, then the return which the owner achieves overall as the result of the injection of new capital can be higher than the return which an outsider achieves from injection of new capital into the enterprise under the same conditions.

Selectivity and incompatibility

According to article 107, paragraph 1, selectivity is not sufficient for an aid to be incompatible with the common market. It is first necessary that the aid distorts competition. However, even if according to settled case law, State aid measures are defined in terms of the effects they produce, not in terms of the objective they pursue implicitly or explicitly, distortions of competition have always been presumed from selectivity. As a result, in the EU practice, State aid decisions are not accompanied by a market analysis nor by a thorough analysis of the distortionary effects of the measure (see Heimler, 2009 and Heimler and Jenny, 2012)[11].

The European case law on State aid in this respect is very different from that in antitrust, where presumptions that competition is distorted are used, at least in principle, only in a subset of circumstances (hard-core cartels). In State aid the presumption that selectivity leads to a distortion of competition is universal. The definition of incompatible state aid under article 107, paragraph 1, is therefore quite wide and a competition analysis is undertaken only very late in the process.

The procedure is as follows. First incompatibility needs to be identified (and this is done with reference to selectivity, not to competition). Then the Commission has to examine whether the State measure can be exempted according to the criteria identified in article 107, paragraph 2 (aid granted to individual consumers, to make good the damages of a natural disaster, or aid granted to the former East Germany) and paragraph 3 (aid to achieve convergence between EU regions, aid to execute an important EU project, development aid, and to promote culture).

In the exemption decisions under article 107, paragraph 3, (in article 107, paragraph 2, decisions the Commission can exercise no discretion) competition issues are addressed only at the balancing stage, after the Commission has shown that the aid provides some overall benefits, that go beyond the aid itself (the benefit is the incentive that the aid provides). Furthermore, competition issues are always considered as a negative element, i.e. distortions. According to established practice, an aid can never have a positive effect on competition (i.e. selectivity means that some competitors do not receive it). But sometimes the effects of the aid increase competition overall (and often not because of the aid but because of the new idea that the aid was able to bring to the market), a very important result that is rarely considered in the analysis.

Finally, if there are no overall benefits originating from the aid (just private benefits), as it happens in many circumstances, the measure cannot be exempted and is declared incompatible with the common market even when the distortions of competition are unnoticeable.

In the individual assessment of a State aid measures, the effect on competition should be a preliminary exercise. If there is no effect on competition, the measure is not an incompatible State aid[12]. Full stop.

A first step of this approach can be seen in the clarification provided by the ECJ on what is an aid. For example, (after the Leipzig Halle judgment[13]), an infrastructure that is not used for economic activity falls outside of State Aid control. Small concert halls, small museums are not caught either since they do not have an impact on intracommunity trade. As for ancillary economic activities, provided the economic activity is small, there is no State Aid. Subsidizing infrastructures that may be big but do not face competition (national road network, bridges on a highway and a rail next to it, etc.), is also fine, provided that the infrastructure be available to everybody on fair, transparent and non discriminatory conditions.

What is clearly State aid is subsidizing airports, ports, broadband, energy, the reason being that these sectors are open to competition.  In such markets, it is not just the infrastructure itself, but also its use that may be subject to State Aid control. Provided there is a competitive tender there is no advantage to the operator and therefore no advantage at the level of the user.

The role of the general block exemption (GBER)

Compatibility decision are a monopoly of the European Commission. However the GBER has extended the scope of Block Exemptions (no notification for these). It is a paradigm shift: In 2011 51% of the State aid schemes were block exempted, they are 89% in 2016.

As described by the Commission in the Vademecum on Community law on State aid,[14] “(T)he GBER consolidates into one text and harmonises the rules previously existing in different regulations. It also enlarges the area covered by notification exemptions by five types of aid which have not been exempted so far (environmental aid, innovation aid, research and development aid for large companies, aid in the form of risk capital and aid for enterprises newly created by female entrepreneurs). The GBER applies only to transparent aid, i.e. grants and interest rate subsidies, loans where gross grant equivalent takes account of the reference rate, guarantee schemes, fiscal measures (with a cap) and repayable advances under certain conditions. Aid is only allowed if it has an incentive effect. The GBER provides different criteria for the verification of the incentive effect with ranging complexity: (i) for certain types of measures, incentive effect is presumed; (ii) for SMEs, the incentive effect is present if the application for aid was submitted prior to the start of the project; (iii) and for large enterprises, in addition to the above, the Member State would have had to verify basic conditions of the documentation.”[15]

All these exemptions are granted presuming that the aid is beneficial, i.e. overcoming very widely defined market failures, an assumption that would need a much more rigorous justification had it been done on a case-by-case basis, considering, for example, that SMEs can very often finance themselves in the market without the need of any aid, that investment into innovations is always appropriable, and so on. This is why an ex-post assessment of State aid schemes may help identify the type of market failure where state aid is more effective in overcoming them.

The GBER is also used for Regional aid. This is an area of increasing inefficiencies. Regional aid is meant to promote convergence among Regions characterized by different degrees of development and of relative competitiveness. Considering that many regions that benefit from generous State aid regimes already benefit from substantial costs advantages (i.e. low labour costs, favourbale exchange rates, etc.), granting State aid without a rigorous assessment of its incentive effect can risk developing into a policy of “beggar thy neighbor”. Because of generous locational aid, firms  have a greater incentive to move from high costs to low costs EU countries, sometimes even to accession countries. When this process takes place in periods of high growth the problems are minimized. However in periods of recession, the process of decentralization of production to low costs countries can become very detrimental and create increasing social costs. According to the GBER, the assessment of the compatibility of State aid is simply done with respect of the territory/country where the aid is granted. What matters is “that a project is carried out, which would not have been carried out in the area concerned or would not have been sufficiently profitable for the beneficiary in the area concerned in the absence of the aid”.

The test is perfectly fine, if it is carried out for aid which is outside of block exempted regimes. For block-exempted schemes the beneficial effect of the aid is presumed. It should not. For investment aid, for regions already characterized by profound cost advantages, which is particularly true when the generous aid standard applies to a whole country, the compatibility of the aid should be decided on a case by case basis.

A possibility could be to introduce a notification obligation for all regimes, including those that are now block exempted, adopting a simplified procedure for assessing their compatibility. Relying on ex post evaluation to fine tune State aid policy, as the Commission suggests, is a good idea but it would take decades for it to produce any effect.

In the existing EU practice (after the 2017 revision of the GBER) only for relocational investment the aid is not block exempted. In such instances the test for assessing the compatibility of such aid should also consider the costs incurred by the other member State because of the relocation.  In other words, for relocational investments, the aid should not be assessed with respect to the new investment only but also by considering all the costs (direct and indirect) incurred because of the relocation from the country where the original plant was localized.

More scope for legislative developments: the corporate income tax.

Multinational companies have benefitted from very favorable tax treatments in some Member States. Such tax provisions are problematic. If they have provided a selective advantage they may be prohibited.  The case law is starting to become extensive: Starbucks (they were charging IP charges for coffee roasting only when the transaction took place between subsidiaries); Belgian excess profit scheme (extra deductions for only those multinational companies that built their headquarter in Belgium) and Apple cases (very low corporate taxes to Apple in Ireland). State aid provisions however are not sufficient for creating a level playing field in the EU.

The Apple case

The main critical issues in this case are two pieces of legislation: an Irish law that allows companies incorporated in Ireland and being fully controlled by foreign individuals not to be taxed in Ireland for profits not originated in Ireland and a US law that allows multinationals to pay taxes on their profits made abroad only when these are returned back to the US. As a result of the combination of these two elements, Apple was not paying taxes on most of its profits outside of the US and transferred to Ireland, the reason being that they were originated in the  United States through the creation of intellectual property and as a result were not taxable in Ireland.

All this is not sufficient for identifying an incompatible State aid because it merely leads to an advantage, i.e  the tax savings that Apple received, measured as the difference between the tax that would have been due under generally applicable domestic law and the tax actually paid under the challenged provision or regime. As for selectivity, the advantage could be considered selective if  “it put(s) … (Apple) ….  in a more favourable position than other undertakings that are in a  comparable factual and legal position”.

An issue here to be discussed is whether the selectivity should be measured against other multinationals similar to Apple, showing that the tax treatment Apple received was more favorable than they did, but these other multinationals may not even be Apple competitors, or whether, much more rightly, the selectivity should be measured with respect of the actual or potential competitors of Apple, putting into question the generality of the measure itself.

Two companies benefitted from the favorable tax in the Ireland-Apple case, Apple Sales International (ASI) and Apple Operations Europe (AOE), both were Irish-incorporated Apple subsidiaries, but they were tax resident nowhere (stateless). According to an agreement with the Irish tax Authority ASI and AOE would pay taxes in Ireland on figurative profits calculated as a percentage  (around 15%) of the branch operating expenses. 

In the course of the negotiations on how to calculate these figurative profits, Ireland and Apple discussed employment levels in Ireland in exchange for a somehow lower tax burden. This is clearly State aid. Furthermore Ireland accepted without any independent assessment Apple representation about the relative contributions of the head offices and the branches (IP licenses should all be attributed to the US and branch profits were presumed according to Apple suggestions). The restitution request did therefore take into account this reassessment. More importantly the advantage Apple received was compared, not to the situation of other multinationals geographically diversified like Apple, but to Apple competitors that would have to buy inputs at market prices (and not as Apple did at tax free prices).

The case is under appeal. In my view the prohibition it introduced may create some discipline for fiscal authorities across the EU, but of course short of any harmonization of the corporate income tax.

The EU however is actively working on these issues also on the regulatory front. In particular, short of rate harmonization, the new proposed directive of the European Parliament and of the Council amending Directive (EU) 2017/1132 as regards cross-border conversions, mergers and divisions provides “a specific, structured and multi-layered procedure for cross-border conversions which ensures a scrutiny of the legality of the cross-border conversion firstly by the competent authority of the departure Member State and secondly by the destination Member State in the light of all relevant facts and information. A crucial element of the procedure is that it would prevent a cross-border conversion where it is determined that it constitutes an abuse, namely in cases where it constitutes an artificial arrangement aimed at obtaining undue tax advantages or at unduly prejudicing the legal or contractual rights of employees, creditors or minority members”.

The Directive however does not introduce some constraints on transfer prices so that, even an existing corporate structure, by illegitimately shifting profits to low tax countries, would not be able to strategically reduce its tax burden.

Achieving a common corporate tax in the EU is a worthwhile objective to be pursued by a specific tax harmonization directive.

5. Conclusion

European and domestic regulations are strictly complementary. The best outcome is achieved when domestic regulation is competition oriented, adding an efficiency pillar to the EU objective of opening up markets. When domestic regulation creates obstacles for competition to emerge, the positive effects potentially associated with European interventions is weakened. In public procurement, for example, the efforts of the EU to allow firms to receive some benefits because of a good reputation as Public Administration suppliers should not be frustrated, as it has been done in Italy when the new European directives were adopted domestically. Quality of supply is what matters, not extending advantages to unfit firms!

The same is true when European law is applied without due consideration to domestic supply conditions. For example article 12 of the Service Directive obliges Member States to introduce a bidding procedure should the number of competitors be naturally limited. The provision was meant to be applied to situations of very tight and stable oligopoly, where demand is captive and the possibility to exercise an activity is impossible for a new entrant, once all possible authorizations had been granted. Everything is fine except that in some markets the value of the activity subject to authorization depends on the sunk investments made by those that have been granted the authorization in the past. Introducing a bidding procedure in such instances leads to an illegitimate expropriation by the State of private sunk investments, weakening the incentive to invest in the first place. Furthermore, where the numbers of such authorizations is high, the market is not blocked and many firms can enter the market by acquiring in the market an already authorized company. Introducing regular biddings, as imposed by the Service Directive, should not be necessary in such instances.

As for State Aid, the process of modernization started in 2012 has not addressed one of the main shortcomings of the practice of State aid control, mainly the fact that the notion of an incompatible aid starts from an assessment of selectivity and not from a competitive evaluation of the affected market. If an aid produces no effects on competition or, even better, it promotes greater competition, it should not be blocked.

Furthermore, instead of exempting aid, the EU should concentrate more on blocking incompatible aid. For example, locational aid was originally meant to contribute to the development of regions which were a small part of existing Member States (for example the Southern part of Italy). With the accession to EU of countries characterized by much lower levels of income per capita, the privilege of locational aid has been granted, contrary to what was happening in the past, to whole countries, already benefitting from strong competitive advantages (low labor costs, favorable exchange rates, etc.). State aid regimes granting locational aid and block exempted should instead all be notified to the Commission and be subject to a simplified authorization procedure. Relying on ex post assessment for reforming State aid policy is a good idea, but it would take decades to produce the desired effects, if any.

Finally corporate income tax harmonization is a necessity in Europe, as highlighted by the recent Apple case. State aid control can eliminate some distortions but it is certainly unable to create a level playing field in the EU. For this it is necessary to intervene with a specific directive ensuring harmonization is properly achieved. 

1 Diverse exchange rate systems remain part of the EU with some countries holding exemptions from the presumption to introduce the Euro and others retaining their national currencies with fixed/flexible rates relative to the Euro and flexible rates vis a vis the rest of the world. This simultaneous maintenance of fixed and flexible rates for non-Euro and for Euro zone countries was not envisaged in the initial discussions of the single currency. It has produced the concept of variable velocity or concentric convergence in which member states can choose the speed at which they introduce the various requirements for membership.

2 While most central banks have restrictions on their ability to finance government expenditures directly, they are all subject to some degree of representative democratic political control, despite the claims of central bank independence. It is also commonly accepted that coordination between monetary and fiscal policy is an essential element of the efficiency of economic policy. The ECB was created in the Maastricht Treaty and is only subject to the conditions in EU Treaties and the power granted to it by the European Commission, not the European Parliament.

[1] Wynne Godley, Derailed, London Review of Books, Vol. 15 No. 16 · 19 August 1993, page 9.

[2] Wynne Godley, ‘Derailed’, London Review of Books, Vol. 15 No. 16, 19 August 1993, page 9.

[3] Wynne Godley, London Observer, August 31, 1997, p. 24.

[4] Otmar Issing, “Europe: Political Union through Common Money?” Occasional Paper 98. London: Institute of Economic Affairs, 1966.

[5] Parenteau, R. 2010. “Minsky and the Eurozone Predicament: Transcending the Dismal Science.” Presented at the 19th Annual Hyman P. Minsky Conference, “After the Crisis—Planning a New Financial Structure,” New York, N.Y., April 15.

1 See http://www.goodreads.com/quotes/4101971-you-can-t-look-at-the-competition-and-say-you-re-going.

2 Many of such agreements were created in the developing world, such as for example the Mercado Commun do Sul (Mercosur), the Andean Community, the Common Market for Eastern and Southern Africa (COMESA), the Caribbean Community (CARICOM), the West African Economic and Monetary Union (WAEMU), the Economic Community of West African States (ECOWAS) and the South African Development Community (SADC), to name a few.

3 See on this Heimler, A. and Jenny, F.  (2013) “Competition law and policy in developing countries: national and regional enforcement”, in Lewis , D. (Ed) Building New Competition Law Regimes, Edward Elgar

4 The text of the Shuman Declaration can be found at http://europa.eu/about-eu/basic-information/symbols/europe-day/schuman-declaration/index_en.htm

5 Judgment of the European Court of Justice of 20 February 1979 in case 120/78, Rewe-Zentral AG and Bundesmonopolverwaltung, Available at http://eur-lex.europa.eu/legal content/EN/TXT/PDF/?uri=CELEX:61978CJ0120&from=en.

6 Commission v Greece, Judgment of the Court, 21 April 2005 in Case C-140/03, available at: http://curia.europa.eu/juris/showPdf.jsf?text=&docid=58138&pageIndex=0&doclang=EN&mode=lst&dir=&occ=first&part=1&cid=8972.

7 In general a quantitative restriction of imports is meant to protect a domestic producer. In this case also domestic producers were hurt and by the way they were probably hurt even more than foreign producers (who at least have a local market where to sell their trailers and entry into the market may be easier than if someone has to sell all its production abroad).

[6] Judgment of the Court, 10 February 2009, in Case C‑110/05, available at: http://curia.europa.eu/juris/document/document.jsf?text=&docid=72844&pageIndex=0&doclang=EN&mode=lst&dir=&occ=first&part=1&cid=11543.

[7] Directive 2014/24/EU Of the European Parliament and of the Council of 26 February 2014 on public procurement. Available at: http://eur-lex.europa.eu/legalcontent/EN/TXT/PDF/?uri =CELEX:32014L0024&from=EN

[8] Albano, GL, Heimler, A. and Ponti, M. (2014), “Concorrenza, regolazione e gare nei servizi pubblici locali: il caso del trasporto pubblico locale”, Mercato, concorrenza e regole.

[9] See Heimler, A. (2015), “Appalti pubblici, vincoli comunitari e prassi applicative: quale spazio per gli aspetti sostanziali?”, Mercato, concorrenza e regole.

[10] See the Italian Public Procurement Code (codice degli appalti, Decreto Legislativo 18 Aprile 2016, n.50), article 80, paragraph 5, letter c.

[11] Heimler, A. (2009), “European State aid policy in search of a standard. What is the role of economic analysis?”. In Hawk Barry (a cura di), International Antitrust Law and Policy, Fordham Competition Law 2009, Juris Publishing;  Heimler, A. and Jenny, F. (2012) “The Limitations of EC State Aid Control”, Oxford Review of Economic Policy.

[12] Should the effect on competition be positive, the extension of the aid to the small number of negatively affected competitors, more than restitution of the aid, may be the appropriate remedy.

[13] Judgment of the European Court of Justice, 19 December 2012, Mitteldeutsche Flughafen AG and Flughafen Leipzig-Halle GmbH, v European Commission, Available at: http://curia.europa.eu/juris/document/document.jsf?text=&docid=131967&pageIndex=0&doclang=EN&mode=lst&dir=&occ=first&part=1&cid=861426.

^[14] Available at: http://ec.europa.eu/competition/state_aid/studies_reports/studies_reports.cfm.

^[15] Pages 19 and 20 of the Vademecum.