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Revisiting the Economic Case for Fiscal Union in the Euro Area

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Abstract

After significant progress as an immediate result of the euro crisis, the drive to complete Europe’s Economic and Monetary Union (EMU) has decelerated. While there is a broad consensus in Europe that EMU needs further development, the exact nature and timing of the reform agenda remains controversial. This paper makes an analytical contribution to the ongoing discussion about the euro area’s institutional setup. An in-depth look at the remaining gaps in the euro’s architecture, and the trade-offs that repairing them would present, suggests the need for long-run progress along three mutually supportive tracks. The first is more fiscal risk sharing, which will help enhance the credibility of the sovereign “no-bailout” rule. The second is complementary financial sector reforms to delink sovereigns and banks. And the third is more effective rules to discourage moral hazard. Helpfully, this evolution would ensure that financial markets provide more incentives for fiscal discipline than they do now. Introducing more fiscal union comes with myriad legal, technical, operational, and political problems, however, raising questions well beyond the domain of economics. These difficulties notwithstanding, without decisive progress to foster fiscal risk sharing, EMU will continue to face existential risks.

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Notes

  1. For recent contributions to the debate see, for example, Thomsen (2017), European Commission (2017), Bénassy-Quéré et al. (2017, 2018), Arnold et al. (2018), Cimadomo et al. (2018), Stráský and Claveres (2019) and the contributions in Bénassy-Quéré and Giavazzi (2017).

  2. See Thomsen (2017), IMF (2017) and Goyal and et al. (2013).

  3. This remains true even though intra-EU labor mobility increased significantly owing to the crisis and interstate migration in the USA has dropped (Molloy et al. 2011; Dao et al. 2017).

  4. Dell’Ariccia et al. (2018b) discuss why financial sector bailouts using taxpayer resources can never be fully off the table, notwithstanding official protestations to the contrary. As it turns out, they are likely to be big precisely when they are most justified. See also Avgouleas and Goodhart (2016) and Gros and de Groen (2015).

  5. The paper demonstrates that even when financial markets are complete in the Arrow-Debreu sense, international fiscal transfers have a role when prices are sticky because people will not buy socially optimal levels of insurance. For example, during recessions, they do not internalize sufficiently the contribution to aggregate demand they make by spending additional insurance receipts. The advantage of transfers over fiscal policies could be even bigger in general than under the calculations presented by Farhi and Werning (2017) because their assumptions make the domestic distributional consequences of an adverse shock implausibly small. For example, even their “hand to mouth” consumers, who are constrained to consume just their incomes, derive part of those incomes from pro rata holdings of shares in domestic firms’ profits. Further, more realistic heterogeneous-agent models of incomplete markets, such as that of Mitman et al. (2019), likely accentuate the advantage of external transfers over domestic fiscal policy, especially under constrained space to run deficits.

  6. See their Fig. 8 for a comparison.

  7. This would be the case even if these government functions were located at the EU level.

  8. Centralized fiscal policy can also internalize potentially inefficient externalities from national fiscal policies such as those modeled by House et al. (2019).

  9. These issues have also bedeviled attempts to apply the BRRD.

  10. Similarly, Cœuré (2016) concludes that “a degree of fiscal risk sharing” underpinned by “a set of rules at euro area level, mutually agreed and enforced by common institutions” may be required for sovereign debt markets to effectively indicate sovereign risk.

  11. Gros and Mayer (2010) presented an early argument for enhancing the credibility of no-bailout through a mechanism that would facilitate orderly sovereign debt restructuring. According to Bénassy-Quéré et al. (2016), the main issue does not concern so much the introduction of a debt restructuring mechanism as it does ensuring that it is feasible—including through banking sector resilience and the introduction of better economic stabilization tools. Bénassy-Quéré et al. (2018) emphasize that credible debt restructuring also requires legal mechanisms that protect sovereigns from holdout creditors—the purpose of the envisioned single-limb aggregation of sovereign liabilities—and procedures to strengthen the no-bailout commitment on the institutional side. Andritzky et al. (2019) and Grund and Stenström (2019) discuss sovereign restructuring mechanisms.

  12. Several factors are at work. Risk sharing might affect bargaining between debtors and creditors, tilting bargaining power toward the latter and making creditor governments more eager to bail out their lenders by orchestrating an EMU bailout of the sovereign. A more direct likelihood, however, is that by shielding the debtor economy in the case of an idiosyncratic shock, risk sharing would reduce lender losses conditional on no bailout, which would, in turn, enhance the credibility of a no-bailout promise.

  13. At the peak the crisis, the EBA imposed capital buffers based on “prudent valuation” of sovereign debt held to maturity. This exercise had a forward-looking element resembling positive risk weights on sovereign bonds. However, a more systematic and fully ex ante approach would provide a better incentive structure for the banking system.

  14. Indeed, due to some costs being external, sovereign defaults may occur too frequently (from the community-welfare perspective) relative to politically difficult domestic adjustment measures. For a discussion of US municipal default from this perspective, see Gillette (2012).

  15. The presence of spillovers will matter in this context. The positive relationship between formal risk sharing and moral hazard is likely to be stronger if the programed support benefits only the crisis country—such as improving a country’s payoff under financial autarky in models of bilateral sovereign debtor/creditor negotiations. However, in a closely integrated currency area, crisis costs are likely to be shared (for example, through trade and financial channels), giving rise to an initially negative effect of higher formal risk sharing on moral hazard.

  16. Addressing this need will be aided by the fact that risk sharing shifts part of the task of stabilizing state-level business cycles to the central level, which makes it easier for states to implement credible deficit limits at their level.

  17. See, for example, the analyses and discussions in de Haan et al. (2004), Beetsma et al. (2009), Carlino and Inman (2013), Gros and Alcidi (2015), Eyraud et al. (2017) and Bénassy-Quéré et al. (2018).

  18. See, for example, Hallerberg (2016) and Demertzis and Wolff (2016). On the European Semester, the analysis of Gros and Alcidi (2015) and Darvas and Leandro (2015) suggests that implementation of recommendations was poor from the start in 2011 and continued to decline over time.

  19. OMT do not constitute a full “backstop for government funding” in the sense of Draghi (2014); that is, they do not eliminate quadrilemma constraint 1 for national governments (though they do relax constraint 2). OMT are subject to conditionality; the ECB Governing Council, not the member state issuing purchased bonds, makes the decision to deploy OMT; member states must pay interest to the European System of Central Banks on any of its bonds purchased owing to OMT; an insolvent sovereign might still have to restructure its debts before eligibility for OMT; and, as noted, OMT remain untested. The European Court of Justice ruled in June 2015 that OMT do not constitute monetary financing of Member States. OMT do not eliminate the risk of multiple equilibria, since there is no assurance the ECB will intervene to remove such equilibria regardless of circumstances.

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Acknowledgements

The authors thank, without implicating, Tobias Adrian, Xavier Debrun, Enrica Detragiache, Vitor Gaspar, Luc Laeven, Ken Kang, Mahmood Pradhan, Linda Tesar (the editor), Poul Thomsen, and especially Jeromin Zettelmeyer for very helpful comments and suggestions. Giang Ho, Roberto Piazza, Gabi Ionescu, and Ilse Peirtsegaele provided excellent technical and editorial support. The views expressed here are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

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  1. Research Department of the International Monetary Fund, Washington, USA

    Helge Berger, Giovanni Dell’Ariccia & Maurice Obstfeld

  2. University of California, Berkeley, Berkeley, USA

    Maurice Obstfeld

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Berger, H., Dell’Ariccia, G. & Obstfeld, M. Revisiting the Economic Case for Fiscal Union in the Euro Area. IMF Econ Rev 67, 657–683 (2019). https://doi.org/10.1057/s41308-019-00089-x

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