Does the eurozone need a budget?

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of PLC.

Those proposing that the euro area needs a fiscal shock-absorbing mechanism might better push for a concrete mechanism that could be implemented among a subgroup of member states instead of jumping to the conclusion that all member states be forced to pay a large part of their tax revenues into a euro area budget, writes Daniel Gros.

Daniel Gros is director of the Centre for European Policy Studies and a member of the World Economic Forum’s Global Agenda Council on Europe

"The Maastricht Treaty created a restrictive European monetary union by keeping fiscal policy national, subject only to a stability pact.  Was this a wise choice?  Many observers now argue that the Achilles’ heel of the euro is that it has no mechanism to ease shocks to individual member states.  The euro area, they argue, needs its own budget to provide some automatic insurance to individual countries when they are hit by these asymmetric shocks. 

Even proponents of a sizeable ‘federal’ euro budget admit that permanent shocks (for example the collapse of a major export market require permanent adjustment in wages and expenditure.  But, what is lacking is allegedly a mechanism to redistribute funds from countries experiencing temporary booms to those in recession. This, they say, would dampen the normal ups and downs of an economy and make short term shocks easier to absorb. They usually hold up the United States and its redistributive federal system as an example of how this can work.

But a closer look reveals that this doesn’t work as well as is widely assumed. It is true that in the US, as in most federal states, the federal budget redistributes income across regions and thus offsets at least part of the interregional differences in income.  But the inference that redistribution is equivalent to a shock absorber is wrong.

For example, in the US, the federal budget offsets a substantial part of the differences in the level of income per capita across states – generally believed to be between 30% and 40% – because poorer states contribute on average lower income tax and receive higher social security payments. However, this does not imply that these mechanisms also provide an insurance against temporary shocks to individual states. Many of the transfers from the federal government, especially basic social support such as food stamps, etc, change little with the local business cycle.  For example, retirees in Florida receive their pensions whether or not the local economy is doing well (as during the real estate boom up to 2007). These pensions do not increase when the local economy enters a bust, as it did after 2008. This type of transfer payments from the federal government thus do not provide any buffer against local shocks.

On the revenue side the degree to which federal taxes absorb shocks at the state level cannot be very large for the simple reason that the main federal sources of revenues that react to the business cycle, such as federal income tax, accounts for less than 10% of GDP.

This low sensitivity of both federal expenditure and revenues to local business cycle conditions explains why on average only a small fraction – estimated about between 10% and 15 % – of any shock to the GDP of any individual state is absorbed via automatic transfers to and from the US federal budget.

A related idea which has come up repeatedly in the European context is to create some European, or euro area, unemployment insurance fund.  This idea is very attractive at first sight. But here again the reference to the US experience is misleading: in the US unemployment insurance is actually organised at the state level. The federal government intervenes only in the case of major nation-wide recessions and provides some supplementary benefits for the long-term employed. But this support is given to all states and thus does not provide those most affected with much more support than the others. 

Moreover, unemployment benefits are not as important as often assumed. In most countries they amount to only about between 2% and 3% of GDP, even during a major recession. In the US, the supplementary federal expenditure amounted to only about  1% of GDP in recent years.  It is thus clear that a euro area unemployment insurance system would never be able to offset major shocks, such as the ones hitting Ireland or Greece where GDP has fallen by more than 10%. 

All in all, it is thus difficult to rest the case for some euro area fiscal shock absorber on the US experience.  

If business cycle shocks were really the key problem, individual member states could first of all ‘self-insure’ by running a prudent fiscal policy and lower their debt level so that they have the freedom to run temporary deficits in case they face temporary shocks.  The ‘Fiscal Compact’ with its target of approximate balance in cyclically adjusted terms is implicitly based on this idea. 

Moreover, those member states that feel most exposed to business cycle shocks could very well agree among themselves to some mutual insurance scheme.  There would be no need to make this scheme compulsory for all member states if the aim is only to pool limited risks on an actuarially fair basis.  It is of course true that the risk pooling becomes more efficient the more member countries participate (and the less their business cycles are correlated).  This implies that if a subgroup of member states starts such a system (in the spirit of what is called in EU legal terms a ‘reinforced cooperation’) the other member states should be attracted as well. The force of attraction of such a scheme would provide a litmus test of its usefulness.

Proponents of the idea that the euro area needs a fiscal shock-absorbing mechanism might thus do better proposing a concrete mechanism that could be implemented among a subgroup of member states instead of jumping to the conclusion that all member states be forced to pay a large part of their tax revenues into a euro area budget."