The Eurozone’s Private and Governmental Shock Absorbers: Current Setup and Future Prospects

Recall that the idea of ‘embeddedness’ is driven from the Opus Magnum of Karl Polanyi, The Great Transformation, where he claims that, within capitalist economies, markets are strongly embedded mostly because they are political institutions and submitted to political control (McNamara 2015, p. 25).

Starting from the seminal article of Mundell (1961), the main conditions for an optimum currency area are, on the one hand, the mobility of factors of production including labour and, on the other hand, price and wage flexibility. As a result, when facing an adjustment problem, these two conditions are mechanisms that can grant automatic equilibrium to the participating economies. Furthermore, the similitude or symmetry of economic structures between countries belonging to the same currency area may also work out as a condition to reach the optimum.

Regulation (EU) No 1174/​2011 of the European Parliament and of the Council of 16 November 2011 on enforcement measures to correct excessive macroeconomic imbalances in the euro area.

Notice that besides the SSM and the Single Resolution Mechanism (SRM), the BU also includes harmonization (not centralization) of the national deposit insurance schemes. The key pieces of legislation concerning the BU are: EU Regulation No 1424/2013, which confers upon the ECB the task of prudential supervision of credit institutions; EU Resolution No 806/2014, which establishes the Single Resolution Mechanism (SRM), a Single Resolution Board (SRB) and a Single Resolution Fund (SRF); EU Directive 2014/59 (Bank Recovery and Resolution Directive—BRRD); EU Directive 2014/49, which harmonizes the key features of national deposit guarantee schemes (see Xafa 2015, p. 6). On this issue, see also Véron (2015, pp. 9–13).

Notice, however, that if national deposit insurance should involve some fiscal burden sharing (at the federal level), then the banking union should imply the notion of budgetary union or at least the idea of a fiscal backstop. On this issue, see Wolff (2012, pp. 5–6). The Author mentions that despite the autonomy of the Federal Deposit Insurance Corporation (FDIC) the US Treasury stands behind providing for credibility in times of crisis. If a similar solution were to be adopted in the EU, then “one could view a euro-area budget as the backbone for such a common fiscal backstop for a new European resolution authority and fund. Such a fiscal backstop ultimately means that the federal level has the ability to borrow on the market” (Idem, p. 6), restoring confidence in situations of crisis.

Explaining in which way equity and bond markets work as a private insurance mechanism in case of asymmetric shocks, see De Grauwe (2014, pp. 18–19). Asdrubali et al. (1996) have empirically validated this idea for the US case. Recall that according to the results then presented (and that seem to maintain appropriateness), part of the shocks to gross state product (39 %) were absorbed by capital markets, while federal government smoothing was only on 13 % and credit markets smoothing of 23 % (with 6 % remaining of non-smoothed shocks). Hoffmann and Sørensen in a similar vein (2012) claim that from the three existing risk-sharing channels—the fiscal insurance, the credit markets and the capital markets channels—the most effective is the latter.

Furthermore, as mentioned by von Hagen and Wyplosz (2008), even though redistributive transfers were not designed explicitly for that purpose, they can be considered insurance mechanisms against asymmetric cyclical shocks, since regions in a more favourable cyclical position than the federation on average pay transfers to regions in a less favourable position. This has the consequence of dampening the relative boom in the former and the relative recession in the latter.

As referred to by Enderlein et al. (2013, p. 32), macroeconomic insurance can exhibit ex ante and ex post moral hazard: ex ante, countries have an incentive to reduce their own resilience to asymmetric shocks by disabling their own automatic stabilizers, triggering larger output gap deviations and thus relying on larger transfer payments from the central fund; ex post, countries could generate the funds they owe or use the funds they receive in a way that does not maximize the effectiveness of the scheme towards more business cycle convergence (they could use the funds where fiscal multipliers are not the highest but more desirable in political terms).

Gros (2014) claims that the institution of a shock absorber within the Eurozone should take into account ‘economics of insurance’—not only to prevent moral hazard behaviour but also to ensure that the mechanism is effective when effectively needed. In his opinion, the Eurozone does not need a system that offsets all shocks by some small fraction, but a system protecting against shocks that could be potentially catastrophic. A system of fiscal insurance with a fixed deductible would therefore be preferable to a fiscal shock absorber that offsets a certain percentage of all fiscal shocks. Notice that the idea of a deductible is first and foremost explained by the need to address moral hazard. But there are other alternatives to the ‘deductible model’. One option relies on the integration of the new insurance device within the SGP framework that might imply either fiscal discipline enhancement as a condition (ex ante) to be eligible for funding if and whenever needed or a penalty (ex post) for countries that had circumvented SGP rules—e.g. overstating potential GDP in order to reduce its payment to the Fund (see on this issue von Hagen and Wyplosz 2008, p. 17).

For this reason, Von Hagen (1998) when listing and classifying several proposals for shock absorbers, considered not only their specific insurance role, but also and first and foremost their general redistributive role. Amongst seminal contributions on this issue see, on the one hand, Sala-i-Martin and Sachs (1991), Von Hagen (1992, 1998), Goodhart and Smith (1993)—all using regression analysis to compute the contribution of fiscal variables, taxes and transfers, to the GDP—and, on the other hand, Pisani-Ferry et al. (1993), using a simulation exercise. See also Wyplosz and Pisani-Ferry (1990).

An initial version of this model was the ‘Blue Bond proposal’ made by Delpla and von Weizäker (2010): EU countries should pool up to 60 % of GDP of their national debt as senior debt, thereby reducing borrowing costs. On the contrary, red debt (beyond that percentage) would be issued as national and junior debt, claiming an enhancement of fiscal discipline as a way to prevent an interest rate premium.

As mentioned by Schelkle (2005), the idea would be to complement the disciplinarian view present in the SGP with an insurance device, and yet controlling moral hazard.

In this case, the SGP should be directly linked to the insurance mechanism. Hence, in good times, countries with budget surpluses would have to contribute to the Fund that would then work as a buffer to be used in case of economic downturn. In these circumstances, countries would also be allowed to run deficits (cyclically-motivated deficits) but only under condition of having accomplished SGP’s and Fiscal Compact’s rules, e.g. structural balance. In fact, past and current structural balance (the compliance of the ‘medium term objective’ settled by the SGP and the Fiscal Compact) should be a condition not only to run deficits but also to benefit from financial support in the event of adverse shock. Moreover, notice that this structural type-link should furthermore require technical arrangements in order to adapt the new financial scheme to the SGP framework, notably vis-á-vis the calculation of the GDP potential and output gaps (see on this computation Mourre et al. 2014).

The main exception in this stance can be found in Beblavý et al. (2015, p. 17), concerning the introduction of the EUBS. In their study they include all EU member countries, and this is mostly because if the purpose of the scheme is to ensure countries against asymmetric shocks, then a larger pool of countries is better than a smaller one.

This helps to explain, for example, why in the measurement of the output gap and of the cyclically-adjusted balance budget it is assumed that indirect taxes have a unitary elasticity with respect to output gap, clearly below the elasticity estimated to direct taxes and social security contributions. On this issue see Mourre et al. (2014).

A different opinion is expressed by von Hagen and Wyplosz (2008, pp. 14–15) stressing that VAT is closer to demand shocks than income and payroll taxes and that the former reacts faster to cyclical movements in the economy than the latter.