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The Euro Area Crisis: Need for a Supranational Fiscal Risk Sharing Mechanism?

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Abstract

The aim of this paper is to assess the effectiveness of risk sharing mechanisms in the euro area and whether a supranational fiscal risk sharing mechanism could insure countries against very severe downturns. Using an unbalanced panel of 15 euro area countries over the period 1979–2010, the results of the paper show that: (i) the effectiveness of risk sharing mechanisms in the euro area is significantly lower than in existing federations (such as the U.S. and Germany) and (ii) it falls sharply in severe downturns just when it is needed most; (iii) a supranational fiscal stabilization mechanism, financed by a relatively small contribution, would be able to fully insure euro area countries against very severe, persistent and unanticipated downturns.

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Notes

  1. See Baldacci et al. (2009), Baldacci and Kumar (2010), Hutchison et al. (2010), Furceri and Zdzienicka (2012) for recent work on the effect of fiscal policy in periods of recession.

  2. Arreaza et al. (1998) focus on periods of positive versus negative output gaps, rather than periods of significant output contractions.

  3. The fact that the remaining 25% is not smoothed is consistent with related empirical evidence on consumption smoothing showing less than full risk sharing. See, for example, Cochrane (1991), Crucini (1999), French and Poterba (1991), and Canova and Ravn (1996).

  4. Arreaza et al. (1998) focus on periods of positive versus negative output gaps, rather than periods of significant output contractions.

  5. Data for income variables are taken from the OECD National Accounts database (2012).

  6. See Asdrubali et al. (1996) for details.

  7. The validity of the interpretations of the β coefficients provided by Asdrubali et al. (1996) has been questioned in the literature. In particular, Mélitz and Zumer (1999) argue that the interpretation may not necessarily hold for three main reasons. First, changes in interregional (international) consumption may be driven by changes in intertemporal preferences rather than output. Second, the Miller-Modigliani theorem of the irrelevance of dividend policy may apply, and higher corporate saving may induce households to consume more, with β m and β s moving in the opposite directions. Third, and perhaps more important, as national account statistics do not measure gains and losses on net foreign assets, β m accounts only for income flows. While, these arguments suggest that the amount of risk-sharing provided by the capital and credit channels should be interpreted with caution, the main focus of the paper is on the total amount of risk-sharing and on the role of supranational stabilization mechanism operating via international transfers.

  8. Harding and Pagan (2002) find that the average magnitude of the downturns is 2.5% for the United Kingdom and the United States, and 2.2% for Australia.

  9. The PCSE parameters used in the analysis are: (i) an AR1 autocorrelation structure; and (ii) panel-level heteroskedastic errors.

  10. See Hepp and von Hagen (2013) for a similar approach and a more detailed discussion.

  11. Differentiating between different public saving components, Afonso and Furceri (2008) find that the largest amount of risk sharing is provided by social benefits.

  12. The two-step GMM-system estimates (with Windmeijer standard errors) are computed using the xtabond2 Stata command developed by Roodman (2009). Lagged GDP growth and the lag of the dependent variable are considered as endogenous (instrumented using up to 3 lags). The significance of the results is robust to different choices of instruments and predetermined variables. Consistency of the two-step GMM estimates has been checked by using the Hansen and the Arellano–Bond tests. The Hansen J-test of over-identifying restrictions, which tests the overall validity of the instruments by analyzing the sample analog of the moment conditions used in the estimation process, cannot reject the null hypothesis that the full set of orthogonality conditions are valid. The Arellano–Bond test for autocorrelation cannot reject the null hypothesis of no second-order serial correlation in the first-differenced error terms.

  13. Two lags of real GDP growth have been used as instruments.

  14. In detail, Eqs. (2)-(7) have been re-estimated over the following time samples: i) 1979–1999; ii) 1980–2000; iii) 1981–2001; iv) 1982–2002; v) 1983–2003; vi) 1984–2004; vii) 1985–2005; viii) 1986–2006; ix)1987-2007; x) 1988–2008; xi) 1989–2009; and xii) 1990–2010.

  15. Pierucci and Ventura (2010) find mixed evidence on the effect of international financial liberalization has on risk sharing.

  16. The amount of smoothing provided by credit markets has decreased even further after the creation of the EMU (see Table 13, Appendix 1).

  17. See, for example, Gali and Perotti (2003) and IMF (2004) for an analysis of the effects of the Maastricht Treaty and Stability and Growth Pact on the effectiveness of automatic stabilizers.

  18. Such a decline in the use of credit market for risk sharing purposes may have arisen from the fall in saving and in the underpricing of risks by markets that characterized the first decade of EMU, in a context of over-optimistic growth expectations.

  19. It is important to highlight the methodological differences between interregional and international risk sharing channels: (i) country-level data are richer than U.S. and Germany state-level data; (ii) capital market smoothing in the U.S. and Germany includes factor income flows and capital depreciation.

  20. The results obtained over shorter but more comparable sample periods, and using the two-step GLS estimates in the comparison with the U.S. (as in Asdrubali et al. 1996), provide similar conclusions (Table 14 in the Appendix 1).

  21. In particular Hoffmann and Shcherbakova-Stewen (2011) find that small firms’ access to financial markets plays an important role in explaining this result: business cycle fluctuations in aggregate risk sharing are more pronounced in states in which small firms account for a large share of output.

  22. Baxter and Crucini (1995) argue that borrowing and lending can provide significant insurance against transitory shocks.

  23. Similar results are obtained by identifying symmetric severe downturns using quarterly data for euro area aggregate GDP.

  24. The results have to be interpreted with caution given the relatively small number of observations (45).

  25. Using the same methodology described in Asdrubali et al. (1996), we find that labor market mobility among euro area countries smoothes only around 3% of GDP per capita fluctuations.

  26. We use GNP, rather than GDP, as a scaling measure of income to control for consumption smoothing that occurs through international capital markets.

  27. Alternative mechanisms proposed in the literature tie payments to national unemployment. While this approach has the main advantage of being close to the existing national social programs, a mechanism based on unemployment benefits could be pro-cyclical instead of counter-cyclical due to delays in the response of unemployment to output shocks. In addition, a system based on unemployment shocks would provide only partial insurance as it only focuses on one production factor. Moreover, given the wide variation in long-term unemployment levels across the EMU, the focus should be restricted to short-term unemployment which is likely to generate only limited risk sharing (Asdrubali et al. 1996). In fact, providing insurance against long-term unemployment would generate redistribution effects from low-unemployment level countries to high-unemployment countries (Wolf 2012).

  28. The literature on public finance has long emphasized that transfers and tax system should be simple to be accepted by the general public (Buchanan and Flowers 1987).

  29. If the required amount of current year transfers exceeds the current year’s contributions to the fund, transfers are drawn out of the funds saved from previous years. When there are no saved funds, only a part of the shock can be smoothed.

  30. The size of the country is measured in terms of DNI as this income variable is the one affected by the net international transfers.

  31. A similar income process has been used by Campbell and Mankiw (1987), Asdrubali et al. (1996) and Mélitz and Zumer (1999) to estimate the persistence of income shocks. The autocorrelation of the estimated residuals of Eq. (17) is close to zero.

  32. Data for output gap are taken from the OECD Economic Outlook (2012).

  33. Output gaps are typically constructed using two-sided filters.

  34. As a simplifying assumption, we assume that the amount of consumption smoothing remains unchanged when the stabilization fund is operative. This corresponds to the implicit assumption that total consumption growth adjusts proportionally to changes in DNI growth.

  35. Furceri and Karras (2007).

  36. The relatively large size of transfers for Finland is driven by the occurrence of the very severe financial crisis in the 90s. The average size of transfers would have been larger over the post-EMU period (see Table 15 in Appendix 1), as mostly of the symmetric severe downturns have occurred in this period (e.g., in 2002 and 2009). In addition, the periphery countries would have contributed relatively more until 2007 than the core countries—as they were growing faster—but would have also received larger net transfers during the Great Recession.

  37. A similar number is also found by applying different transfer mechanisms. For example, a contribution equivalent to 1.9% of GNP would be sufficient to fully finance transfers payments to absorb serially uncorrelated shocks on total consumptions.

  38. See, for example, Melitz and Vori (1992), Italianer and Vanheukelen (1992), Hammond and von Hagen (1998) for different types of insurance mechanisms.

  39. The full set of results is available upon request.

  40. The full set of results is available upon request.

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Acknowledgments

The authors would like to thank Celine Allard, Jochen Andritzky, Alan Auerbach, Roel Beetsma, Ansgar Belke, Helge Berger, Olivier Blanchard, John Bluedorn, Xavier Debrun, Pierre-Olivier Gourinchas, Jana Grittersova, Daniel Gros, Jules Leichter, Prakash Loungani, Franziska Ohnsorge, Tigran Poghosyan, Frank Smets, Livio Stracca, participants to the conference Fiscal Policy and Coordination in Europe (Central Bank of Slovakia) and the ECB/IMF conference Reforming EU Fiscal Governance, for very useful discussions and suggestions. We are also grateful to the editor George Tavlas and to two anonymous referees for useful comments. Shanti Karunaratne provided excellent editorial assistance.

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  1. International Monetary Fund and University of Palermo, IMF, 700 19th Street NW, Washington, DC, 20431, USA

    Davide Furceri

  2. International Monetary Fund, IMF, 700 19th Street NW, Washington, DC, 20431, USA

    Aleksandra Zdzienicka

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  1. Davide Furceri
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Correspondence to Davide Furceri.

Annex I. Magnitude of downturns

Annex I. Magnitude of downturns

Table 13 Channels of output smoothing across countries- pre-EMU vs. post-EMU
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Table 14 Channels of output smoothing across countries
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Table 15 Average transfers in the case of full stabilization, 1999–2010 (% of country’s GNP)
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Furceri, D., Zdzienicka, A. The Euro Area Crisis: Need for a Supranational Fiscal Risk Sharing Mechanism?. Open Econ Rev 26, 683–710 (2015). https://doi.org/10.1007/s11079-015-9347-y

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