Concerns have been expressed that the future adoption of a single currency among some members of the European Union will limit their ability to deal with asymmetric shocks (i.e. shocks that are idiosyncratic to either regions or countries). Since prices and wages are not flexible enough to compensate for the loss of exchange rates and the degree of labour mobility in Europe is very limited, there is a fear that asymmetric shocks could lead to deep regional recessions and large increases in unemployment, which could create a social burden that would be politically unacceptable to many governments.

Fatás explores the example of the US, where automatic inter-regional transfers take place through the federal budget. These transfers play an insurance role that compensates for the lack of internal exchange rates. This has been presented as an example of a tax system that helps to alleviate the costs associated with a single currency. The estimates of the benefits of inter-regional transfers in the US are large. A fall in state income causes transfers (or reductions in taxes) that amount to between 30% and 40% of the original fall in income. The absence of a European fiscal federation thus represents an additional element that highlights the lack of significant adjustment mechanisms in EMU to asymmetric shocks.

Fatás presents four sets of findings that suggest that the benefits associated with the creation of a European fiscal federation are much smaller than previously thought.

 

• First, some of the previous estimates of the amount of interstate insurance provided by the US federal budget overestimate the true amount of insurance by a factor of 3. This is because the original estimates measured the stabilization effect of the tax system on disposable state income and not the degree of insurance. The two are equivalent only under the assumption that there is no aggregate risk in the federation.

 

• When a state suffers a recession, and the fall in its tax revenues is not compensated by revenue increases coming from other states, the federal budget will run a deficit that will need to be paid in the future by all states. As a result, the state in a recession does not benefit as much as indicated by the smoothing of disposable income and, moreover, the other states suffer because of the future tax payments.

Fatás applies the same reasoning to data from countries of the European Union and finds estimates of insurance potential that are very close to those for the US.

 

• A European-wide fiscal system that managed to reduce the volatility of disposable income by 30% would only provide less than 10% insurance. The other two-thirds would be intertemporal stabilization through countercyclical budgets, a tool that is already available to European countries and will be available to future member countries of EMU.

This result has clear policy implications. It highlights the importance of maintaining the future flexibility in conducting fiscal policy at the national level, and signals the possible costs of the Stability and Growth Pact. If government deficits are constrained by the limits of the stability pact, the ability of the current national systems to adjust to shocks through intertemporal transfers will disappear.

Under this scenario, there will be a much greater need for a European fiscal federation because, in the absence of national fiscal policies, the benefits of a European fiscal federation will also include the intertemporal stabilization role that the national systems, constrained by the Stability and Growth Pact, will not be able to play.

 

• Second, Europe already has national tax systems that partially insure regions from idiosyncratic risk. Fatás estimates the importance of these systems by comparing the current system with a hypothetical European-wide system that would replicate the stabilizing properties of the national systems. He finds that the current national systems insure more than 50% of a European fiscal federation.

 

• Third, he finds some evidence that the potential insurance benefits of a European fiscal federation have decreased over time. In the post-EMS period, because of increased correlations across countries, the potential for insurance of a European fiscal federation has been reduced. If, as a consequence of EMU, this trend persists in the future the insurance possibilities of a fiscal federation will continue to fall.

 

• Fourth, he examines cross-country differences with respect to the insurance benefits that a European fiscal federation would provide. These benefits are a function of the amount of risk that different countries have and the correlation with the European aggregate. Some countries – the UK or Ireland – could greatly benefit from the system, but others – France or Austria – could benefit much less. This implies that if these countries are offered the possibility of joining the federation, they might decline, which will in turn reduce the overall insurance possibilities of the federation. If all countries are forced into the system the only solution to solve this tension is to have a different risk premium for different countries depending on their volatility. This asymmetry adds to the already complicated design of the system and would make its implementation even more problematic.

Fatás concludes from his analysis that the potential to provide additional inter-regional insurance by creating a European fiscal federation is modest. He finds it difficult to argue that these benefits can compensate the many problems associated with the design and implementation of a European fiscal federation.

EMU: Prospects and Challenges for the Euro is a special issue of the review, Economic Policy: A European Forum. It contains revised versions of the papers presented to the Twenty-Sixth Economic Policy Panel Meeting held in Bonn on 17/18 October 1997, with the support of the Zentrum für Europäische Integrations-forschung. The Economic Policy Panel meets twice annually to discuss papers that are specially commissioned by the editors to provide timely and authoritative analyses of the choices confronting policy-makers. The articles use the best of modern economic analysis, but are easily accessible to a wide audience and highly readable. Each paper is discussed by a rotating Panel of distinguished economists whose comments are published to provide the reader with alternative interpretations of the evidence and a sense of the liveliness of the current debate.

Economic Policy is published in association with the European Economic Association for the Centre for Economic Policy Research, the Center for Economic Studies of the University of Munich and the Département et Laboratoire d’Economie Théorique et Appliquée (DELTA), in collaboration with the Maison des Sciences de l’Homme.

Antonio Fatás is Associate Professor of Economics and Coordinator of the Economic and Political Sciences Department at INSEAD, Fontainebleau. He is also a Research Fellow in CEPR’s International Macroeconomics programme.

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