## _sdn1309

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### EXECUTIVE SUMMARY
- Crisis exposed a critical gap in EMU: country-level shocks—exogenous or home-grown—can spread across the euro area, threatening the viability of the common currency.
- Deeper fiscal integration can reduce incidence and severity of future crises and lend long-term credibility to current crisis measures.
- Important measures already taken: improved economic and fiscal governance, country-level adjustment, euro area support via the ESM/EFSF and the OMT backstop, and progress toward a banking union.
- Core argument: a clearer ex ante approach to fiscal discipline and transfers will strengthen EMU architecture and stability.
- Minimal essential elements to make future crises less severe:
  - (i) Better oversight and stronger incentives for sound national fiscal policies.
  - (ii) Subject to oversight, temporary transfers or joint provision of common public goods/services to increase fiscal risk sharing.
  - (iii) Credible pan-euro area backstops for the banking sector to break the sovereign-banking loop.
  - (iv) Some form of common borrowing (backed by common revenue) to finance risk sharing and stronger backstops, and to provide a safe asset.

### SOVEREIGN–BANK FEEDBACK LOOPS, CONTAGION, AND RISK REDUCTION
- Findings on feedback loops and contagion:
  - Large adverse shocks at the end of the 2000s were left unmitigated, increasing probability and impact of sovereign and bank distress.
  - Domestic fiscal buffers were rapidly depleted.
  - Banks extended beyond the capability of national sovereigns to rescue them and held sizeable shares of domestic sovereign debt, creating severe negative feedback loops between sovereigns and domestic banks.
  - In a highly integrated union, localized stress in 2010 spread through interconnected euro area banks and was quickly amplified to systemic level.
- Risk reduction via strengthened fiscal governance — key principles:
  - Smarter fiscal rules: move prominence to medium-term/structural targets rather than headline balances defined independently of the cycle.
  - Robust corrective mechanisms: reduce temptation for under-enforcement by national Ministers; minimize political interference.
  - Coordination: stronger centralization of budget oversight to internalize spillovers of imprudent national fiscal policies.
- Prerequisites for credible market discipline:
  - A minimum of fiscal risk sharing to prevent deprivation of essential services during severe distress.
  - Ex ante rules involving private actors in bailouts, including predictable resolution mechanisms and collective action clauses—requirement in the ESM treaty for new euro area government bond issuances with maturity above one year to include aggregated collective action clauses as of January 2013 cited as a step.

### RISK SHARING — RATIONALE, GAPS, AND CHANNELS
- Rationale:
  - Larger national buffers matter, but magnitude and contagion potential justify euro area-level insurance mechanisms to smooth demand in negative income/activity shocks.
- Current gaps and magnitudes:
  - Federations such as the U.S., Canada or Germany smooth about 80 percent of local shocks; the euro area insulates about half of that amount.
  - When GDP contracts by 1 percent in one euro area country, households’ consumption in that country is depressed by as much as 0.6 percent (as opposed to 0.2 percent in the U.S., Canada or Germany).
  - Cross-border ownership of assets within the euro area remains limited; cross-border saving/borrowing provide some insulation but break down during severe downturns.
  - Cross-country fiscal risk sharing is almost nonexistent in the EU and the euro area given the small size and focus of the EU budget.
- Channels for cross-country risk-sharing:
  - Markets (cross-border credit markets and diversified private portfolios).
  - Governments (intergovernmental fiscal arrangements, central budget with dedicated revenues).

### INCREASING RISK SHARING — OPTIONS AND FEATURES
- Crisis management measures:
  - Financial support through the EFSF and the ESM has provided some fiscal risk sharing elements; TARGET2 cushioned sharp reversal in private capital outflows. These were ex post and costly in lost output.
- Banking union:
  - Would reinforce credit markets’ role in risk sharing and prevent financial market fragmentation along national borders.
- Capital market (re-)integration:
  - Reversing financial de-integration requires time; aided by common reporting standards and harmonized regulations.
- Fiscal risk-sharing role:
  - Fiscal risk sharing provides smoothing when other channels break down and can catalyze investor behavior by making stressed countries appear less risky.

### SPECIFIC FISCAL INSTRUMENTS CONSIDERED
- Rainy-day fund:
  - General features: dedicated fund collecting revenues at all times and making transfers to countries experiencing negative shocks; could borrow at low cost if revenues guaranteed.
  - Size estimate: "1½ to 2½ percent of GNP would have been sufficient to provide income stabilization comparable to Germany" since euro inception.
  - Context: Germany smooths 80 percent of regional income shocks; the euro area currently smooths 40 percent.
  - Total resources devoted to euro area firewalls (ESM and EFSF), at their maximum, will amount to about 7½ percent of GNP (euro 700 billion).
  - Pros: ex ante support before shocks become funding crises; lighter to manage than full budget; allows region-wide counter-cyclical responses.
  - Cons: detecting activation events is challenging; hard to disentangle temporary vs permanent shocks; risk of free-riding if transfers become permanent.
- Common unemployment insurance:
  - Rationale: minimum level of unemployment benefits at euro-area level provides insurance; funding via social security contributions links to cycle.
  - Pros: identifiable variable; ex ante defined parameters offer automaticity; advances harmonization in labor taxation and Single Labor Market.
  - Cons: unemployment reacts with lags; focus should be on short-term unemployment benefits to avoid permanent redistribution and disincentives to reform.
- A euro area budget:
  - Rationale: full budget allows risk sharing via revenues and spending; jointly provided services can be used counter-cyclically.
  - Pros: greater centralization increases risk sharing and coordination.
  - Cons: requires larger loss of national fiscal sovereignty and is unlikely to have constituent electorates’ support at this stage.
- Common backstop for the banking union:
  - Rationale: single resolution mechanism with common backstop severs adverse sovereign-bank feedback loops and aids cross-border resolution.
  - Funding: industry-funded resolution fund used first (levies building over time, plus ex post levies); in systemic crises, taxpayer money and a fiscal backstop from the center may be required.
  - Fiscal backstop options: an ECB credit line with safeguards; ESM can provide a bridge (e.g., ESM direct bank recapitalization) but a pooled fiscal credit line would provide the best insurance.
- Borrowing at the center:
  - Long-term solution: with assigned fiscal revenues, a euro area debt instrument could finance temporary transfers, central spending, and a banking union backstop and help develop a safe asset.
  - Such debt requires creation of central entities able to issue debt on their own behalf (examples in source: euro area Stabilization Fund, euro area Unemployment Fund, or entity managing euro area budget).

### FISCAL POLICY DESIGN, RULES, AND INSTITUTIONS
- Structural fiscal targets:
  - Apply structural targets more systematically; 2005 SGP reform and Fiscal Compact allow focus on structural rather than headline balance targets.
- Independent forecasts:
  - Switching to structural targets requires careful output gap estimates; rely on independent national agencies coordinated with central oversight as foreseen in the "Two Pack."
- Binding medium-term fiscal plans:
  - Fiscal policy credibility needs medium-term plans anchoring the path back to lower debt; any cyclical accommodation must be offset over the medium term, possibly automatically.
- Transparency and fiscal councils:
  - Entrust Fiscal Councils or national independent agencies with assessing credibility of medium-term plans; harmonize budget presentation, fiscal reporting and accounting; ensure timely reporting of fiscal outturns.

### ENFORCEMENT, TRANSITION, AND POLITICAL ACCOUNTABILITY
- Transitional "center-based" approach:
  - Market discipline cannot be restored overnight; enforcement may need to be imposed more directly by the center in the interim (and possibly long term).
- Clear bailout rules:
  - ESM support under market stress remains best immediate defense; credible conditionality rules required to preserve reform incentives.
- Enforcement mechanisms discussed:
  - Legal challenges at national level and possible EU court jurisdiction (would likely require Treaty changes).
  - Leverage via a larger central budget: threat of losing transfers or conditioning access to funds on compliance; drawback is reduced automatic stabilization effect.
  - Consideration of veto power from the center over national budgets for extreme non-compliance—would require treaty changes and significant sovereignty loss.
- Political accountability:
  - Deeper fiscal integration raises questions about democratic accountability; political bodies must act in euro area collective interest.

### COSTS, LEGAL CONSIDERATIONS, AND IMPLICIT COSTS OF CURRENT MEASURES
- Political costs:
  - Ceding national budget sovereignty requires extensive public debate and legal changes; where Treaty basis limited, strengthening legal framework or intergovernmental treaties could be necessary.
- Operational and financial costs:
  - Identification errors of temporary shocks can lead to undesired permanent transfers; ineffective centralized oversight could increase moral hazard and financial costs.
- Legal considerations (TFEU and alternatives):
  - TFEU does not envisage common fiscal policy elements specifically for the euro area; Treaty changes or intergovernmental treaties (as with Fiscal Compact) may be required for some reforms.
  - Secondary legislation could introduce some measures (independent agencies, rainy-day fund), but more complex schemes (euro area unemployment benefit, strong central veto powers) may need Treaty change.
- Implicit costs of existing crisis management:
  - Disbursed crisis financing: about €277 billion out of €390 billion in program commitments from ESM, EFSF, EFSM, and the Greek Loan Facility.
  - Eurosystem exposure: about €1,137 billion to countries with liquidity needs, including through the ECB balance sheet and TARGET2.
  - Implicit transfer estimated between €44 and €75 billion per year for Greece, Ireland, Italy, Portugal, and Spain.
  - Netting out contributions by these countries, implicit transfer by euro area net creditors ranges between ¾ and 1¼ percent of their GDP.

### PROS, CONS, AND DISTRIBUTIONAL CONSIDERATIONS
- Pros:
  - Future crises would be less frequent, less severe, and less prone to systemic spillovers.
  - Centralized fiscal policy elements reduce idiosyncratic national policy risks, expand counter-cyclical policy scope, and enable better fiscal coordination with governance safeguards.
  - A roadmap toward fiscal integration would raise confidence in EMU and support current crisis management.
- Cons and risks:
  - Political costs from ceding national budget sovereignty.
  - Risk that centralized oversight fails to rein in imprudent national policies—strengthening enforcement is critical before increasing risk sharing.
  - Operational complexity and potential identification errors leading to undesired permanent transfers.
- Distributional concern:
  - With safeguards, fiscal integration is not zero sum; ex ante risk sharing implies cyclical redistribution but not permanent transfers. Historical analysis indicates all current euro area members would have benefited from transfers at some point over a sufficiently long period.

### IMMEDIATE PRIORITIES, ROADMAP, AND LEGACY ISSUES
- Time-sensitive priority:
  - The single supervisory mechanism should be quickly complemented by a firm and early commitment to establish a single resolution framework with an adequate backstop to anchor banking sector confidence and sever sovereign-bank feedback loops.
- Maintain momentum for longer-term reforms:
  - Governance reforms in train (Six-Pack, Fiscal Compact, Two-Pack) should proceed; agreeing a time-bound roadmap for implementation will help anchor confidence in EMU viability.
- Legacy issues:
  - Proposals target future crises and will not resolve the existing debt overhang.
  - Tradeoffs in dealing with the debt overhang:
    - Relying entirely on country adjustment risks debt-deflation dynamics and prolonged stagnation in the periphery.
    - Mutualization of existing debt risks selling insurance after the fact and weakening incentives to restore competitiveness.
  - Possible compromise: transform part of excessive sovereign debt into common debt held by euro area entities conditional on medium-term fiscal plans and structural reforms (Debt Redemption Fund proposal cited as example).
  - Linking legacy resolution to the roadmap: resolving legacy issues and providing a common fiscal backstop could create an embryonic framework for stronger fiscal risk sharing and momentum for governance reforms.

*Source: _sdn1309 - EXECUTIVE SUMMARY and selected excerpts (IMF).*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 4

### _sdn1309 - EXECUTIVE SUMMARY ___________________________________________________________________________ 4

### EXECUTIVE SUMMARY
- The crisis exposed a critical gap in EMU: country-level shocks—exogenous or home-grown—can spread across the euro area, threatening the viability of the common currency.
- Deeper fiscal integration can help correct architectural weaknesses by reducing incidence and severity of future crises and lending long-term credibility to current crisis measures.
- Important measures already taken: improved economic and fiscal governance, country-level adjustment, euro area support via the ESM/EFSF and the OMT backstop, and progress toward a banking union (Box 1).
- Argument: a clearer ex ante approach to fiscal discipline and transfers will strengthen EMU architecture and stability.
- Complementarity: this paper complements a companion paper investigating the role of a banking union for the euro area (IMF, 2013a).

### WHAT CRITICAL GAPS HAS THE CRISIS EXPOSED?
- Initial expectations underestimated the frequency and size of idiosyncratic shocks and idiosyncratic policies.
- Failures identified:
  - Insufficient national fiscal buffers in good times.
  - Spillovers from idiosyncratic policies were not adequately taken into account.
  - Coupling of domestic fiscal and banking risks plus extensive cross-border financial linkages turned country shocks into systemic ones.
- Market discipline and fiscal governance were weak; the “no bailout” clause lacked credibility, undermining ex ante market enforcement.
- Consequence: sovereign and bank stresses moved together, creating sovereign-banking feedback loops and systemic risk (Figures 1–4 referenced).

### HOW CAN GREATER FISCAL INTEGRATION ADDRESS THESE GAPS?
- First-best: larger national fiscal buffers remain essential.
- Role of fiscal integration:
  - Provide a zone-wide insurance mechanism with ex ante framework for enforced fiscal discipline and temporary transfers to contain shocks.
  - Insurance with strict ex ante rules could improve credibility relative to the current ad hoc responses that have undermined the no bailout clause.
  - Interim consequence: stronger enforcement powers by the center until market discipline is re-established in tranquil times.

### MINIMAL ELEMENTS FOR A FISCAL UNION
Four elements deemed essential to make future crises less severe:
- (i) Better oversight and stronger incentives for sound national fiscal policies to build buffers and address common concerns.
- (ii) Subject to better oversight and stronger incentives, some system of temporary transfers or joint provision of common public goods or services (e.g., organized by a centralized budget) to increase fiscal risk sharing.
- (iii) Credible pan-euro area backstops for the banking sector to help break the sovereign-banking loop.
- (iv) Some form of common borrowing (backed by common revenue) to finance better risk sharing and stronger backstops, and to provide a safe asset to reduce large portfolio shifts between sovereigns.

### PROS, CONS, AND IMMEDIATE CONSIDERATIONS
- Pros with elements in place:
  - Future crises would be less frequent, less severe, and less prone to systemic spillovers.
  - A shared approach with centralized fiscal policy elements would reduce idiosyncratic national policy risks, expand counter-cyclical policy scope, and enable better fiscal coordination with appropriate governance safeguards.
- Cons and risks:
  - Political costs from ceding national budget sovereignty.
  - Risk that ineffective centralized oversight fails to rein in imprudent national policies—strengthening enforcement is critical before increasing risk sharing.
- Distributional concern:
  - With appropriate safeguards, fiscal integration is not zero sum. Ex ante risk sharing implies cyclical redistribution at any point in time but not permanent transfer roles; analysis shows all current euro area members would have benefited from transfers at some time over a sufficiently long period.

### CONTEXT AND RECENT EUROPEAN ACTIONS
- Crisis revealed sovereigns could be priced out of markets and private borrowing costs can diverge widely despite a single monetary policy; contagion can produce deep recessions with spillovers.
- Strengthening of governance to date:
  - Six-Pack went into force in December 2011.
  - Fiscal Compact agreed in December 2012 and ratified by 15 euro area member states.
  - Two-Pack regulation approved by the European Parliament in March 2013, to apply to the 2014 budgeting period.
- June 2012 summit: European leaders asked the European Commission and the President of the Council to issue proposals for a time-bound roadmap toward a genuine Economic and Monetary Union, including greater fiscal integration (Box 1).
- Divergent views across members: some favor greater solidarity; others prioritize stronger national fiscal policies; concerns exist about moral hazard from debt mutualization.

### EUROPEAN PROPOSALS OUTLINED IN BOX 1
- European Commission’s blueprint:
  - Short term (next 18 months, actions within the current Treaty framework): full implementation of governance reforms (European Semester, Six-pack, Two-pack); single resolution mechanism for banking union funded by the industry; creation of a “Convergence and Competitiveness Instrument.”
  - Medium term (18 months to 5 years, actions requiring Treaty changes): stronger central control on national budgets including a right to request changes in national fiscal decisions; a central fiscal capacity with dedicated resources; borrowing under joint and several liabilities (European Redemption Fund and Eurobills).
- President of the Council’s report:
  - Stage 1 (end-2012 and 2013): complete stronger fiscal governance framework; harmonize national resolution and deposit guarantee frameworks funded by industry; operational framework for direct bank recapitalization through the ESM.
  - Stage 2 (2013-2014): complete integrated financial framework with common resolution authority and appropriate backstop; set up mechanism to coordinate structural policies through contractual arrangements with potentially temporary financial support.
  - Stage 3 (post 2014): establish a well-defined and limited fiscal capacity to improve shock absorption through a central insurance system with built-in incentives for sound policies.
- Next steps: President of the Council to present a new report in mid-2013 on short-term actions. New governance framework needs rigorous implementation with strong enforcement by the center.

### PRIORITIES AND TIME-SENSITIVE ACTIONS
- Time-sensitive priority: the euro area single supervisory mechanism being established should be quickly complemented by a firm and early commitment to establish a single resolution framework with an adequate backstop to anchor banking sector confidence.
- Maintain momentum for longer-term reforms: historical experience shows effective crisis management often coincides with far-reaching long-term reforms, including stronger central oversight.

### REMAINING CHALLENGES INHERITED FROM THE CRISIS
- Proposals target future crises and will not resolve the existing debt overhang.
- Tradeoffs in addressing the debt overhang:
  - Relying entirely on country adjustment risks debt-deflation dynamics in the periphery and prolonged stagnation.
  - Mutualization of existing debt risks selling insurance after the fact and reducing incentives to restore competitiveness and fiscal sustainability.
- Dealing with the debt overhang will remain delicate due to these tradeoffs.

*Source: _sdn1309 - EXECUTIVE SUMMARY (IMF).*

### 8.       Sovereign-bank feedback loops. When,

### _sdn1309 - 8.       Sovereign-bank feedback loops. When,

### Sovereign-bank feedback loops
- Large adverse shocks at the end of the 2000s were left unmitigated, increasing the probability and impact of sovereign and bank distress.
- Domestic fiscal buffers were rapidly depleted.
- Financial market integration increased greatly in the first ten years of EMU, while real convergence fell short of expectations.
- Some banks extended themselves beyond the capability of their national sovereigns to rescue them, while many banks continued to hold a sizeable share of their domestic sovereign debt.
- This combination set the stage for escalation of domestic stress:
  - Problems in banks raised doubts about sovereign creditworthiness.
  - Sovereign stress aggravated pressure on banks’ balance sheets.
  - Severe negative feedback loops between sovereigns and domestic banks emerged.
- With no clear circuit-breaker in the system, markets could start pricing in default in a self-fulfilling way.

### Contagion and financial sector interconnectedness
- In a highly integrated union, deleterious shocks can travel fast across borders.
- Localized points of stress in 2010 spread through interconnected euro area banks and were quickly amplified to a systemic level.
- Financial sector interconnectedness transmitted shocks across the euro area through bank stress.

### Risk reduction — strengthening fiscal governance
- Objective: gear national governments toward more prudent behavior and reduce the severity of future crises.
- Key principles for improving fiscal governance:
  - Smarter fiscal rules at the national level:
    - The binding target in the SGP applies to the headline fiscal balance and is defined independently of the cycle, yielding suboptimal outcomes.
    - Medium-term targets need more prominence, allowing flexibility to spread consolidation efforts overtime, with more consideration for the position in the business cycle.
  - Robust corrective mechanisms:
    - When left to the Council (national Ministers), there is temptation to under-enforce fiscal rules and delay adjustment (e.g., 2003 suspension of the excessive deficit procedure against Germany and France—a decision later reversed by the EC Court of Justice SGP process).
    - Countries should have incentives to take corrective measures systematically; potential for political interference should be minimized.
  - Coordination:
    - Stronger centralization of budget oversight would internalize negative spillovers of imprudent national fiscal policies for other member states.
    - Less national sovereignty on fiscal issues would be offset by (i) benefits of avoiding being priced out of markets or losing market access in times of stress from imprudent policies or contagion, and (ii) benefits of a properly functioning monetary union.

### Risk reduction — international experience and long-term options
- Different federations use distinct disciplining mechanisms:
  - Market discipline underpinned by a credible “no bailout” rule and self-imposed budget constraints (U.S., Canada).
  - Stronger center oversight where bailouts occurred (Brazil, and more recently Germany).
  - Intermediary systems use dialogue and intergovernmental coordination (Australia, Belgium) or direct democracy (Switzerland).
- Evolution after crisis episodes:
  - Crises often lead to more central control temporarily (e.g., U.S. end of 18th century; Brazil in the 1990s).
  - Return to market discipline may occur after a transitional period or after regional bankruptcies test no bailout rules (e.g., U.S. in the 1840s).
- Long-term options for the euro area:
  - Restore credibility of the no bailout clause, including clear rules for private creditor involvement when support facilities are activated; transition must be gradual and coordinated.
  - Rely extensively on a center-based approach, implying a permanent loss of fiscal sovereignty.
  - The steady state may embed elements of both market discipline and stronger governance.

### Prerequisites for credible market discipline
- Conditions required to make market discipline effective and to minimize spillovers:
  - A minimum of fiscal risk sharing:
    - Would prevent a country facing severe financial distress from being deprived of essential government services, social security, and financial stability.
    - Would contain social and economic costs and reduce likelihood that country-specific shocks damage other members.
  - Ex ante rules involving private actors in bailouts:
    - Combine crisis support facilities with predictable resolution mechanisms when activated to help markets assess and price sovereign risks.
    - Requirement in the ESM treaty for all new euro area government bond issuances with maturity above one year to include aggregated collective action clauses as of January 2013 is a step in that direction.

### Risk sharing — rationale and channels
- Rationale:
  - Larger national fiscal buffers help smooth country-specific shocks, but given magnitude and contagion potential, euro area-level insurance mechanisms would be beneficial.
  - Such mechanisms allow countries to smooth demand during negative income or activity shocks and better insulate fellow members from damaging spillovers.
- Channels for cross-country risk-sharing:
  - Markets: cross-border credit markets allow saving in good times and borrowing in crises; private capital markets provide insurance via diversified portfolios.
  - Governments: intergovernmental fiscal arrangements allow temporary transfers; a central budget with dedicated revenues can finance common public services.

### Risk sharing in the euro area — current gaps and magnitudes
- The euro area lacks the degree of risk sharing seen in federations:
  - Little overall insurance:
    - Federations such as the U.S., Canada or Germany smooth about 80 percent of local shocks.
    - The euro area insulates about half of that amount.
    - When GDP contracts by 1 percent in one euro area country, households’ consumption in that country is depressed by as much as 0.6 percent (as opposed to 0.2 percent in the U.S., Canada or Germany).
  - Little market-based insurance:
    - Cross-border ownership of assets within the euro area remains limited compared with, for example, U.S. states or German Länder.
    - Cross-border saving and borrowing provide some insulation but break down during severe downturns and financial crises.
  - Little fiscal risk sharing:
    - Cross-country fiscal risk sharing is almost nonexistent in the EU and the euro area given the small size and focus of the EU budget.

### Increasing risk sharing going forward
- Measures to increase risk sharing:
  - Crisis management measures:
    - Financial support through the EFSF and the ESM has provided some fiscal risk sharing elements.
    - TARGET2 has cushioned against sharp reversal in private capital outflows.
    - These measures have been ex post and came after severe economic impact, with high cost in lost output.
  - Banking union:
    - Would reinforce the role of credit markets in risk sharing and prevent financial market fragmentation along national borders.
  - Capital market (re-)integration:
    - Reversing recent financial de-integration and further integrating capital markets will take time.
    - Improvements could be aided by common financial market reporting standards and further harmonization of financial market regulations.
  - Fiscal risk-sharing role:
    - Fiscal risk sharing can provide a minimum amount of smoothing when other channels break down and serve as a catalyst for investor behavior: credible government insurance would make private markets view stressed countries as less risky and be more willing to provide market insurance.

### Moral hazard and governance
- Increased safety nets can create moral hazard (free-riding), calling for reinforced governance.
- International experience indicates stronger risk-sharing typically goes hand in hand with stronger governance.
- Any increase in fiscal risk sharing should be accompanied by strengthened governance and enforcement provisions.

### Dampening spillovers and stemming contagion
- Common backstop for the banking union:
  - An effective macro-prudential supervisory framework would prevent build-up of financial sector imbalances.
  - A single resolution mechanism covering all banks regardless of nationality would help sever adverse sovereign-bank feedback loops.
  - Some insurance against banking accidents should be funded by the industry.
  - Common backstops for recapitalization, resolution and deposit insurance schemes within the single supervisory mechanism’s jurisdiction would reduce contagion risk and limit transmission of sovereign distress via the banking system.
- Pooled debt instruments:
  - Large reversals in capital flows to sovereign bonds can amplify and propagate shocks.
  - With very few sovereign bonds considered safe assets, sharp portfolio shifts between sovereigns will persist.
  - Common debt issued by euro area bodies could provide relief against this contagion channel and a more stable source of funding.

### Minimal elements for a fiscal union
- Four essential elements to make future crises less severe:
  - (i) Better oversight of national fiscal policies and enforcement of fiscal rules to build buffers and ensure common concerns are addressed.
  - (ii) Subject to strong oversight and enforcement of fiscal discipline, some system of temporary transfers or joint provision of common public goods or services to increase fiscal risk sharing.
  - (iii) Credible pan-euro area backstops for the banking sector.
  - (iv) Some common borrowing to finance greater risk sharing and stronger backstops and provide a common—albeit limited in size—safe asset.

*International Monetary Fund — Toward a Fiscal Union for the Euro Area (excerpt).*

### 21.      Fiscal policy design. Ex ante, fiscal policies can be better organized, with commonly agreed

### 21.      Fiscal policy design.

### Ex ante fiscal policy design: rules and institutions
- Structural fiscal targets should be applied more systematically; the 2005 reform of the SGP (through the “effective action” clause) and the Fiscal Compact allow focus on structural—instead of headline—fiscal balance targets.
- Independent forecasts are essential:
  - Switching to structural targets requires careful estimates of the output gap.
  - Governments have tended to rely on overly optimistic forecasts to build their budgets.
  - Relying on independent national agencies—in coordination with central oversight—to assess fiscal policy design and implementation would improve the process, as foreseen in the “Two Pack” regulation.
- Binding medium-term fiscal plans are needed:
  - Flexibility in fiscal rules will be credible only if fiscal policy is anchored in medium-term plans that clearly state the path back to lower debt levels.
  - Any accommodation for the cycle during downturns needs accompanying plans to offset this over the medium term, possibly in an automatic way.
  - Corrective mechanisms have in principle been agreed in the Fiscal Compact but must be designed at the national level and made consistent across countries.
- Increased transparency:
  - Entrust Fiscal Councils or other national independent agencies with assessing the credibility of medium-term plans and corrective measures.
  - Harmonize budget presentation, fiscal reporting and accounting at all levels of government.
  - Ensure timely reporting of fiscal outturns to improve fiscal oversight.

### Transitional considerations on reinstating discipline
- Countries need proper incentives to comply with fiscal rules and a credible threat if they do not.
- “Center-based” approach:
  - Market discipline cannot be restored overnight; enforcement will need to be imposed more directly by the center in the interim (and possibly long term).
- Clear bailout rules for now:
  - ESM support to sovereigns under market stress will continue to be the best line of defense while deeper fiscal integration elements are put in place.
  - Credible rules in the form of conditionality will be needed to preserve incentives to reform and ensure decisive implementation of adjustment measures.

### Enforcement mechanisms in a center-based approach
- Legal challenges at the national level:
  - With fiscal rules enshrined into national legislation, enforcement would become a national matter; cases of infringement could be brought to domestic courts depending on domestic legal tradition and implementing provisions.
  - EU court jurisdiction over compliance of national domestic rules could be considered but would likely require treaty changes and its real-time deterrence is uncertain.
- Leverage to sanction with a larger central budget:
  - If a larger euro area budget emerges, member states could face the threat of losing some transfers from the center in cases of non-compliance.
  - Targeted transfers could reward implementation of beneficial structural reforms; conditions could apply for access to a rainy day fund or crisis mechanisms like the ESM.
  - Main drawback: making support contingent on compliance reduces the automatic stabilization effect of transfers.
- A veto power from the center:
  - “Two Pack” allows national authorities to be requested to revise budgets, but does not give the center enforcement power.
  - Consideration for stronger central powers to set or veto national spending/borrowing when commonly agreed rules are breached.
  - Such powers would require treaty changes and significant loss of national sovereignty; gradation in loss of sovereignty could be considered depending on degree of non-compliance.
  - Significant loss in fiscal autonomy and extensive fiscal custody would be reserved for extreme rule violations and when financial support is extended—variations exist in countries such as Brazil or Germany.

### Political accountability
- A larger central role raises questions about political and democratic accountability for European and euro area decision bodies.
- Existing fiscal unions are also political unions; deeper fiscal integration may require changes in political organization.
- Essential that political bodies implementing and enforcing central fiscal rules be mandated to act in the euro area’s collective interest rather than individual national interests.

### Temporary transfers or common provision of public services: options overview
- Various options exist to ensure better common insurance against country-specific shocks, with differing degrees of centralization and legislative change requirements.

### Rainy-day fund
- General features:
  - A common dedicated “rainy-day fund” would collect revenues from euro area members at all times and make transfers to countries experiencing negative shocks.
  - With a dedicated and guaranteed flow of revenues, the fund might borrow at low cost to smooth downturns.
- Size of the fund:
  - Estimated needed annual contributions since inception of the euro: 1½ to 2½ percent of GNP would have been sufficient to provide income stabilization comparable to Germany.
  - Germany smooths 80 percent of regional income shocks; the euro area currently smooths 40 percent.
  - Total resources devoted to euro area firewalls (ESM and EFSF), at their maximum, will amount to about 7½ percent of GNP (euro 700 billion).
  - Caveat: estimates may be underestimates if contagion risk has increased or if misidentification of shocks occurs.
- Pros:
  - Provides ex ante support before shocks become funding crises.
  - Lighter to manage than a full euro area budget; no devolution of spending responsibilities to the center.
  - Allows region-wide counter-cyclical fiscal responses with contributions saved in good times and paid out in bad times.
- Cons:
  - Detecting events warranting activation is challenging; methods to identify negative growth shocks are error-prone and complex in real time.
  - Hard to disentangle temporary from permanent shocks, and exogenous from policy shocks.
  - Parameters of intervention could be hard to communicate, raising transparency and accountability issues.
  - As an unconditional insurance scheme, risk of “free-riding” and reduced national fiscal buffers or reforms if permanent transfers emerge.

### Common unemployment insurance
- Rationale:
  - Moving a minimum level of unemployment benefits provision to the euro area level would provide insurance against individual income risk.
  - In many federations, unemployment insurance is highly centralized; the federal role often increases in severe negative shocks (see IMF 2014 and background note).
  - Such a scheme should accompany efforts to enhance and harmonize labor market arrangements across countries.
- Pros:
  - Funding via social security contributions links naturally to the cycle.
  - Would require minimum harmonization in labor taxation and potentially pension rights, advancing a Single Labor Market.
  - Unemployment is a highly identifiable variable; a common fund with ex ante defined parameters would be understandable and acceptable and offer automaticity.
- Cons:
  - Unemployment reacts with lags; transfers may not be sufficiently timely.
  - Given wide variation in long-term unemployment across the euro area, focus should be on short-term unemployment benefits connected to negative shocks.
  - Providing central insurance against long-term unemployment would amount to redistribution and could disincentivize labor market reform.
  - Focusing on short-term unemployment reduces smoothing but mitigates risks of permanent redistribution.

### A euro area budget
- Rationale:
  - A full-fledged euro area budget would allow risk sharing through revenues (hit countries contribute less) and through spending (hit countries continue to receive centrally-provided public services if in compliance).
  - Jointly provided services—e.g., public infrastructure—can be used counter-cyclically.
- Pros:
  - Greater centralization of revenue and spending responsibilities increases risk sharing.
  - Facilitates coordination of fiscal stance at the euro area level and fosters fiscal harmonization for taxes dedicated to the common budget.
- Cons:
  - Requires more extensive loss of national fiscal sovereignty than other options (transfer of taxation and spending responsibilities).
  - Unlikely at this stage to have constituent electorates’ support.

### A common backstop for the banking union
- Rationale:
  - A single resolution mechanism covering all banks with a common backstop would sever adverse sovereign-bank feedback loops in stress times.
  - Would internalize home-host concerns and aid cross-border resolution and burden sharing; complements the single supervisory mechanism.
- Funding:
  - Clear ex ante burden sharing mechanisms are necessary for least-cost resolution and to provide investor incentives and market discipline.
  - In systemic crises exceptional treatment may require taxpayer money and a fiscal backstop from the center.
  - No existing federation has sub-national responsibility for resolving or providing deposit insurance for troubled systemic banks in this crisis; where no ex ante national fund existed, public means were used ad hoc.
- Funding from the industry:
  - Industry contributions via a resolution fund should be used first; the fund would build resources over time through levies on the industry and could be complemented by ex post levies to recoup net losses.
- Fiscal backstop:
  - If private contributions and loss allocation are insufficient in systemic crises, a common backstop including an ECB credit line—with safeguards—would ensure adequate liquidity.
  - The existence of a common backstop anchors confidence in the banking system.
  - The ESM can provide a bridge to permanent fiscal backstops (e.g., ESM direct bank recapitalization), but ultimately a credit line from pooled fiscal resources would provide the best insurance.

### Borrowing at the center
- Long-term solution:
  - With appropriate governance and assigned fiscal revenues to the center (dedicated fund or full budget), a euro area debt instrument backed by those revenues could finance temporary transfers, central spending responsibilities, and a common banking union backstop.
  - Such debt would help develop a new safe asset, though initially it would only marginally reduce portfolio shifts driven by safe-haven motives.
  - Borrowing from the center could increase counter-cyclicality through inter-temporal risk sharing.
  - Common bonds would require creation of entities at the center able to issue debt on their own behalf (examples: a euro area Stabilization Fund, a euro area Unemployment Fund, or an entity managing the euro area budget).

### Pros, cons, and immediate considerations
- Pros:
  - Benefits from further fiscal integration accrue in the short and long term.
  - In the steady state, the likelihood and severity of future crises and systemic spillovers would decrease.
  - Spelling out a roadmap toward further fiscal integration would raise confidence in the union and support current crisis management.
  - A shared approach with centralized fiscal policy elements would allow better fiscal coordination and expand counter-cyclical tools when national policies are constrained by limited market access or fiscal rules.
  - In constrained circumstances, central tools would more than offset loss of country-level stabilization capacity resulting from stronger national budget control and transfer of fiscal responsibility to the center.

*Source: IMF — “TOWARD A FISCAL UNION FOR THE EURO AREA” (Chapter excerpt)._sdn1309*

### 33.      Cons. There are also costs to deepening fiscal integration.

### 33.      Cons. There are also costs to deepening fiscal integration.

### Political costs
- Political hurdles to ceding some national sovereignty over budgets are considerable, and they would require extensive public debate.
- Many steps may necessitate legal changes.
- Where existing EU Treaties provide only a limited legal basis for euro-area specific reforms, strengthening the legal framework over time would help clarify the role of euro area versus EU members—but it would require approval by all EU countries.
- Alternatively, intergovernmental treaties outside the EU framework could be considered, where feasible, as was done with the Fiscal Compact (Box 3).

### Operational challenges and financial costs
- Mechanisms for deeper fiscal integration could be complex to put in place.
- Mistakes in the identification of temporary shocks could lead to more permanent transfers than desirable.
- Centralized fiscal oversight could prove ineffective in curbing moral hazard and instilling policy discipline, implying financial costs.
- Fiscal risk sharing would have a headline cost in terms of transferred revenues to central institutions—although deeper fiscal integration would also mean transferring some spending responsibilities to the center.

### Costs versus the costs of ex post crisis measures
- Current ex post crisis management carries substantial costs despite creditor countries’ indirect benefits from safe haven flows:
  - A cost in terms of lost output and increased unemployment, as ex post measures are delayed in implementation.
  - A cost in providing subsidized financial support to countries under stress through programs (Box 4).
  - (Contingent) TARGET2 liabilities would not have increased as much in the presence of ex ante fiscal risk sharing.

### Legal considerations (Box 3)
- Missing euro area framework:
  - The TFEU does not envisage common elements of fiscal policy specifically at the euro area level; it does not recognize the euro area as a separate entity, and the currency union lacks a legal personality.
  - Some reforms could be introduced as EU secondary legislation, but strengthening the legal framework might be required in the long run to anchor deeper fiscal integration as an objective under the Treaty.
  - Alternatively, euro area countries could enter into an intergovernmental treaty outside the EU framework, as with the Fiscal Compact.
- Fiscal policy design:
  - The current EU framework provides flexibility to assess fiscal targets in structural terms, alongside headline targets.
  - Secondary legislation could introduce independent agencies responsible for fiscal forecasting (Articles 121 and 136 TFEU), as in the two-pack.
  - Automatic correction mechanisms are being introduced in national legislation, as required by the Fiscal Compact.
- Enforcement mechanisms:
  - Options to veto national budgets when national policies are deemed non-compliant with common fiscal rules would require Treaty changes.
  - Changes to national legislation and constitutions—possibly also referenda—could be required.
- Increased fiscal risk sharing:
  - Secondary legislation could be used to introduce a rainy-day fund (Articles 122, 136, and 352 TFEU) and a euro area budget as part of the larger EU budget.
  - A euro area unemployment benefit scheme would be more complex to accommodate in the current legal framework; Treaty changes may be necessary in the long run.
  - Alternatively, an intergovernmental treaty among euro area countries could be considered along with creation of a euro area entity to manage the fund, scheme or budget.
- Fiscal backstop to the banking union:
  - Secondary legislation could establish a euro area resolution fund with industry contributions collected at the national level (Article 114 and 352 TFEU).
  - In the medium term, providing an explicit legal underpinning in the EU treaties for financial stability arrangements, including a fiscal backstop for the banking union, would strengthen legal soundness.
  - Alternatively, the ESM Board of Governors could decide to provide a more general ESM backstop for the banking union—in addition to direct recapitalization of banks (Article 19 ESM Treaty).

### Implicit costs of existing crisis management measures (Box 4)
- Crisis financing disbursed and exposures:
  - Euro area countries have disbursed about €277 billion out of €390 billion in program commitments from ESM, EFSF, EFSM, and the Greek Loan Facility.
  - The Eurosystem has an additional exposure of about €1,137 billion to countries with liquidity needs, including through the ECB balance sheet and TARGET2 payment system.
- Implicit transfers:
  - Rates charged on most crisis financing reflect the average cost of funding of creditor countries and the ECB’s lending rate and fall well below the market rates faced by crisis countries.
  - Liquidity provision through the Eurosystem has allowed the reduction in foreign investors’ exposure to occur without a generalized liquidity or currency crisis.
  - The implicit transfer is estimated at between €44 and €75 billion per year for Greece, Ireland, Italy, Portugal, and Spain (see table).
  - Netting out the contributions by these countries to crisis financing, the implicit transfer by euro area net creditors ranges between ¾ and 1¼ percent of their GDP.
  - These are rough estimates and do not capture potentially very large costs (longer crisis duration, lower output, and higher unemployment) associated with ex post risk sharing.
- Table highlights (as of February 2013):
  - EU arrangements: 1/5.8 20.5 20.1 31.0 14.7 14.3 25.2
  - ECB: 2/20.3 49.7 48.1 70.2 29.3 27.7 49.9
  - Gross total: 26.1 70.2 68.1 101.2 44.1 42.0 75.1 (percent of euro area GDP) 0.3 0.7 0.7 1.1 0.5 0.4 0.8
  - Net total 3/: 24.7 67.5 66.0 98.4 42.8 41.3 73.7 (percent of net contributors' GDP) 0.4 1.1 1.0 1.5 0.7 0.6 1.2
  - Footnotes in source: 1/ Includes EFSF, ESM, EFSM, and Greek Loan Facility. 2/ Includes increase in Target2 and currency issuance above allocation since December 2007. 3/ Totals net of the contributions by Greece, Ireland, Italy, Portugal and Spain. 4/ Germany bond yield plus CDS spread. 10-year bond yield for Greece. 5/ Estimates for 10-year yields, see Fiscal Monitor, October 2012, p. 40.

### Fiscal union not a zero-sum proposition
- With appropriate safeguards, greater risk sharing need not mean permanent redistribution.
- All benefit in the long run:
  - Deeper integration would provide insurance from fellow euro area members against bad events, preventing worse outcomes for the membership at large.
  - Support could span several years if shocks are persistent, but no system should provide permanent transfers to compensate for permanent lack of competitiveness or enduringly low income levels.
  - Historical analysis indicates that net beneficiaries would have varied greatly year-to-year; a rainy day fund simulation shows that since the late 1970s, all countries would have benefited from transfers at some point (Figure 8).
- Small versus large countries:
  - Smaller countries’ activity might be more volatile and subject to idiosyncratic shocks if business cycles are less synchronized with the euro area, leading them to resort more frequently to fiscal risk sharing.
  - Larger countries affected by country-specific shocks receive some stabilization via monetary policy, as their inflation evolution weighs more on euro area-wide price indices.
  - Fiscal risk sharing at the euro area level would complement other policy instruments in fostering macroeconomic stability.

### Immediate priorities and roadmap
- Maintain crisis management measures taken since 2010 to accompany ongoing country-level adjustment.
- Progress toward a banking union is in train.
- Current proposals to strengthen fiscal governance (Box 1) are a major step forward; any element of fiscal risk sharing will need to be preceded by further strengthening of that framework and a stronger role for the center.
- Time-sensitive priority:
  - A euro area common fiscal backstop for the region’s systemic banks should be put in place quickly to sever negative sovereign-bank feedback loops and anchor confidence in the banking system.
  - The single supervisory mechanism should be complemented by a firm and early commitment to establish a single resolution framework with adequate backstops.
- A roadmap now for future fiscal integration:
  - Agreeing details and a time-bound roadmap for implementation will help anchor confidence in EMU viability.
  - Governance reforms in train should proceed.
  - Once the roadmap is agreed, legal requirements to support stronger center oversight, fiscal risk sharing and eventual borrowing at the center should be assessed comprehensively.

### Legacy issues
- Proposals are aimed at future crises and will not tackle the existing debt overhang; resolving that is a burden-sharing issue rather than pure risk sharing.
- Striking the appropriate balance:
  - Relying entirely on national adjustment could trigger debt-deflation dynamics in the periphery, dragging the entire region into prolonged stagnation with heightened financial instability risk.
  - Debt mutualization at this stage could be akin to selling insurance after the fact and could reduce incentives to restore competitiveness.
- Conditioning support:
  - One compromise: transform part of sovereign debt where excessive to common debt—euro area entities would hold the debt—against a commitment from participating countries to repay over time, conditional on fiscal medium-term plans and structural reforms.
  - The Debt Redemption Fund proposal (German Council of Economic Experts, 2011) is cited as one such option.
- Linking legacy issues to the roadmap:
  - Resolving legacy issues and providing a common fiscal backstop to the banking union could create an embryonic framework for stronger fiscal risk sharing and a window to generate momentum for more ambitious reforms to strengthen fiscal governance and central oversight.

*Source: IMF staff estimates.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2013/_sdn1309.pdf_