Reducing Risk While Sharing It: A Fiscal Recipe for The EU at the Time of COVID-19

IMF Working Papers, September 4, 2020

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Canonical URL: Reducing Risk While Sharing It: A Fiscal Recipe for The EU at the Time of COVID-19

Authors: Nicoletta Batini, Francesco Lamperti, Andrea Roventini
Date: September 4, 2020
Core problem: COVID-19 lockdowns require large fiscal responses across European countries, but countries differ in economic conditions and fiscal space.
Approach: Builds on the model by Berger et al. (2019) to compare gains from alternative mechanisms of EU fiscal integration in the presence of moral hazard.

Any EU response strategy to the COVID-19 crisis that excludes mutual financial support to member countries lacks credibility.
Some form of fiscal risk sharing is better than none, especially when sovereign default risk for some EU member countries is increasing.
Risk sharing creates moral hazard; this moral hazard can be hedged by introducing fiscal delegation to Brussels.
The optimal level of fiscal delegation depends on delegation costs:
- When delegation costs are low, risk sharing and delegation are substitutes: optimal policy is high delegation and low risk sharing.
- When delegation costs are high, centralization and risk sharing are complements: both high delegation and high risk sharing are needed.
Proposed EU arrangements in response to the COVID-19 shock appear to combine fiscal risk sharing and delegation via fiscal spending conditionality, reflecting these insights.

Implement some form of mutual financial support across EU member countries to ensure credibility of the EU response.
Combine fiscal risk sharing with mechanisms to mitigate moral hazard—specifically, design delegation of fiscal authority to Brussels with appropriate conditionality.
Calibrate the degree of delegation according to the costs of delegation:
- If delegation costs are low, prioritize delegation over extensive risk sharing.
- If delegation costs are high, implement both stronger centralization and more extensive risk sharing.