A Central Fiscal Stabilization Capacity Can Benefit All Euro Area Countries

IMF Blog, April 9, 2018

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The euro area relies too much on monetary policy to stabilize the economy when hit by a shock; the recent crisis tested the limits of this overreliance.
The European Central Bank (ECB) cut interest rates below zero and purchased large amounts of bonds, but growth took a long time to recover and inflation remains low.
Fiscal policy needs to play a bigger role in smoothing future economic shocks to supplement monetary policy.
A central fiscal capacity at the euro area level would strengthen the ability to use fiscal policy to help stabilize countries’ economies in a downturn and could prevent a repeat of the recent acute crisis where countries raised taxes and cut spending due to limited fiscal space.

Countries save in good times by contributing to a “rainy-day” fund to build buffers during economic upturns.
In a downturn, countries’ fiscal policies are the first and main line of defense; transfers from the fund provide financing to cushion the impact of a downturn.
The fund is designed to build up assets that will almost always be enough to finance the needed transfers; in an extreme shock the fund would be allowed to borrow, and any borrowing would be repaid by countries’ future contributions.
The fund would “be a temporary cushion and not a permanent pillow.” (quote)
Net transfers from the fund would be conditional on countries’ compliance with European Union fiscal rules, serving both as a safeguard for the fund and as an incentive for prudent national fiscal policies.

Conditionality: countries would get net transfers only if they comply with European Union fiscal rules.
Usage premium: a country pays a premium in good times based on transfers it got in bad times.
Contribution cap: a cap on how much countries need to contribute so that countries do not become large net contributors.
Receipt cap: a cap on how much a country can receive so that transfers do not substitute for necessary policy adjustment.

If countries contribute 0.35 percent of GDP per year, the fund could build up assets of about 2 percent of euro area GDP during a typical expansion.
In a large region-wide shock, with constrained monetary policy, the fund could finance sufficient transfers to reduce the negative effects on output by more than 50 percent.
Historical simulation example: if the fund had existed since the euro began, Germany would have received gross transfers of about 2.5 percent of GDP during the downturn of 2003-06; this would have left Germany in balance with the fund before the global financial crisis, while Spain and Italy would have been net contributors before the crisis.

The proposal balances the need for better stabilization with strong safeguards to address concerns about incentives and cross-country transfers.
Countries would be required to take greater responsibility for putting their houses in order.
The initiative faces political difficulty and doubts among many countries; the authors present the proposal as a contribution to the debate aimed at adding a macrostabilization tool with a better mix of fiscal and monetary policy to make the euro area more resilient and prevent another crisis.

Op-ed by Adrienne Cheasty and Mahmood Pradhan, April 9, 2018.