## A Central Fiscal Stabilization Capacity Can Benefit All Euro Area Countries

_IMF Blog, April 9, 2018_

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## Bibliographic details
- Authors: Adrienne Cheasty, Mahmood Pradhan*
- Published: April 9, 2018

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### Rationale for a central fiscal stabilization capacity
- 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.

### Design features and safeguards
- 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.

### Mechanisms to prevent moral hazard and permanent transfers
- 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.

### Quantitative findings and scenarios
- 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.

### Policy message and political considerations
- 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.*

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## References

- [central fiscal capacity](http://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2018/03/22/A-Central-Fiscal-Stabilization-Capacity-for-the-Euro-Area-45741)
- [recent speech in Berlin](http://www.imf.org/en/News/Articles/2018/03/26/sp032618-a-compass-to-prosperity-the-next-steps-of-euro-area-economic-integration)

_Source: https://www.imf.org/en/blogs/articles/2018/04/09/a-central-fiscal-stabilization-capacity-can-benefit-all-euro-area-countries_