16 March 2022

Vox: A proposal for a central fiscal capacity for the EMU targeting euro area, national, and regional shocks

The global crisis and Covid-19 pandemic highlighted the limitations of the European Economic and Monetary Union, particularly the lack of a fiscal union for cross-border risk sharing.

This column proposes a central fiscal capacity for the euro area in which transfers to/from regions are driven by euro-area, country-specific, and region-specific shocks. The scheme can produce substantial stabilisation of regional growth with a limited need for the system as a whole to borrow in any given year. The success of the current Recovery and Resilience Facility will be an important litmus test for such a broader central fiscal capacity.

The crises over the past 15 years, culminating with the recession triggered by the Covid-19 pandemic, have shown that the architecture of the European Economic and Monetary Union (EMU) is still incomplete in several dimensions. Apart from the absence of a fully-fledged banking union and a capital market union, the EMU lacks a fiscal union that facilitates cross-border risk sharing through central-level fiscal instruments (Van Rompuy et al. 2012).1 

Hence, several proposals have been made for a central fiscal capacity (CFC) that allows EMU member state economies to be stabilised in response to adverse macroeconomic shocks (e.g. Juncker et al. 2015, Arnold et al. 2018). Existing proposals mainly aim at cushioning the effects of euro area-wide or country-specific shocks. The recently established EU Recovery and Resilience Facility (RRF), adopted in response to the Covid-19 pandemic, has some features of such a CFC.2

None of the existing CFC proposals targets region-specific shocks. Regional shocks are important business cycle drivers and can come from different sources – for example, from a natural disaster hitting a specific region or from the sectoral specialisation of a given region. Importantly, stabilisation of regional shocks may usefully complement monetary and national fiscal policies, which address shocks that are common across all regions in the euro area or across all regions of a country. In fact, these common policies will suit a wider range of individual regions when the latter feature business cycles that are better aligned. 

In a recent paper (Beetsma et al. 2022), we propose a CFC for the euro area, in which transfers to and from regions are simultaneously driven by euro area-wide and country-specific shocks, but also by region-specific shocks. The scheme is highly flexible and can be easily modified in response to new crises. The main advantage of our proposal is that it encompasses the shocks coming from the three levels (euro area, national, and regional) into one single scheme, thus allowing more or less weight to be given to one level versus another according to political and economic considerations. 

Our proposed transfer scheme works as follows. First, we collect data on regional output growth for 928 NUTS3 euro area regions from 1999 until 2021 (from the European Commission’s ARDECO dataset). Second, we decompose regional output growth (in deviation from the region’s historical average) into three different components, or ‘factors’, which may be viewed as distinct business cycles: a euro area-wide component, a national component, and region-specific one.3 Indeed, intuitively, one can think of a region being influenced by common shocks hitting the whole euro area (e.g. the global financial crisis in 2009 or the Covid-19 pandemic in 2020), shocks affecting only one country or a sub-set of euro area countries, and shocks hitting a specific region or a few regions but not all other regions in the same country. Third, fiscal transfers from the CFC are engineered to (partially) compensate for each of these shocks. Importantly, the scheme is symmetric. Therefore, in periods of growth above historical average, a specific region would contribute to the scheme.

Figure 1 shows that the euro area factor explains most of output variation in the Western part of Germany, Northern Italy, some regions in Eastern France, the Netherlands, and Belgium. Together, these regions broadly correspond to what is traditionally considered as the ‘euro area core’. However, for some other countries, the country factor is by far the most important driver of regional output. Greece, for example, was highly exposed to the sovereign debt crisis, which had country-specific features. 

The regional factor is important in some parts of the euro area periphery, namely, most of Ireland and some regions of Greece, the South of Italy, and Portugal. Interestingly, most of Eastern Germany and South Italy also fall into this group.  This may not be surprising. These areas are economically less developed and less active in competing on the EU internal market.

Vox

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