Don't expect too much from EZ fiscal union – and complete the unfinished integration of European capital markets!

by Mathias Hoffmann

Vox
November 9, 2012

How do members of existing monetary unions share risk? Drawing on a decade of research, this column argues that fiscal transfers in fact make a limited contribution to economic coherence. In the context of Europe’s current crisis, the evidence suggests that unfinished capital market integration must be completed if we wish to see adequate and effective risk sharing.

The sovereign debt crisis apparently suggests that Eurozone economies should now move substantially closer towards fiscal union. Current policy discussions revolve much more around how such a fiscal union should be designed than whether fiscal union can solve Europe’s underlying problems of economic coherence. What can we expect from a fiscal union? Aren't private capital markets better suited to economic coherence? Even within well-established monetary unions, such as the US, it is clear that fiscal transfers make a limited contribution to economic coherence compared to private capital markets. Europe needs better capital market integration.

The limits of fiscal transfers

Fiscal transfers help countries maintain their standard of living in regional recessions; the fallout from shocks, such as those which have recently hit Greece and Spain, could be cushioned if such countries receive transfers from other countries that are doing better. The need for such ‘fiscal smoothing’ mechanisms was, from the very outset, at the heart of the debate about the creation of a monetary union in Europe (cf. literature surveyed in Commission of the European Communities 1990). Early evidence suggested that fiscal smoothing is the main mechanism alleviating economic asymmetries in the US (cf. Sala-i-Martin and Sachs 1992; von Hagen 1992). Some academics have also drawn attention to the potential for additional smoothing that could come from the integration of private capital markets (cf.Atkeson and Bayoumi 1993). But this early literature could not provide a conclusive, quantitative answer to the question of what the relative roles of private capital markets and fiscal smoothing are likely to be in a monetary union. Yet, this question is of paramount importance for understanding the future of the Economic and Monetary Union (EMU). The current debate largely overlooks the empirical fact that the role of fiscal transfers is dwarfed by the role of capital markets in established monetary unions such as the US.

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