implemented in a way that does not increase the cost of labor further. An obvious way to do
that would be to replace a part of the existing unemployment insurance schemes at the
national level to the euro-area level. Note, however, that Italy today does not have an
unemployment insurance system at the national level. Thus, this approach would require the
institution of a new branch of social insurance in this country.
Second, many European countries have experienced an increase in non-traditional forms of
employment in recent years, which are not included in the existing social insurance schemes.
However, these new forms of employment are precisely those that are the most flexible ones
in the labor market and, therefore, the most responsive ones to asymmetric shocks. The
implementation of a euro-area wide unemployment insurance would most likely be most
efficient, if non-traditional jobs could be integrated into the scheme. But doing so should not
destroy their very purpose of providing flexibility to the labor market.
Third, European countries suffer from very different rates of permanent unemployment. The
main moral hazard problem of a euro-area wide insurance is that it creates incentives for
national governments to raise (or to not do enough to lower) permanent unemployment in
order receive permanent net transfers through the mechanism. One obvious way of dealing
with this problem is to insist on co-insurance. Euro-area wide unemployment insurance would
only be provided for countries that have substantial unemployment insurance at the national
level. Given the concern over the high cost of labor in the euro area, this would limit the
amount of insurance that can be provided at the aggregate level. An alternative solution would
be to limit the duration of the unemployment insurance provided by a euro-area wide
mechanism strictly to periods of six to twelve months.
5. Institutional Requirements for a Transfer System
The analysis carried out in the previous section suggests that the most promising mutual
insurance system rests on tax revenue sharing with a mutual fund that need not be balanced
year after year. There are two main moral hazard problems challenging the viability of such a
system. The first is that it might create opportunities for cheating by individual countries
trying to induce permanent redistribution in favor of individual countries. The second is that it
will be abused as a way to circumvent the borrowing restrictions under EMU, leading to
permanent indebtedness of the system at the aggregate level. We now take issue with these
challenges.
5.1. Moral Hazard Problems at the Country Level
The purpose of the fiscal insurance system would be to insure the tax revenues of the
participating governments against transitory asymmetric shocks. Such shocks may be
correlated over time, but, in order to guarantee that the insurance system does not run
permanent surpluses or deficits, only shocks that do not affect the level of taxes permanently
can be insured. Since tax revenues in practice are affected by a mixture of permanent and
transitory shocks, the viability of a fiscal insurance system requires a method to identify
transitory shocks and separate them from permanent shocks. As demonstrated in Hammond
and von Hagen (1998), this is possible, if the system can be based on sophisticated
econometric models. This, however, is unlikely for a system that results from an agreement
among governments of different countries.
Ruling out complicated econometrics, a simple mechanism for calculating the transfers paid
within the system must be found. Assuming that tax revenues of government i in period t, Tit,
are proportional to GDP, Yit,
(15) Tit =αYit
this can be achieved by tying payments into the system to the asymmetric deviation between
actual and potential GDP, Pit,
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