(16) tit =λα[(Yit-Pit)-β(Yt-Pt)],
where λ determines the degree of insurance chosen by government i, Yt and Pt, are the actual
and the potential level of euro-area GDP, and β is the weight of country i in euro-area
potential GDP. Countries enjoying a boom relative to the euro area would pay into the
insurance scheme, while countries suffering from a relative recession would receive transfers.
By definition, these deviations are transitory, assuring that the system is balanced on average
over the business cycle. Note that, as business cycles among the participating countries
become more correlated, transfer payments into and out of the system will become smaller.
A moral hazard problem arises from the fact that, in each period, a government has an
incentive to overstate its potential GDP in order to reduce its payment into the system. To see
this, note that (dtit/dPit) = - λα(1-β2) < 0. In other words, faced with formula (16) as a basis for
its payments, governments have an incentive to declare that their economy is in a recession.
This implies that the computation of potential GDP cannot be left to the governments alone.
One approach would be to delegate these computations to a politically independent agency,
e.g., the European Commission or an independent research institute.
An alternative solution would be to modify (16) in a way that assures balance over
time independently of the way how potential (and actual) output are calculated. Assuming
that potential output is constant over time for simplicity, this can be done by using the
following formula:
t-N
(17) tit =λα[(Yit-Pit)-β(Yt-Pt)]-∑(1+rt)N+jtit-N-j.
j=0
The penalty term reduces any transfers received in period t by a part of the accumulated
transfers paid in the past. Letting N be the length of the business cycle assures that this would
not interfere with stabilizing cyclical movements. Under this approach, any misrepresentation
of potential output in period t leads to a reduction in transfers received or an increase in
payments made into the system in the future. By applying an appropriate interest rate r, the
incentive to cheat is balanced by the desire to avoid future reductions in transfers received. If
potential output is calculated properly, the penalty term converges to zero over time. It is
straightforward to extend this approach to the case of growing potential output.
5.2. Moral Hazard Problems at the Aggregate Level
At the aggregate level, the moral hazard problem lies in the possibility for the participating
countries to abuse the insurance scheme as a way of circumventing the borrowing constraints
under EMU. Governments running budget deficits close to three percent of GDP might ask
for payments out of the insurance system in order increase its borrowing outside its own
budget. Obviously, as long as a penalty as in equation (17) is applied and strictly enforced,
these governments will be forced to run budget surpluses in future periods in order to pay
back what they borrowed indirectly. If this is true, such indirect borrowing does not increase
government debt permanently and does not endanger the sustainability of the common
currency. Therefore, there is no problem for the monetary union as a whole.
The moral hazard problem comes from the possibility that the governments agree collectively
not to enforce the repayment embedded in the penalty. Note that, as long as each country
strictly keeps its own account within the fiscal insurance system and is responsible for the
liabilities created by any transfers paid to it, no government must fear becoming financially
responsible for the misbehavior of other governments. But this may imply that governments
would rather give into the demands of others to borrow indirectly through the insurance
mechanism than facing an open conflict with them. The experience with the enforcement of
the SGP in the years after 2001 suggests that this possibility cannot be ruled out.
Ultimately, this problem is linked to the governance of the insurance mechanism. It could be
mitigated by delegating the governance of the system to a politically independent body which
has a vital interest in preserving its financial sustainability, either the European Commission
of the European Central Bank. These bodies would then have the right to veto the payment of
transfers to individual countries and to impose a penalty formula such as the one given in
17