equation (17). For example, a veto might be triggered, if the sum of a government’s budget
deficit and the transfer payment received from the insurance system exceeds three percent of
GDP. Even if it is hard to imagine that such an outside body could consistently withstand
pressures from the participating governments, delegating such veto power would have the
advantage that such pressures are made visible to the public in the countries participating in
the monetary union. This would strengthen the democratic accountability of the governments
and give the voters an opportunity to penalize financially irresponsible governments.
6. Conclusions
The Euro area will likely remain for a long time a one-of-its kind arrangement with a
centralized monetary policy and decentralized fiscal policies. This is, after all, the same
arrangement as in most federal states, with two key differences. First, in Europe, the “federal”
budget is very small and largely automatic. Second, in contrast with may federations where
decentralized budgets are subject to strict imbalance limits while the center carries out fiscal
policy, Europe’s centralized budget must be balanced while sub-central budgets are in charge
of fiscal policies.
Concern with this arrangement has led to the SGP. We have argued that the meaningful
concern is the risk of fiscal dominance. We have also examined the record of national fiscal
policies before and after the adoption of the Maastricht Treaty and found evidence that the
quality of fiscal policies has improved in two ways: they are more clearly countercyclical - or
less procyclical - and they are more readily used to restore competitiveness than to attempt to
boost demand when competitiveness is eroded.
These observations suggest that fiscal policy remains a useful instrument. One question is
whether it can be augmented - or perhaps substituted for - with a collective insurance system.
Collective insurance is one alternative to external borrowing and lending and therefore one
way to deal with the concerns that the SGP is meant to address. It is no panacea, though. We
find that, to be effective and politically acceptable, a collective insurance system must be able
not to balance every period. Put differently, effective system moves (part of) national deficits
to the collective level.
We have examined in more detail two collective insurance systems: tax revenue sharing and
unemployment insurance sharing. We find that the earlier is more promising and examine in
some detail how it could be set up. A nice feature of any sharing system is that it is
structurally balanced over time. In other words, it cannot lead to debt accumulation. But is it
fool-proof? Examining various potential loopholes, we find that, if well structured, such a
system has desirable incentives characteristics. Individual countries that attempt to take
advantage of the system to achieve short-term political advantage can be discouraged.
There remains the possibility that collectively, Euro area governments may be tempted to use
the insurance scheme to raise their debts. Individual governments could be tempted to
misrepresent their true economic situation - by providing overblown estimates of their
potential GDP - in order to obtain larger transfers. This moral hazard can be dealt with either
by delegating the task of assessing potential GDP to an independent body, or by including in
the net transfers a penalty, respectively a repayment, that correspond to the accumulated
transfers received from, respectively paid into, the insurance scheme. Another risk is that
collectively member governments agree to use the insurance mechanism to bypass the SGP.
Here again, a solution would be to delegate to an independent body the right to block
payments and to impose a penalty scheme. Of course, it is impossible that the independent
body will always the gravitas to overrule a strong coalition of member governments.
In the end, therefore, we face the unavoidable fact that any insurance mechanism entails
moral hazard and that moral hazard can, at best, only be mitigated, not eliminated. If the risks
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