EMU's Decentralized System of Fiscal Policy

EMU’s Decentralized System of Fiscal Policy

Jürgen von Hagen

Department of Economics, University of Bonn
and

Charles Wyplosz

Graduate Institute of International Studies and CEPR

Abstract:

This paper reviews the macroeconomic use of national fiscal policy in EMU and examines the
rational and scope for a collective insurance system which redistributes income among
countries in response to asymmetric cyclical shocks. The analysis of the record of national
fiscal policies before and after the adoption of the Maastricht Treaty finds 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. We examine 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. It is no panacea, though. Any insurance
mechanism entails moral hazard and that moral hazard can, at best, only be mitigated, not
eliminated.

JEL classification: E61, E62, E63

Key words: Economic and Monetary Union, fiscal stabilization, collective insurance
mechanism.

Paper presented at the Conference on EMU at 10: achievements and challenges held in
Brussels on 26-27 November 2007. We are grateful to Lucio Pench, Martin Larch, our
discussants and the conference participants for very useful comments.

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