Rainy day funds and risk-sharing: Any lessons for Europe?

Most European countries are limited in their ability to conduct independent monetary or fiscal policies to stabilize their individual economies because the European Central Bank sets monetary policy for the entire common currency area and the restrictions placed on EMU-member countries by the Maastricht Treaty. Therefore, the establishment and effective use of rainy day funds are one tool European countries could employ to dampen the effects of downturns. Elder and Wagner (2012) examine a number of European countries and estimate the distribution of savings levels that the countries would have to individually achieve to weather economic downturns. Moreover, Elder and Wagner (2013) examine the benefits of US state governments pooling their savings to weather economic downturns. They estimate that the reduction in the pooled savings amount, relative to the aggregate sum of individual savings amounts, can be sizeable meaning that governments who pool their resources can save less relative to the amount they would have to save if they did not pool their resources. The primary reason for this reduction is that US state business cycles are not perfectly synchronized. There is ample evidence that the business cycles of European countries are less synchronized than those of the US states so the risk-sharing benefits that could exist for European governments who pool their fiscal resources over the business cycle should be greater than the benefits found for US states. In this paper, we estimate a coincident index based on a set of monthly economic indicators, and explore the issues associated with European national government risk-sharing and provide estimates of the potential benefits to national governments who pool their fiscal resources.