The optimal design of a fiscal union
The optimal design of a fiscal union
Thursday, 17 March 2016: 4:20 PM
Currency unions are typically federations comprised of a common central bank, a centralized fiscal authority and a subset of regional fiscal authorities. The euro area stands in stark contrast: a currency union with no centralized fiscal authority or fiscal union (Bordo et al(2011)). While the European Central Bank conducts monetary policy for the euro area as a whole, fiscal policy is largely carried out by self-interested national authorities. In addition, financial markets in the euro area play much less of an insurance role than in other federations, primarily due to lower cross-border ownership of assets. While federations like the U.S., Canada and Germany smooth over 80 percent of the impact of local shocks through a combination of fiscal transfers and financial market integration, the euro area only insures half that amount (IMF (2013)).
The relative paucity of cross-border risk-sharing in the euro area combined with the self-interested behavior of national fiscal authorities has prompted much debate about the need for a fiscal union between member states. Although the concept of a fiscal union has received a great deal of attention in policy circles, there is still considerable uncertainty about how to design such a union. The literature has typically studied this question in an environment of perfect cross-country risk-sharing, where full consumption insurance is provided by internationally complete asset markets or by terms of trade movements, and where national fiscal authorities are not self-interested but cooperative. However, the challenge facing the euro area is a direct consequence of these features missing from the literature: too little cross-country risk-sharing and too much self-interest on the part of national fiscal authorities.
To address this gap in the literature and the policy realm, we study the optimal design of a fiscal union in an open economy model where cross-country risk-sharing is imperfect and fiscal authorities are self-interested. Self-interested national fiscal authorities use fiscal policy to tilt the terms of trade in their favor, giving rise to terms of trade externalities --- a crucial component of the present crisis in the euro area that has yet to be addressed in the literature. We examine the interplay of nominal rigidities with imperfect risk-sharing and terms of trade externalities and find that the negative welfare impact of these distortions is highly sensitive to the elasticity of substitution between goods produced in different countries.
The relative paucity of cross-border risk-sharing in the euro area combined with the self-interested behavior of national fiscal authorities has prompted much debate about the need for a fiscal union between member states. Although the concept of a fiscal union has received a great deal of attention in policy circles, there is still considerable uncertainty about how to design such a union. The literature has typically studied this question in an environment of perfect cross-country risk-sharing, where full consumption insurance is provided by internationally complete asset markets or by terms of trade movements, and where national fiscal authorities are not self-interested but cooperative. However, the challenge facing the euro area is a direct consequence of these features missing from the literature: too little cross-country risk-sharing and too much self-interest on the part of national fiscal authorities.
To address this gap in the literature and the policy realm, we study the optimal design of a fiscal union in an open economy model where cross-country risk-sharing is imperfect and fiscal authorities are self-interested. Self-interested national fiscal authorities use fiscal policy to tilt the terms of trade in their favor, giving rise to terms of trade externalities --- a crucial component of the present crisis in the euro area that has yet to be addressed in the literature. We examine the interplay of nominal rigidities with imperfect risk-sharing and terms of trade externalities and find that the negative welfare impact of these distortions is highly sensitive to the elasticity of substitution between goods produced in different countries.