Fiscal Transfers in a Monetary Union with Sovereign Risk

Abstract

This paper considers a scheme of fiscal transfers between member states of a monetary union subject to sovereign spread shocks. The scheme consists of a set of cross-country transfer rules triggered when sovereign spreads widen. I study its implementation in a twocountry model with financial frictions estimated for Portugal and the Eurozone. The model illustrates how domestic fiscal policy is unable to buffer the widening of sovereign spreads when public debt is high and spreads are responsive to the fiscal outlook. On the contrary, because transfers are made between governments, they alleviate the strain caused on the fiscal stance directly and reduce the pass-through of sovereign risk to private lending to firms. I find that, for welfare to improve for all member states, their relative size and fiscal profile need to be nearly symmetric. Nevertheless, I show that for a cost to the remaining members states significantly smaller than the benefits they derive from being part of the union, a small country like Portugal can secure sizeable increases in life-time consumption.

Reforming the Eurozone: Assessment of the Reform Package by the European Commission – Treating Symptoms or Root Causes?

“…Werning (2017) provides theoretical support for those mechanisms and the benefits of a fiscal union. However, at the same time, there exists research showing the risks of a fiscal union as well as the ineffectiveness of fiscal transfers in the Eurozone (Kehoe & Patorino 2017, Martinez-Garcia 2017, Bandeira 2018. They demonstrate that a fiscal union is unnecessary and costly, unless policy-makers establish a political union as prevalent in sovereign states.…”

“…Despite fiscal contraction in recent years -Germany has budget surplusesthe growth dynamic did not slow down. Moreover, Bandeira (2018) shows in a DSGE model that fiscal transfers cause a welfare loss by the funding distortions of the capacity. He concludes on page 35 "welfare can actually fall when fiscal transfers are implemented.…”

“…In Ireland, Greece, Spain, Italy, Luxembourg, Germany, Netherlands, Austria, Portugal, Slovenia, Slovakia, and Finland, the asymmetric shocks continue for more than four years (Table 3). In general, the long duration indicates a massive problem for any fiscal capacity, including a supranational fiscal union (Farhi & Werning, 2017, Bandeira, 2018. Note that a fiscal stimulus is only effective in the short-term (Tcherneva, 2011).…”

“…At the same time, countries that do need support receive modest funding despite large asymmetric shocks. In fact, letting the (domestic) automatic stabilizers work is likely more effective than a fiscal capacity responsive to large asymmetric shocks (Bandeira, 2018).…”