Euro Area Policies: Selected Issues


Euro Area Policies: Selected Issues

Options for a Central Fiscal Capacity in the Euro Area1

A key proposal of The Five Presidents’ Report is the establishment of a euro area treasury to enhance joint decision-making on fiscal policy. In practice, this implies creating a central fiscal capacity (CFC) at the euro area level. This paper outlines three options for the design of a CFC, focusing on the economic rationale and highlighting pros and cons of each option. The paper is descriptive, rather than normative, and aims to lay the groundwork for further dialogue on this subject.

A. Background and Motivation

1. The issue. The design of the European Economic and Monetary Union (EMU) was initially structured around two main pillars: (i) monetary policy to deal with EMU-wide shocks, and (ii) national fiscal policies to address country-specific shocks, within the constraints of the Stability and Growth Pact (SGP). However, some architects of EMU and observers noted that a fiscal capacity would still be desirable (European Commission, 1977), while the global crisis has exposed serious shortcomings in the functioning of the EMU (Allard and others, 2013, 2015; Andrle and others, 2013).

  • Monetary policy’s capacity to mitigate euro area-wide shocks can be constrained when policy rates approach the effective lower bound (ELB) and with impaired private sector balance sheets. Without central fiscal support, the policy mix may rely too heavily on monetary policy and take longer to close the output gap.

  • The buildup of public debt and the slow recovery have reduced fiscal space in many countries, limiting their capacity to respond to shocks. And limited private risk-sharing through capital markets can also exacerbate these country-specific shocks with negative spillovers to the rest of the union.

2. Central fiscal capacity. Recognizing these shortcomings in the architecture and building on earlier proposals by the European Commission and the European Council, the Five Presidents’ Report (Junker and others, 2015) presented a ten-year roadmap to complete the economic and monetary union. A key element of this plan is the establishment of a euro area treasury to strengthen joint decision-making on fiscal policy in the EMU as a whole and enhance resilience to country-specific shocks. In practice, this implies creation of a central fiscal capacity (CFC) at the euro area level.

3. Objectives. In principle, the main objective of a CFC would be to provide fiscal support at the euro area level and enhance the EMU’s capacity to respond to both area-wide and country-specific shocks (Allard and others, 2013, 2015; Cottarelli, 2013). Moreover, similar to existing federations and fiscal unions, the CFC could have the following functions (Poghosyan and others, 2015):

  • Fiscal stabilization. There is a strong case for a CFC to cushion euro area-wide shocks as it would allow for a more effective and balanced policy response. A CFC would also make an important, albeit indirect, contribution to improved policy coordination in the EMU when fiscal space at the country level is limited and macroeconomic conditions call for fiscal support.

  • Fiscal risk-sharing could be especially useful since private risk-sharing is still limited in the EMU.2 Greater ex ante risk-sharing would limit contagion from national shocks and mitigate the likelihood of resorting to ex post ESM support. If market-based risk-sharing mechanisms are strengthened and harmonization is enhanced to the levels observed in existing fiscal unions, the need for fiscal risk-sharing would be reduced somewhat, but would not disappear.

Other objectives could include enhancing fiscal discipline at the national level and promoting structural reforms.

4. Constraints. These objectives would need to be achieved within a set of constraints. First, a CFC would need to take into account fiscal conditions at the individual country level. For example, in response to a shock, any fiscal expansion through a CFC would have to be compatible with debt sustainability in individual member states, and should allow for better use of the available fiscal space under the SGP through enhanced coordination. The second constraint is political feasibility. There are likely to be objections to creating a CFC if it is seen as a transfer union, entails mutualizing credit risk across countries, or encourages moral hazard.3 Establishing a CFC may also take time, especially if it requires Treaty changes. Third, a CFC which focuses on the euro area and the need for fiscal coordination among members of the monetary union would also need to comply with broader EU rules and regulations.

B. General Characteristics of a Central Fiscal Capacity

5. Design features. CFC design schemes differ according to the following broad criteria:

  • Institutional setup. A CFC could be set up by expanding the mandates of existing European institutions, or by creating a new entity.

  • Type of resources. A CFC could be financed by (i) transfers from member states (akin to the contributions made to the EU budget), (ii) direct tax collections from individuals or entities within member states, or (iii) borrowing by a separate institutional unit that would be repaid using taxes/contributions or revenues from its operations (i.e., not mutualized debt).4

  • Form of demand support. A CFC could support aggregate demand at the EMU level by: (i) providing intergovernmental transfers or loans to member states which would then use these funds to support demand; (ii) directly funding expenditures in member states, such as infrastructure projects or transfers to individuals (e.g., unemployment benefits); or (iii) providing funding and incentives for the private sector to spend or invest (akin to the EFSI).

Figure 1.
Figure 1.

Design Features of a Central Fiscal Capacity

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A003

6. Operations. Depending on the specific scheme, CFC operations could be discretionary or automatic (see below). In addition, CFC operations could be time-dependent, with the degree of stabilization increasing in the presence of large and persistent shocks (Carnot and others, 2015).

7. Size. A relatively small CFC could go a long way in enhancing risk-sharing and stabilization. While central budgets in existing federations can exceed 20 percent of GDP, these budgets perform a much broader set of functions beyond fiscal stabilization, including redistribution. Allard and others (2013) estimate that a relatively small centralized fiscal scheme (1.5–2.5 percent of GNP collected annually) could enhance the risk-sharing capacity of euro area, bringing it to the level observed in Germany. For adequate stabilization, the required size of a CFC would depend on the fiscal multipliers and the severity of the economic slowdown. Experience from the global crisis suggests that a temporary fiscal stimulus in the range of 1–2 percent of euro area GDP could suffice to mitigate a severe euro area-wide shock (IMF, 2010).

C. Three Options for a Central Fiscal Capacity at the Euro Area Level

Tax-Transfer Scheme

Tax-transfer schemes reallocate funds across countries. In each period, a country could be either a net recipient or a net contributor to the scheme depending on its cyclical position (e.g., output gap or unemployment). The most widely discussed option is a common unemployment insurance fund.

8. Design. A typical example of a tax-transfer scheme is an unemployment insurance fund (UIF). At the euro area level, a UIF could enhance stabilization against country-specific shocks by pooling risks across countries (Dolls and others, 2014). It would redirect a portion of social contributions from national budgets towards the UIF, and provide minimum unemployment benefits comparable across states that could be capped at a certain level and/or duration.5 Given that a UIF is a tax-transfer scheme, it would not change the overall level of taxation or rely on common borrowing. It would also not affect the aggregate euro area fiscal stance as the scheme would operate only through automatic stabilizers. Nevertheless, aggregate demand could expand through compositional effects; for example, fiscal multipliers are higher in countries with greater slack or unemployment.

9. Alternative options. Alternative tax-transfer schemes could provide support to member states rather than to individuals. They could also use different criteria for providing cyclical support, such as the output gap (e.g., a “rainy-day” fund) (Carnot and others, 2015). Alternative revenue options could target different tax bases (e.g., value added) or rely on contributions proportional to country size.

10. Pros. A UIF would aim to enhance resiliency to country-specific shocks. The cyclical nature of the funding, via social security contributions, and the provision of unemployment benefits would enhance fiscal stabilization. Social security contributions raised in countries in good times could be used to fund benefits in countries experiencing an economic downturn. With parameters defined ex ante, unemployment benefits would be automatic with limited scope for politically-motivated discretionary actions. A scheme could be designed in a budget-neutral fashion at the euro area level to avoid common borrowing.6 In the absence of common debt issuance, there would be no effect on the debt of individual countries. Finally, a UIF could provide an incentive to accelerate labor market reforms if the common unemployment insurance mechanism requires a minimum degree of harmonization of labor taxation. In addition, country access to the scheme could be conditional on reaching a certain level of labor market flexibility.

11. Cons. A UIF would have a limited ability to handle common shocks, especially if designed in a deficit-neutral fashion. High cyclicality of revenues and expenditures might stretch the fund in global downturns (when demand for unemployment benefits goes up while payroll taxes shrink), even if the fund has the ability to save surpluses in upturns, although this could be addressed if borrowing were allowed. The responsiveness to shocks might not be timely given that unemployment reacts with a lag to changes in economic activity. Also, if not carefully designed, a UIF might give rise to income redistribution from countries with low structural unemployment to countries with high structural unemployment. One possibility to limit the scope for permanent transfers would be to constrain unemployment benefits to short-term unemployment, which is more closely linked to temporary adverse shocks. Finally, without conditionality on access, a UIF might contribute to moral hazard and slow implementation of reforms.

Borrowing-Lending Scheme

Borrowing-lending schemes entail a central entity, similar to a multilateral bank, which borrows from the market and on-lends the funds either to the public or the private sector.

12. Design. Several borrowing-lending schemes already exist in the EU, e.g., the ESM, EIB, EFSI, but they do not have an explicit economic stabilization mandate. A new entity could receive capital contributions from EMU members and borrow from the market.7 Borrowing costs could be kept low by the capital commitments of member states. Funds borrowed by the entity could be lent to EMU members and possibly earmarked for specific projects, such as infrastructure, and then repaid over time by member states that have received funds. In response to a large common shock, a borrowing-lending scheme could be part of a strategy that involves invoking the SGP’s systemic escape clause to provide temporary fiscal support.

13. Alternative options. On-lending schemes could also provide loans to the private sector. For instance, the EIB and EFSI borrowing capacity could be expanded by injecting new capital and focusing lending on euro area projects. Another possibility would be to channel the funds for national projects through the EU budget by opening a separate euro area chapter. Such a scheme could direct funds raised by the borrowing-lending entity to national governments in the form of grants, potentially earmarked for specific purposes. The funds would be repaid to the borrowing-lending entity over an extended period of time using regular transfers from euro area members. This would allow individual members to use the current favorable borrowing environment to frontload spending while avoiding risk mutualization.

14. Pros. The scheme would create new fiscal space by allowing countries to borrow from the central entity at lower rates.8 The entity would enhance stabilization by expanding aggregate demand in response to euro area-wide shocks. The debt of the entity would not be a joint liability financial instrument, and with a sufficiently high credit rating, the debt could be a new safe asset and eligible for ECB monetary policy operations. Also, the scheme could provide affordable financing to SMEs or other projects. Proper vetting (supported by the EIB/EFSI) could help ensure the efficiency of projects. Finally, the scheme could provide impetus for sound policies if access is conditional on compliance with fiscal rules and a strong structural reform track record, such as implementation of EC country-specific recommendations.

15. Cons. The political challenges of creating such a new entity are high, as it might require amendments to existing EU Treaties or intergovernmental Treaty negotiations outside of the EU framework.9 Economically, new debt issuance by the center could crowd out national borrowing, leading to higher interest rates for some countries,10 as well as lower budgeted public investment, resulting in a smaller addition to aggregate demand due to the “windfall effect.”11 In addition, there would be no automaticity as in a UIF, as the entity would provide loans on a discretionary basis with longer implementation lags and possible risks of political interference. There might also be a buildup of contingent liability risks for shareholders. An on-lending scheme might create a liability for the shareholders in case of default, either because they would need to recapitalize the entity or because they would have guaranteed its debt. Finally, in the absence of conditionality, the scheme may give rise to moral hazard and undermine fiscal discipline.

Small Euro Area Budget

A small euro area budget would combine the characteristics of the previous two options with more policy levers and flexibility to respond to aggregate and country-specific shocks.

16. Design. A new budget could be established at the euro area level (EAB). An EAB would receive revenues in the form of contributions from member states or from taxes for which it would be given the authority to collect, such as value added or corporate income taxes. Expenditures carried out centrally could focus on common public goods or strengthening social safety nets. Expenditure could also be via transfers to member states in a neutral (proportional to country weights) or targeted (supporting more those undergoing downturns) fashion.

17. Funding capacity. An EAB could also have the ability to issue its own debt, supported by a dedicated revenue stream. This scheme would differ from the tax-transfer option (which does not entail borrowing), the borrowing-lending option (which does not carry out expenditure), and the EU budget (which is broader than the euro area, does not focus on stabilization, and does not have a borrowing capacity).12

18. Alternative options. The EU budget could be increased and its mandate expanded to provide a stabilization function, in addition to redistribution and public goods provision, but its operations cover EU, and not just euro area, countries.

19. Pros. The scheme could cushion both euro area-wide and country-specific shocks. Automatic stabilizers could operate through central revenues and expenditures, providing risk-sharing in response to country-specific shocks. The EAB could expand aggregate demand in response to euro area-wide shocks by issuing common debt and creating new fiscal space.13 Also, the EAB could generate economies of scale, as centralized provision of some public goods (e.g., infrastructure projects with large network externalities, national defense, R&D, and foreign affairs) could enhance spending efficiency (Escolano and others, 2015). The EAB could also facilitate the coordination of the euro area fiscal stance by influencing and coordinating national budgets from the center.14 By creating a comparable institution to the ECB on fiscal policy, it would strengthen the credibility and responsiveness of euro area macroeconomic policies. It could also foster harmonization of those taxes and expenditures managed by the center.

20. If an EAB’s centrally-supported risk-sharing were conditional upon SGP compliance and structural reform progress, an EAB could enhance incentives for strong policies.15 Finally, the EAB could be established as an independent statistical unit so its debt would not appear as individual members’ debt.16 At the same time, issuing EAB bonds would increase the pool of safe assets.

21. Cons. An EAB may be the most politically challenging among the options discussed, as it would involve transferring taxation, spending, and borrowing powers to the center, subject to corresponding Treaty changes. To be legitimate and credible, an EAB would need some political oversight, such as by the European Parliament, and perhaps even the appointment of a euro area finance minister, which could also increase effectiveness. Any increase in the overall tax burden could generate resistance, if not matched by reductions at the national level. An EAB might indirectly result in income redistribution from richer to poorer countries through permanent differences in tax bases and or transfer needs. Evidence of indirect redistribution is present in existing federations without an explicit constitutional mandate of redistribution (e.g., the U.S.) (Poghosyan and others, 2015). The establishment of a separate budget could lead to an increase in government size and impose an additional tax burden at the euro area level, although offsetting the new spending and taxes with smaller national budgets would reduce or eliminate the expansionary effects. Central borrowing might crowd out national borrowing, although this is less likely when economic conditions are weak and monetary policy is accommodative. Finally, the EAB might lead to moral hazard in the absence of conditionality and market pressure.

D. Next Steps

22. Next steps. While the Five Presidents’ Report makes a strong case for a CFC, it does not elaborate on its design and potential functions. The details are to be laid down in a white paper slated for spring 2017. A special working group in the European Commission will consider details of a CFC and prepare the white paper. However, given the complexity of the issue and various constraints, any move toward a CFC is likely to be gradual in order to accommodate the various concerns and political views regarding further fiscal integration.


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Prepared by Tigran Poghosyan. Helpful comments and suggestions were provided by FAD and EUR colleagues, and counterparts at the European Commission and ECB.


Fiscal risk-sharing in the euro area is much smaller than private risk-sharing in existing federations. For instance, risk-sharing through capital and credit markets is about five times larger than fiscal risk-sharing in the U.S. (Asdrubali and others, 1996). Fiscal risk-sharing in the euro area is also much smaller than in other federations (Allard and others, 2013).


As shown in Poghosyan and others (2015), income redistribution could emerge as a byproduct of a central fiscal capacity. In the EMU case, large permanent transfers across states may be difficult to establish in the absence of a political union.


Joint-liability bonds (such as Eurobonds) have also been discussed as an option to finance national deficits. They are outside the scope of this paper.


A UIF could mimic the design of similar schemes in existing federations, where minimum insurance against individual income risk is provided through the center. For instance, in the U.S., the federal-state unemployment insurance system is managed largely by the states. Workers are eligible for a maximum of 26 weeks of unemployment insurance in normal periods. Depending on the state, the insurance aims to replace about half of workers’ previous earnings up to a maximum level and is funded by federal and state payroll taxes. In periods of economic stress, the insurance period could be expanded beyond 26 weeks through additional support from the federal government (see


At the individual country level, the scheme may create fiscal deficits or surpluses in a particular period of time, but would be deficit-neutral over an extended period of time.


The funds borrowed from the market would be recorded on the balance sheet of the entity and would not increase national debts.


The national debt of the shareholders would nonetheless increase moderately by the amount of capital they have to provide. Also, the lending activities of the entity would be recorded as debt of the countries borrowing from it. Finally, the entity should meet a number of criteria and have sufficient autonomy to limit the risk of debt reclassification.


For instance, ESM was founded on the basis of a new treaty (the Treaty Establishing the European Stability Mechanism), which stipulated that ESM would be established if member states representing 90 percent of its original capital requirements ratify it. In addition, 27 EU members had to ratify the amendment to Article 136 of the Treaty on the Functioning of the European Union (TFEU) to authorize establishment of the ESM under EU law.


Nevertheless, this is unlikely when economic conditions are weak and monetary policy is accommodative, as is the case now, and given the small size envisaged for the scheme.


The “windfall effect” refers to a temporary and sudden increase in available budget resources, part of which could be saved for various reasons (including meeting SGP targets).


An EAB might share common features with the EU budget. The European Commission is responsible for executing the EU budget, with the European Council and European Parliament all having a say in determining its size and allocation. The European Commission could also be responsible for executing the EAB, with the Eurogroup and European Parliament being involved in determining its size and allocation.


In addition to borrowing to finance EAB spending, if an EAB has a credible revenue stream and/or there is backing (explicit or implicit) by member states of central debt, interest rates paid by the EAB might be below those of highlyindebted countries. Hence, issuing debt at a central level could be cheaper than issuing separately at national levels.


Other federations typically have relatively large central budget capacities.


Stabilization by itself could also support implementation of structural reforms indirectly (IMF, 2016).


Statistically speaking, a central budget is generally recorded as a separate “institutional unit” which borrows on its own behalf (rather than on behalf of its shareholders) and is responsible for repaying its debt from a legal point of view. The central budget’s borrowing is backed by future streams of its own central revenues. As a result, its fiscal operations (revenue, expenditure, and borrowing) are recorded separately from its shareholders, similar to the EU budget accounting. This is the case even if member states guarantee the debt issued by the central budget.