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Is a fiscal capacity really necessary to complete EMU?

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  • Feld, Lars P.
  • Osterloh, Steffen

Abstract

[Conclusion] The necessity of establishing a fiscal capacity at the European level in order to smooth asymmetric shocks in EMU is largely based on the theory of optimum currency areas. If countries do not have the possibility to align exchange rates, the effects of asymmetric shocks on a country's income must be absorbed by other mechanisms. In an economy with sticky wages and prices as well as with low factor mobility, only a transfer mechanism between countries provides for a compensation of such adverse cyclical effects and thus serves as an insurance against the risk of asymmetric shocks. This rationale is based on many assumptions regarding the economic conditions in a country. Instead of a fiscal capacity for risk-sharing an increase in factor mobility or a higher wage and price flexibility also allow for an absorption of shocks. Indeed, a monetary union requires economies to become more flexible. The analysis in this paper shows that the contribution of a fiscal capacity to absorb shocks in federations in which a fiscal union is established is relatively low. This holds for the US, Germany and Canada alike. More important according to empirical studies are capital markets. The more integrated capital markets are, the better they serve as an interregional risk-sharing mechanism. Thus, the creation of a banking union along the lines proposed by Buch et al. (2013) in the EU will be the best way of insuring EMU member countries against adverse asymmetric shocks. In addition, higher labor mobility and higher wage and price flexibility will help to accommodate future shocks. Moreover, if member countries consolidate their budgets following the rules of the fiscal compact and the six pack regulations, their ability to smooth shocks by national fiscal policy will be increased. It should be noted that the establishment of a fiscal capacity does not only provide for at best a rather small risk-sharing mechanism. It also induces negative incentives for member countries to reduce the probability of being affected by economic shocks adversely. Reforms of labor and products markets aiming at higher wage and price flexibility will be postponed. Consolidation efforts will wane. Moral hazard occurs. Given this downside of a fiscal capacity, its introduction cannot be advised.

Suggested Citation

  • Feld, Lars P. & Osterloh, Steffen, 2013. "Is a fiscal capacity really necessary to complete EMU?," Freiburg Discussion Papers on Constitutional Economics 13/5, Walter Eucken Institut e.V..
  • Handle: RePEc:zbw:aluord:135
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    1. Viktor Vanberg, 2007. "Corporate social responsibility and the ‘game of catallaxy’: the perspective of constitutional economics," Constitutional Political Economy, Springer, vol. 18(3), pages 199-222, September.
    2. Vanberg, Viktor J., 2005. "Auch Staaten tut Wettbewerb gut: Eine Replik auf Paul Kirchhof," Freiburg Discussion Papers on Constitutional Economics 05/2, Walter Eucken Institut e.V..
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    Cited by:

    1. Theodoros S. Papaspyrou, 2017. "A new approach to governance and integration in EMU for an optimal use of economic policy framework - priority to financial union," Working Papers 229, Bank of Greece.

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