Blog Post

The euro area’s need for stabilization in historical perspective

It is not unusual that some European countries register strong growth rates and others less so. Yet, significant divergence in output is historically associated with dramatic events (or crises). This implies that a euro area budget used for stabilization will end up being activated only a few times. Moreover, there is no historical record of core Europe marching above and the periphery below potential. This makes it unrealistic to conceive of a euro area budget that transfers resources on the spot from badly hit to just moderately hit countries. Some institutional engineering would be necessary.

By: Date: January 8, 2013

Figure 1: The incidence of large asymmetric shocks over time

Source: Bruegel based on AMECO database.

The debate on the need to introduce a euro area budget (or an EU-wide risk sharing mechanism) stems from the realization that all potential stabilization tools have so far not been very useful or even damaging to countries (see debate on fiscal austerity in bad times), and that an EU stabilization fund may indeed serve to smoothen cyclical fluctuations that affect members of the monetary union in opposite directions (or asymmetric shocks)1.

How often does it happen that countries pertaining to the same economic area are in dramatically different business cycle positions? How severe is the divergence? How persistent is it?

Figure 1 shows the standard deviation in the output gap across eleven countries that entered the monetary union between 1999 and 2001 (Austria, Belgium, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain). The data go back to 1965 at a time when Ireland, Greece, Portugal and Spain were not even members of the European Union but the figures still give an indication of European output trends and allow for comparison with recent crisis times2.

We juxtapose the standard deviation in each year with the average standard deviation in output gaps across the entire period from 1965 to 2013 (forecasts for 2012 and 2013). We also include the average of the period following the inception of the EMU regime to control for the fact that the single currency may automatically (or endogenously) produce business cycle synchronization, thereby reducing average volatility.

Data in Figure 1 confirm the following: i) that some countries go through hard times and other through better times in the same period is a standard feature of the European economy but above-average output divergence is something that is historically associated with dramatic events (ie currency crisis in the early 1970s, recession in the early 1980s, currency crisis in the early 1990s and the Euro area crisis); ii) more recent divergence peaks have been generally more persistent, a possible explanation being that deeper economic integration enhances the international propagation of shocks across partner countries, which creates further (pro-cylical) feedback effects.

Output divergences do not per se justify having a risk-sharing mechanism that transfers resources from least deviating to most deviating countries. If all countries are below potential but to different extents, the EU stabilization fund would just transfer money from less poor to poorer countries.

In Figure 1 we also plot the average output gap to bring to light periods in which a high standard deviation is just the result of the fact that countries are facing more or less severe hard times, whilst but all being in recession3. By looking simultaneously at standard deviation and averages, it appears that large asymmetric shocks have been historically associated with boom bust cycles, with first all countries growing but to different extents and then all countries stuck below potential but to different degrees. In other words, euro area countries tend to occupy the same territory (whether positive or negative).

To make this clearer, Figure 2 describes the average output gap over time distinguishing between two areas, the North and the South of the euro area. There is not a point in time when the average output gap in one area is negative and the other positive, which is the only situation where transfers would be politically acceptable since they move from booming to busting economies.

Figure 2: Average output gap in the North (AUT, BE, DE, FR, LUX) vs South (EL, ES, IE, IT, PT)

Source: Bruegel based on AMECO database

The patterns described here provide insights into the debate about if/how to design a euro zone’s fiscal capacity to cushion asymmetric shocks:

  • a rigorous enforcement of the Excessive Imbalance Procedure (EIP) and thus “early treatment” of boom bust cycles reduces the need for a European fiscal capacity when the bust occurs;
  • the EU should extract an interest-bearing deposit rather than a proper fine from countries that fail to solve their macroeconomic imbalances; the cash should be paid into a fund, which provides transfers when the bust occurs, anywhere in the monetary union and in proportion to the severity of the bust;
  • the latter mechanism is unlikely to create moral hazard, as governments will continue to regard the interest-bearing deposit as a stigma;
  • alternatively, the new fiscal capacity should be allowed to borrow on capital markets and may only be balanced over five-year periods and not less, as this is the average duration of EU-wide below-potential periods (see Figure 1);
  • a functional equivalent to an EU-wide risk-sharing mechanism is fiscal expansion in all countries during recessions, which would imply that all euro area countries are temporarily allowed to have nominal deficits above 3% of GDP4;
  • assuming the shock is on the supply side, stronger government consumption may not be sufficient to offset it; in this case, deficits above 3% of GDP should be allowed but anything above 3% should just go towards financing government investment (ie it would qualify as a state-contingent temporary “golden rule”).

The debate remains open.


1. For a discussion on why the euro area needs a shock-absorbing budget, se Wolff G.B., A Budget for Europe’s Monetary Union, Bruegel Policy Contribution, December 2012.

2. By using the output gap as a measure of economic activity we are not implying that this is best indicator. In fact, there may be others that provide more reliable real-time information (eg labour market indicators), but the latter would be typically pro-cyclical so that our general assessment of the size and duration of instability remains valid.

3. Data in bold refer to years during the divergence peak when the average output gap in the euro area is negative.

4. An earlier suggestion is in Marzinotto B. and Sapir A., Fiscal rules: timing is everything, Bruegel Policy Brief, September 2012.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Topics

Comments

Read article

Blog Post

IMG_20151009_103117 (3)
Portraits Bruegel staff 2014

Can mass migration boost innovation and productivity?

The long-term impact of migration on innovation and productivity growth in host countries is a neglected issue in the current debate on refugees. Research shows that these effects can be substantial, but if Europe wants to capitalize on this potential it will need better information systems to match migrants’ skill sets with host environments.

By: Nuria Boot and Reinhilde Veugelers Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: February 10, 2016
Read article More by this author

Parliamentary Testimony

Inquiry of the House of Lords’ EU Financial Affairs Sub-Committee on “Completing Europe’s Economic and Monetary Union”House of Lords

Inquiry of the House of Lords' EU Financial Affairs Sub-Committee

The enquiry on "Completing Europe’s Economic and Monetary Union" took place on 27 January 2016 in Brussels.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance, House of Lords, Parliamentary Testimonies Date: February 8, 2016
Read article More on this topic

Blog Post

Pia Hüttl
Schoenmaker pic

European banking union: should the 'outs' join in?

To address coordination failures between national institutions regulating banks, we need supranational policies. Banking union encourages further integration of banks across borders, deepening the single market, and could also benefit countries outside the euro which have a high degree of cross-border banking.

By: Pia Hüttl and Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: February 4, 2016
Read article Download PDF More on this topic

Policy Contribution

Should the ‘outs’ join the European banking union?

Should the ‘outs’ join the European banking union?

This paper analyses the banking linkages between the nine ‘outs’ and 19 ‘ins’ of the banking union. It finds that the out countries could profit from joining banking union, because it would provide a stable arrangement for managing financial stability.

By: Pia Hüttl and Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: February 4, 2016
Read article More on this topic More by this author

Opinion

Guntram B. Wolff

The economic consequences of Schengen

The president of the European Commission, Jean-Claude Juncker, recently warned that “without Schengen and the free movement of workers, of citizens, the euro makes no sense.” And in fact, it is the single currency and the ability to travel freely without identity documents that most Europeans associate with the EU. So how does it really stand with Schengen and the euro?

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: February 2, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

Blaming the Fed for the Great Recession

What’s at stake: Following an article in the New York Times by David Beckworth and Ramesh Ponnuru, the conversation on the blogosphere was dominated this week by the question of whether the Fed actually caused the Great Recession. While not mainstream, this narrative recently received a boost as Ted Cruz, a Republican candidate for the White House, championed it.

By: Jérémie Cohen-Setton Topic: European Macroeconomics & Governance Date: February 1, 2016
Read about event More on this topic

Upcoming Event

22 
Feb
2016
12:30

Economic weakness and demographic challenges: what next for Europe?

After a year of weak recovery what is next for Europe? This event will look at both the general macroeconomic situation as well as the challenges posed by changing demographics

Speakers: John Driffill, Torben M. Andersen and Pia Hüttl Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Opinion

Guntram B. Wolff

The fallout from the European refugee crisis

Of the 1.5 million refugees that reached the European Union last year, more than 1 million ended up in Germany, but the initially welcoming atmosphere has changed drastically.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: January 29, 2016
Read about event More on this topic

Upcoming Event

23 
Feb
2016
12:30

Adjustment in the Economic and Monetary Union

This event will look at shocks and adjustment in the euro area in the light of recent crises and analyse the functioning of a key internal adjustment process in EMU

Speakers: Robert Anderton, Antoine Berthou, José Leandro and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article Download PDF More on this topic

External Publication

Analysis of developments in EU capital flows in the global context

Analysis of developments in EU capital flows in the global context

The purpose of our report is to provide a comprehensive overview of capital movements in Europe in a global context.

By: Zsolt Darvas, Pia Hüttl, Silvia Merler and Thomas Walsh Topic: European Macroeconomics & Governance Date: January 28, 2016
Read article Download PDF More on this topic

Blueprint

Blueprint

Measuring competitiveness in Europe: resource allocation, granularity and trade

This new Bruegel Blueprint provides a differentiated understanding of growth, productivity and competitiveness and the important role public policy needs to play.

By: Carlo Altomonte and Gábor Békés Topic: European Macroeconomics & Governance Date: January 28, 2016
Read article Download PDF More on this topic

Policy Brief

One market, two monies: the European Union and the United Kingdom

One market, two monies: the European Union and the United Kingdom

So far, having more than one currency in the EU has not undermined the single market. However, attempts to deepen integration in the banking, labour and capital markets might require governance integration that involves only euro-area countries. Safeguards are needed to protect the interest of the UK and other euro-outs.

By: André Sapir and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: January 28, 2016
Load more posts