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 European Macroeconomics & Governance Tags & Topics

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.

View comments
Read about event

Upcoming Event

Sep
6-7
09:30

Bruegel Annual Meetings 2016

The Annual Meetings are a high point in Bruegel's calendar.

Speakers: Michel Barnier, Corso Bavagnoli, Joachim Bitterlich, Arnoud Boot, Albert Bravo-Biosca, Elmar Brok, Nadia Calviño, Tom Carver, Daniel Daianu, Zsolt Darvas, Paulina Dejmek-Hack, Jeroen Dijsselbloem, Alicia García-Herrero, Sylvie Goulard, Charles Grant, Dominique Guellec, Connie Hedegaard, Vazil Hudák, Brigitte Knopf, Pascal Lamy, Lawrence J. Lau, Matthew Lobner, Robert Madelin, Sylvie Matherat, Simone Mori, Erik F. Nielsen, Barbara Novick, Jean Pisani-Ferry, Romano Prodi, Olli Rehn, Carmen M. Reinhart, André Sapir, Dirk Schoenmaker, Ludger Schuknecht, Egon Schulz, Maroš Šefčovič, Jeremy Shapiro, Scott Stern, Jean-Claude Trichet, Laszlo Varro, Nicolas Véron, Reinhilde Veugelers, Helen Wallace, Guntram B. Wolff and Georg Zachmann Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Location: Autoworld, Brussels, Belgium
Read article More on this topic More by this author

Blog Post

IMG_1985

How to make the single market more inclusive after Brexit

The creation of the single market generated winners and losers. Yet redistribution remains first and foremost a competence of national governments. It is thus fair to state that a failure in national, more than European, policies and welfare systems can be partly blamed for current discontent with the EU and the single market.

By: Alessio Terzi Topic: European Macroeconomics & Governance Date: August 18, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

The state of macro redux

What’s at stake: In 2008, Olivier Blanchard argued in a paper called “the state of macro” that a largely shared vision of fluctuations and of methodology had emerged. With the financial crisis and our inability to prevent the greatest recession since the 1930s, the discipline entered into a period of soul searching. The discussions on the state of macro received new echoes this week after Blanchard published a short essay on the future of DSGE models.

By: Jérémie Cohen-Setton Topic: European Macroeconomics & Governance Date: August 16, 2016
Read about event More on this topic

Upcoming Event

Sep
29
08:30

Inclusive growth in the European Union

Why is inclusive growth important and how do the EU’s social problems differ from social problems in other parts of the world?

Speakers: Zsolt Darvas, Monica Brezzi, Jana Hainsworth, Reinhilde Veugelers and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Oct
4
12:30

Barriers to long-term investment

Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Opinion

Dalia Marin

What’s the matter with Austria?

Austrian firms invested heavily in Central and Eastern Europe. They offshored the parts of the value chain that required specialized skills and produced valuable research. This resulted in lowered growth in Austria.

By: Dalia Marin Topic: European Macroeconomics & Governance Date: August 9, 2016
Read article More on this topic More by this author

Blog Post

André Sapir

Should the UK pull out of the EU customs union?

The UK Government appears divided on whether the United Kingdom should seek to remain within the European Union’s customs union after Brexit. The United Kingdom is likely to want to leave the customs union, even it remains in the EU’s single market. But the UK should try and keep to the EU’s commitments at the WTO, at least at the start, in order to minimise the trade disruption that Brexit entails.

By: André Sapir Topic: European Macroeconomics & Governance Date: August 1, 2016
Read article More on this topic

Opinion

Grégory Claeys
Schoenmaker pic

Now is the time to open Strasbourg’s ‘Bronislaw Geremek’ European University

It is the right time to revive the proposal made 10 years ago by Bronislaw Geremek and Jean-Didier Vincent to create a truly European University in the European Parliament buildings in Strasbourg.

By: Grégory Claeys and Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: August 1, 2016
Read about event More on this topic

Upcoming Event

Nov
21-22
13:30

Vision Europe Summit 2016

The 2016 Vision Europe Summit is titled "Redesigning European Migration and Refugee Policy" and will be held in Lisbon on 21-22 November 2016.

Topic: European Macroeconomics & Governance Location: Lisbon
Read article More by this author

Blog Post

Zsolt Darvas

Single market access from outside the EU: three key prerequisites

In relative terms, Norway’s current net financial contribution to the EU is similar to the UK’s. Switzerland and Liechtenstein pay surprisingly little, while Iceland is a net beneficiary. Relative to their population, Switzerland, Norway, Iceland and Liechtenstein received about twice as large an inflow of EU immigrants as the UK. These countries also have to adopt the vast majority of EU regulation to gain access to the single market.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: July 19, 2016
Read article More on this topic More by this author

Opinion

Guntram B. Wolff

The difficulties of defining EU-UK economic relations

Negotiations on the UK's exit from the EU have not yet begun, but the UK leadership needs to find a balance between single market access and free movement. There are also tensions between the demands of voters and what EU partners can plausibly agree. Guntram Wolff doubts the likelihood of a Norway- or Switzerland-style deals, and urges caution on all sides.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 19, 2016
Read article More on this topic More by this author

Blog Post

Marek Dabrowski

Iran: from isolation to economic cooperation

With some sanctions temporarily lifted, now is the chance for Iran to reintegrate into the global economy and political system. But comprehensive economic and political reforms are needed.

By: Marek Dabrowski Topic: European Macroeconomics & Governance Date: July 15, 2016
Load more posts