The central government budget in a common currency area provides `regional insurance' by dampening any reduction to the income of a region in recession, which may compensate for its inability to modify its terms of trade by altering its exchange rate. In the European Community, the parts of national government budgets that provide regional insurance are mainly designed for income redistribution and general revenue-raising. In Discussion Paper No. 697, Research Fellow Jacques Mélitz and Silvia Vori stress the need to distinguish the stabilizing and redistributive effects of the central government budget: temporary measures such as unemployment compensation can have a substantial stabilizing effect on regional income with no permanent equalizing effect, while measures of income redistribution that are not affected by current shocks (expenditure on general education) or which depend on employment (old age and maternity benefits), can affect regional income differentials without playing any stabilizing role.

Mélitz and Vori examine the creation of a common Community insurance fund from which regular disbursements would be made to member states on the basis of their relative misfortunes to offset the loss of national macroeconomic policy autonomy. Such insurance may be valuable when the `national reference levels' are defined in terms of income, since standard deviations of some 2% of per capita income amount to a significant risk, but they find strong potential for such insurance only in Denmark, Ireland and the UK. In Belgium, France, Greece and Spain, little insurance is feasible, since bad outcomes at home tend to be matched by bad outcomes in the rest of the Community; the position is only slightly better for Germany and Italy. Similar results based on national unemployment rates are even less encouraging.

Mélitz and Vori also examine the response of insured values to common external and country-specific shocks but find little evidence of unevenness, and even this depends heavily on the method of measurement. They suggest in conclusion that EC member states may do better to seek insurance in the traditional manner, as a by product of future enlargement of the Community central budget and broader national identification with Community interests.

National Insurance Against Unevenly Distributed Shocks in a European Monetary Union
Jacques Mélitz and Silvia Vori

Discussion Paper No. 697, August 1992 (IM)