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Don't expect too much from EZ fiscal union – and complete the unfinished integration of European capital markets!

How do members of existing monetary unions share risk? Drawing on a decade of research, this column argues that fiscal transfers in fact make a limited contribution to economic coherence. In the context of Europe’s current crisis, the evidence suggests that unfinished capital market integration must be completed if we wish to see adequate and effective risk sharing.

The sovereign debt crisis apparently suggests that Eurozone economies should now move substantially closer towards fiscal union. Current policy discussions revolve much more around how such a fiscal union should be designed than whether fiscal union can solve Europe’s underlying problems of economic coherence. What can we expect from a fiscal union? Aren't private capital markets better suited to economic coherence? Even within well-established monetary unions, such as the US, it is clear that fiscal transfers make a limited contribution to economic coherence compared to private capital markets. Europe needs better capital market integration.

The limits of fiscal transfers

Fiscal transfers help countries maintain their standard of living in regional recessions; the fallout from shocks, such as those which have recently hit Greece and Spain, could be cushioned if such countries receive transfers from other countries that are doing better. The need for such ‘fiscal smoothing’ mechanisms was, from the very outset, at the heart of the debate about the creation of a monetary union in Europe (cf. literature surveyed in Commission of the European Communities 1990). Early evidence suggested that fiscal smoothing is the main mechanism alleviating economic asymmetries in the US (cf. Sala-i-Martin and Sachs 1992; von Hagen 1992). Some academics have also drawn attention to the potential for additional smoothing that could come from the integration of private capital markets (cf.Atkeson and Bayoumi 1993). But this early literature could not provide a conclusive, quantitative answer to the question of what the relative roles of private capital markets and fiscal smoothing are likely to be in a monetary union. Yet, this question is of paramount importance for understanding the future of the Economic and Monetary Union (EMU). The current debate largely overlooks the empirical fact that the role of fiscal transfers is dwarfed by the role of capital markets in established monetary unions such as the US.

Sharing the risk asymmetric business cycle shocks

Asdrubali, Sorensen, and Yosha (1996) first provided a framework that allows us to measure, in an integrated way, how economic asymmetries are cushioned through different risk sharing channels. Thus, we can empirically assess the relative importance of these channels. The framework comprises three broad channels of risk sharing:

  • First, suppose a country suffers a drop in aggregate output. Then, part of this drop may not fully affect the income of the country's residents because part of the region's capital stock may be owned by residents of other regions. Hence, profits will drop and everybody who holds claims to the region’s capital income will be negatively hit – irrespective of where they reside1. If cross-border ownership of assets is well-diversified, the region's downturn will be shared with other regions. The role of this channel of risk sharing can be measured from net capital income flows – the difference between a country's or region's output (GDP) and its income (GNI) and how these react to GDP shocks. This is the first channel, the ‘capital market channel’, so called because risk sharing through international income flows largely reflects income on capital that domestic residents own abroad.
  • Second, income will be subject to redistribution through government intervention. This is the ‘fiscal insurance channel’ whose effect can be gauged by looking at the difference between income and disposable income – after taxes and transfers.
  • Third, households and firms may accumulate – or decumulate – assets. They save or dissave using credit markets. We can measure how saving reacts to GDP shocks in order to capture how credit markets help smooth shocks.
    Some simple economic logic suggests three main channels through which the risk of asymmetric business cycle shocks can be shared; cross-border ownership of assets, fiscal transfers, and credit markets.
The case of federal states in the US

The first column of Figure 1 shows how a typical business cycle shock is shared amongst US federal states. The estimates here are stylized and roughly based on Asdrubali et al. (1996) and Sorensen and Yosha (1998). They are typical for how business cycle risk is shared between the regions of a country and they have been broadly corroborated for many other countries and more recent time periods2.

Figure 1. Effect of business cycle shocks amongst US federal states

Risk sharing among and within countries

The sum of the three channels is 75-80%. This implies that for a typical 1% business cycle shock (relative to the US average) in Texas affects Texans’ consumption by about 0.2%. The rest is somehow diversified away. How? The channel decomposition tells us that the most important channel of risk sharing is cross-border factor income flows, alleviating 40% of the shock. Credit markets smooth about 25% and fiscal transfers only around 10-15%.

The second column provides the same decomposition for OECD countries, based on Sørensen and Yosha (1998) and other, more recent cross-country studies. By comparing the two, it seems risk sharing among countries is lower than risk sharing within countries; only 20-25% of shocks get insured. Fiscal insurance is absent, but the main reason is that there is very little risk sharing through capital income flows.

Risk sharing during a downturn

In an economic downturn, risk sharing attained through fiscal mechanisms or through credit markets is limited by the borrowing capacity of private and sovereign debtors. Private credit markets can dry up making risk sharing impossible when it is most urgently needed (cf. Hoffmann and Shcherbakova-Stewen 2011; Hoffmann and Nitschka 2012). Certainly, the smoothing capacity of a country’s government is generally higher than that of the private sector, in particular for countries that were fiscally disciplined during the preceding boom. Kalemli-Ozcan et al. (2012) show how countries – Greece being prominently among them – that increased fiscal spending in the years before the crisis are now forced to save. This comes at a time when risk sharing would require them to spend in a countercyclical manner.

These are strong arguments for better fiscal coordination and, possibly, for fiscal union. Yet, the cases of Ireland and Spain show that even fairly fiscally disciplined governments face limits to borrowing during a crisis. Turning to Germany and the Netherlands, we see that a fiscal union that entails permanent transfers from its richer members is bound to run into political resistance. Ultimately, this limits the amount of risk sharing that is possible through sustained fiscal transfers in severe downturns.

By contrast, risk sharing through capital markets is the result of diversification of ownership, which works quite seamlessly once disaster strikes – even in the face of persistent shocks (Becker and Hoffmann 2006). The intuition is simple: if a New Yorker owns shares in Alaskan oil and the oil price drops permanently, the New Yorker shares the loss through a drop in share values. Instead, if Alaskans had borrowed to build oil rigs, they might now default or the federal government might transfer funds to Alaska, possibly for a long time and against political resistance.

Has globalisation helped?

Financial globalisation over the last decade has surely changed the nature of risk sharing. As countries' equity portfolios have become more diversified, risk sharing has increased (cf. Sorensen et al. 2007; Artis and Hoffmann 2008a; b; Demyanyk et al. 2008; Kose et al. 2007). That said, virtually all major firms in the US are owned by out-of-state investors, a level of private cross-border ownership that is generally not seen in Europe.

How is the EMU integrated?

Integration among EMU countries – and among those in the Eurozone in particular  has not involved individuals and small firms; retail finance is nationally fragmented and Europeans do not own much foreign equity. Instead, much of the integration has taken place through direct investment by large firms and through bank credit. This has undoubtedly promoted capital flows both among EMU members and in the EU as a whole, in particular to the emerging European periphery (cf. Schmitz and von Hagen 2011). Importantly, most of these capital flows came in the form of debt. Too few came in the form of equity ownership.


The potential importance of risk sharing through capital markets has been acknowledged by leading policymakers, for example Trichet (2007), who cites the Asdrubali et al. (1996) numbers as the benchmark. Yet, these ideas are missing when we look at the current discussion in Europe. European policymakers seem convinced that fiscal union is needed to complete monetary union. But fiscal union can only help absorb a relatively small fraction of country-level risk. Foremost, we should complete the integration of European capital markets. What is needed are steps that encourage a wide geographical diversification of private sector wealth, as is observed among US federal states.

Policy recommendations

How is this to be done? At a general level, cross-border ownership of equity can be encouraged through the creation of financing and investment conditions that are the same across all Eurozone countries. This should not only be for large corporations but also for small firms and private households. Here, a common banking regulation has an important role to play (cf. Demyanyk et al. 2007; Hoffmann and Shcherbakova-Stewen 2011; Burda et al. 2012) as has the integration of the retail finance sector. Harmonisation of business and tax laws will also matter. Government intervention may help in making the transition from a Eurozone linked by cross-border debt holdings to a Eurozone with large cross-border equity claims (recently been suggested by Gros and Meier 2012). We do not attempt to offer a complete policy prescription list here. Rather, our aim is to draw attention to the fact that an increase in private cross-border ownership of assets is an indispensable part of macroeconomic integration in Europe and that this has been so far neglected in discussions within Europe.


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1 Dividend payments are relatively small but returns to capital include delayed pension payments, interest, even equalization of wages between plants within the same firm. A detailed breakdown is not available.
2 See Hoffmann and Shcherbakova-Stewen (2011) for the United States and von Hagen and Hepp (2010) for a recent application to Germany with similar results.

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