VoxEU Column Monetary Policy

Fiscal stabilisation in monetary unions

If properly designed, even a small fiscal capacity can maximise its stabilisation effect. The column studies the macroeconomic stabilisation provided by the federal budget in the US as an example for monetary unions. Corporate income tax, on the revenue side, and social security, on the spending side, are the two most effective items. The key is to collect revenues based on the income of the most mobile factor, and to provide support to the income of the least mobile factor. 

Following the Great Recession, Europe is once again debating the use of fiscal instruments for macroeconomic stabilisation, with the experience of a monetary union with common fiscal shock absorbers, such as in the US, as a reference. Research on fiscal stabilisation and risk-sharing in the US was originally a reference for Economic and Monetary Union (EMU). Sachs and Sala-i-Martin (1992), Von Hagen (1992), and Bayoumi and Masson (1995) proposed different approaches to quantify the role of fiscal transfers in the US for redistribution and risk sharing, and to draw lessons for the forthcoming EMU. But the EMU does not represent one country or a political union, and so the option of fiscal transfers is constrained. 

Our recent work (Nikolov and Pasimeni 2019) expands this research in three ways:

  • We measure stabilisation not only as inter-state risk-sharing of asymmetric shocks, but also as intertemporal stabilisation of common shocks.
  • We do this for several items in the US federal budget, both on the revenue and on the expenditure side.
  • We also measure the impact of the federal system of unemployment benefits and of its extension as a response to the Great Recession.

Stabilisation of common and asymmetric shocks

The stabilisation from market mechanisms and other existing instruments is limited, and this is the  economic rationale for fiscal stabilisation in a monetary union. Factor mobility helps to smooth the effect of large shocks (Asdrubali et al. 1996, Nikolov 2016), but the Great Recession showed that market stabilisation is generally inadequate (Berger et al. 2018) because markets tend to behave pro-cyclically (Furceri and Zdzienicka 2015, Ferrari and Rogantini-Picco 2016).

When shocks affect the whole area, monetary policy can stabilise the economy. Problems arise when the interest rate is close to the effective lower bound, and there are decreasing returns from using further 'unconventional' tools (Blanchard et al. 2015). 

National structural reforms and fiscal policies can address country-specific situations, but critically they are subject to coordination problems and have limits. Structural reforms have important short-term costs (Eggertsson et al. 2014), particularly when they are implemented during negative cyclical conditions (OECD 2015) and when monetary policy is already constrained (Vogel 2014), posing a drag on aggregate demand (Duval and Furceri 2017). When there is a large shock, market pressure can force national fiscal policies in a monetary union to behave pro-cyclically, limiting their capacity to stabilise.

Therefore it is difficult to rule out the role of a common stabilisation capacity in a monetary union. On one hand, the less a monetary union relies on a fiscal capacity for stabilisation of asymmetric shocks (cross-country risk-sharing), the more it needs structural reforms and prudent fiscal policies to enhance the adjustment capacity and build fiscal buffers at the national level. This may create stronger deflationary pressure on the whole area (OECD 2015, Duval and Furceri 2017) and stronger pressure on monetary policy to counteract that deflationary pressure (Corsetti et al. 2019), meaning it approaches its effective lower bound faster. Consequently there is a greater need for a fiscal instrument to provide intertemporal stabilisation to support monetary policy.

On the other hand, the less we use a common fiscal capacity for intertemporal stabilisation of common shocks, the more we need to rely on monetary policy to counteract the common shock. The closer monetary policy gets to its limits, the higher the short-term costs of structural reforms and fiscal consolidation (Eggertsson et al. 2014, OECD 2015) and the lower their effectiveness. There is a greater the need for a fiscal instrument for cross-country stabilisation of asymmetric shocks.

In other words, there is a trade-off when we do not use a fiscal instrument for these two objectives. The less we are willing to use a common fiscal instrument for intertemporal stabilisation of common shocks, the more we will have to resort to it for cross-country stabilisation of asymmetric ones.

The impact of different items in the budget

EMU does not have a common budget and the EU budget has very limited stabilisation impact (Pasimeni and Riso 2018). But the US has a federal budget larger than 20% of its GDP and can run deficits and borrow, collect taxes directly, and give direct transfers to states and individuals. We have evaluated the net stabilisation impact of the different items in the federal budget, on the revenue and expenditure side.

Overall, the US federal budget, despite not being primarily designed to achieve macroeconomic stabilisation, is able to stabilise about 21% of macroeconomic shocks through its system of federal-to-state net transfers, including interstate stabilisation of asymmetric shocks (about 10%) and inter-temporal stabilisation of common shocks (about 11%). Different items have different stabilisation properties, independent of their size.

Figure 1 Intertemporal and interstate stabilisation through fiscal channels in the US

Source: Nikolov and Pasimeni (2019).

The stabilisation impact of each item is not directly related to its size, meaning that even small items can have an impact. Social Security benefits and federal personal income taxes are the most effective stabilisers against asymmetric shocks. Federal corporate income taxes, although quite small, are the most effective intertemporal stabilisers for common shocks, and their small size implies they are also one of the most efficient ways to provide stabilisation.

Corporate income taxes are generally collected with longer lags than other taxes. This is consistent with the finding that this item in the federal budget provides sensible stabilisation over time, but it is not particularly relevant for cross-country risk sharing.

The role of emergency unemployment insurance

The US system of unemployment insurance is a joint federal-state programme that provides direct support to eligible workers during a spell of unemployment. The support can be extended when there is an increase in the unemployment rate above certain thresholds. All states must have an unemployment benefit scheme in place, but there are large differences in coverage, replacement rates, and generosity (Fischer 2017). 

In principle the extended benefit programme is jointly funded at the state and the federal level, but in practice during the deepest recessions the federal share of the total unemployment benefit cost increases enormously (O’Leary, 2013). This system leads to permanent transfers. Under the extended benefit programme, if a state unemployment benefit scheme is underfunded and cannot afford full coverage, the state can borrow from the federal government. 

To prevent moral hazard, this borrowing must be paid back in two years, otherwise the compulsory federal tax rate of 0.6% under the FUTA can be increased by 0.03%. But this incentive is extremely weak, and states show a clear preference for maintaining a low tax rate so that firms do not relocate to other states, meaning that unemployment benefits are underfunded (Fischer 2017). 

In Nikolov and Pasimeni (2019) we measure the stabilisation effect of an ad hoc response to high unemployment during the Great Recession. The Emergency Unemployment Compensation (EUC08) programme operated between mid-2008 and end-2013. It extended federal benefits to individuals who were still eligible and had exhausted other options. This programme was fully funded by the federal budget and supported by its borrowing capacity. 

We condition on the number of EUC08 claims per state, as a proxy for state need. We find that the programme raised the fiscal smoothing of common shocks for the average state by approximately 6 percentage points. This can be interpreted as its marginal role for stabilisation. The federal system of unemployment insurance in the US played an important stabilisation role, in particular when enhanced by the discretionary programme of extended benefits.


In the EMU fiscal transfers are constrained by the lack of a political union, but we find that fiscal stabilisation through a common budget is relevant in a monetary union. There is a case for addressing both common and asymmetric shocks, but the instruments we choose will have different capacities to address these stabilisation needs. 

The design of the budget, in particular the balance of revenue and expenditure, can maximise its stabilisation effect. The key is to bridge the gap between higher mobility of capital and lower mobility of labour, by collecting revenues based on the income of the most mobile factor (corporate income tax) and providing support to the income of the least mobile factor (social security).

A discretionary program of extended unemployment benefits, mainly funded by the federal level and supported by the borrowing capacity of the federal government, proves a powerful example of a timely and effective stabilisation instrument when we require a specific, contingent stabilisation function.

Authors’ note: The views expressed are the authors and do not necessarily reflect those of the European Commission.


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