The Fiscal Transfer Mechanism to the Rescue?

The economies of the European Economic and Monetary Union (EMU) have continued to recover since the financial crisis, albeit at an acutely slow rate. According to Eurostat, EMU’s GDP during the second quarter of 2016 rose by 0.3 percent relative to the previous quarter. Compared to a year ago, EMU’s economies grew 1.6 percent.

Despite modest growth, as of August 2016, EMU’s unemployment rate remains high at 10.1 percent, which is more than double that of the United States, while Spain and Greece have rates as high as 20 percent and 23 percent, respectively. Furthermore, the EMU experienced zero percent inflation in 2015, a sign of economic stagnation.

Unable to conduct independent monetary policies, countries in the EMU relied on fiscal measures to stimulate their economies during the recession, particularly since the European Central Bank focuses more on price stability rather than unemployment. Excessive fiscal spending has thus caused several countries, namely Greece, Italy, and Portugal, to accumulate a large amount of debt.

Skeptics of the EMU, such as Columbia University economist Joseph Stiglitz, have argued that the EMU is doomed to failure since it possesses inherent problems. Other scholars such as University of California, Berkeley professor Barry Eichengreen point out that the EMU did not meet the criteria for an optimal currency area, which include labor mobility, capital mobility, fiscal transfer mechanisms and similar business cycles among member states.

While there is free flow of capital in the EMU, there is limited labor mobility, no fiscal transfer mechanisms and no co-movement of business cycles (even though there is high synchrony among the “core” countries, such as Germany, France, and the Netherlands). This difference in business cycles prevents the European Central Bank from developing an effective monetary policy that is appropriate for the economic conditions of all member states.

Does this mean then that currency unions that do not satisfy the criteria of an optimal currency area are doomed to failure? The case of the Eastern Caribbean Currency Union (ECCU) may provide closer insight into currency unions and the EMU.

The ECCU comprises eight members, including Anguilla, Antigua and Barbuda, Commonwealth of Dominica, Grenada, Montserrat, St. Kitts and Nevis, St. Lucia and St. Vincent and the Grenadines. The union created and adopted the Eastern Caribbean dollar in 1965, and it has been pegged to the U.S. dollar at a rate of $1.00 US to $2.70 EC since 1976. The EC dollar is pegged to the US dollar because the United States is the ECCU’s largest external trading partner, so this peg would eliminate price uncertainty for a substantial number of imports and exports, thus promoting stability and predictability in the economy.

In contrast with the EMU, where both a central bank and national banks exist, the Eastern Caribbean Central Bank (ECCB) is the currency union’s sole central bank and is responsible for regulating the region’s money supply, maintaining the dollar’s stability, managing a common pool of foreign exchange reserves and coordinating a monetary policy conducive to economic growth.

Another significant difference between the EMU and the ECCU regards business cycles, which is an important criterion of the optimal currency area theory. The Eastern Caribbean members share a similar business cycle, and individual economies within the union experience peaks and troughs at similar times. Local economies have similar industries and structural conditions, namely service-based economies heavily dependent on tourism.

This co-movement of business cycles in the ECCU theoretically allows the central bank to better coordinate monetary policies to control inflation during economic expansions and stimulate the economy during recessions.

However, even though the central bank is theoretically able to create policies that would be appropriate for the economic conditions of all member states, it nevertheless could not use currency devaluation to attenuate the dips in both exports and tourism during the financial crisis due to the fixed peg with the dollar. Thus, like their European counterparts, ECCU governments tried to offset lower external demand through increased public spending, which caused the accumulation of high levels of debt. The gross public debt of the eight ECCU members reached 89.8 percent of total regional GDP (2012). Each member is also ranked among the 15 most indebted emerging countries.

Evidently, without overall monetary independence (the ECCU’s monetary policy is limited by its fixed exchange rate), even currency unions with a synchrony of business cycles would face significant fiscal pressure during recessions. Unless the ECCU achieves monetary flexibility by, for example, revaluating the EC dollar, ECCU countries can only use fiscal measures to stimulate growth, which further exposes them to debt problems.

One potential solution to high amounts of debt is the fiscal transfer mechanism, where taxes are collected from countries during times of economic expansion and distributed to members experiencing a recession at some point in the future. Such a transfer mechanism would moderate the economic burden for member states and allow the asymmetric negative economic shocks to be mitigated. Although some may worry about potential moral hazards, IMF research economists have concluded through simulations that specific countries would not always be net recipients and that assistance would be mutual.

The transfer mechanism would be a better solution than financing the output gap through government spending, because the government would have to pay back the debt through collecting higher taxes or lower spending at some point in the future, essentially postponing the current economic burden to the future. The transfer mechanism would enable EMU and ECCU member states to better respond to asymmetric country-specific economic shocks without dramatically increasing public spending and accumulating high levels of national debt.

The recent financial crisis has revealed the necessity for further fiscal integration and risk-sharing between member states of each currency union. Implementing the fiscal transfer mechanism, an important criterion of the optimal currency area theory, would strengthen the currency unions’ sustainability, overall credibility and ability to respond to future economic crises.