EUROPEAN COMMISSION Brussels, 31.5.2018 SWD(2018) 297 final COMMISSION STAFF WORKING DOCUMENT



IMPACT ASSESSMENT

Accompanying the document Proposal for a Regulation of the European Parliament and of the Council on the establishment of a European Investment Stabilisation Function {COM(2018) 387 final}

{SEC(2018) 277 final}

{SWD(2018) 298 final}



Table of contents 1.Introduction: Political and legal context 2.Problem definition 2.1.Business cycles in the EA/EU 2.2.Fiscal developments and implications for public investments 2.3.Other instruments and policies 2.4.Conclusion on problem definition 3.Why should the EU act? 3.1.Existing lines of defence 3.2.The need for economic stabilisation at the European level 3.3.Stakeholders’ views 3.4.Legal basis 4.Objectives: What is to be achieved? 4.1.General objectives 4.2.Specific objectives 5.What are the available policy options? 5.1.What is the baseline from which options are assessed? 5.2.Description of the policy options 6.Impact evaluation of the options

6.1.Selection of the activation trigger 6.1.1. Choice of trigger variable 6.1.2. Choice of trigger design and parametrisation 6.1.3. The total support envelope for option 2 6.1.4. A modulated amount of loans can provide larger and more targeted support 6.1.5. Simulation of past functioning 6.1.6. The financial calibration of the insurance mechanism 6.2.Stabilisation impact 6.2.1. Main qualitative impact 6.2.2. Quantitative estimates of the stabilisation impact 6.2.3. Stabilisation impact of a euro area budget 6.3.Cross-country neutrality 6.4.Environmental and social impact 6.5.Conclusions, preferred option and implementation plan 6.5.1. Implementation plan 7.How will actual impacts be monitored and evaluated? 7.1.1. Macroeconomic impact 7.1.2. Use of funds 7.1.3. Quality of public investment management Annex 1: Procedural information

Annex 2: Stakeholder consultation Annex 3: Analytical methods Annex 4: References Annex 5: Glossary and acronyms 1.Introduction: Political and legal context On 2 May 2018, the European Commission adopted its proposals for a new Multiannual Financial Framework (MFF) for 2021-2027. Under these proposals , the European Investment Stabilisation Function will have an overall ceiling for lending backed by the EU budget of EUR 30bn over this period. This impact assessment report reflects the decisions of the MFF proposals and focuses on the changes and policy choices which are specific to this instrument. The financial turbulence and severe economic downturn of the late 2000s and early 2010s stress-tested the foundations of the euro and the EU. While important governance changes have been undertaken in response, the euro architecture remains a vulnerable construction. Policy leaders at the national and the European level are therefore engaged in a discussion to learn the lessons of the past years and further bolster the resilience of the zone. One focal point of that debate is the appropriate euro area fiscal framework and in particular the adequate arrangements for providing fiscal stabilisation. The topic of a common stabilisation function to underpin the single currency has garnered much attention over the years and decades. Over 40 years ago the Mac Dougall report (European Commission, 1977) already emphasised the desirability to accompany the creation of a single European currency with a common budget of meaningful size. As of today the euro area remains an area with a centralised monetary authority and a plurality of national fiscal actors. Developments since the inception of the euro have however shed a new light on this discussion. Indeed, the events unfolding as part of the euro area sovereign debt crisis in the early 2010s have pointed out the limited resilience of the euro area to macroeconomic shocks, thereby renewing interest for such an instrument. At present, there is a lively debate on the need and form that could take such a stabilisation function. Some Member States positively support further fiscal integration as a crucial component of EMU deepening. The case for ambitious fiscal integration, in the form of a euro area budget that would notably provide stabilisation, has been made by the French President. The national ministries of economy or finance from Italy and Spain have issued papers lining out proposals for specific funds providing macroeconomic stabilisation. However, doubts have also been raised in other constituencies on the value added and risks from a common stabilisation instrument. The Prime Minister of the Netherlands has been explicitly sceptical in a recent speech. Some Member States appear open to further discussions without necessarily being supportive. The coalition agreement underpinning the current German government mentions a future investment budget for the euro area that could also provide stabilisation. While registering this spectrum of views, the Commission has actively contributed to this discussion. The Commission has made the case for a stabilisation instrument while laying out important guiding principles, e.g. in its Communication on "new budgetary instruments for a stable euro area within the Union framework" from 6 December 2017 and the Reflection Paper on the deepening of the Economic and Monetary Union. Taking note of the diversity of views, the Commission has set out different options and approaches were presented, thereby nourishing the discussion. The introduction of a stabilisation function is also seen as part of a wider drive to modernise the EU budget and maximise its impact. To this end, the 6 December Communication proposed four new instruments: 1.) A new way to support national reforms identified in the European Semester, 2.) a dedicated convergence facility for Member States on their way to joining the euro, 3.) key features of a backstop for the banking union, and 4.) the roll-out of a stabilisation function, which is the focus of this impact assessment. The stabilisation function would tackle a vulnerability in the EMU architecture, which is why access would be especially desirable for euro area Member States. This Impact Assessment describes the current gaps in the euro area's capacity to respond to shocks and discusses different policy options and the impact of possible EU action. This document explains why and to which extent the euro area’s response to the recent crisis was constrained. It assesses which factors contributed to its aggravation and the increasing divergence among Member States. The analysis shows how the institution of a common stabilisation function would raise the resilience of the euro area by increasing the capacity to withstand future large asymmetric shocks, thereby avoiding the risk of Member States departing from EU economic and social cohesion objectives. Such a stabilisation function should be properly designed and may have to be built over time. This document therefore also reviews the options for building a stabilisation function, evaluates their respective effectiveness, motivate the proposals made by the Commission, and explains how the stabilisation function will be monitored. It is important to note that the quantification of impacts described in this document does not capture the entire scope of the problem analysed. In terms of the quantitative analysis presented, specific caveats should be borne in mind. These include technical limitations of the statistical data and of the simulation models available. It is in the nature of macroeconomic analysis that the assessment depends on (well-justified) assumptions and that future outcomes are per definitionem not certain but will depend crucially on the – partially random – unfolding of events. In light of the above, this document presents a proportionate assessment of impacts. The impacts are primarily described through a qualitative assessment and, where possible, a quantification of impacts is outlined. Procedural information regarding the preparation of this Impact Assessment can be found in Annex 1. 2.Problem definition The problem to be addressed by this initiative, in summary, is the insufficient ability of available instruments to absorb large macroeconomic shocks in the euro area. In modern economies, fiscal and monetary policies are the main means for managing business cycles. Monetary policy is generally viewed as the most flexible tool, while fiscal policy responds in the first instance through the so called automatic stabilisers. The euro area is however confronted with a particular set-up: monetary policy can only focus on aggregate fluctuations of the zone, while fiscal policy is 'decentralised' and in principle can respond to country-specific shocks. This arrangement appears viable for normal times but it is confronted with critical problems whenever large economic disruptions arise. This has especially been illustrated by developments in the economic and financial and the euro crisis, which has evidenced strong limits to the functioning of national automatic stabilisers for coping with asymmetric shocks, even sometimes in Member States with sound fiscal credentials. This has resulted in a pro-cyclical pattern for fiscal policies, which has also been detrimental to the quality of public finances and in particular public investments. The sequence of recent events also suggests that too much weight may be put on the monetary authority to provide stabilisation in severe economic circumstances. These observations point to a stabilisation gap and the risk of procyclical cuts in public investment in the current EA/EU setting, pointing to the need for a common fiscal instrument for the future. In turn, that shortcoming has contributed to widespread differences in macroeconomic performance between Member States, imperilling the cohesion of the EU. The remaining of this section documents this fundamental problem and identifies problem drivers by shedding light on: i) business cycles in the EA/EU, showing that business cycle fluctuations are large and reflect both a common component and substantial country-specific components ;

ii) the experience over the years of the crisis that erupted a decade ago and saw the occurrence of sizeable pro-cyclical fiscal adjustments that weighed especially strongly on public investments. It will then be explained (section 3) why these problems will continue to represent a major threat in the future, even taking into account the existence or the development of new instruments in the EA/EU setting and assuming that Member States preserve their national fiscal space by strictly respecting the fiscal rules framework. This makes the case for an EU-level instrument to provide stabilisation support in some circumstances that characterise a large asymmetric shock. 2.1.Business cycles in the EA/EU The overall macroeconomic performance in the euro area has been lacklustre since the eruption of the crisis. The crisis and the subsequent double-dip recession in the euro area has induced low growth. The low resilience of the euro area appears to have a permanent effect on real GDP. The gap with the US in terms of growth performance has widened over the past ten years and reflects a weaker capacity to absorb and recover from shocks. While the US reached its pre-crisis real GDP level already in 2011, the EA reached it only four years later, in 2015. Beyond the aggregate growth performance, economic divergences between Member States have resurfaced. In the decades running up to 2008, important economic convergence took place in the EU. Since the crisis however, this trend has reversed, as illustrated in Figure 1 . In a number of Member States, GDP levels have only recently recovered to their pre-crisis starting points. Figure 1: Real GDP, selected Member States Figure 2: Unemployment rates, selected Member States Source/Note: European Commission 2017 autumn forecast Source/Note: EC 2017 autumn forecast. These developments were mirrored in a jump in unemployment rates across some Member States. Changes in unemployment rates are highly correlated with business cycle fluctuations. Strong increases in unemployment rates are thus an important indication for a large economic shock. During the recent crisis, unemployment rates shot up across the euro area, and even more so in those Member States hit hardest by the downturn ( Figure 2 ). Overall, divergences in unemployment dynamics have increased significantly with the crisis, even more than for GDP. Unemployment rates for the long-term unemployed, the low-skilled and the young have peaked more than "headline" unemployment and still remain at very high levels in the EA, while involuntary part-time and hidden labour force signal that slack is still present in the economy. The lack of monetary policy and exchange rate adjustment channels at the national level hampers the resilience to asymmetric shocks. The introduction of the euro was highly beneficial for the European Union and has contributed to prosperity and stability. It has completed the single market and contributed to more intra-EU trade (see Baldwin and others 2008; Berger and Nitsch 2008). Nonetheless, in a currency union, exchange rates cannot adjust and monetary policy is set at the euro level. To facilitate macroeconomic adjustment and cushion large shocks, Member States thus need to rely more on the remaining instruments of economic policy, namely structural reforms and fiscal policy instruments, making the adjustment more difficult overall. The lack of a fiscal stabilisation at the centre also implies a heavier reliance on monetary policy to stabilise overall economic activity. Figure 3: Standard deviation of the output gaps by Member States (2000-2017) Figure 4: Standard deviation of the output gaps across Member States Source/Note: European Commission 2017 autumn forecast, Authors’ calculations Source/Note: European Commission 2017 autumn forecast, Authors’ calculations Twenty years after the introduction of the euro area, important asymmetries in the business cycles remain across Member States. Since the early 2000s, the average magnitude of the output gap fluctuations in the euro area is equal to 1.8% of GDP. This aggregate volatility hides larger fluctuations at the national level and sizeable disparities both between countries ( Figure 3 ) and through time ( Figure 4 ). Indeed, the Euro Area aggregates smooth out the disparities between Member States and most countries experience larger economic fluctuations than the Euro Area as a whole. In addition, in the wake of the crisis disparities between Member States' output gaps have increased ( Figure 4 ). Each country's correlation with the others reveals the great disparities existing across countries ( Figure 5 ): the correlation of national output gaps with that of the other Member States is on average around 60% but varies from close to 0 to 90%. For instance the output gap correlation between Germany and Greece is only equal to 3%, and it is only 7% between Portugal and Lithuania. It is however as high as 96% between France and Italy. Figure 5: Business cycle correlation across EA19 Member States Figure 6: Business cycle fluctuations in EA Member States and their common factor Source/Note: European Commission 2017 autumn forecast, Authors' calculations The correlation of national output gaps with that of the other Member States is on average around 60% but varies from close to 0 to 90% Source/Note: European Commission 2017 autumn forecast, Authors' calculations The Common Factor captures as much of the joint fluctuations as possible and is computed by Principal Component Analysis. The business cycles convergence in the euro area remains partial. Since the late nineties, for the 19 Member States of the euro area, at most 60% of the fluctuations in output can be ascribed to a common factor ( Figure 6 ). Therefore, more than 40% of the fluctuations in output either stem from asymmetric sources, or at least reflect asymmetric transmission across Member States of common shocks. Indeed, both common and country-specific shocks can generate the desynchronised economic cycles observed in the EMU. For example a common shock on the foreign exchange rate has an impact on each Member State that will depend on its trade openness with the rest of the world, on its export and import structure as well as on the size of its financial sector. Some Member States are however more affected than other by idiosyncratic developments. For example, if we restrict the analysis to the EA12 Member States, the common factor accounts for up to 80%, leaving 20% of the fluctuations to be asymmetric. Overall, the limited business cycle synchronisation can be considered a key problem driver. 2.2.Fiscal developments and implications for public investments

National public finances provide a crucial extent of stabilisation, via automatic stabilisers and discretionary fiscal policies. National fiscal stabilisation operates mainly via automatic stabilisers, meaning that a fall in tax revenues, an uptick in social benefits and the inertia of other spending support the economy in downturns. European Commission (2017 E) shows that, in the euro area average, around one third of a shock to disposable income of households is absorbed by automatic stabilisers. However, the importance of such smoothing differs widely across Member States. In addition to automatic stabilisers, discretionary fiscal policies are an important tool to cushion large shocks. As part of the policy response to the financial crisis of the late 2000s, the European Recovery Plan was implemented, which provided discretionary aggregate support. Fiscal rules as in the Stability and Growth Pact do give room for the automatic stabilisers to play out and for discretionary fiscal policy under specific conditions. Still, in particular situations they might also act as a constraint. A build-up of fiscal buffers is thus needed in good times. In light of the crisis experience, the fiscal framework was strengthened with the introduction of the Six-Pack, Two-Pack and the “Treaty on Stability, Coordination and Governance in the Economic and Monetary Union”. Member States need to build sizeable fiscal buffers in normal and good times to afford the fiscal space needed for the free operation of automatic stabilisers. Public deficits have recently been reined in and public debts put on a downward path. Many Member States, however, still face a legacy of very high debt burdens that will take time to wind down. In these cases, more efforts are needed to replenish fiscal buffers for future downturns. Nonetheless, even Member States with sound fiscal policies might become constrained in their fiscal policy choices due to market pressure. Moreover, as a result of the crisis, public debt levels have increased to fairly high levels, in some Member States above 100% of GDP. Due to this legacy of high public debt, fiscal room for manoeuvre might be somewhat constrained until these debt levels have be wound down. Still, in the wake of large shocks, public finances can deteriorate strongly. As shown in Figure 7 , public deficits worsened strongly during the crisis. In the euro area as a whole, the deficit surged by around 4% of GDP and public debt shot up by more than 30% of GDP. This slump was worse in Member States hit hardest by the downturn. One important underlying reason was the often sudden and dramatic collapse of public revenues. In normal downturns, revenues develop broadly in line with the economic cycle, or more precisely in line with a constant elasticity linked to the relevant tax bases (see Mourre et al., 2014). In case of a drop in GDP, this mechanism already leads to a major fall in revenues compared to budgetary plans. In a large downturn, however, these developments can be exacerbated, i.e. they become more than proportional to the GDP slump, and materialise as sizeable revenue shortfalls. In the case of the recent crisis, revenues and budget balances fell dramatically, as illustrated in Figure 7 and Figure 8 . Cumulated revenue shortfalls reached several percentage points of GDP for programme and vulnerable Member States, in addition to revenue losses due to lower activity. Member States either need to run higher deficits to maintain spending plans or find other savings to compensate. Figure 7: Budget balances, country groups Figure 8: Revenue windfalls/shortfalls, country groups Source/Note: Programme: IE, EL, PT, CY. Vulnerable: IT, ES. Weighted avgs. Authors’ calculations based on EC 2017 autumn forecast. Source/Note: Year-on-year windfalls/shortfalls. Discretionary revenue measures taken into account from 2010 onwards. Authors’ calc. based on EC 2017 autumn forecast A countercyclical conduct of fiscal policy, including the free operation of automatic stabilisers, can be hindered by financial market instability and constrained market access. In the early 2010s, a strong deterioration in public finances, jointly with doubts about the functioning of the euro area under periods of intense stress resulted in weakened investor confidence and significant financial market fragmentation during and after the outbreak of the crisis, see Figure 9 . Bold policy actions at several levels were needed to re-establish market confidence and achieve a reversion of this fragmentation. The European Central Bank’s (ECB) announcement of Outright Monetary Transactions (OMT) led to a reduction in the perceived redenomination risk. Steps towards Banking Union helped cushion sovereign-bank doom loops. Major reforms in the Member States most affected by the crisis, including structural reforms and fiscal consolidation, were undertaken and in some cases supported by provision of financial assistance. Nonetheless, this experience reveals that national fiscal policies, even in cases where initial debt levels are low, risk being overburdened in case of large shocks. Figure 9: Sovereign bond spreads, selected Member States Source/Note: ECB statistical data warehouse To keep deficit and debt levels under control in the face of market pressures, there is a risk that Member States resort to highly pro-cyclical and low quality fiscal adjustments. Some of these Member States had failed to build sufficient fiscal buffers ahead of the crisis. Others, however, were running prudent fiscal policies, at least at face value, and had accumulated low levels of public debt before the crisis struck. In the recent crisis, several Member States were under extreme market pressure, as their spreads vis-à-vis the German sovereign bonds increased sharply, with important implications on the cost of servicing their debt and running higher deficits. As a consequence, EL, IE, PT and CY had to revert to financial assistance programmes. Overall, the euro area, in particular in Member States without market access and vulnerable to financial market instability, has undertaken strong fiscal adjustments ( Figure 10 ). On aggregate, the euro area has been prone to pro-cyclical fiscal consolidation in the downturn. As a consequence of national consolidations, the euro area fiscal stance turned highly restrictive in 2012-2013, while the downturn was still deep, see Figure 11 . To compensate, a very large weight has been put on the ECB, testing the limits of monetary policy at times of unprecedentedly low interest rates. These weaknesses in the architecture have contributed to further deepening the economic downturn. Figure 10: Structural adjustment by country groups Figure 11: Euro area fiscal stance Source/Note: EC 2017 autumn forecast. Change in structural primary balances. Pre-2010 change in cyclically-adjusted primary balances. Source/Note: EC 2017 autumn forecast. Fiscal adjustment is measured by the change in the structural primary balance. Unused capacity is measured by the output gap. In many countries, the tightening of fiscal policy translated into severe cuts in public investment. While these cuts may partly have been a response to previously excessive spending, short-term budgetary pressures have in many cases led to myopic policymaking in which governments slash public investment given their lower political costs to achieve savings. Those Member States facing the biggest pressure for front-loaded consolidation made significant cuts in public investment ( Figure 12 ), on average around 2% of GDP. These cuts in public investment came on top of decreases in private investment. This type of adjustments has sometimes deepened and lengthened the recession in those countries, negatively impacting the economic and social cohesion of the Member States. The EU budget has helped to some extent to weather the crisis. Thanks to its inherent stability in the medium term, EU-funded public investments and transfers – e.g. for training unemployed people or for urban and rural development – has acted as a countercyclical force during the recession that began in 2009, despite the relatively modest share of EU spending out of national governments' total expenditure. Figure 12: Public investment in selected Member States Source/Note: EC 2017 autumn forecast. Preserving growth-friendly public investment is key to foster (potential) growth also during recessions. Weak investment spending has not only negative consequences for short-term growth via its impact on aggregate demand, but also for the medium-term productivity via its impact on the capital stock. Furthermore, the short-term impact of high-quality investment on growth is typically found to be larger than that of other types of spending. Therefore, it is important to preserve growth-friendly public investment also in economic bad times to ease the necessary adjustment burden and return on a sustainable growth path as quickly as possible.

2.3.Other instruments and policies Some policies and instruments can reduce the need for providing stabilisation through fiscal instruments. In the EMU setting, this concerns: ·Well-functioning markets and structural reforms which raise resilience ·Cross-border risk sharing through financial markets ·The action of the ECB ·The provision of financial assistance subject to strict conditionality, as provided by the European Stability Mechanism (ESM) Well-functioning markets are indispensable to absorb economic shocks efficiently across Member States. Such market mechanisms form the first line of defence. Conceptually, market mechanisms play a key stabilising role in monetary unions, through greater internal resilience to shocks and improved mobility of the production factors capital and labour. The efficient functioning of the single market, including in the financial markets and labour markets, feature among the crucial ingredients to make European economies more resilient. Labour mobility is another mechanism which facilitates economic adjustment, although the room for further improvements appears limited in the medium term. (Molloy et al., 2011; Beyer and Smets, 2015; Dao et al., 2014). Structural reforms can also increase the economic resilience of Member States. They help address macroeconomic imbalances and lift economic potential. That is why the Commission has proposed the creation of a Reform delivery tool on 6 December 2017 to further increase incentives for structural reforms. Still, structural reforms per se would not stabilise demand fluctuations. On the contrary, in the short term, they can weaken the recovery, in particular when implemented during the downturn or when monetary policy is constrained. Such issues call for an appropriate 'sequencing' and 'packaging' of reforms that takes advantage of synergies and complementarities (Berti and Meyermans, 2017). Private sector cross-country risk sharing works through cross-border factor income. With domestic productive assets partially held abroad, the consequences on domestic income of a country-specific shock may be smoothed by reduced dividends and interest payments to foreign residents, together with sustained earnings on foreign assets held by domestic agents. This is the so called capital market channel for private risk sharing. Labour compensation across borders may also contribute to smoothing domestic incomes. In addition to these income smoothing effects, there can also be a consumption smoothing channel through borrowing and saving on international capital market. This is the so called credit channel of consumption smoothing. Consumption smoothing behaviour is however conceptually distinct from risk-sharing stricto sensu (Alcidi and Thirion, 2016). The amount of private sector cross-country risk sharing through financial markets remains low in Europe compared to other currency unions. Market mechanisms allowing for higher mobility of capital consist of the so-called capital market channel, the credit market channel, and the cross-border labour compensation channel. In the US and other federations, private sector channels have been found to smooth out a significant fraction of shocks on consumption, possibly of the order of 60% (when including the credit channel). The contribution of public risk-sharing is generally found to be smaller, of the order of 15-20%. Private risk-sharing appears far less developed in the case of the EU (Berger, Dell'Ariccia, Obstfeld, 2018), providing a strong case for completing the banking union and achieving a capital markets union raising the degree of cross-border risk sharing. The creation of Banking Union is underway, in order to severe bank-sovereign doom loops. In the past, Member States repeatedly found themselves in situations where large amounts of public money were spent to bail out failing banks, in some cases leading to doubts about the sustainability of their public finances. The creation of common supervision for big banks and a common resolution framework and fund have alleviated the burden on national sovereigns, thereby contributing to the severance of the so-called sovereign-bank doom loop. To strengthen the resilience of the common resolution approach, the Commission has proposed to create a common backstop for the Single Resolution Fund. The Capital Markets Union, for its part, has the potential to considerably broaden cross-border risk-sharing. There is evidence that public risk sharing is a necessary catalyst for private risk sharing in a currency union, especially in stressed times when it matters the most. Private sector risk sharing can turn pro-cyclical in downturns and is more effective when working in conjunction with public sector risk sharing (Kalemli-Ozcan et al. , 2014). In other advanced currency unions, such as the US, Canada and Germany, private risk sharing channels are supported by public mechanisms. Furceri and Zdzienicka (2015) find that the degree of risk-sharing in the euro area falls sharply in severe downturns, more precisely: "the amount of unsmoothed shocks in periods of recession is significantly larger than during normal times, and the increased inability to smooth output shocks is driven by the lack of consumption smoothing provided by private saving via the credit channel. This is particularly true for severe downturns that are persistent and unanticipated". The conclusion is therefore that a degree of public risk-sharing is a necessary catalyst for private risk-sharing to work effectively in stressed times, when it matters the most. Among existing common European instruments, the ECB is at the forefront of regular macroeconomic stabilisation. The common monetary policy provides a first response to stabilise the economy in the event of shocks affecting the whole area, through the pursuit of price stability. Its primary, traditional instrument is the interest rate. During the crisis, the toolbox of the ECB has evolved, adding new unconventional instruments such as the OMT and liquidity support to the banking sector. Nonetheless, there is a risk of overburdening monetary policy, especially when the interest rate is close to the zero lower bound (ZLB). In those cases, further reducing nominal interest rates may be difficult. Unconventional tools can complement, but their impact might be decreasing with increased use (see Blanchard et al, 2015). Moreover, a common monetary policy cannot react to individual country shocks; thus the need for a fiscal instrument to complement (Berger, Dell'Ariccia, Obstfeld, 2018). During the past ten years, the ESM was created to deal with crisis situations. The ESM provides financial assistance to Member States having lost market access subject to strict conditionality. It thereby acts as a lender of last resort to national sovereigns. However, the experience of sudden and sometimes excessive stops in market access calls for a more preventive approach to support Member States hit by large shocks. Concerning the institutional setup, the Commission has made proposals to strengthen the ESM’s governance framework and integrate is into the community framework on 6 December 2017. 2.4.Conclusion on problem definition From the inception of the euro it has been asked whether the EMU set-up offered enough space for macroeconomic stabilisation. This question arises naturally as countries in a monetary union lose crucial channels of adjustment to asymmetric shocks by giving up an own monetary policy and the possibility of nominal exchange rate changes. The initial understanding over the euro was that this loss might be 'compensated' by a natural convergence of business cycles within the union. In addition, national fiscal policies remained available in order to absorb country-specific shocks. However, the experience suggests that these assumptions were too optimistic. Business cycles remain sizeable in EMU, reflecting a key external problem driver. They reflect both a common component and substantial idiosyncratic cyclical developments in Member States, particularly in the more volatile economies of the euro area. The behaviour of national fiscal policies is a key internal problem driver. National fiscal stabilisers have functioned at times and in some countries but have also exhibited serious limitations. In fact, fiscal policies have too often turned out pro-cyclical, and in particular public investment cycles have followed a boom and bust profile that has been detrimental to growth in both the short and long terms. Figure 13 provides an illustrative overview of these key problem drivers. Figure 13: Key internal and external problem drivers Source/Note: Stylised illustration prepared by authors While the euro area economy is now expanding again, these vulnerabilities remain and the capacity of the euro area and Member States to smooth large macroeconomic shocks is not yet sufficient. The expansion appears solid at present, but the heterogeneity in the euro area is fuelling the potential for further tensions that could have severe consequences including for the very integrity of the euro area and the EU. Therefore, a more complete set of collective defences to tackle large shocks and prevent divergences among the Member States is needed. Such shocks and crises can persistently alter growth trajectories to the detriment of welfare and cohesion. Underinvestment and the persistence of high unemployment in some Member States are of particular concern as they could inflict long-term economic and social damages. In part, the failings highlighted above may have reflected an insufficiently sound conduct of fiscal policies in the better part of the cycle. However, as will be argued in the next section, there are inherent constraints to national fiscal stabilisation policies even when budgets respect strictly the rules. As a result, the present EMU framework leaves a larger role for macroeconomic stabilisation on the ECB jointly with national fiscal policies.

3.Why should the EU act? This section explains why the existing instruments do not suffice to provide enough space for fiscal stabilisation in the EA/EU set-up. In line with the subsidiarity principle, a stabilisation function is needed as a complementary tool in severe circumstances. This section therefore: - explains why private sector adjustment mechanisms do not suffice without an element of fiscal risk sharing; - then explains why the workings of national fiscal stabilisers, while essential, needs to be complemented by the EU level in certain circumstances, in particular to protect public investment; - considers the state of play of stakeholders views in this respect; - notes the availability of a legal basis (Article 175, TFEU) for building such an instrument. 3.1.Existing lines of defence In a currency union, there are several lines of defence against disruptive shocks. Cœuré (2018) has pointed to a stylised description of three lines of defence needed to deliver a stable currency. Flexible markets are crucial to start with, including also efficient financial markets across the zone (to which the banking union underway contributes). Sound government policies are the second essential elements. In the fiscal field, this includes in particular the need to build fiscal buffers in good economic times in order to have space for absorbing shocks when those occur. Finally, some common instruments have already been introduced to deal with crisis situations, notably the European Stability Mechanism (ESM). Integrated, European markets are indispensable to absorb economic shocks efficiently across Member States. Such market mechanisms form the first line of defence. The amount of private sector cross-country risk sharing through financial markets remains relatively low in the euro area, providing a strong case for completing Banking Union and capital markets union. Banking Union would also help severe sovereign-bank doom loops. Nonetheless, private risk sharing is at the risk of running dry in the downturn, mirroring the sometime pro-cyclical nature of market discipline, calling for public risk sharing as necessary complement and enabler. Structural reforms can also increase the economic resilience of Member States, as they help address macroeconomic imbalances and lift economic potential. National governments play a key role in the stabilisation of the European economy against shocks. They can be considered as a second line of defence, as even well-functioning markets cannot fully mitigate shocks. In particular, national public finances provide a crucial extent of stabilisation, via automatic stabilisers and discretionary fiscal policies. A build-up of fiscal buffers is needed in good times, but might still prove insufficient in large downturns. Nonetheless, as analysed in section 2, even Member States with strong fiscal positions might become constrained in their fiscal policy choices due to market pressure. Among existing common European instruments, the ECB is at the forefront of regular macroeconomic stabilisation. The common monetary policy provides a first response to stabilise the economy in the event of shocks affecting the whole area. Still, there is a risk of overburdening monetary policy, especially when the interest rate is close to the zero lower bound (ZLB). In addition, the European Stability Mechanism (ESM) was created to deal with crisis situations. It provides financial assistance to Member States and thereby acts as lender of last resort. However, markets tend to bite late but harshly. The experience of sudden and sometimes excessive stops in market access calls for a more preventive approach to support Member States hit by large shocks. 3.2.The need for economic stabilisation at the European level Even with all these elements in place, national fiscal policies risk being overwhelmed calling for support at the European level. In large economic downturns, the combination of increasing deficits and falling nominal growth rates can generate market uncertainty about the sustainability of public finances, even for countries whose debt may be initially low. Limited fiscal space may prevent governments in a currency union from efficiently and effectively using their national fiscal policy to smoothen the impact of macroeconomic shocks. On the contrary, they may be hard pressed to cut expenditures, with investment politically easier to cut, although with harmful economic consequences in the short and longer term. In normal times, the current setting, resting on prudent decentralised fiscal policy and single monetary policy absorbing common shocks, seems to suffice in stabilising the EU economy. This corresponds to the philosophy of the Maastricht Treaty: area-wide shocks are tackled by monetary policy, while asymmetric shocks (affecting the demand side) could be fixed by national fiscal policy. There is thus an important justification to maintain a high level of subsidiarity in fiscal policy. In this setting, fiscal prudence allows the automatic stabilisers to play in full, absorbing the asymmetric economic shocks in real time, while ensuring the sustainability of public finances in the medium term. National fiscal stabilisation operates primarily via automatic stabilisers, meaning that a fall in tax revenues, an uptick in social benefits and the inertia of other spending support the economy in downturns. To enable the workings of automatic and discretionary fiscal stabilisers at the national level, Member States need to create sizeable fiscal buffers, ensuring sustainable deficit and debt positions. However, in the presence of large shocks, the automatic stabilisers may become insufficient to ensure proper stabilisation, especially in small open economies. Such situations exemplify limits to the subsidiarity principle. Large shocks can put important strain on a Member State's public finances, leading to a rapid increase in deficit and debt levels. Significant market pressure can then build up, preventing the free operation of national stabilizers. The crisis experience shows that even Member States with low levels of public debt and seemingly sound public finances are not immune to this risk and might be in need of further fiscal policy support. Figure 14 shows that small open economies, such as Luxembourg, Ireland, Slovenia, Finland and the three Baltics, recorded very large cyclical swings in output, much larger than the euro area average. These were particularly acute during the financial crisis in 2008-10, with a sharp drop of output gaps by around 14 percentage points and a strong persistence of negative output gaps in 2011-2013. By contrast, the two largest economies of the euro area –also hit by the crisis – experienced smaller cyclical fluctuations than the whole area. At the same time, the automatic income stabilisation generated by the tax and benefits system represents below 40% for most of the euro area countries, as illustrated in Figure 15 (below 30% for one third of them; see European Commission: Public Finances Report (2017) for a more detailed discussion).

Figure 14: Disparities of cyclical variation across countries (output gap) Figure 15: Automatic income stabilisation Source/Note: The aggregate "Small open economies" covers EE, IE, LT, LU, LV, SI, FI. The aggregate "Two largest economies" covers DE and FR. based on European Commission 2017 autumn forecast. Source/Note: Degree of automatic income stabilisation (in per cent) of the current tax and benefit system with the degree of stabilisation assuming a hypothetical average effective tax rate (AETR). Authors’ simulations based on EUROMOD using EU-SILC data. European Commission: Public Finances Report (2017) This is aggravated by the inability of an overburdened monetary policy to fully respond to common negative shocks. When the monetary policy hits the zero lower bound, that is, when key interest rates are very close to zero in nominal terms, it becomes more difficult to relax it further to address negative shocks affecting the whole euro area. Moreover, in better times, monetary policy will also be constrained if there is a risk for financial stability. The euro area therefore needs a fiscal instrument to help coping with large shocks. In this sense European action is needed to overcome an overburdening of national subsidiarity. As a vital complementary element, the stabilisation function should be active in the event of large shocks affecting a Member State, or several Member States, when the limits of other mechanisms and national policies materialise, posing great economic risks for the Member State itself but also for the area as a whole. It would be important to avoid that shocks and significant downturns result into deeper and broader situations of stress. A stabilisation function would avoid such situations through the possibility to support Member States under large stress. More adequate and countercyclical fiscal policies at national level would also contribute to a more consistent aggregate fiscal stance, entailing positive spill-overs for other Member States as well. Moreover, the stabilisation function would support Member States when means for stabilisation at the national level are narrowing down, but before recourse to financial assistance is needed. Figure 16 summarises the value added of a stabilisation function. Figure 16: The value added of a stabilisation function Source/Note: Stylised illustration prepared by authors 3.3.Stakeholders’ views There is a long history of public debate about a stabilisation function for Europe. Before the creation of the euro area, reports committed by the European Commission, namely the “Marjolin Report” and the “MacDougall Report”, pointed to the need for sizeable central budgets, also to achieve fiscal stabilisation. At the launch of the euro, only limited forms of fiscal union could realistically be contemplated. Proposals emerged for mimicking the stabilisation properties of central budgets through tailored instruments (e.g. Italianer and Vanheukelen (1993). The idea went partly dormant as the euro was successfully introduced but renewed interest has come in recent years as the euro area struggled to maintain balanced fiscal policies in the crisis aftermath. Recently, the topic of a stabilisation instrument for the euro area has garnered renewed attention. The political declarations from Member States in this debate have been mixed, with some expressing strong support in principle for a stabilisation instrument while others have shown scepticism. France has been amongst the most ambitious advocates for central fiscal capacity, with President Macron (2017) proposing a permanent, fully-fledged euro area budget that would finance common public goods include migration, defence and disruptive innovation. The national ministries of economy or finance from Italy and Spain have issued papers lining out proposals for specific funds providing macroeconomic stabilisation (see below). While views floated in the German government appear mixed, the coalition agreement includes a reference to "devoting specific budget funds to economic stabilization, social convergence and structural reform in euro zone. Those funds could form the basis for a future ‘investment budget’ for the euro zone." In contrast, other Member States have been more sceptical of the need for an instrument for the absorption of large economic shocks, as reflected in recent speech by Dutch Prime Minister Rutte (2018). This was mirrored when the finance ministers of six euro area Member States (Estonia, Finland, Ireland, Latvia, Lithuania, the Netherlands) plus Denmark and Sweden did not mention a central fiscal capacity in their priorities for EMU reform. Other stakeholders than Member States have generally been supportive of the idea overall. The European Parliament's Committees on Budgets and Economic and Monetary Affairs issued a report on a budgetary capacity for the Eurozone in 2017 and the European Parliament adopted a resolution outlining a roadmap for the creation of a budgetary capacity for the Eurozone in 2017. The European Central Bank has seen a fiscal capacity as an important part of EMU deepening (Coeuré, 2016). Other European actors such as the European Economic and Social Committee have emphasized the need for a fiscal union while the European Stability Mechanism has offered to support financially a macroeconomic stabilisation function if one is created. In the academic literature, there is a wide array of papers supporting the case for a stabilisation function for Europe, with some dissenters as well. Broad studies on fiscal union have put forward the notion of a common stabilisation capacity for coping with large shocks and share risks. This is in particular the case of surveys from international organisations such as the IMF and the OECD (e.g. Allard et al. (2013); Berger et al., 2018; OECD, 2018). These international institutions have made detailed proposals for a central fiscal stabilization capacity, with variants of an insurance mechanism and a common unemployment scheme.A non-exhaustive list of specific proposals from economic papers includes Dullien (2009, 2013), Enderlein et al. (2013), Pisani-Ferry et al. (2013), Delbecque (2013), Dolls et al. (2014), Drèze and Durré (2014), Lellouch and Sode (2014), Beblavy and Maselli (2014, 2015), Carnot et al. (2015, 2017), Benassy-Quéré et al. (2018), Arnold et al. (2018), Dullien et al. (2018) and Claveres and Stratsky (2018). Some academics have however also warned against the notion of a stabilisation function, or at least drawn attention to its risks (Feld and Osterloh, 2013; Hebous and Weichenrieder, 2015). In policy circles, there is an emerging debate when it comes to more specific proposals. In October 2015, the Italian Ministry of Finance published a proposal for a European Public Unemployment Benefit system, which was updated in August 2016. Recently, the Spanish Ministry of Economy suggested a two-pronged stabilisation instrument to help countries cope with large asymmetric shocks comprised of a grant-based insurance mechanism and a loan-based scheme to support private investment. The French Treasury published an outline of a euro area investment budget (Bara et al., 2017). The European Commission outlined the need for a macroeconomic stabilisation function in general in its "Reflection Paper on EMU" of May 2017 and subsequently in its Communication to the European Parliament and European Council in December 2017, where several options were considered. Preliminary discussions among Member States at a more technical level have also reflected varied views towards the value added and form of a central fiscal capacity. First discussions at the Economic Financial Committee and among their alternates confirm varied views. Notably, besides some supportive and some sceptical Member States, there is a sizeable group of Member States who acknowledge the merit of in-depth discussions but do not yet hold a firm view. The proposal to be presented by the Commission in May could seek to bridge these gaps among Member States, although it is likely that extensive subsequent discussions will be needed in order to create a consensus on both the necessity and operational characteristics of such an instrument. 3.4.Legal basis Article 175, paragraph 3, TFEU may be used as a legal basis for the stabilisation function on condition that it can be established that that function is necessary to strengthen the economic, social and territorial cohesion of the Union, in order to promote its overall harmonious development, in particular by reducing disparities between the levels of development of the various regions and the backwardness of the least favoured regions. This would require that the functions deploys its aim of supporting the level of public investment in specific sectors where it can be shown that maintaining that level will lead to the economic, social and territorial cohesion of the Union. Besides, to preserve the link with cohesion policy, financial consequences should ensue in case the cohesion policy objectives have not been achieved. 4.Objectives: What is to be achieved? 4.1.General objectives

The general objective of a stabilisation function is to raise the cohesion and resilience of the EU architecture, by supporting single Member States to withstand large shocks. By reinforcing the capacity of Member States to withstand such shocks, it should increase economic and social cohesion and convergence among Member States. Such an instrument should allow national fiscal policies to follow a more predictable course. It should complement the national fiscal stabilisers with a supra-national intervention when needed, therefore removing a major source of disruption. 4.2.Specific objectives More specific objectives can be delineated across six dimensions: ·First, it should contribute to a reduced amplitude and asymmetries of business cycle fluctuations across Member States. To this end, it needs to be economically meaningful, timely and effective. It would thus address the problem of sizeable and only partially synchronised national business cycles. ·Second, it should contribute to a conduct of fiscal policies that is more counter-cyclical, or at least reduce the risks of pro-cyclicality. It would thus help avoiding the problems of strongly pro-cyclical consolidations and lack of building buffers in good times. ·Third, it should contribute to smoother public investment trajectories and economic cohesion, in particular to avoid ill-advised cutbacks in downturns with negative impact on growth. It should preserve the flow of investments supported by national budgets, ensuring stable levels of public investments, also in the event of major downturns. It would address the problem of overreliance on cuts in investment in periods of fiscal consolidation. ·Fourth, it should contribute to the prevention of full-fledged financial market crises, including sovereign debt crises, through the provision of support when a Member State faces difficult economic circumstances and tight financing conditions on the markets. It should however not act as crisis management tool, but rather a crisis prevention tool, making it distinct from the ESM and other EU funds for investment. A stabilisation function is an in-between instrument. In this logic, assistance from the ESM would be called upon if and after support from the stabilisation function was not sufficient. ·Fifth, it should preserve cross-country neutrality. The scheme is not aimed to be redistributive and therefore should not lead to permanent transfers. It is also necessary to preserve incentives for sound national policies. The stabilisation function should in fact contribute to strengthening the economic governance framework, including the application of rules for prudent fiscal policies. This includes that it should be conditional on sound policies leading to convergence within the euro area. ·Sixth, a stabilisation function should contribute to the integrity of the Union. The setting up of a stabilisation function would send an important signal of common commitment to the deepening of EMU. It would thus address the problem encountered in the euro crisis when the currency union was questioned in its very fundamentals. A stabilisation function would find its place as a complement to existing tools in the EMU architecture: ·It would act in conjunction with economic governance provisions, in particular the rules governing the EU fiscal framework. To allow for an adequate fiscal policy response in large downturns, the workings of a stabilisation function and the application of the fiscal rules need to go hand in hand. As discussed above, a stabilisation function would complement existing stabilisers, in particular national fiscal policies. In deep downturns, the flexibility in the Stability and Growth Pact allows for a measured fiscal policy response that balances the primary objective of sustainable public finances with the dimension of economic stabilisation. The stabilisation function could allow a better reconciliation of the involved trade-off, by providing support in severe circumstances and possibly also incentivising sounder positions in good times. ·A stabilisation function would operate as a crisis prevention tool, making it different from existing forms of ESM assistance granted in support of a macroeconomic adjustment programme, calling for a careful design of their interaction. A stabilisation function would kick in case of a large shock, which is less grave than a full-blown economic crisis. Ideally, it would allow cushioning economic shocks to prevent recourse to the ESM. Still, in case financial assistance becomes necessary, the operation of a stabilisation function needs to be clearly delimited. For instance, support from a stabilisation function, which operates via the provision of favourable loans, would cease with recourse to the ESM in the event of full-blown financial assistance programmes. However, the resources that would have been transferred by the stabilisation function to the Member State would be covered by the programme envelope. By stopping the stabilisation function when financial assistance is granted, the limited resources of the stabilisation function could be used to stabilise economic activity in other Member States particularly in those hit by negative spill-overs. By contrast a stabilisation function, which operates via the provision of budget support or direct spending programmes, would be complementary to financial assistance programmes by the ESM and could thus operate in parallel and in conjunction with those. 5.What are the available policy options? Different policy options are available for a stabilisation function, which are not mutually exclusive. For the sake of simplicity, this section will focus on selected stylised designs. It will link these to the proposal put forward by the European Commission as part of the MFF proposal. All options have pros and cons vis-à-vis the objectives of the stabilisation function. It should be noted upfront that the active policy options below are non-exclusive and therefore can be combined. In this section, they will be presented one by one. On the question of the geographical scope, there are economic reasons to target a stabilisation function on the euro area but a more inclusive approach can also be defended. As lined out in the problem definition, the need for additional means of macroeconomic stabilisation is particular pressing for the euro area, as national stabilisers might become overburdened in absence of a country-specific foreign exchange rates and monetary policies. This is why the adoption of such an instrument is more especially desirable for euro area Member States, which is retained as working assumption for the geographical scope in this impact assessment. However, it can also be argued that participation in a stabilisation function would also be beneficial to non-euro area Member States. Even before adoption of the euro, the additional macroeconomic support provided by a stabilisation function could provide cushion for countries affected by large shocks. There are also political considerations to assess in choosing between a focused versus a more inclusive approach. One additional dimension to be considered is that not-yet-euro area Member States may find it joining the scheme useful when joining the ERM-II mechanism, since already at this stage their national monetary and exchange rate policies might become constraint. This makes a case for extending the stabilisation function to at least countries within ERM-II. The categorisation of the policy options follows a taxonomy of designs. It focuses on the conceptual nature of the instrument. This distinguishes between a borrowing-lending scheme, an insurance mechanism, and a euro area budget. Within each of those general options, sub-options and sub-varieties can be envisaged: sub-options pertain to issues such as calibration, triggering criteria, eligibility conditions, and use of funds. Those choices are also presented and discussed.

5.1.What is the baseline from which options are assessed? Option 1: Status quo The benchmark option would be to maintain the status quo. Over the past years, the EMU architecture was strengthened and further improvements are underway, as described in section 2. There could thus be a merit in further analysing the operation of these innovations, also in light of political obstacles to additional innovations. The status quo presumes that currently pending legislation and proposals by the Commission would be adopted. Option 1 thus presumes that a backstop for the Single Resolution Fund (SRF) is being put in place. This contributes importantly to furthering the Banking Union but does not modify the analysis concerning the need for macroeconomic stabilisation mechanisms. Option 1 presumes that the different proposals for the capital markets union and the recent package on non-performing loans are in place and yield the desired risk reduction in financial markets. Furthermore, the Reform Delivery Tool is in place and creates additional incentives for needed structural reforms. The status quo also assumes that the proposal for the creation of the EMF is adopted, leading to more transparency and accountability in its operations and decisions, but not per se entailing new instruments. It is possible that the ESM/EMF shareholders establish new lending instruments, and in particular, eventually develop a stabilisation instrument, which could be similar to the ones envisaged in the options presented subsequently. The creation of such an instrument, while envisaged, is nevertheless not enshrined in the legal provisions of the EMF proposed Regulation, and therefore is not considered as being part of the baseline scenario. However, if the ESM/EMF were in the future entrusted with such an instrument, it would be possible and desirable that it works in complement to the options described below, in particular when it comes to option 2. The possibility of complementary instruments backed by the EU budget and by the ESM/EMF jointly contributing to enhanced macroeconomic stabilisation is explicitly foreseen in European Commission (2017 D). The status quo option would leave the euro area exposed to the risks evidenced over the past and presented in previous sections. While the euro area economy is now expanding again, the vulnerabilities exposed in sections 2-3 remain and the capacity of the euro area and Member States to smooth large macroeconomic shocks is not yet sufficient. In the presence of large shocks, even in highly integrated financial markets as achieved by the completion of Banking Union, there is a risk of a pro-cyclical drop in risk sharing in absence of central fiscal instruments (see section 2). Furthermore, the automatic stabilisers may become insufficient to ensure proper stabilisation, especially in small open economies. This may be aggravated by the inability of an overburdened monetary policy to fully respond to common negative shocks (see section 3). The cost of non-acting could range from moderate to very large. A moderate cost of insufficient shock absorption capacities would consist in sub-optimal fiscal and public investment policies, characterised as in the past by strong pro-cyclical tendencies, notwithstanding the preventive effects of fiscal rules. This has significant costs in terms of amplifying business cycles and their consequences on unemployment, as well as compromising investments that foster long-run growth and productivity. But more dramatic costs can also ensue in the baseline under a worst case scenario which would involve a re-run of the past crisis or some variant thereof. This may eventually trigger highly disruptive crises and increase risks of fragmentation of the zone, with the ultimate risk involving a break-up with wide-ranging economic and political consequences for the EMU and EU projects. 5.2.Description of the policy options Option 2: Borrowing and lending scheme (favourable loans) In a borrowing lending scheme a central agent, e.g. the European Union, borrows in order to on-lend to the concerned Member State(s) at the same conditions it gets on the market. Such a mechanism provides Member States with the necessary financing to continue executing their budgets. In the Commission proposal, the support would be used to maintain adequate levels of public investment in the cohesion sectors. In this particular design, the loan is accompanied by a limited grant component in the form of an interest rate subsidy. The latter would be used to further reduce the interest rate of the back-to-back loan given to the Member State. The size of the borrowing and lending scheme depends on the margin available under the EU budget. In a similar fashion to the EFSM, all loans issued under this option would have to be guaranteed in full by the EU's own resources. The ability to issue loans would therefore be limited to an earmarked part of the headroom between the own resources ceiling and the annual budget, the so-called margin. It would therefore depend on the possibility to raise the own resources ceiling and on arbitrages with other instruments based on the same margin. In numerical simulations, this document considers a maximum volume of outstanding loans set between EUR 30 and 100 billion (see section 6, in particular sub-section 6.1.3, for a discussion). Support is activated in case of large country-specific shocks, defined through triggering conditions. Support should be targeted to situations where Member States are especially hit by a large macroeconomic shock. To allow for timely and undisputed activation, triggering should be automatic and rapid on the basis of pre-defined parameters, as evoked in European Commission (2017 C). This document briefly review some possible triggering criteria, including those based on output gap and GDP growth, but favours and examines in more details triggering conditions based on unemployment rates (see section 6, in particular sub-section 6.1). A double condition on unemployment rates appears as a pragmatic option for such an activation trigger. There is no perfect design or parametrisation of an activation trigger, as the notion of an automatic criterion inevitably bears a degree of simplicity and some imperfections. However, a pragmatic option, retained in the Commission proposal, is a “double condition” on unemployment rates: it links the activation of the stabilisation support to a condition involving both the level of the national unemployment rate (compared to its past average) and the change in unemployment (compared to a certain threshold). While not perfect, such a condition appears robust to characterise the existence of large asymmetric shock and avoid significant 'mistakes'. Section 6 will provide additional reflections on this matter, including simulations confirming the adequacy of activation provided by the double condition. To ensure that the availability of support through the stabilisation function does not reduce incentives for prudent fiscal policy, strict eligibility criteria are needed. As highlighted in section 3, prudent national fiscal policies remain primordial for an effective fiscal policy response in case of large downturns. That is why conditions of compliance with the EU surveillance framework appear needed as an eligibility criterion. Given that option 2 entails mainly support in the form of loans which are legally required to be repaid (as opposed to outright transfers, as would materialise notably in option 3), the set of eligibility conditions could nevertheless be relatively focused. A possibility to consider would be inspired by conditions employed in the framework for macroeconomic conditionality. Those require that: ·Concerning fiscal surveillance, Member States in excessive deficit procedures and in significant deviation procedures need to deliver effective actions. ·Concerning the Macroeconomic Imbalances Procedure, Member States shall not repeatedly fail to deliver sufficient corrective actions plans or fail to take recommended corrective action. Therefore, under these conditions Member States could for instance be in an excessive deficit procedure and still benefit from the stabilisation function, as long as they meet the requirements from EDP recommendations. Such an approach avoids that Member States are 'cut off' from the instrument at the very moment when they may need it the most.

In this approach, it is natural that the degree of support, as materialised by the amount of lending granted, takes into account the size of the economic shock. Once the triggering conditions for the stabilisation function have been met, the amount of support given to a Member State could be determined as a function of an overall envelope in conjunction with the severity of the shock. Box 1 provides a detailed description. The use of an explicit formula for establishing the degree of support is consistent with an instrument functioning in a quasi-automatic and predictable manner. Timeliness and predictability are a key elements to ensure that support is available before a full blown crisis could emerge. Automaticity also carries a signalling effect towards financial markets, which can positively affect the borrowing conditions of concerned Member States beyond the direct effect of the scheme. The procedure for granting loans would be quasi-automatic. Once triggering conditions and eligibility criteria are met, the concerned Member State would know that it has access to the facility, should it wish so. A Member State would remain free to tap into the lending made available by the stabilisation function, i.e. the procedure for granting lending support would have to be initiated by the concerned Member State. Once this is the case however, the support should come rapidly and in a quasi-automatic manner. This is consistent with a timely stabilisation support and the objective of preventing a difficult economic situation from getting worse. In this spirit, it would be logical that once support is requested and again, assuming that the triggering and eligibility criteria are met, the decision and implementation of support is left to the European Commission, without involving a decision from the Council. Box 1: Determination of size of the loan support The maximum envelope for the loan support would be determined by: The main component is the ratio of eligible public investment to GDP in the EU at current prices and on average over a period of certain number of years (e.g. 5 years) before the request of the support: . This ratio is calibrated by the GDP of the Member State concerned (in current prices and on average over a period of five years before the request for support). The underlying logic is that an adequate level of public investment should be taken as a reference, while ensuring equal treatment among Member States. The amount of the public investment level supported by the stabilisation function is further scaled by a factor α. This factor reflects the maximum amount which can be made available with the backing of the EU budget. This must be set taking into account the budget constraint but also the probability and severity of shocks which could activate the stabilisation function in the future. The latter two are estimated in reference to the past activation periods (see subsection 6.1.3 on the numerical calibration of the parameters). The actual amount of the loan to be granted would be a function of the severity of the shock. It captures the increase of the national unemployment rate above the threshold that triggered the activation of the stabilisation function. The formula below is applied:



Where β is a sensitivity parameter to the severity of the shock. The size of support is capped by the maximum available level for a given Member State determined in the previous step. In specific circumstances, the size of the loan can be topped up. In addition to the automatic component, the Commission may decide, under specific circumstances to increase the loan up to the maximum support Is. The Commission would take into account extraordinary factors including the increase in the national unemployment rate of the Member State concerned. To avoid budget overruns, two additional lines of defence should be introduced. At the aggregate level, it could be provisioned that the outstanding amount of loans should not exceed a certain ceiling. In addition, the support to a member state could be capped to avoid exhausting the remaining resources under this ceiling. Although such provision may be required for budget certainty, to ensure that the loans mechanism plays in full, it is important that they are binding only in exceptional and rare cases. For this reason, the parametrisation of the support must be carefully calibrated. This approach to decision-making would nevertheless differ from the procedure in place for other instruments. In the case of financial assistance programmes such as those granted under the EFSM, there is considerably more discretion in the decision-making process, and the Council must make an explicit decision on a case by case basis. However, these other instruments are usually related to a process of economic policy coordination in the context of a macroeconomic adjustment programme and financing needs are determined on a case-by-case basis. A heavy decision making process seems therefore justified in these cases, while the stabilisation function would benefit from having a light procedure given the quasi-automaticity of the formula. To make the lending more attractive and effective, a grant component could be used in order to de facto subsidize the interest rate charged on the back-to-back loans. The purpose of such grants is two-fold: first, it can provide additional support to a Member State undergoing an adverse economic event and facing particularly tight financing conditions on the market without yet being in a financial assistance context. Second, it would make the stabilisation function more attractive, also for Member States benefiting from low interest rates on the market. A simple approach would be to proportion the amount of grants to the interest costs pertaining to the back-to-back loan that the Member State is availing of. The overall size and cost of the grant component would therefore be limited and predictable. First, the interest subsidy could at most compensate for the interest expenditure linked to individual loans. Second, the interest subsidy would be proportional to the overall loan volumes. This grant component could a priori be financed with different means, including from the EU budget and/or from member states' contributions. As regards the financing of the grant component, two options are possible. One possibility would be for the EU budget to directly provide the interest subsidy. This would require a line in the EU budget under the payments ceiling. That approach would have the advantage of securing the interest subsidy as part of the EU budget, consistent with the provision of lending also backed by the EU budget. A possible complication may nevertheless arise if the geographical scope of the stabilisation function focuses on a subset of EU Member States (such as the euro area). Still, amounts would be fairly small and this risk could be attenuated by a careful design of the contributions to such financing. As another (non-exclusive) possibility, Member States could voluntarily agree to pool national contributions in order to allow for the financing of the interest subsidy. Irrespective of the exact source of financing, the resources for a limited grant component could be pooled in a dedicated fund. Option 3: Insurance mechanism An insurance mechanism would provide sizeable fiscal policy support to Member States in the form of grants to cushion large shocks. Conceptually, it is comparable to a rainy day fund, with or without the possibility of borrowing. Similar to an insurance, it would provide pay-outs to Member States in pre-defined adverse circumstances. In return, regular contributions or an own resource would be needed to balance the system in the long run. The pay-outs could take the form of budget support or may be tied to critical public expenditure, such as public investments or unemployment benefits. Critically, an insurance mechanism would need to accumulate funds to be disbursed in case of large shocks. At this stage, the Commission has not adopted a specific proposal, but has stated the intention to complement option 2 with an insurance mechanism. A stylised vision of an insurance mechanism is presented below, elaborating and discussing selected design choices and sub-options. Similar to option 2, the triggering and size of support in option 3 could be tied to a double condition on unemployment rates. Also in case of an insurance mechanism the double condition on unemployment would allow for a pragmatic measure of large shocks. Similarly, the size of support would be tied to the size of the shock, e.g. the increase in unemployment over and above a certain threshold increase, to ensure the most effective distribution of means. To ensure a balanced position a regular flow of resources is needed. They could take the form of contributions from Member States or of a new own resource. Simulations suggest that already a small, regular stream of resources would allow for disbursements of sizeable support in the downturn. Resources could take the form of regular contributions or could be scaled as a function of the business cycle and past access to the insurance funds (in the logic of insurance premia). The latter features may be important to ensure cross-country neutrality over time. The possible addition of a borrowing capacity has important repercussions on the functioning and impact of an insurance mechanism. In the absence of a borrowing capacity, often referred to as a rainy day fund sensu stricto, an insurance mechanism could only dispense support up to accumulated contributions. In practice, this could entail that support runs dry during the downturn and/or create problems with regards to the equal treatment of Member States due to the sequencing of support. A limited borrowing capacity would solve these risks and allow for smaller accumulation of funds ex ante. Nonetheless, it may complicate the political acceptability of such a mechanism. Option 4: A euro area budget A common budget for the euro area would arguably be the most ambitious design for a stabilisation function. The proposal was brought up several times in the past years and has gained renewed attention. President Macron (2017) called for a euro area budget for common investments and to ensure stabilisation in the event of economic shocks. In practice, a common budget would involve permanent own resources on the revenue side and permanent spending functions on the expenditure side. In this case, the stabilisation effect comes from the cyclicality of the revenues or expenditures comprising the budget. In option 2 and 3, the stabilisation properties of the instruments are generated by their activation and dis-activation depending on economic shocks. A common budget would not primarily target economic stabilisation, but rather the provision of European public goods. Still, reliance on cyclical revenues (e.g. corporate income tax) and countercyclical spending (e.g. unemployment benefits) contribute to macroeconomic stabilisation via automatic stabilisers at the EU level. In addition, one could foresee discretionary elements which could further foster stabilisation properties. A combination of options A combination mixing the above approaches is conceivable. As will emerge from the assessments of the options (see notably the conclusions of sub-section 6.5), the options can be seen as fulfilling the objectives in a complementary manner. It is therefore conceivable that they co-exist in a long-term perspective. It is also possible to conceive a step-based approach to the stabilisation function. As a first step of a phased approach, one could envisage a loans facility, together with limited grants that would allow favourable interest rates, in order to support public investment. A Member State facing a large asymmetric shock would automatically be entitled to benefit from available financing provided through the stabilisation function. The support would mostly rely on loans, to be supplemented with a limited grant support. The EU budget would provide back-to-back loans. Grants from the EU budget would be used to achieve particularly favourable interest rates to the benefit of Member States. Such an approach was discussed in European Commission (2017 D) and corresponds to option 2.

In a later, second step, one could envisage the creation of an insurance mechanism. This suggestion was proposed by European Commission (2017 D) as a second step to be implemented in the future when conditions for it are met. This corresponds broadly to option 3. 6.Impact evaluation of the options This section analyses qualitatively and quantitatively the value added of the various options (laid out in section 5) in reaching the objectives (exposed in section 4). Option 1 will serve as benchmark against which proposals are assessed. The section lays out the main channels through which the different options would contribute to strengthening the resilience of the European economies and to the achievement of the specific objectives. As appropriate, quantitative methods, such as simulations and regressive analysis, are used to substantiate the qualitative evaluation. This section evaluates the choices to be made and the relevance of the different options along three dimensions: ·The selection of the activation trigger, which needs to be timely. This is a common issue for option 2 and option 3. Therefore, the discussion of the activation trigger will be made irrespective of that option. In the case of a full budget (option 4), there is no need for a trigger. ·The stabilisation power. This is the effectiveness of the scheme in absorbing asymmetric shocks, allowing the conduct of smoother fiscal policies, and preserving public investments. ·The cross-country neutrality. This relates in particular to the absence of permanent transfers, and means to secure that objective. 6.1.Selection of the activation trigger An activation trigger is a crucial element in option 2 and 3. Its design and calibration are discussed in detail in this sub-section. The Commission Communication on new budgetary instruments for the euro area calls for a stabilisation function that is 'timely and effective'. For eligible countries, "triggering should be activated automatically and rapidly on the basis of pre-defined parameters (for example, based on a large temporary negative deviation from their unemployment or investment trend)". The objective is to complement the national stabilisers in the event of "large asymmetric shocks". 6.1.1.Choice of trigger variable The triggering criterion should be based on the evidence of large cyclical shocks affecting the concerned Member State(s). The possible options are: i. The output gap. In theory, the output gap is the most straightforward indicator of cyclical developments, but it faces implementation issues. In practice the output gap is 'unobservable' and its estimation reflects many assumptions. Given the possible controversies over measurement and the large revisions of the output gap over time, it is probably not the best option to base the activation of a macroeconomic stabilisation function on. ii. GDP growth. Two sub-options: ·Recession (negative growth) as the trigger. This option is limited by the large differences between Member States regarding their potential growth (Malta: 5.6%; Ireland: 5.1%; Greece: -0.9%; Italy: 0.2% - figures for 2017 from Commission autumn 2017 forecast). Using recession as a criterion would massively skew the scheme in favour of countries with the lowest potential growth. ·GDP growth compared to trend growth. To correct for the limitation of the above option, GDP growth could be compared to its trend. This indicator is therefore equal to the change in the output gap. It is therefore exposed to the problem of unobservable variables (although with lesser uncertainty than on the level of the output gap). In addition, there would be situations where the sole information from the change in the output gap is too limited: for example one may not wish to support a country with a positive level output gap just because the output gap is declining. iii. An unemployment rate trigger. The unemployment rate has several valuable properties: it is well-known, harmonised, available at high frequency with short delays, and subject to limited revisions. It is an excellent indicator of the business cycle, purging some of the short-term noise of GDP ( Figure 17 ). It reacts however with some lag to the business cycle. This may not be such an issue for a stabilisation function focused on large shocks. Moreover the effects of shocks on public finances also tend to lag the growth cycle and actually to more or less match the unemployment cycle. In addition, it is important for the credibility of the system that in the initial phase of the shock national

Figure 17: Cyclical indicators, the output gap and the unemployment rate Source/note: Eurostat, and AMECO. The opposite of the unemployment rate (in blue) replicates closely the fluctuations of the output gap (in yellow). automatic stabilisers and policies are called to operate. Thereby the lag reflecting the use of unemployment level until the stabilisation function is activated, would not undermine the utility of the latter. A more significant potential limitation of the unemployment rate, however, is that its sensitivity to cyclical shocks may differ across Member States, for example because some economies have more developed working-time arrangements in downturns. Another technical consideration is the risk that the assessment of cyclical developments are affected by structural improvements in labour markets, but such effects appear limited empirically. iv. Discretionary approach based on a set of indicators. A fourth option would be based on a set of indicators to identify the presence of a large cyclical disturbance for the Member State. The indicators can include notably business surveys, GDP, the labour market and inflation. It is however likely that such an approach based on a range of indicators would have to involve a degree of judgment (i.e., not just reflect a 'pre-defined' algorithm, as the latter would be very challenging to write down to cover all possible situations). This may be the most encompassing avenue from an economic viewpoint, but it conflicts with the automatic nature of the triggering. Overall, an unemployment based trigger appears as a viable pragmatic option for the activation of support. This line of reasoning favouring the unemployment rate as the indicator to trigger the mechanism is found in several recent studies (see Table 1 ) as well as in the European Fiscal Board's Annual Report (2017). Across the literature, broad support has emerged to favour the unemployment rate as basis for the trigger indicator. 6.1.2.Choice of trigger design and parametrisation A stabilisation function for the euro area should cushion large asymmetric shocks only, calling for prudent activation and limiting the risk of questionable support. As highlighted in the 6 December Package, national fiscal policies, monetary policy and structural reforms remain the core levers to ensure reliance in the wake of downturns. The stabilisation function is supposed to complement these in case of truly large asymmetric shocks, calling for a calibration which places much emphasis on avoiding unduly support. Such a restrictive approach appears essential to prevent moral hazard and permanent transfers. Nonetheless, it would entail an opportunity cost in the sense of sometimes not providing support even though a case could be made for it. The technical discussions around an unemployment-based activation trigger focus on two designs: a simple trigger and a double trigger ( Table 1 ). Simple triggers can refer to either the level or the change in unemployment. Arnold et al. (2018) and Dullien et al. (2017) propose the mechanism to be triggered if the level of unemployment rates is above previous years averages. A group of French-German economists (Bénassy-Quéré et al., 2018) propose to trigger the mechanism if the unemployment rate increases significantly. In either cases, thresholds can be introduced to react only to large deviations. Both concepts have merits, such as a higher extent of simplicity. A double trigger, in contrast, combines both a condition on the level and on the change in unemployment. It has been proposed by Carnot et al (2017) and Claveres and Stráský (2018). Table 1: Comparison of activation triggers proposed in the literature Carnot et al. (2017) Dullien et al. (2017) Arnold et al. (2018) Claveres and Stráský (2018) Bénassy-Quéré et al. (2018) Double condition: - unemployment level above the 10-15 years moving average - unemployment rising, possibly above a threshold Level of unemployment rate exceeding average level of past 5 years, by 0.2 pp for national compartment, by 2.0 pp for stormy day fund Level of unemployment rate above 7 year moving average (in pp or in %) Double condition: - unemployment level above the 10 year moving average - unemployment rising Change in unemployment rate, employment or wage bill above/below a threshold (e.g. 2 pp for unemployment) The specific approach that is favoured here relies on a condition involving both the level and the rate of change of the national unemployment rate. Specifically, in light of the simulations presented in what follows, the stabilisation support could be triggered based on the observation of both: ·An unemployment rate above the historic average of the country, for example its average over the past 10-15 years. This condition is needed to put countries on par, irrespective of their permanent (structural) level of unemployment; ·An unemployment rate that is increasing over the past year. To restrict the activation conditions further, it is considered that the increase should go beyond a certain threshold, specifically 0.5-1.5 percentage point, with a value of 1.0 percentage point taken as the central assumption. The amount of support should be linked to the increase in the unemployment rate (beyond the threshold if there is a threshold). Such a double condition, especially when incorporating a threshold, ensures with a great degree of assurance that the Member State is indeed confronted with a large shock with a temporary and country specific element. With a threshold set between 0.5 and 1.5 percentage point (i.e. increases below this value does not trigger the mechanism), between one third and four fifth of the unemployment increases would be entirely left to the responsibility of the national stabilizers ( Figure 18 ). Based on past experience, for a threshold of 1 percentage point, the frequency of activation would be slightly above 10% (i.e. once per decade for a country) ( Figure 19 ). Figure 18: Proportion of unemployment increases above a certain value Figure 19: Frequency of activation depending on the threshold Source: Eurostat, authors’ calculations based on year-on-year increases in quarterly unemployment rates since 1985. Available data may start later for some Member States. Source/Note: Eurostat, authors’ calculations.

Based on simulation for the EA19 since 1985. Coloured areas correspond to the range of values for reference rates computed over10 to 15 years. This dimension only has a secondary effect on the frequency of activation especially with the double trigger. The double condition allows for support to be targeted at times of sizeable economic worsening. Figure 20 and Figure 21 illustrates the application of the simple trigger and the double trigger on the unemployment rate. The double trigger targets more specifically the situations where unemployment is rising, i.e. times of economic worsening. In comparison, a simple trigger offers support also when the recovery is already on track. For both kinds of approaches (single or double trigger), a threshold can allow support to be less often distributed ( Figure 20 .b. and Figure 21 .b.). This option is not very attractive for the simple trigger as it mostly delays the support, but for the double trigger it allows not to provide support when the economic shock is deemed minor. Figure 20: Illustration of activation of support with simple trigger (Irish case) Figure 21: Illustration of activation of support with double trigger (Irish case) a. no threshold a. no threshold b. threshold 1 pp b. threshold 1 pp Source/Note: European Commission 2017 autumn forecast, authors’ calculations

reference rate = 15 year moving average of the unemployment rate

Simulations for the EA19 since the mid-nineties confirm that the double trigger is more targeted than the simple one. In particular, during the period 2009-2014 the double trigger would have induced two peaks of support for 80% and 40% of the Member States ( Figure 22 ) which weighted for a similar fraction of the euro area GDP ( Figure 23 ). On average over the period, support would have been granted for almost 12% of the cases with the double trigger (more than 34% with the simple trigger). This frequency of activation depends largely on the chosen threshold: a higher threshold leaves the adjustment to larger shocks under the sole responsibility of Member States and therefore provides support less often ( Figure 19 ). Without threshold, the mechanism proposed would provide support in up to 30% of the cases while with a threshold of 2.5 percentage points on the annual increase in unemployment this frequency would fall below 5%. Figure 22: Share of EA19 countries which would have been under support Figure 23: Share of EA19 countries which would have been under support (GDP weighted) Source/Note: Eurostat, authors’ calculations Reference rate computed as the average over the past 10 years. 6.1.3.The total support envelope for option 2 The parameterisation of the amount of support entails a trade-off between the available budgetary means and the macroeconomic meaningfulness of the support. Technically, the choice of the amount of lending available for a Member State fulfilling the conditions is reflected in the parameters 'alpha' and 'beta' in the formula for granting support (see Box 1 above): ·As lending would be backed by the EU budget, the setting of those parameters has to be broadly proportionate to means made available for the purpose in the EU budget. Specifically, the ability to issue loans under option 2 is limited to an earmarked part of the headroom between the own resources ceiling and the annual budget, the so-called margin. This limitation corresponds to a prudent strategy by which the EU budget can guaranty in full all emitted loans. ·At the same time, the amounts made available must be of a meaningful macroeconomic size in comparison with the borrowing needs of Member States, particularly with regard to the financing of their investment expenditures. While the shares of public investment of GDP vary across Member States within a range of 2-4 percent, it can be considered that meaningful support in the event of a severe shock should be sufficient to fund a significant fraction of that total. In practice, it can be considered that the availability of financing support should reach at minimum a few tenths of percentage points of GDP for large shocks. More significant support would be of the order of 1 percent of GDP or even above in the event of very large shocks. Using backward simulations, it is possible to give a conservative estimation of the maximum support affordable per Member State, given an overall ceiling for the total lending capacity of the stabilisation function. This estimation is such that over the past periods of activation of the scheme (and in particular the recent crisis), it would have been possible to provide all the loans due without breaching a given overall total ceiling. To provide an illustrative range, two values for such an overall ceiling are considered, specifically EUR 30 billion and EUR 100 billion (i.e., between 0.3-0.9 percent of euro area GDP). For these values of the total lending capacity of the instrument, the maximum support affordable under option 2 for a Member States in a given year ranges between 0.2% and 1.3% of the Member State's annual GDP, depending on the choice of total ceiling and other parameter choices ( Table 2 and Table 3 ). Overall, a total ceiling for the lending capacity in the lower range envisaged (30 billion) allows supporting a non-negligible but limited fraction of public investment, while a higher overall ceiling (100 billion) allows supporting a proportionally higher fraction of public investment: ·For an envelope of EUR 30 billion (0.28% of euro area GDP ), simulations run for the period 1985-2017 show that the maximum support which could have been provided on an annual basis ranges from 0.21% to 0.40% of the Member State’s average GDP over the previous five years in current prices ( Table 2 ). This corresponds to a value for the parameter α ranging between 7% and 14%. It corresponds for the parameter β to a value ranging from 0.5 to 2. ·For the higher total envelope of EUR 100 billion, the maximum support and the parameter α must be scaled up while the parameter β is unchanged. The maximum support then reaches up to 1% percent of national GDP or even a bit more, depending on the other parameterising choices. Table 2: (Option 2) Affordable maximum support (on an annual basis, in percent of national GDP) depending on the plausible range of parameters and for an envelope of 0.28% of EA GDP (EUR 30 billion) Table 3: (Option 2) Affordable maximum support (on an annual basis, in percent of national GDP) depending on the plausible range of parameters and for an envelope of 0.93% of EA GDP (EUR 100 billion) Source: Author's calculations Reported numbers correspond to the maximum support, which can be provided as a percentage of the Member State's GDP if it receives a maximum support for the quarters of the same year. Concerning the setting of other parameters, the maximum support available to a Member State is higher when (see Tables 2-3): ·the threshold on the increase in unemployment for triggering support is higher. The maximum support is highest when the threshold is set at a 1.5 percentage point increase in unemployment, and lowest for a threshold of 0.5 percentage point increase. A value of 1.0 percentage point may be a good compromise between maximising support on very large shocks and timely activation. ·the reference period for calculating average past unemployment is longer (15 years versus 10 years); ·the amount of support is modulated as function of the severity of the shock (i.e., is a proportion of the increase in unemployment rate beyond the threshold point, as in the formula of Box 1, and as opposed to a fixed amount). This latter point is further explained and documented below (see sub-section 6.1.4). The grant component associated to the loans would only be a fraction of the loans issued. To make the loans more attractive, it can be envisaged as noted above that the interest rate cost would be (partially) covered by a grant. The estimation of the needed resources for that purpose is highly uncertain as it depends on the degree of effective take-up of the available loans, as well as the implied degree of subsidisation of the financing. An upper bound can be gauged by assuming that the full lending capacity of the scheme (EUR 30-100 billion) is being mobilised, with a significant intere