Assessing the Euro area's shock-absorption capacity : risk sharing, consumption smoothing and fiscal policy.
Date: 2017-01-27
Institutions: Directorate-General for Employment, Social Affairs and Inclusion
Subjects: budget policy, capital market, consumption, economic integration, euro area, fiscal policy, governance, labour mobility, unemployment insurance

Assessing the Euro Area’s 

Shock-Absorption Capacity 

Risk sharing, consumption smoothing and fiscal policy 

Written by Cinzia Alcidi and Gilles Thirion 
January – 2017 

Social 
Europe 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
EUROPEAN COMMISSION 

EUROPEAN COMMISSION 

Directorate-General for Employment, Social Affairs and Inclusion 
Directorate A — Employment & Social Governance 
Unit A4 — Thematic analysis  

Contact: Eric Meyermans  

E-mail:  EMPL-A4-UNIT@ec.europa.eu   

European Commission 
B-1049 Brussels 

2017 

2 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
EUROPEAN COMMISSION 

Assessing the Euro Area’s 

Shock-Absorption Capacity 

Risk sharing, consumption smoothing and fiscal policy 

European Commission 
Directorate-General for Employment Social Affairs and Inclusion  
Directorate Employment & Social Governance 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
EUROPEAN COMMISSION 

This  working  paper  is  based  on  a  deliverable  prepared  in  light  of  Task  3A  of  the  research  project 
“Feasibility and Added Value of a European Unemployment Benefit Scheme”, commissioned by the 
European  Commission,  Directorate-General  for  Employment,  Social  Affairs  and  Inclusion  and 
initiated  by  the  European  Parliament.  It  was  prepared  by  Cinzia  Alcidi  and  Gilles  Thirion  (CEPS). 
Cinzia Alcidi is Head of the Economic Policy Unit and LUISS Research Fellow at CEPS. Gilles Thirion 
is  a  Researcher  in  the  Economic  Policy  unit  at  CEPS.  The  authors  are  indebted  to  Daniel  Gros  for 
insightful conversations with him on the subject and thankful to Paul De Grauwe for his comments. 
This  document  reflects  the  views  only  of  the  authors,  and  the  Commission  cannot  be  held 
responsible for any use that may be made of the information contained therein. The content of this 
study does not reflect the official opinion of the European Union. Responsibility for the information 
and  views  expressed  in  the  report  lies  entirely  with  the  author(s).  The  report  is  published  on  the 
CEPS website with the kind permission of the European Commission. 

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LEGAL NOTICE 

This  working  paper  was  written  as  part  of  Task  3A  for  the  research  project  ‘Feasibility  and  Added  Value  of  a 
European  Unemployment  Benefit  Scheme’  (contract  VC/2015/0006).  The  research  project  is  undertaken  by  a 
consortium comprising the following institutions: the Centre for European Policy Studies (CEPS), the Centre for 
European  Economic  Research  (ZEW),  the  Institute  for  Social  and  Economic  Research  (ISER),  Cambridge 
Econometrics (CamEcon), EFTHEIA and the University of Leuven (KUL); we use ‘the Consortium’ as a shortcut 
throughout this paper. 

This document has been prepared for the European Commission. It reflects the views only of the authors. The 
Commission  cannot  be  held  responsible  for  its  content  or  for  any  use  which  may  be  made  of  the  information 
contained therein. 

More information on the European Union is available on the Internet (http://www.europa.eu). 

Luxembourg: Publications Office of the European Union, 2017 

ISBN: 978-92-79-64981-3 
doi: 10.2767/14963 
© European Union, 2017  

Reproduction is authorised provided the source is acknowledged.  

European Commission 
Directorate-General for Employment Social Affairs and Inclusion  
Directorate Employment & Social Governance 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Feasibility and Added Value of a European Unemployment Benefit Scheme 

Table of Contents 

ABSTRACT ................................................................................................................. 6 

1. 

2. 

3. 

4. 

INTRODUCTION ................................................................................................... 7 

EU  ECONOMIC  GOVERNANCE  AND  FISCAL  POLICY:  WILL  FISCAL  POLICY  BE  LESS 
PRO-CYCLICAL? ................................................................................................. 10 

2.1.  Fiscal policy over the cycle: some stylised facts ............................................. 10 

2.2.  Fiscal  policy  to  smooth  the  cycle:  what  to  expect  from  the  new  fiscal 

governance framework .............................................................................. 11 

2.2.1 The ‘soft’ aspect of governance: Learning by doing ................................ 13 

LABOUR MOBILITY AS STABILISATION MECHANISM ............................................... 14 

INTEGRATION OF CREDIT AND CAPITAL MARKETS ................................................. 16 

4.1.  The role of markets and government in smoothing consumption and income: a 

literature review ....................................................................................... 16 

4.1.1 The EMU vs. fully-fledged federations .................................................. 17 

4.1.2 Financial integration and risk sharing in the EMU ................................... 18 

4.2.  What to expect from Banking Union and Capital Markets Union ........................ 21 

4.2.1 Banking Union: An ex-ante perspective ................................................ 22 

4.2.2 Banking Union: An ex-post perspective ................................................ 23 

4.2.3 Banking Union and the housing bubbles in Ireland and Spain .................. 25 

4.2.4 Capital Markets Union ....................................................................... 26 

4.3. 

‘Guesstimating’  future  shock-smoothing  properties  of  EMU:  An  exercise  based 
on the experience of core EMU countries ...................................................... 28 

4.3.1 Empirical analysis: the experience of the core and non-core countries ...... 29 

4.3.2  The  role  of  cross-border  equity  during  banking  crises:  The  BELLS  vs. 

Spain and Ireland ......................................................................... 32 

5.  CENTRALISED  FISCAL  INSURANCE  AND  PRIVATE  RISK  SHARING:  SUBSTITUTES  OR 

COMPLEMENTS? ................................................................................................ 35 

5.1.  Rationale for fiscal insurance ...................................................................... 35 

5.2.  Fiscal and market insurance: Substitute or complement? ................................ 36 

6.  CONCLUDING REMARKS ..................................................................................... 39 

REFERENCES ............................................................................................................ 41 

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ABSTRACT 

Based  on  a  combination  of  quantitative  analysis  and  a  qualitative  forward-looking 
approach, this paper assesses both the state of play and the future capacity of the EMU 
to  respond  and  adapt  to  asymmetric  shocks.  The  objective  is  to  provide  a  basis  upon 
which to gauge the potential value added of a European Unemployment Benefits Scheme 
(EUBS),  against  the  background  of  the  recent  plans  for  the  Banking  Union,  the  Capital 
Markets  Union  and  the  reform  of  the  fiscal  governance  framework.  We  find  that  the 
capacity  of  the  system  to  deal  with  asymmetric  shocks  (and  in  principle  reduce  their 
occurrence)  is  likely  to  increase  due  to  these  changes,  but  it  will  remain  limited  in  the 
medium  term  and  certainly  lower  than  in  the  US.  We  also  argue  that  given  the  broad 
pro-cyclicality  of  fiscal  policy,  the  idea  that  national  policies  alone  can  deal  alone  with 
asymmetric  shocks  is  not  realistic.  Lastly,  we  maintain  that  an  ex-ante  fiscal  insurance 
mechanism  can  provide  some  degree  of  income  smoothing  and  is  likely  to  catalyse 
market  insurance.  Fiscal  and  market  insurance  can  reduce  the  role  of  credit  and 
borrowing, which until now has been the main channel for shock absorption in the euro 
area  but  also  the  least  effective  in  times  of  crisis.  We  conclude  that,  from  a 
macroeconomic  point  of  view,  an  EUBS  is  a  useful  tool  to  improve  shock  absorption 
capacity and is not mutually exclusive with market risk sharing.     

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1.  INTRODUCTION 

This paper seeks to assess both the general state of play and the future capacity of the 
euro  area  to  smooth  and  absorb  asymmetric  shocks  through  various  channels.  The 
objective  is  to  provide  a  basis  for  gauging  the  potential  value  added  of  European 
Unemployment  Benefits  Scheme  against  the  background  of  the  recent  plans  for  further 
integration  such  as  the  Banking  Union  (BU)  and  Capital  Markets  Union  (CMU),  and  the 
reform  of  the  fiscal  governance  framework.  In  particular,  we  ask  whether  private  risk 
sharing and domestic fiscal policy could be sufficient adjustment mechanisms to allow the 
E(M)U  to  effectively  deal  with  shocks  in  the  future.  The  assessment  is  based  on  a 
combination  of  quantitative  analysis  of  the  relevant  adjustment  channels  and  a 
qualitative forward-looking perspective. 

The starting point for this analysis is our contention that the discussion on the benefits of 
a  future  stabilisation  device,  such  as  the  European  Unemployment  Benefits  Scheme 
(EUBS),  needs  to  be  embedded  in  a  broader  debate:  one  that  considers  the  role  of 
different  shock-absorbing  mechanisms.  Indeed,  in  a  monetary  union,  the  impact  of 
country-specific  shocks  can  be  absorbed  via  various  channels,  whether  they  are 
domestic,  like  fiscal  policy  and  price  adjustments,  or  international,  namely  cross-border 
mobility of workers and access to international financial markets.  

This  paper  focuses  on  the  role  played  by  the  integration  of  financial  markets  and  by 
domestic fiscal policy, in the framework of the EU governance architecture.  

The degree of development and integration of the financial system affects the working of 
capital and credit markets and their ability to function as shock absorbers to asymmetric 
shocks. Indeed shocks can be smoothed via: 

o 

International  (spatial)  risk  sharing  made  possible  through  access  to  international 
capital markets; and 

o  Consumption  smoothing  (or  intertemporal  risk  sharing)  through  use  of  savings  and 

access to international credit markets. 

Domestic fiscal policy deals with asymmetric shocks through automatic stabilisers and, in 
principle, countercyclical discretionary spending to stabilise domestic income.  

These two areas have been the object of important changes recently, and both are likely 
to  affect  the  shock  absorption  capacity  of  the  E(M)U  in  the  near  future.  However,  the 
capacity  to  adapt  and  respond  to  shocks  also  depends  on  other  factors:  in  particular, 
wage  corrections  and  labour  mobility.  These  involve  adjustments  in  the  labour  markets 
and they become inevitable when an asymmetric shock is permanent.  

In  the  case  of  a  supply  shock,  whether  symmetric  or  asymmetric,  changes  in  relative 
prices  and  production  patterns  are  inevitable.  While  certain  policies  can  provide 
temporary buffers and gain time, they cannot necessarily assure structural change. 1  

The original optimum currency area (OCA) theory (Mundell, 1961) identifies cross-border 
mobility  of  labour2  as  a  crucial  adjustment  mechanism  to  (long-lasting)  asymmetric 
shocks. In the euro area, this channel seems to have worked only moderately. 

1  The  investigation  of  this  channel  goes  beyond  the  scope  of  this  paper,  for  a  more  detailed 
analysis see among others, OECD (1999) and the role of labour markets in adapting to shocks. 

2 See Alcidi et al. (2016) on how an EUBS could affect the mobility of workers.  

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Lastly,  as  argued  by  Kenen  (1969)  in  the  case  of  monetary  unions,  where  monetary 
policy  is  not  anymore  available  to  respond  to  asymmetric  shocks,  common  fiscal 
resources  can  be  an  important  complement  to  domestic  fiscal  policy.  They  can  also  be 
important is the case of symmetric shocks, as it is the case in the US. Various forms of 
transfers from the federal government to states generally exist in federations. Transfers 
can  have:  i)  redistribution  effects  (permanent  transfers  from  richer  to  poorer  regions), 
and  ii)  insurance  effects  against  country-specific  macroeconomic  shocks  via  temporary 
transfers  (like  a  common  unemployment  insurance  scheme),  or  iii)  insurance  effects 
against common shocks (inter-temporal stabilisation under certain conditions).  

By assessing the effectiveness of different shock absorption mechanisms, we attempt to 
offer  an  overview  of  the  resilience  of  the  EMU  to  shocks  that  takes  into  account  the 
recent  governance  developments  and  help  understand  if  and  which  additional 
mechanisms  are  required.  The  question  of  how  to  enhance  the  EMU  responsiveness  to 
shocks  is  indeed  particularly  relevant  in  the  current  context  where  a  number  of  official 
reports, including the recent Five President Report3, have referred to the introduction of 
economic  stabilisers  for  the  euro  area.  This  is  also  important  in  the  current  political 
debate, which is divided between two opposing views. On the one hand, those who argue 
that  the  new  integration  efforts  and  governance  changes  will  boost  the  functioning  of 
market  mechanisms  for  private  risk  sharing  and  restore  the  capacity  of  domestic  fiscal 
policy  to  stabilise  the  economy  against  asymmetric  shocks,  hence  making  additional 
(supranational) fiscal tools unnecessary. On the other hand, those who argue that further 
financial  integration  will  not  be  sufficient  to  ensure  that  market  mechanisms  deal  in  a 
proper way with the effects of asymmetric shocks and that it could even be a source of 
instability.  In  addition,  given  the  member  states’  poor  track  record  in  enforcing  fiscal 
rules and the outstanding weaknesses in the EMU’s architecture, it remains unsure as to 
whether the new system of governance will be sufficient to allow national fiscal policy to 
act  as  a  significant  stabilisation  tool.  For  these  reasons,  some  forms  of  fiscal  insurance 
are desirable. 

Prior to reading the analysis, one should recognise that the forward-looking nature of the 
exercise,  which  looks  at  how  some  of  the  channels  illustrated  above  will  work  in  the 
future,  entails  several  levels  of  complexity.  Indeed,  the  CMU  project  is  still  in  the 
planning stage, a fully-fledged BU does not exist yet and we do not have the hindsight to 
detect  the  effect  of  the  new  system  of  economic  governance.  Hence,  what  we  want  to 
measure is  in fact unobservable,  and is surrounded by uncertainty. Overall, this implies 
that some features of the channels can be investigated only in a qualitative fashion and 
that only a few of their properties can be translated into quantitative variables.  

Lastly, it is worth noting that while this contribution refers to both the EU and EMU, the 
literature  that  looks  into  ‘regional’  stabilisation  mechanisms  is  usually  concerned  with 
monetary unions. Indeed, the loss of national monetary policy implies that the economic 
rationale for common fiscal risk sharing mechanism will become stronger. Therefore, the 
analysis  will  focus  on  the  euro  area.  However,  it  must  be  noted  that  European 
governance  refers  more  broadly  to  the  EU  (with  some  specific  provisions  for  euro-area 
countries) while the Banking Union is mostly (but not only) important for countries that 
share  the  euro,  with  the  European  Central  Bank  (ECB)  playing  a  key  role.  Similarly, 
developments  in  the  Capital  Markets  Union  will  be  highly  intertwined  with  the  single 
market regulations, which have an EU basis.  

Against  this  background,  section  2  focuses  on  the  role  of  national  fiscal  policy  as  a 
countercyclical tool and discusses what one could expect from the new fiscal governance 
framework.  Section  3  moves  to  international  adjustment  channels  and  summarises  the 
role of labour mobility as shock absorber, based on the most recent literature. Section 4 

3 Available at: https://ec.europa.eu/priorities/sites/beta-political/files/5-presidents-report_en.pdf 

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attempts  to  shed  light  on  the  policy  debate  about  the  role  of  international  market 
mechanisms  by,  first,  looking  into  the  existing  literature,  and,  second,  by  proposing  a 
forward-looking analysis. In particular, we complement the discussion on the capital and 
credit  markets’  smoothing  capacity  with  an  empirical  exercise  seeking  to  ‘guesstimate’ 
the capacity of shock absorption of EMU in the medium term (by which time the Banking 
Union  should  be  well  in  place  and  some  progress  towards  a  CMU  should  have  been 
made).  Section  5  discusses  whether  market  and  fiscal  insurance  mechanisms  are 
alternative or complementary. The last section draws conclusions on the future capacity 
of the euro area to smooth the impact of shocks and the possible benefits, if any, of an 
EUBS.  

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2.  EU  ECONOMIC  GOVERNANCE  AND  FISCAL  POLICY:  WILL  FISCAL 

POLICY BE LESS PRO-CYCLICAL? 

2.1.  Fiscal policy over the cycle: some stylised facts 

The  value  added  of  creating  an  EUBS  directly  depends  on  the  income-stabilisation 
capacity  of  national  fiscal  policies4.  The  Stability  and  Growth  Pact  (SGP)  was  primarily 
designed  with  the  idea  that  (ex-ante)  fiscal  rules  would  be  able  to  reduce  the  risk  of 
negative  externalities  related  to  excessive  deficits  and  debt  accumulation,  and  would 
allow  to  build-up  sufficient  fiscal  buffers  in  order  to,  in  principle,  provide  fiscal 
stabilisation  ex-post  when  the  economy  faces  an  economic  slack  (the  3%  deficit). 
However, simple empirical evidence on the fiscal policy stance over the different phases 
of  the  business  indicate  that  the  fiscal  governance  framework  fell  short  in  terms  of 
counter-cyclical  policy  outcomes.  Figure  1  captures  the  behaviour  of  the  discretionary 
component  of  the  national  fiscal  policy  stances  (measured  as  changes  in  the  cyclically 
adjusted primary balance) over the cycle. It provides an account of the episodes of pro-
cyclical  and  counter-cyclical  fiscal  policy  stances5  of  the  member  states  over  three  sub-
periods (pre-EMU, up to the crisis and the crisis), distinguishing between the ‘good times’ 
(output  gap  >0)  and  ‘bad  times’  (output  gap  <0).  It  shows  that  there  is  a  pro-cyclical 
bias,  with  only  20  to  45%  of  episodes  of  counter-cyclicality,  across  the  three  periods 
under consideration6.  

Instead  of  counting  the  cases  of  pro-  and  counter-cyclicality  across  countries,  Figure  2 
considers the aggregate fiscal stance of the euro area and displays the changes (from the 
previous period) in the structural (cyclically adjusted) and in the discretionary component 
of  the  fiscal  balance.  It  thus  illustrates  the  overall  fiscal  impulse  and  provides  a  more 
encompassing picture of the stabilisation of fiscal policy over the cycle in the euro area.7 
It appears that, on aggregate, fiscal policy was generally less pro-cyclical during the pre-
crisis years than suggested by Figure 1. One explanation for this is that larger countries 
were  more  counter-cyclical.  By  contrast,  the  pro-cyclicality  of  the  discretionary 
component  is  strongly  visible  from  2011  onwards,  when  discretionary  policy  is 
contractionary  while  the  output  gap  is  still  negative  and  even  declining.  The  figure  also 
shows that such a trend was offset by the cyclical component.  

4 For a more detailed analysis, see Alcidi, Gros and Thirion (2016) 
5 Pro (counter) – cyclical policy stance is defined as a case where output gap is positive (negative) 
and changes in the primary cyclically adjusted balance are negative (positive). Note that while 
other authors use the changes  in  output  gap  rather  than levels,  we  prefer  to use levels since 
this better reflects the position in the cycle.  

6 Note that there is a substantial amount of heterogeneity. For instance, Germany has exhibited a 

relatively low degree of pro-cyclicality.  

7  Note  that  there  are  limits  to  the  stabilising  features  of  fiscal  policy  activism.  Blanchard  at  al. 
(2010) emphasise the importance of discretionary fiscal actions in mitigating the effects of a severe 
and protracted slump, but suggest that discretionary fiscal measures tend to come too late to fight 
a standard recession, leading only to limited counter-cyclicality during ‘normal times’. 

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Figure  1.  Episodes  of  pro-  and  counter-
cyclical  fiscal  policy  in  the  EMU  (1995-
2014) 

Figure  2.  Fiscal  stance  decomposition,  euro 
area 

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

all og>0 og<0 all og>0 og<0 all og>0 og<0

1995-1999

2000-2010

2010-2014

Episodes of pro cyclical fiscal policy

Episodes of counter cyclical fiscal policy

Source: Alcidi et al. (2016). 

3

2

1

0

-1

-2

-3

-4

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Cyclical component (automatic stabilizers)

Cyclically adjusted Primary Balance (discretionary
changes)
output gap

It  seems  then  that  fiscal  rules  have  not  worked  effectively  to  create  room  for 
countercyclical  fiscal  policy  at  national  level  so  that  it  could  act  as  an  income  stabiliser 
tool  in  response  to  asymmetric  shocks.  One  critical  shortcoming  of  the  SGP  stems from 
the asymmetry of its rules. This problem was compounded by the poor credibility of the 
no-bail  out  clause  that  resulted  in  weak  market  discipline  prior  to  the  sovereign  debt 
crisis.    According  to  De  Grauwe  (2013),  fiscal  rules  tended  to  create  a  deflationary  and 
recessionary bias in the eurozone, by becoming binding in times of recession. However, 
according  to  empirical  evidence  presented  in  Alcidi  et  al.  (2016),  the  picture  is  more 
nuanced:  risk  premia  and  high  public  debt  rather  than  fiscal  rules  appear  to  have 
affected  the  policy  stance  during  the  recession.  In  broad  terms,  the  level  of  debt,  rules 
and  risk  premia,  all  tend  to  exert  pressure  for  a  prudent  fiscal  stance,  but  fail  to  affect 
the  cyclicality  of  the  fiscal  policy  stance  in  a  systematic  way.  In  bad  times,  high  risk-
premia  induce  pro-cyclicality  while  fiscal  rules,  which  become  binding  because  of  the 
level of deficit, eliminate the counter-cyclicality observed when governments have fiscal 
space. In good times, fiscal rules seem to reduce pro-cyclicality but there is no evidence 
that  in  any  way  induce  counter-cyclical  behaviour.  Overall,  fiscal  policy  exhibits  pro-
cyclicality  but  it  is  difficult  to  identify  how  much  is  to  be  ascribed  to  fiscal  rules  or  to 
other factors, like lack of (or excessive) market discipline and high debt.   

2.2.  Fiscal policy to smooth the cycle: what to expect from the new fiscal 

governance framework 

The  crisis  unveiled  the  weaknesses  of  the  existing  framework  of  economic  and  fiscal 
governance and triggered a number of reforms.8 New rules were added to previous ones 
and  balanced  budget  rules  were  enshrined  into  national  law.  Coordination  and 
surveillance  were  reinforced,  going  beyond  fiscal  policy  with  the  Macroeconomic 
Imbalances Procedure (MIP). The MIP’s purpose is to prevent the emergence of excessive 
imbalances  by  imposing  prudent  behaviour  and  encouraging  the  correction  of  excessive 
imbalances  at  an  early  stage  before  they  lead  to  large  shocks  that  could  spill  over  into 

8 It should be noted that given the general discontent about current fiscal rules, both in term of the 
lack  of  enforcement  and  their  inability  to  prevent  imbalances,  the  debate  on  the  re-design  of 
rules is likely to continue. This implies that the system of fiscal governance may look different 
in the medium term.    

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other countries. New rules were also introduced for the coordination of national economic 
policies if a shock occurs.  

If  the  new  framework  were  to  function  effectively  and  member  states  were  not 
constrained in the use of automatic stabilisers, national fiscal policy could play a relevant 
stabilisation role and the value added of a common scheme at European level would be 
limited. Against this background, the rest of this section evaluates the potential benefits 
and limits that the new framework could bring about.  

The enshrinement of fiscal rules in national law (Fiscal Compact) constitutes, at least in 
theory,  an  important  step  towards  better  enforcement  and  a  contribution  to  reduce  the 
risk of future large shocks. However, most countries seem to have forgotten about their 
existence.  Moreover,  the  current  approach  of  the  Juncker  Commission,  which  tends  to 
grant a flexible interpretation of the Stability and Growth Pact9 under certain conditions, 
while  reasonable,  raises  questions  on  the  credibility  of  full  compliance  with  the  rules  in 
the future.  

The legacy of the crisis, in terms of high debt and weak economic conditions, means that 
we may experience a long transition before rules are be strictly enforced. It may be not a 
coincidence that the MIP was never used. 

In the context of EMU, another more subtle element that could complicate the ability of 
the system to implement the rules is the existence of possible trade-offs between fiscal 
targets and the goals of the MIP scoreboard in the short term. The latter greatly depends 
on the competitiveness profile of a country. Improving one country’s competitiveness or 
avoiding  the  emergence  of  bubbles,  the  build-up  of  debt  and  other  kinds  of  imbalances 
(thus  assigning  a  positive  probability  to  the  respect  of  MIP  indicators)  may  have  short-
term  costs  in  terms  of  lower  growth,  thus  making  fiscal  targets  more  difficult  to  meet. 
Such  a  trade-off  should  disappear  in  the  long  term,  but  it  could  continue  to  be 
consequential in the current context.  

One of the important novelties of the new framework of governance is that some of the 
key fiscal targets enshrined in national law are defined in structural or cyclically adjusted 
terms,  rather  than  in  nominal  terms.  In  theory,  structural  targets  have  the  advantage 
that they make it easier for national automatic stabilisers to work when needed, and to 
induce  member  states  to  build  fiscal  buffers  during  upturns.  Bova  et  al.  (2014)  find 
partial  evidence  that  some  features  of  ‘second-generation’  rules,  such  as  the  use  of 
cyclically-adjusted targets (like the new set of EU rules) and well-defined escape clauses, 
together with stronger legal and enforcement arrangements, may be associated with less 
pro-cyclicality.  However,  structural  indicators,  albeit  “smarter”  in  theory,  have  a 
fundamental  limit  in  that  structural  variables10  are  not  observable.  They  are  typically 
surrounded by a large degree of uncertainty and often subject to large revisions. On the 
one  hand,  this  makes  it  very  difficult  for  parliaments  to  design  domestic  budgetary 
policies to comply with targets that may turn out to be wrong few months later. On the 
other  hand,  because  the  potential  output  is  unobservable,  policy-makers  might  be 
tempted to interpret temporary revenue gains as permanent, leading to higher spending 
or tax cuts that further fuel booming aggregate demand. Indeed, the IMF (2015) argues 
that  while,  from  a  long-term  perspective,  symmetry  in  fiscal  responses  between  good 
and bad times is important, in reality it does not occur. Uncertainty around the potential 

9 See the European Commission’s Communication, “Making the best use of the flexibility within the 
January  2015 

the  Stability  and  Growth  Pact”,  Brussels,  13 

existing 
(http://ec.europa.eu/economy_finance/economic_governance/sgp/pdf/2015-01-
13_communication_sgp_flexibility_guidelines_en.pdf).  

rules  of 

10 See Alcidi and Gros (2014). 

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output,  combined  with  the  fact  that  a  rapidly  growing  pool  of  revenues  complicates 
efforts to keep a tight lid on total expenditure, tends to result in a pro-cyclical bent. 

For  the  reasons  laid  out  above,  it  seems  unrealistic  to  assume  that  the  new  fiscal 
framework will be sufficient to address the tendency towards pro-cyclical behaviour, and 
we  cannot  rule  out  the  possibility  that  member  states  will  be  forced  to  cut-off  fiscal 
stabilisers when faced with large asymmetric shocks. As a result, it is unlikely that fiscal 
policy will act as a strong stabilisation mechanism.  

2.2.1 The ‘soft’ aspect of governance: Learning by doing 

While  the  current  rules-based  governance  system  has  proven  little  success,  the  soft 
aspects of the new economic governance should not be underestimated. It can be argued 
that one of the essential functions of the European Semester is to create a ‘learning-by-
doing loop’, where national policy-makers commit to achieving certain targets and learn 
to  think,  develop  and  implement  their  economic  policies  in  a  coordinated  fashion. 
Thinking  about  national  economic  policies  as  a  part  of  a  wider  process  will  become  a 
standardised,  natural  part  of  domestic  policy-making.  The  creation  of  a  system  of 
financial  incentives  for  coordination  and  structural  reforms  could  accelerate  such 
learning.  In  line  with  this  way  of  thinking,  one  could  assume  that  the  probability  of 
fulfilling  fiscal  and  economic  commitments  increases  over  time  as  the  effect  of  the 
learning  process  of  coordination.  As  it  becomes  more  and  more  natural  to  think  of  one 
country’s  economic  and  fiscal  policy  as  a  part  of  a  larger  coordination  exercise,  the 
probability of respecting the fiscal and economic targets tends to increase. 

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3.  LABOUR MOBILITY AS STABILISATION MECHANISM  

As  mentioned  in  the  introduction,  labour  mobility  is  one  channel  for  smoothing  the 
impact  of  shocks.    According  to  OCA  theory  (Mundell,  1961),  the  mobility  of  workers 
constitutes  an  important  stabilising  mechanism  in  a  monetary  union.  An  increase  in 
unemployment in one member state (or a fall in wages) should induce workers to move 
to  other  countries;  while  a  shortage  of  labour  supply  (or  higher  wages)  should  attract 
foreign  workers.  In  principle,  these  flows  reduce  the  cost  of  regaining  full  employment 
through  a  painful  and  long  process  of  wage  adjustment  and  a  long  period  of 
unemployment.11 However, the empirical literature is far from conclusive as regards the 
effect of labour mobility in Europe.  

As argued in Barslund and Busse (2014), labour mobility has responded very little to the 
crisis that started in 2010, taking into account its depth and temporal extent, and with a 
long  time-lag,  suggesting  that  this  is  only  a  rather  marginal  tool  for  achieving  the 
objective of income stabilisation. Yet, recent research on the role of regional mobility as a 
tool  for  equilibrating  labour  markets  in  the  context  of  monetary  unions,  in  particular 
comparing the US and the euro area, has emphasised that the role of mobility as a shock 
absorber  somewhat  increased  during  the  crisis  and  became  more  responsive  to 
unemployment  differentials.  According  to  Beyer  and  Smets  (2015),  both  in  Europe  and 
the  US,  labour  mobility  accounts  for  about  50%  of  the  long-run  adjustment  to  region-
specific labour demand shocks, but the adjustment takes much longer in Europe. Jauer et 
al.  (2014)  find  that  in  contrast  to  the  pre-crisis  situation  and  the  findings  of  previous 
empirical studies, the mobility response to the crisis has been considerable in Europe, as 
opposed to in the United States, where the crisis and subsequent sluggish recovery were 
not accompanied by greater interregional labour mobility. Their estimates suggest that, if 
all  measured  population  changes  in  Europe  were  due  to  migration  for  employment 
purposes,  up  to  about  a  quarter  of  the  asymmetric  labour  market  shock  would  be 
absorbed  by  migration  within  a  year.  In  the  eurozone,  however,  the  reaction  mainly 
stems  from  migration  of  third-country  nationals.  Even  within  the  group  of  eurozone 
nationals,  a  significant  part  of  the  free  mobility  stems  from  immigrants  from  third 
countries who have taken on the nationality of their eurozone host country. 

Arpaia et al. (2014) find that euro-area membership (as opposed to EU membership) did 
not  significantly  increase  mobility,  but  it  is  associated  with  a  stronger  reaction  to 
unemployment differentials. In quantitative terms, they find that mobility absorbs about 
a quarter of a 1% shock to labour demand and this rises to 60% after 10 years. This is 
lower and slower than in the US.  

In  the  context  of  the  analysis  of  the  different  mechanisms  for  smoothing  the  impact  of 
asymmetric shocks (which are usually measured relative to a shock on GDP) it would be 
interesting  to  compare  the  role  of  labour  mobility  relative  to  the  capacity  of  other 
channels.  This  implies  understanding  the  relationship  between  changes  in  GDP  and 
labour  demand,  which  is  broadly  measured  using  ‘Okun’s  law’.  Such  a  relationship  is 
difficult  to  estimate  and  may  vary  dramatically  across  countries.  Yet,  Anderson  et  al. 
(2014)  estimate  the  euro  area’s  aggregate  Okun  coefficient  and  find  a  value  of  -0.31, 
which suggests that a 1% fall in GDP growth is associated with a contemporaneous 0.31 
percentage  point  increase  in  the  unemployment  rate.  Under  this  assumption,  the 
estimates of Arpaia et al. (2014) and Jauer et al. (2014) suggest that about one-fourth of 
labour demand shock is absorbed by mobility, which would mean that labour mobility in 
the euro area absorbs around 0.08% (1/4 of 0.031) of a 1% shock to GDP. This suggests 

11  The  ECB's  President  argued:  “Certainly,  greater  cross-country  mobility  would  be  welcome,  and 
we should encourage measures that facilitate it. But research suggests that it is unlikely that cross-
country  migration  flows  will  ever  become  a  key  driver  of  labour  market  adjustment  after  large 
shocks. And no country will thrive anyway if its population deserts it.” (Draghi, 2014) 

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that  the  role  of  mobility  is  limited  but,  as  will  be  shown  later,  the  magnitude  of  its 
importance may be comparable to that of other channels.12 

12 It should be noted that this is a matter where data availability is still a real issue. The mobility 
levels  of  EU,  EA  and  third-country  nationals  are  difficult  to  distinguish  and  to  capture.  In 
several  studies,  regional  mobility  also  includes  mobility  within  countries,  which  may  not  be 
relevant to an EUBS. 

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4.  INTEGRATION OF CREDIT AND CAPITAL MARKETS  

In  a  monetary  union,  cross-country  risk  sharing  and  consumption  smoothing  are 
particularly  relevant  because  monetary  policy  can  no  longer  respond  to  country-specific 
shocks,  and  the  exchange  rate  is  no  longer  floating.  The  empirical  literature  addressing 
the measurement of the channels that smooth the effect of shocks across countries in the 
face  of  asymmetric  shocks  has  distinguished  between  the  private  market  channels 
(international  credit  and  capital  markets)  and  government  (tax  and  transfers  from  the 
centre).  Under  the  assumption  that  markets  are  complete,  capital  markets  provide  full 
insurance  against  asymmetric  shocks,  and  is  no  justification  for  interregional  fiscal 
transfers  (Eichengreen,  1991).  This  is  why  it  is  important  to  gauge  how  far  financial 
integration can go in terms of risk-sharing benefits. 

The  debate  on  how  to  make  the  E(M)U  sustainable  in  the  long  run  is  often  divided 
between those who believe that the market should be the main shock absorber, and the 
camp  that  argues  that  fiscal  risk  sharing  arrangements  are  warranted  regardless.  In 
practice, the (political and) economic case for an EUBS also crucially depends on how this 
question is settled.  

Given  recent  efforts  to  foster  financial  market  integration,  an  analysis  should  not  only 
look at the past, but also include an assessment of the degree of market risk sharing that 
can be achieved in the future. This implies asking what role the BU and the CMU can play 
to  endow  the  Union  with  a  capacity  to  insure  itself  against  asymmetric  shocks,  and  to 
reduce  their  occurrence.  Working  from  this  perspective,  this  section  will  first  provide  a 
review of the empirical literature on the channels of international risk sharing in existing 
federations and in Europe, paying particular attention to the role of financial integration. 
We then proceed to a forward-looking discussion on the effects that the BU and potential 
CMU  could  play  in  reducing  the  probability  of  shocks,  and  in  improving  private  risk 
sharing. Finally, we carry out an empirical exercise that consists in comparing the level of 
risk sharing achieved by the core countries, which remained financially integrated during 
the  crisis,  as  opposed  the  non-core.  To  the  extent  that  the  BU  and  potential  CMU  will 
make core  and  non-core  countries  more  closely  integrated,  this exercise  should  provide 
us with a ‘guesstimation’ of the future euro area risk-sharing capacity.  

4.1.  The role of markets and government in smoothing consumption and 

income: a literature review 

The political and academic debate about which channels should be used to smooth the 
impact of shocks often fails to distinguish risk sharing and consumption smoothing and 
generally refers to ‘international risk sharing’. However, the distinction between the two 
concepts  is  crucial.  Risk  sharing  is  a  concept  that  relates  to  the  idea  of  risk 
diversification  and  is  linked  to  the  existence  of  different  ‘states  of  nature’,  some  good 
and  others  bad,  that  could  materialise  and  the  fact  that  people  want  to  protect 
themselves  against  the  risk  that  bad  states  adversely  affect  their  well-being.  In  broad 
terms, (market) risk sharing requires access to international capital markets and occurs 
either  through  having  a  diversified  portfolio  of  international  assets  or  an  explicit 
insurance  policy,  hence  it  is  based  on  ex-ante  arrangements  that  kick  in  automatically 
to  smooth  domestic  income  in  the  event  of  a  shock.  Consumption  smoothing  posits  a 
consumption  choice  on  different  dates,  it  is  an  inter-temporal  concept  according  to 
which individuals (or countries) can maintain a steady level of consumption over time in 
the  face  of  temporary  shocks  that  may  result  in  fluctuations  in  income,  which  in  turn 
can  translate  into  fluctuations  in  consumption.  The  buffering  of  consumption  against 
income  shocks  usually  occurs  through  savings  and  borrowings  in  international  credit 
markets whereas consumption smoothing is a form of intertemporal risk sharing, albeit 
cross-country,  and  it  occurs  ex-post.  Asdrubali  et  al.  (1996)  provide  an  integrated 
framework  to  quantify  relative  inter-state  risk  sharing  for  various  channels  for 
smoothing shocks. The key channels identified are measured as follows: 

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  International  capital  markets  (private  risk  sharing  via  cross-ownership  of 
assets  or  income  smoothing).  This  channel  relates  to  international  portfolio 
diversification.  The  effect  of  a  drop  in  output  in  a  country  on  its  residents’  income 
directly  depends  on  how  much  of  the  country’s  productive  assets  (in  particular 
capital) are owned by residents of other regions and how much of foreign productive 
assets  are  held  by  nationals.  For  instance,  if  financial  intermediaries  lend  to  foreign 
borrowers,  the  flow  of  interest  payments  from  abroad  provides  a  cushion  in  the 
lending country.  

  International  credit  markets  (or  consumption  smoothing  or  ‘inter-temporal’ 
risk-sharing). Saving and borrowing allow the smoothing of consumption over time 
through the business cycle, as households and firms, as well as national governments 
can accumulate assets, save or borrow using the credit market (mostly banks). This 
is an ex-post mechanism 

  Government  redistribution  (fiscal  risk  sharing).  Federal  tax,  transfers  and 
grants are used in federations to absorb the negative effects of asymmetric shocks 

This  classification  is  the  usual  starting  point  for  measuring  the  role  of  the  different 
channels. 

4.1.1 The EMU vs. fully-fledged federations  

The early empirical literature on risk sharing started in the 1990s and mainly focused on 
inter-state risk sharing between the US States. Research has focused on the risk sharing 
provided  through  federal  fiscal  transfers.  For  instance,  Sachs  and  Sala-i-Martin  (1991) 
consider  nine  US  States  for  the  period  1970-1980  and  find  that  net  transfers  (risk 
sharing  and  distribution)  made  by  the  federal  government  absorbed  one-third  and  one-
half  of  the  shock.  This  approach  was  refined  by  Bayoumi  and  Masson  (1995)  who 
disentangle  the  risk  sharing  component  of  federal  taxes  and  transfers  from  their 
permanent redistribution effects. They find that in the US, the risk-sharing effect of net 
transfers amounts to around 30%. In Canada, risk sharing through net federal transfers 
is smaller (17%). More recently, Poghosyan et al. (2014) focus on the role of net fiscal 
transfers only in Australia, Canada and the US. Their main finding is that fiscal transfers 
at the central level have little effect in terms of risk sharing. In particular, the impact of 
net fiscal transfers on risk sharing as a response to asymmetric shocks ranges between 
4% and 11%, while a larger impact (between 13% and 24%) is found for inter-temporal 
stabilisation, i.e. in response to common shocks and a simultaneous fall in output across 
regions.  

In their path-breaking paper, Asdrubali et al. (1996) find that 62% of a shock to a state’s 
GDP is cushioned through the combined role of capital markets (39%) and international 
credit  markets  (23%),  while  federal  tax  and  transfers  account  for  a  further  13%  (and 
25% remains unsmotthed). Athanasoulis and van Wincoop (2001) find that around 70% 
of the shocks in the United States are smoothed through private and public risk-sharing 
mechanisms. Again, financial markets play the biggest role, allowing around 60% of the 
total smoothing, while federal fiscal policy covers the other 10%. For Germany, Hepp and 
von  Hagen  (2013)  find,  in  the  pre-unification  period,  that  the  federal  tax  transfer 
provided  most  of  the  smoothing  and  grant  system  (55%),  while  for  the  post-unification 
period,  international  factor  income  flows  have  become  the  most  important  channel, 
contributing about 51% of total income smoothing.  

European  Monetary  Union  triggered  new  interest  in  international  risk  sharing.  Clearly, 
Europe was, and to some extent still is, fundamentally different from these federal states 
since it lacks a central government with a federal budget, and exhibits a weaker quality 
and  degree  of  financial  integration.  Sorensen  and  Yosha  (1998)  find  that  only  40%  of 
asymmetric  shocks  to  output  is  smoothed  among  OECD  countries,  with  50%  of  the 
smoothing occurring via government saving and 50% via private saving. The role of the 

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international  capital  market  is  found  to  be  non-existent  prior  to  1999.  A  more  recent 
study by Furceri and Zdzienicka (2013) considers a panel of euro-area countries over the 
period  1979-2010  and  finds  that  the  euro  area  stills  lacks  the  degree  of  risk  sharing 
observed in existing federations. According to their estimates, the share of unsmoothed 
cross-country  shocks  in  the  euro  area  (EA)  is  about  60%,  much  higher  than  in  other 
federations like US, Canada or Germany where according to past studies (see Asdrubali 
et al. 1996; and Hepp and Van von Hagen, 2013) it amounts to about 20%.  

4.1.2 Financial integration and risk sharing in the EMU 

In  the  context  of  a  discussion  on  the  new  EMU  governance  architecture,  it  is  crucial  to 
look  more  closely  at  the  role  that  financial  integration  has  played  and  can  play  in  the 
future in fostering market risk-sharing (i.e. via capital and credit markets). Indeed, from 
theoretical point of view (see Mundell, 1973), financial integration can provide important 
benefits, as it creates opportunities for adapting to shocks by increasing risk sharing and 
consumption smoothing.  

However,  when  looking  at  the  experience  of  the  euro  area,  empirical  accounts  call  for 
some  more  nuance  in  drawing  conclusions.  Kalemli-Ozcan  et  al.  (2010)  show  that  the 
channels for risk sharing evolved after the creation of EMU. In particular, they find that 
risk sharing through factor income flows and capital gains was close to zero prior to the 
introduction of euro in 1999, but it has then increased to 6% for each channels. Kalemli-
Ozcan  et  al.  (2008)  and  Demyank  et  al.  (2007)  find  that  increased  holdings  of  foreign 
assets and banking integration in the EMU have spurred risk sharing, ‘improving ex-post 
the optimality of the EMU’. However, capital markets remain largely untapped in Europe, 
if  one  considers  that  in  the  US  inter-state  risk  sharing  through  factor  income  reaches 
40%.  Moreover,  Kalemli-Ozcan  et  al.  (2013)  find  that  during  the  crisis,  international 
factor income did not provide any risk sharing; on the contrary, it may have acted as a 
shock  amplifier.  As  Allard  et  al.  (2014)  point  it  out,  the  general  explanation  for  the 
subdued international risk sharing in the euro area is that the cross-border ownership of 
assets  remains  very  limited  within  the  union,  which  reduces  the  capital  markets’ 
insurance. Moreover, Demyank et al. (2007) stress that asset holdings outside the EMU 
tend  to  have  the  largest  risk-sharing  properties,  as  their  return  is  more  likely  to  be 
uncorrelated with the euro area cycle. The latter observation has important implications 
when  it  comes  to  assessing  the  future  impact  of  a  capital  markets  union  and  more 
generally  of  further  integration:  convergence  in  business  cycles  and  correlation  in  asset 
returns could also potentially reduce the scope for risk sharing. 

Furceri and Zdzienicka (2013) find that the bulk of risk sharing continued to come mainly 
from the credit channel, through borrowing and savings, since the EMU’s creation. Yet, it 
is unclear whether the higher degree of integration in the interbank market has produced 
positive  effects  in  terms  of  shock  absorption  capacity.  Estimates  by  Demyank  et  al. 
(2007) point to a decrease in the overall international credit smoothing in the five years 
following the EMU, compared to the five previous years. While there appears to be some 
variability in the estimated role of the credit channel, the overall trend seems to point to 
a small decline over 1999-2007. As for the role of public versus private saving, the main 
finding is that public saving consumption smoothing remained fairly steady after the EMU 
introduction,  while  private  credit’  role  has  tended  to  decline.  According  to  Furceri  and 
Zdzienicka  (2013),  the  reduction  of  private  credit  as  a  smoothing  factor  after  the 
introduction  of  the  euro  reflects  the  fact  that  credit  flows  have  become  less  counter-
cyclical, even though amounts have increased.  

One  crucial  characteristic  of  the  credit  channel  is  that  it  tends  to  be  ineffective  during 
crises. Hoffman and Nitschka (2012) argue that the effectiveness of risk sharing channels 
during prolonged crises tends to differ from periods of normal business-cycle fluctuations. 
Furceri  and  Zdzienicka  (2013)  examine  how  different  types  of  crises  affect  risk  sharing 
over the period 1980-2010 and find that risk-sharing via the international credit markets 

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tends  to  be  lowest  when  it  is  most  needed  because  (interbank)  credit  markets  have  a 
high  propensity  to  freeze  up  during  crises.  Overall,  this  feature  of  the  credit  channel 
suggests  that  large  shocks  can  strongly  impair  consumption  smoothing  by  constraining 
private  and  public  sector’s  capacity  to  borrow.  Kalemli-Ozcan  et  al.  (2014)  find  that 
international  consumption  smoothing  has  remained  stable  during  the  global  financial 
crisis  in 2008-2009 as the stimulus produced by governments, compensated for the fall 
in  that  from  private  channels.  By  contrast,  the  eruption  of  the  sovereign  debt  crisis  in 
2010 led to a collapse of the role of governments in responding to shocks. In particular, 
countries  that  had  run  prolonged  expansionary  policies  in  the  booming  years,  or  had 
experienced bubbles, were forced to save when the crisis erupted.  

Overall,  the  literature  seems  to  suggest  that,  in  Europe,  the  capacity  to  respond  to 
shocks  remains  weak,  as  compared  to  federations,  and  it  is  vulnerable  during  crises. 
Although  there  is  no  doubt  that  the  EMU  boosted  financial  integration,  little  private  risk 
sharing  has  taken  place.  Indeed,  large  parts  of  country-specific  shocks  remain 
unsmoothed,  as  the  role  of  the  market  is  relatively  small  and  mainly  driven  by  credit 
markets, rather than by capital markets, whose functioning tends to be more stable over 
the  cycle.  This  implies  that  while  the  system  is  endowed  with  a  certain  capacity  to 
smooth  consumption,  it  seems  unable  to  ensure  sufficient  risk  sharing  during  period  of 
important  stress.  A  possible  explanation  for  it  is  that  financial  debt  instruments, 
particularly  the  wholesale  funding  of  banks,  rather  than  cross-country  ownership  of 
equity,  dominated financial  integration  in  Europe.  This has  important  implications,  since 
capital markets are less subject to reversal (See Box 1) and can absorb loss associated 
with permanent shocks, whereas intertemporal consumption smoothing can only address 
temporary shocks (Bolton et al., 2013 and Valiante, 2016). 

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Box 1. Financial market (dis)integration during the crisis: equity and debt 

taken  during 

Figure  3.  Price-  and  quantity-based  SYNFINT*  in 
the euro area 

Between  the  creation  of  the  EMU  and  the  beginning  of  the  financial  crisis,  financial 
integration,  broadly  defined  as  increasing  cross-border  claims  and  falling  dispersion 
across market prices, grew to three times its original level at the end of 1998, both in 
terms  of  price-convergence  and  even  more  in  relative  terms  for  quantity  indicators 
(see  Figure  3).  Nonetheless, 
the  hit 
the 
financial crisis of 2008-09 took 
a  heavy  toll  on  the  financial 
integration  process,  reversing 
the degree of integration (both 
in 
the 
the  core  and  at 
Price-based 
periphery). 
indicators  dropped  across  the 
board 
great 
divergence  of  prices  and 
yields,  and  volumes  were 
affected with  the  deepening  of 
the  sovereign  debt  crisis  and 
the  subsequent  segmentation 
interbank  market 
in 
starting  in  2011.  Indicators  of 
financial 
have 
started to recover since, both in terms of quantities and prices. 

* SYNFIT is a synthetic indicator developed by the ECB. Source: ECB.  

integration 

due 

the 

to 

a 

After 2009, the cross-country dispersion of both the cost of borrowing for non-financial 
corporations  and  of  interest  rates  on  deposits  increased  substantially  and  has  only 
narrowed  down  in  recent  times.  In  particular,  the  gap  between  the  average  financing 
cost  in  the  core  and  non-core  countries  dramatically  increased  over  the  2008-09 
period, and has only started to narrow since 2015. Beyond the divergence between the 
core  and  non-core  countries  in  terms  of  development  of  their  banks  and  funding 
structures, indicators of integration in the debt securities market also point to financial 
fragmentation.  Similarly,  the  dispersion  of  sovereign  bond  yields  sharply  increased  at 
the  height  of  the  EMU  crisis,  with  severe  consequences,  as  we  know.  Following  the 
introduction of the OMT, the dispersion came back to levels close to what was observed 
prior to the sovereign debt crisis, but holdings are much lower. 

Figure 4 shows that cross-border holdings of debt securities by monetary and financial 
institutions (MFIs) fell drastically during the crisis in the euro area. This was one of the 
main  manifestations  of  the  financial  fragmentation  that  exacerbated  the  economic 
crisis in peripheral euro-area countries, showing that larger cross-border financial flows 
and large stocks of debt can create instability (Mink and de Haan, 2014). Indeed, euro 
area  member  countries’  financial  systems  are  heavily  bank-centred,  while  stock  and 
bond markets provide a relatively modest share of the financing to the private sector. 
In fact, total bank assets account for 283% of GDP in the EU, compared to about 65% 
of GDP in the US (Fuceri and Zdzienicka, 2013). 

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

Figure 4. Share of MFI cross-border holdings of debt 
securities  issued  by  EU  corporates  and  sovereigns, 
(%)
2005-14) 

Source: Valiante (2016), based on ECB data 

Figure 5 shows that cross-border holdings of equity as a share of total equity holdings 
did not fall. Holdings of equity across the euro area have doubled since the introduction 
of  the  euro,  both  in  distressed  and  non-distressed  countries  and,  importantly,  it  has 
exhibited  strong  resilience  to  the  financial  and  sovereign  crises.  Nonetheless,  as 
already  pointed  out  total  equity  holdings  are  still  limited  compared  to  other  financial 
instruments,  especially  debt  securities.  For  euro  area  MFIs,  cross-border  holdings  of 
equity  amount  to  about  25%  of  cross-border  debt  security  holdings  (based  on  ECB 
data). 

Figure  5.  Cross-border  holdings  of  equity  issued  by 
euro-area residents (% of total holdings) 

Note: Non-distressed countries are Germany, the 
Netherlands, France, Austria and Finland. Distressed 
countries are Italy, Spain, Portugal, Greece and Ireland.  
Source: Valiante (2016), based on ECB data. 

4.2.  What to expect from Banking Union and Capital Markets Union 

As previously discussed, the political and economic case for an EUBS crucially depends on 
the degree of market risk sharing that can be achieved in the future. A relevant question 
is thus to ask what role the BU and the potential CMU can play to endow the Union with a 

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

capacity to absorb asymmetric shocks. Against this backdrop, this section discusses the 
expected effects of the BU and CMU. We break down the analysis of the effect of the BU 
into  an  ex-ante  perspective  (risk  reduction)  and  an  ex-post  perspective  (absorbing  the 
impact  of  shocks).13  We  then  proceed  to  a  hypothetical  discussion  of  what  would  have 
happened in Spain and Ireland had a banking union been in place at the time. Finally, we 
discuss the potential impact that a CMU could have on risk sharing. 

4.2.1 Banking Union: An ex-ante perspective 

The  remarkable  steps  achieved  towards  the  creation  of  a  European  Banking  Union  are 
arguably the most significant economic policy change since the introduction of the euro. 
The  Single  Supervisory  Mechanism  (SSM),  which  is  the  first  pillar  of  the  BU,  started  its 
supervisory  role  in  2014.  It  is  expected  improve  the  detection  of  financial  risks,  reduce 
the  propagation  of  shocks  and  to  some  extent  boost  financial  integration.  A  more-
encompassing  monitoring  could  thus  reduce the  frequency  of  large  financial  shocks  and 
could  affect  their  nature  (transitory  versus  permanent)  and  transmission  to  the  real 
economy.  

The BU’s functions that relate to the centralisation of monitoring and assessment of risk 
in  the  banking  sector  are  supposed  to  be  an  important  tool  for  risk  reduction.  By 
providing centralised supervision of the banking sector, the SSM should offer a European-
wide  view  of  emerging  risks  in  the  banking  sector.  By  the  same  token,  it  should  help 
overcome problems of coordination among national supervisors, which contributed to the 
financial  fragmentation  at  the  peak  of  the  crisis  in  the  euro  area.  As  an  independent 
supervisor,  the  ECB  is  better  positioned  to  pursue  long-term  stability  objectives,  in 
contrast  to  more  political  short-term  goals,  which  have  affected  the  behaviour  of  some 
national supervisory authorities in the past.  

Whereas there are clear potential benefits to adopting a common supervisory framework, 
it must also be highlighted that not all European banks fall under the new framework of 
supervision and the BU may not imply a big change for them, at least in terms of early 
detection  of  risks.  In  particular,  small  banks  remain  under  the  national  supervisor 
authority.  They  will  have  to  follow  guidelines  imposed  by  Frankfurt  if  the  national 
regulator  does  not  abide  by  the  single  regulatory  framework,  but  will  not  be  subject  to 
the  direct  supervision  of  the  SSM.  Despite  their  individual  size,  small  banks,  which 
account  for  about  15%  of  EMU  banking  assets  (ECB,  2013),  can  pose  a  systemic  risk. 
The experience of Spain proved that this is not trivial  -  small banks can lead to a large 
crisis.  

Looking  ahead,  the  risks  associated  with  small  banks,  which  may  look  rather  irrelevant 
when considered in isolation, could be more an issue in Germany than in Spain. Indeed, 
in  Spain  many  small  banks  disappeared  as  a  consequence  of  acquisitions  and  mergers 
(e.g.  Bankia)  and  now  fall  under  the  SSM.  By  contrast,  in  Germany,  there  are  large 
networks  of  very  small  banks,  which  would  escape  any  changes  introduced  by  the 
Banking Union, and in an adverse scenario, their tight linkages could lead to a large risk. 
In  principle,  one  of  the  tasks  of  the  European  Systemic  Risk  Board  (ESRB)  is  to  detect 
such risks.  

Besides  the  reduction  of  risk,  the  BU  is  also  likely  to  affect  equity  market  dynamics  by 
favouring cross-border banking integration, even though this is likely to be limited in the 
initial phase. Many banks in Europe that have a cross-border dimension (i.e. they operate 
in  more  than  one  member  state)  have  often  encountered  difficulties  because  of  the 

13 Longer-term effects of further financial integration, like the possible impact of very high capital 
market integration on the bargaining power of labour, go beyond the scope of this analysis and 
are not addressed. 

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

different behaviours of the different national supervisory authorities. National supervisors 
have had  a natural  tendency  to  protect  the national  champions,  limiting  de  facto cross-
border mergers and  acquisitions  and  the  formation  of  multinational  banks,  despite their 
commitment to the EU single market. Since prudential supervision has been transferred 
to the ECB, these barriers no longer exist. The SSM will guarantee the uniformity in the 
application  of  the  supervision  rules  and  cross-border  banks  will  have  a  single  point  of 
contact.  Cross-border  equity  investments  in  the  banking  sector  are  hence  expected  to 
become  more  frequent.  This  could  work  as  a  stabilising  factor  during  a  crisis,  as  the 
experience of the Baltic countries has shown.14  

Similarly,  if  the  BU  is  successful  at  limiting  the  intervention  of  governments  in  the 
countries  where  the  banks  are  based  and  at  reducing  the  costs  of  bank  resolution  then 
investors  should  be  better  able  to  compare  banks  on  their  own  merits  rather  than 
according to the judgement of their home country.  

4.2.2 Banking Union: An ex-post perspective 

From  an  ex-post  perspective,  i.e.  relating  to  the  absorption  of  (financial)  shocks,  the 
second  pillar  of  the  BU  –  namely  the  Single  Resolution  Mechanism  (SRM),  with  a 
centralised  resolution  approach  and  common  financial  resources  (the  Single  Resolution 
Fund, or SRF) – is of critical importance.  

The crisis revealed the difficulty of operating efficiently without common monitoring and 
resolution procedures in an increasingly integrated banking sector. As argued by Buch et 
al.  (2015)  a  bank-based  financial  system  within  a  monetary  union  may  lead  to  limited 
effective  private  risk  sharing  across  countries,  because  national  supervisors  and  policy-
makers  have  an  incentive  to  protect  their  banking  system.  In  particular,  they  tend  to 
present  banking  issues  as  being  of  a  liquidity  nature,  which  often  implicitly  results  in 
shifting  the  responsibility  for  managing  the  risks  to  the  central  bank  via  its  refinancing 
operations.  

In this respect, the common supervision and resolution framework provided by the SSM 
and SRM, should help significantly to reduce the risk of collective action failures observed 
during the crisis (Veron, 2014) and should lead to more private risk sharing as the new 
framework  involves  a  bail-in  prior  to  considering  any  form  of  bail-out.  Ideally,  the 
common  resources  should  then  allow  cutting  the  doom-loop  between  banks  and  their 
sovereigns as resolution is moved to a central level.15 

In cases where severe problem emerge, risk sharing should occur through bail-in, which 
would  distribute  losses  among  all  creditors  and  not  only  among  capital  holders.  This 
should  increase  the  loss-absorption  capacity  of  banks  without  recourse  to  common 
money.16 In fact, in the current system, the bail-in of creditors is a necessary condition 
for the intervention of the SRF. If creditors are geographically diversified, bail-in is a tool 
for  sharing  losses  across  borders.  This  also  implies  that,  since  depositors  (especially 

14 See Gros and Alcidi (2015).  
15 The strong interdependence that exists between banks and their sovereign states led to the so-
called  doom  loop  between  sovereigns  and  their  banks.  This  is  the  result  of  the  fact  that 
European  banks  remain  heavily  exposed  to  their  sovereign  due  to  home  bias  in  terms  of 
domestic  bond  holdings,  and  of  guarantees  –  even  of  an  implicit  nature  –  of  national 
governments in favour of domestic banks. This created a strong link between the dynamics of 
sovereign states’ bonds and the cost of funding for banks in capital markets (see IMF, 2012).  
16 In the new framework, before the SRF is used, shareholders and creditors must bear losses of at 
least 8% of liabilities (based on historical losses). Then the SRF can contribute up to 5% of the 
bank  liabilities.  Under  such  a  system,  the  bail-in  of  creditors  is  most  likely  and  larger  when 
banks  have  low  capital  relative  to  total  liabilities.  It  also  implies  that  some  banks  may  be 
excluded from the SRF recapitalisation because they do not meet the requirements for bail-in.  

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

small savers) tend to be domestic, it is essential to safeguard their interests in order to 
limit the negative impact of the bail-in on the domestic economy. Indeed, if creditors that 
are  to  participate  in  the  bail-in  are  preponderantly  residents,  local  households  or  other 
local  financial  intermediaries,  the  bail-in  can  severely  harm  the  domestic  economy  and 
aggravate  the  crisis,  leading  to  contagion  throughout  the  domestic  economy.  In  this 
case, while public finances are not directly affected, indirect negative effects (erosion of 
pensions and other savings) may hit the economy, which, in turn, can result in adverse 
fiscal effects. Under these conditions, the BU cannot help much in terms of loss sharing.  

In  this  respect,  the  specific  design  of  the  bail-in  clauses  will  matter  in  a  crucial  way  in 
defining  how  much  risk  sharing  they  can  contribute  to.17  Some  uncertainty  is  likely  to 
remain, if for instance, bail-in implies some conversion of debt into capital. In that case, 
it is impossible to establish ex-ante how much risk and losses are shared.  

Despite  the  remarkable  steps  already  taken,  the  BU  is  still  incomplete:  it  lacks  a  fiscal 
backstop for the Single Resolution Fund (SRF) and a common deposit insurance scheme. 
The delay in the process and the limited size of the SRF (€55 billion18) reflect, on the one 
hand, the reluctance of EMU leaders to pool fiscal resources and, on the other hand, the 
challenges faced by to recovering from the crisis.  

Gros and Belke (2014) note that the SRF is sufficient to deal with individual bank failures 
or  even  a  domestic  systemic  crisis  in  small  to  medium-sized  countries.  De  Groen  and 
Gros (2015) show that, during the period 2007-14, in the euro area, 72 banks received 
capital  support  in  the  form  of  state  aids.  The  banks  aided  (representing  approximately 
45%  of  the  total  euro-area  bank  assets)  experienced  total  losses  of  more  than  €300 
billion.  Of  those  72  banks,  more  than  30  might  have  received  support  under  the  new 
mechanism (the SRF and the bank recovery and resolution Directive, BRRD), had it been 
in place.19 

By contrast, Schoenmaker (2014) emphasises that without a common fiscal backstop to 
the  SRF,  the  transmission  from  bank  to  sovereign  will  not  be  cut  in  the  case  of  large 
crisis. In other words, the banking union, in its current state, would not be able to handle 
a systemic crisis.  Indeed,  losses  of  failing  banks can  be very  large  and  both  bail-in  and 
the  SRF  interventions may  turn  out to  be insufficient20 to  cover all losses21 and prevent 
the  burden  to  fall  on  possibly  weakened  sovereigns.  In  this  respect,  a  common  deposit 
guarantee  scheme  or  a  reinsurance  scheme  for  national  deposit  insurance  schemes 
(Gros, 2013) could be of crucial  importance for the stability of the financial system and 
its  resilience  to  systemic  events  22(see  Gros,  2015).  In  the  absence  of  this  element,  it 

17  A  bail-in  of  creditors  is  a  mechanism  either  to  cancel/reduce  liabilities  of  failing  banks  or  to 
restore  a  bank’s  capital  position  by  converting  its  debt  into  equity;  this  can  follow  different 
modalities. 

18  From  2016  onwards,  the  SRF  will  collect  the  funds  for  the  recapitalisation  of  euro-area  banks. 
The  fund  has  a  target  level  of  1%  of  covered  deposits,  which  the  European  Commission 
estimated to equal about €55 billion. Euro-area banks will have to pay a risk-adjusted annual 
premium  (on  average  12.5%)  of  the  target  level.  In  the  period  2016-23,  the  fund  will  raise 
approximately €6.9 billion per annum. If ex-ante contributions were to be complemented with 
ex-post contributions, the maximum firepower of the fund could be increased by €20.6 billion 
to  €75.6  billion.  See  De  Groen  and  Gros  (2015)  for  more  details  on  the  estimates  of  the 
bridging needs and the SRF.  

19 See De Groen and Gros (2015) for a detailed analysis. 
20 See De Groen and Gros (2015). 
21 See Gros (2014b). 
22  This  gives  rise  to  complex  political  economy  implications  as  this  presupposes  the  creation  of  a 
common pool of resources and would eventually involve some degree of fiscal risk sharing. As 
reflected  in  the  current  debate  between  the  Northern  and  Southern  member  states,  going 

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would  be  illusory  to  expect  the  BU  to  have  the  same  effects  as  the  Federal  Deposit 
Insurance  Corporation  (FDIC),  which  features  both  a  common  resolution  system,  and 
common  deposit  insurance  backed  by  the  US  government.  While  there  is  no  explicit 
backstop,  one  can  argue  that  the  ESM  is  already  a  sort  of  implicit  fiscal  backstop,  and 
could serve in the direct recapitalisation of banks if a sovereign state is not able to fund 
itself.  

Finally,  from  a  broader  point  of  view,  breaking  the  sovereign-bank  nexus  and  reducing 
the  differences  in  supervisory  activities  are  also  key  steps  for  monetary  policy  as  they 
should  help  repair  the  transmission  mechanisms  of  ECB  monetary  policies.  During  the 
crisis,  financial  fragmentation  was  driven  by  the  sovereign–bank  doom  loop,  and  low 
interest rates were not transmitted to those member states hit the hardest by the crisis, 
thereby cancelling out the ECB’s actions to stimulate those economies.  

4.2.3 Banking Union and the housing bubbles in Ireland and Spain 

To  illustrate  the  importance  of  BU  in  the  case  of  financial  asymmetric  shocks,  one  can 
conduct the thought experiment of how the boom-bust cycles in Ireland and Spain would 
have played out, if the SRM had been fully operational (i.e. after the end of the transition 
period).  

From  the  ex-ante  point  of  view,  it  makes  little  sense  to  assume  that  the  SSM  would 
necessarily have detected the presence of a housing bubble. However, it is reasonable to 
believe  that  the  SSM  and  the  European  Systemic  Risk  Board  (ESRB)  would  have  been 
much  more  likely  than  a  local  supervisor  to  warn  banks  about  excessive  real-estate 
valuations,  thus  imposing  limits  on  over-lending.  Admittedly,  dealing  with  a  bubble  is 
always  very  difficult.  The  experience  of  advanced  economies  from  Japan  to  the  US,  but 
also  China  more  recently,  shows  the  great  difficulty  in  detecting  bubbles  ex-ante  and 
even  more  so,  taking  the  political  decision  to  intervene  to  stop  them  in  a  booming 
economy.  This  suggests  that  while  prudential  macro  policies  are  certainly  useful  and 
important, the assumption that boom-bust shocks will no longer happen is not realistic. 
The  more  realistic  expectation  is  that  the  presence  of  the  SSM  should  reduce  the 
likelihood that busts pose a risk of triggering a sovereign default. 

When the real estate bubble turns into a bust and the local banks get into big difficulty, 
as  occurred  in  Ireland,  the  ECB  would  be  expected  to  flag  the  banks  in  difficulty  to  the 
SRF, which would then decide whether to allow them to fail and put them into resolution 
or whether to save them because of their systemic nature. The funds needed to save any 
bank  (or  enable  an  orderly  resolution)  would  have  come  from  the  SRF  first,  instead  of 
coming  entirely  from  the  national  government,  as  was  the  case  in  2011.  Thus,  the  SRF 
should have prevented the feedback loop between bank and sovereign. 

Importantly,  the  potential  financial  intervention  of  the  SRF  would  have  probably  been 
lower in cost than the losses incurred by the Irish government because the bail-in rules, 
under the BRRD, mandate that public funds can be provided only if shareholders but also 
(some) creditors have accepted a loss. This did not happen in Ireland. At that time, the 
entire euro-area banking system was in difficulty and it was thought that letting any Irish 
banks  fail  would  have  sparked  another  panic,  comparable  to  the  one  that  followed  the 
failure of Lehman Brothers in the autumn of 2008 (Gros and Belke, 2014). 

The  Irish  government  would  have  had  to  participate  ‘automatically’  only  in  the  costs 
associated  with  banks  where  losses  were  so  large  that  the  national  deposit  insurance 
scheme had to intervene to guarantee that no insured depositor made a loss.23 The case 

forward  in  that  direction  is  likely  to  require  reducing  the  exposure  of  sovereigns  to  their  own 
bank. 

23 See De Groen and Gros (2015) for a simulation exercise of the probable distribution of losses by 
six  Irish  banks,  if  the  new  system  of  resolution  (and  the  €55  billion  of  the  SRF)  had  been  in 

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

stresses  again  the  need  for  soundly  capitalised  banks  and  credible  deposit  insurance 
schemes. 

The experience of the boom and bust in Spain was different from that in Ireland, owing 
to the structure of its banking sector, but also because there was a certain consensus at 
EU level that the Irish scenario had to be avoided. One of the key features of the Spanish 
banking  sector  before  the  crisis  was  its  strong  market  segmentation.  The  industry  was 
characterised,  on  the  one  hand,  by  a  few  very  large,  internationally  diversified  banks, 
which remained almost unaffected by the crisis and, on the other hand, by many small, 
local banks (cajas). This large number of (regional, semi-public) savings banks had lent 
heavily  to  property  developers  and  the  bursting  of  the  bubble  essentially  bankrupted 
them. Given the large number of banks involved, the losses were widely dispersed across 
the  industry  and  nationalisation  was  not  considered  a  reasonable  option.  In  Ireland, 
where  losses  were  highly  concentrated  in  two  financial  institutions,  nationalisation  was 
the  immediate  solution.  In  Spain,  several  small  banks  were  merged  (to  create  Bankia), 
and  Spain  was  offered  a  credit  line  (up  to  €100  billion)  to  proceed  to  a  thorough 
restructuring of the banking sector. If the current framework had been in place, existing 
funds in banks, the bail-in of creditors and the SRF24 would have absorbed three-quarters 
of the estimated losses, implying a much smaller intervention on the part of the Spanish 
government.  

Overall,  the  experiments  suggest  that,  on  the  one  hand,  the  BU  framework  should 
prevent  banks  from  taking  excessive  risks  and  force  private  risk  sharing  through 
contributions  from  the  banking  industry  to  the  SRF.  On  the  other  hand,  it  should  also 
protect, at least partially, sovereigns from domestic bank failures, by transferring part of 
the risk to debt- and capital holders.  

The degree of risk sharing that ultimately develops will depend not only on the effect that 
the BU has on financial integration but also on the effect of the CMU. 

4.2.4 Capital Markets Union25 

The  aim  of  the  CMU  project26  is  to  bolster  integration  in  capital  markets  and  to  move 
towards a more market-based financial system. If successfully achieved, this could have 
a  substantial  impact  on  the  risk-sharing  capacity  of  the  monetary  union.  As  argued 
above,  there  is  no  doubt  that  EMU  has  bolstered  financial  integration  in  the  euro  area, 
but this happened only in certain market segments. Financial integration relied heavily on 
interbank  credit  markets  (Fecht  et  al.,  2012;  Lane  et  al.,  2008)  and  when  the  crisis 
erupted, the euro area was still far from being a true single financial market. In fact, it 
still  is  far  from  it.  The  crisis  has  shown  that  credit  flows  can  abruptly  stop  and  even 
reverse,  especially  if  claims  are  unequally  distributed  and  inflows  are  concentrated,  as 
was the case in peripheral member states of the euro area until 2010. The sudden stop 
to  lending  experienced  by  several  countries,  from  the  Baltic  States  to  Greece,  provides 
ample evidence of this phenomenon.  

place. The paper shows that about half of the losses (more than €60 billion) would have been 
covered by the banks’ own funds, the bail-in and the SRF.  

24  De  Groen  and  Gros  (2015)  show  that  for  the  13  Spanish  banks  considered  for  the  simulation 
exercise, the SRF alone would have contributed about €30 billion of the €70 billion in estimated 
losses. 

25  See  Valiante  (2016)  for  an  extensive  analysis  of  the  Capital  Markets  Union,  also  including  its 

potential impact on risk sharing.  

26 On 30 September 2015, the Commission launched the Capital Markets Union Action Plan to build 
a 
(see  http://europa.eu/rapid/press-release_IP-15-
5731_en.htm). While the Action Plan has prompted substantial debate, the transition towards a 
complete Capital Markets Union is likely to take several years.   

single  market 

capital 

true 

for 

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Overall,  the  experience  of  the  crisis  suggests  that  the  dominant  role  of  banks  and  debt 
may  be  a source  of  vulnerability.  According  to  Fuceri  and  Zdzienicka  (2013)  the  lack  of 
capital market integration and the bias towards banks are precisely the factors hindering 
further risk sharing in the euro area.  

In contrast to debt instruments, equity flows, either in the form of investment portfolios 
or  (even  more  so)  in  the  case  of foreign  direct  investment, tend  to be  more  stable  and 
less likely to be quickly reversed in the event of a crisis because they are more costly to 
liquidate.  FDI  flows  are  indeed  more  sensitive  to  information  specifically  related  to  a 
certain project or country than to the global market sentiment.  

As  discussed  above,  the  issue  of  cross-country  capital/equity  ownership  is  relevant  for 
risk-sharing purposes in the case of banks, but more broadly in the case of companies. In 
fact ‘true’ market risk sharing in the case of asymmetric shocks can only be increased if 
the  ownership  of  capital  is  geographically  diversified.  This is  one  of  the  purposes  of  the 
CMU. The CMU is still in the proposal stage and it is difficult to predict its progress in the 
medium term. Yet two observations can be made at this point. On the one hand, given 
the low starting level of capital market insurance, there is a lot of room for improvement. 
On the other hand, given the very high number of small- and medium-sized enterprises 
and  family-run  companies,  where  the  participation  of  foreigners  in  providing  capital  is 
either  impossible  or  very  difficult,  US  levels  are  unlikely  to  be  a  realistic  benchmark 
against which to evaluate EMU any time soon. 

It  is  worth  mentioning  that  while  financial  integration  can  be  beneficial  from  several 
points  of  view,  it  carries  risks.  When  financial  integration  occurs,  policies  and  the 
regulatory  framework  should  ensure  the  elimination  of  barriers  to  the  circulation  of 
capital  in  order  to  have  a  fully-fledged  cross-border  market  but  also  to  avoid  excessive 
concentration  of  holdings  in  some  parts  of  the  system  and  excessive  leverage.  Market 
mechanisms  alone  are  usually  insufficient  to  manage  risk,  especially  when  the  level  of 
integration is very high. Indeed, markets and financial institutions can be subject to self-
fulfilling  prophecies  (Allen  and  Gale,  1998)  accelerated  by  fast  movements  of  capital, 
which  may  quickly  affect  liquidity  conditions  both  of  banks  and  financial  markets.  This 
can lead to more easily spread contagion in the event that a large financial crisis erupts. 
If  the  shock  is  large  and not  quickly  absorbed  by the system,  there  is  a risk  that  it  will 
become systemic and the adjustment costs for the real economy will become very large. 

Large cross-border claims can mitigate the local impact of financial shocks (as happened 
through the presence of foreign banks in the Baltic States), but they can also propagate 
shocks  to  the  overall  financial  system.  A  strong  presence  of  foreign  banks  can  transmit 
financial  shocks  abroad  to the  domestic  economy  if  the  foreign  banks  operating  are  not 
sufficiently resilient or if they just cut their exposure.  

An example of the mitigation of financial shocks occurred at the beginning of the global 
financial  crisis  when  some  large  banks  from  some  euro-area  member  states  started  to 
pull  back  capital  and  credit  lines  from  their  subsidiaries  in  Central  and  Eastern  Europe. 
These  banks  were  mostly  based  in  countries  with  relatively  weak  fiscal  and  balance-of-
payment positions or were very large relative to the size of their home country, such as 
Italy,  Austria  and  Belgium  (Gros  and  Belke,  2014).  The  ‘Vienna  initiative’  in  2009, 
stopped  the  action.  The  key  stakeholders  agreed  to  prevent  a  large-scale  and 
uncoordinated  withdrawal  from  the  region  and  committed  to  maintaining  their exposure 
as  well  as  to  recapitalising  their  subsidiaries.  The  opposite  could  have  triggered  a 
systemic bank crisis. 

An  example  of  the  propagation  of  the  shock  through  cross-border  bank  exposure 
occurred on a large scale after 2010. Banks from core, euro area countries started to cut 
their  exposure  vis-à-vis  sovereigns  and  other  banks  located  in  the  periphery.  Since  the 
cross-border  exposure  did  not  entail  capital  (unlike  for  those  banks  involved  in  the 

2017 

27 

 
 
Feasibility and Added Value of a European Unemployment Benefit Scheme  

Vienna imitative) the decision to cut was easy and fast. Moreover, unlike for the Vienna 
initiative, there was no coordinated action to avert the liquidity crisis. 

financial 

Another  risk  associated  with  high 
to  production 
specialisation.27  As  movements  of  capital  become  easier,  production  tends  to  specialise 
according  to  comparative  advantage.28  In  the  case  of  banks,29  this  can  result  in  higher 
systemic  risks.  In  the  case  of  manufacturing  and  other  industries,  it  could  result  in  a 
situation  where  different  regions  of  the  Union  are  prone  and,  in  principle,  vulnerable  to 
different  output  shocks,  hence  increasing  the  likelihood  of  asymmetric  shocks  for  which 
price and wage adjustment are inevitable. 

integration  relates 

4.3.  ‘Guesstimating’  future  shock-smoothing  properties  of  EMU:  An 

exercise based on the experience of core EMU countries  

Assuming  that  the  BU  and  the  CMU  will  provide  the  euro-area  capital  markets  with  a 
capacity to absorb losses that is comparable to that in the US does not seem appropriate. 
As  mentioned  earlier,  estimates  suggest  that  about  40%  of  a  GDP  shock  in  the  US  is 
absorbed  by  international  factor  income,  while  the  same  is  currently  negligible  in  the 
EMU.  The  US  is  an  interesting  benchmark  but  given  its  large  experience  as  a  monetary 
and banking union and federal state, it is unrealistic to assume that any plausible change 
in  the  EMU  could  lead  to  similar  features.  At  best,  the  US  capacity  is  an  upper-bound 
benchmark.  This  is  especially  the  case  once  the  idea  that  market-based  insurance 
mechanisms do not operate independently of fiscal risk sharing (non-existent in the EMU 
but functioning in the US) is taken into consideration. 

This  section  complements  our  analysis  with  an  empirical  exercise  that  could  be  thought 
of  as  a  ‘guesstimation’  of  the  degree  of  risk-sharing  that  could  be  achieved  in  the  euro 
area if the BU and CMU led the whole region to reach a similar degree of integration  to 
that  of  the  core  countries.  We  start  from  the  observation  that  the  crisis  played  out 
differently  in  core  northern  euro-area  countries  and  in  the  euro-area  periphery:  core 
countries remained financially integrated during the crisis, while financial markets in the 
periphery became again national as fragmentation ensued. Core countries are defined as 
Germany, Belgium, the Netherlands, France, Finland and Austria. We define the non-core 
as Portugal, Ireland, Italy, Greece, and Spain.  

The hypothesis we want to test is whether the fact that core countries have been highly 
integrated  for  a  long  time,  both  from  an  economic30  and  financial31  point  of  view, 
improved  their  capacity  to  smooth  the  impact  of  shocks  relative  to  the  peripheral 
countries. In particular, the fact that both credit and equity markets remained integrated 
even  at  the  peak  of  the  crisis  could  be  seen  as  the  outcome  one  might  expect  in  the 
presence of the BU32 and the CMU. If this is the case, the degree of market risk sharing 
that occurred in the core countries during the crisis should provide us with an estimate of 
what to expect in terms of market insurance in the future EMU as whole.   

27 See Krugman (1991) and the core-periphery patterns theory and OECD (1999) chapter 4. 
28  If  higher  mobility  of  capital  lead  to  increasing  return  on  capital,  this  will  tend  to  depress  the 

labour share of income and hence in the long term the bargaining power of labour. 

29 See Fecth et al. (2012).  
30  It  should  also  be  added  that  Germany  and  its  surrounding  countries  (e.g.  Belgium,  the 

Netherlands and Austria) are also economically (production and trade) very integrated. 

31 Unfortunately, data on capital market integration among countries are not readily available and 

building an indicator of it would be methodologically challenging.  

32 Of course, these countries did not have common supervision or resolution mechanisms. 

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

4.3.1 Empirical analysis: the experience of the core and non-core countries 

In  this  analysis,  we  propose  to  estimate  the  different  channels  through  which  the 
smoothing of shocks is achieved in the two groups of countries separately. This exercise 
is  based  on  the  approach  proposed  by  Asdrubali  et  al.  (1996)  and  relates  to  a  recent 
contribution by Kalemli-Ozcan et al. (2014).  

Following the methodology of Asdrubali et al. (1996) and Sorensen and Yosha (1998), we 
undertake  a  variance  decomposition  of  shocks  to  GDP  in  order  to  quantify  the  share  of 
smoothing achieved via the various channels identified above. We disaggregate GDP into 
the  following  national  accounts  aggregates:  Gross  National  Income  (GNI),  National 
Income  (NI),  Net  National  Disposable  Income  (NNDI)  and  total  consumption  (C+G). 
From these aggregates, we identify the following channels through which GDP shocks are 
smoothed 

GDP-GNI =international income transfers (factor income flows)  
GNI-NI = capital depreciation  
NI-NNDI = net international taxes and transfers  
NNDI-(C+G) = total (private and public) net (of investment) savings  

We consider the following identity: 

(1) 𝐺𝐷𝑃𝑖 =

𝐺𝐷𝑃𝑖
𝐺𝑁𝐼𝑖

𝐺𝑁𝐼𝑖
𝑁𝑖𝑖

𝑁𝑖𝑖
𝑁𝑁𝐷𝐼

𝑁𝑁𝐷𝐼𝑖
𝐶𝑂𝑁𝑆𝑖

∗ 𝐶𝑂𝑁𝑆𝑖 

Taking the first difference and transforming (1) into a logarithm, we obtain the following 
five  equations,  which  come  down  to  a  simple  variance  decomposition  of  GDP  into  five 
factors: 33 

𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑓𝑎𝑐𝑡𝑜𝑟: ∆ log  𝐺𝐷𝑃𝑖,𝑡 −   ∆ log 𝐺𝑁𝐼𝑖,𝑡   

=   𝑎𝑡

𝑖𝑓 + 𝛽𝑖𝑓∆ log 𝐺𝐷𝑃𝑖,𝑡 + 𝜀𝑖,𝑡    

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛: ∆ log  𝐺𝑁𝐼𝑖,𝑡    −   ∆ log 𝑁𝐼𝑖,𝑡  

=   𝑎𝑡

𝑑 + 𝛽𝑑∆ log 𝐺𝐷𝑃𝑖,𝑡 + 𝜀𝑖,𝑡    

𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑡𝑟𝑎𝑛𝑠𝑓𝑒𝑟𝑠: ∆ log 𝑁𝐼𝑖,𝑡 − ∆ log 𝑁𝑁𝐷𝐼𝑖,𝑡 

=   𝑎𝑡

𝑡 + 𝛽𝑡∆ log 𝐺𝐷𝑃𝑖,𝑡 + 𝜀𝑖,𝑡    

𝑇𝑜𝑡𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠: ∆ log 𝑁𝑁𝐷𝐼𝑖,𝑡   −   ∆ log 𝐶𝑂𝑁𝑆𝑖,𝑡

=   𝑎𝑡

𝑠 + 𝛽𝑠∆ log 𝐺𝐷𝑃𝑖,𝑡 + 𝜀𝑖,𝑡    

𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛: ∆ log 𝑇𝑂𝑇 𝐶𝑂𝑁𝑖,𝑡 =   𝑎𝑡

𝑐 + 𝛽𝑐∆ log 𝐺𝐷𝑃𝑖,𝑡 + 𝜀𝑖,𝑡      

𝑎𝑡   denotes  the  time-fixed  effects,  the  𝛽𝑠  capture  the  percentage  of  smoothing  achieved 
by the different smoothing channels and 𝜀𝑖,𝑡    is the error term. Note that no constant is 
included  in  the  estimation.  These  equations  aim  to  capture  how  GDP  shocks  propagate 
through the economy. The sum of all βs, for a certain time, equals one by construction. 
In particular, if 𝛽𝑐= 1 (the coefficient for consumption), the impact of a shock to GDP is 
fully absorbed by consumption, meaning that no risk sharing takes place. Conversely, if 
𝛽𝑐=  0  risk-sharing  mechanisms  provide  full  stabilisation  to  a  shock,  with  no  impact  on 
consumption.  

33 See Furceri and Zdzienicka (2013) for a detailed derivation. 

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

All  data  are  from  the  OECD  national  accounts  database  and  are  measured  in  per capita 
(real)  terms.  We  consider  a  panel  of  11  countries  that  were  part  of  the  euro  area  in 
201434 over the period 1990-2014. In order to evaluate the effectiveness of risk-sharing 
mechanisms  during  the  pre-crisis  years  (1990-2007),  the  global  financial  crisis  (namely 
2008-09)  and  the  euro  area  crisis  (2010-14),  we  allow  the  coefficients  to  vary  by 
interacting  the  GDP  shocks  with  dummy  variables  for  the  three  different  time-periods. 
Moreover, in the same vein as Kalemli-Ozcan (2014), we further interact the GDP shocks 
with  dummies  for  the  core  and  non-core  country  groups,  which  allows  us  to  test  our 
initial hypothesis. Therefore, the general equations presented above are extended in the 
following  way  (here  with  the  example  of  international  factor  income  on  the  left  hand 
side):  

∆ log 𝐺𝐷𝑃𝑖,𝑡 −   ∆ log 𝐺𝑁𝐼𝑖,𝑡 =  𝑎𝑡   + 𝛽𝑐𝑜𝑟𝑒 90−07∆ log 𝐺𝐷𝑃𝑖,𝑡 ∗ 𝐷𝑖,𝑡

90−07 ∗ 𝐷𝑖,𝑡

𝐶𝑜𝑟𝑒

+ 𝛽𝑁𝑜𝑛−𝐶𝑜𝑟𝑒 90−07∆ log 𝐺𝐷𝑃𝑖,𝑡 ∗ 𝐷𝑖,𝑡
+   𝛽𝐶𝑜𝑟𝑒 08−09∆ log 𝐺𝐷𝑃𝑖,𝑡 ∗ 𝐷𝑖,𝑡
+   𝛽𝑁𝑜𝑛−𝐶𝑜𝑟𝑒 08−09∆ log 𝐺𝐷𝑃𝑖,𝑡 ∗ 𝐷𝑖,𝑡
+   𝛽𝑐𝑜𝑟𝑒 10−13∆ log 𝐺𝐷𝑃𝑖,𝑡 ∗ 𝐷𝑖,𝑡
+   𝛽𝑁𝑜𝑛−𝑐𝑜𝑟𝑒 10−13∆ log 𝐺𝐷𝑃𝑖,𝑡 ∗ 𝐷𝑖,𝑡

08−09 ∗ 𝐷𝑖,𝑡

90−07 ∗ 𝐷𝑖,𝑡
𝐶𝑜𝑟𝑒
08−09 ∗ 𝐷𝑖,𝑡
𝐶𝑜𝑟𝑒

10−13 ∗ 𝐷𝑖,𝑡

𝑁𝑜𝑛−𝐶𝑜𝑟𝑒   

𝑁𝑜𝑛−𝐶𝑜𝑟𝑒

10−13 ∗ 𝐷𝑖,𝑡

𝑁𝑜𝑛−𝐶𝑜𝑟𝑒 +   𝜀𝑖,𝑡 

We thus estimate five equations, with each of them distinguishing between the three key 
time-  periods  and  core  and  non-core  countries.  This  leads  to  six  series  (rows)  of 
estimates, which we report in Table 1.  

Table 1. Core vs. non-core estimates 

Net savings 

International 
factor 
income 

K 
depreciation 

International 
transfers 

Unsmoothed 
(consumption
) 

0.63*** 
(0.07) 
0.61*** 
(0.19) 
0.72*** 
(0.23) 

-0.06* 
(0.03) 
0.26*** 
(0.10) 
-0.06 
(0.12) 

-0.12*** 
(0.02) 
-0.05 
(0.05) 
-0.13*** 
(0.05) 

0.03** 
(0.01) 
-0.00 
(0.03) 
-0.07 
(0.07) 

0.52*** 
(0.05) 
0.18 
(0.14) 
0.54*** 
(0.15) 

0.24*** 
(0.06) 
0.38*** 
(0.14) 
0.12* 
(0.07) 
275 
0.59 
11 

0.09** 
(0.04) 
-0.02 
(0.10) 
0.03 
(0.05) 
275 
0.19 
11 

-0.01 
(0.01) 
0.02 
(0.04) 
-0.11*** 
(0.02) 
275 
0.56 
11 

0.03** 
(0.01) 
-0.03 
(0.03) 
0.01 
(0.02) 
275 
0.14 
11 

0.65*** 
(0.05) 
0.65*** 
(0.11) 
0.94*** 
(0.06) 
275 
0.88 
11 

Observations 
Adjusted R-squared 
Number of countries 
Note:  Core=  Germany,  Netherlands,  Belgium,  Austria,  Finland  and  France;  non-CORE=  Italy, 
Spain, Portugal, Greece and Ireland.  
Source: Authors’ own elaboration, based on OECD national accounts data (2015). 

Core versus Non-
Core 

Core (1990-2007) 

Core (2008-09) 

Core (2010-2014) 

Non-core (1990-
2007) 

Non-core (2008-09) 

Non-core (2010-14) 

34  Some  countries  were  not  included  due  to  data  unavailability.  We  have  left  out  Cyprus  and 

Luxembourg, given the special features of their banking sectors. 

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30 

 
 
 
 
 
 
 
 
 
                                                 
Feasibility and Added Value of a European Unemployment Benefit Scheme  

Figures 6 and 7 visualise the result of the table, for an easier reading. 

Figure  6.  Core  countries:  decomposition 
(1997-2014) 

Figure 
Non-core 
decomposition (1997-2014) 

7. 

countries: 

100%

80%

60%

40%

20%

0%

-20%

26% 

61% 

3% 

63% 

-6% 

72% 

-6% 
-7% 

80%

70%

60%

50%

40%

30%

20%

10%

0%

-10%

3% 
9% 

24% 

38% 

-2% 
-3% 

1% 
3% 
12% 

1990-2007

2008-09

2010-14

1990-2007

2008-09

2010-14

Net savings: Total

International income

Net savings: Total

International income

International transfers

International transfers

Source: Authors’ own elaboration, based on OECD national accounts data (2015). 

Overall,  the  unsmoothed  impact  of  the  shocks,  as  measured  by  the  consumption 
coefficient, is much larger in the  non-core countries than in the core group of  countries 
across  each  period.  GDP  loss  absorption  seems  to  have  worked  particularly  well  in  the 
core  countries  during  the  global  financial  crisis,  when  the  part  of  impact  of  the  shocks 
remained  unsmoothed  is  below  20%  (and  statistically  non-different  from  zero).  In  the 
non-core  countries,  the  shock  absorption  collapsed  after  2010,  with  the  shock  on  GDP 
almost fully reflected in consumption (more than 90%). The estimates also suggest that 
both  in  core  and  in  peripheral  countries,  the  credit  channel  has  been  the  only  one  to 
mitigate  the  effect  of  shocks  on  consumption,  through  savings  and  borrowing.  Not 
surprisingly, this channel has worked in a much more powerful way in the core countries, 
where savings were larger than in the periphery. 35  

With  one  exception,  international  factor  income  is  either  insignificant  or  very  small  and 
with  an  unexpected  negative  sign.  International  factor  income  smoothed  26%  of  the 
shocks  in  the  non-core  countries  during  the  years  of  the  global  financial  crisis  (2008-
2009):  it  is  the  only  case  where  capital  markets  seem  to  have  provided  some  loss-
absorption capacity. It is interesting to note that when Finland is taken out from the core 
group, given the crisis it experienced, the positive and significant coefficient of the factor 
income  over  the  period  2008-09  becomes  statistically  insignificant.  This  would  suggest 
that  the  factor  income  channel  has  been  particularly  relevant  for  Finland.  The  result  is 
consistent with  the  story  that  Nokia,  which was  at  the origin  of  the  crisis,  was  not  fully 
owned domestically and the losses of the collapse were shared with other countries. 

Overall,  assuming  that  the  factor  income  channel  is  properly  measured,  even  the 
countries  that  remained  financially  integrated  and  exhibited  strong  trade  linkages 

35 In this setting, the unsmoothed part of the shock will affect total consumption, both public and 
private.  It  is  possible  to  decompose  the  so-called  credit  (or  better  saving)    channel 
distinguishing  private  and  public  sector,  so  to  measure  the  effect  of  the  shock  on  private 
consumption  only  and  to  capture  the  role  of  fiscal  policy  as  consumption  smoothing 
mechanism.  Because  of  data  availability,  this  decomposition  is  only  possible  after  1997.  In 
order to present results from 1990, we do not display this additional decomposition. In broad 
terms, the simple regressions we run suggest that fiscal policy payed a limited role in the core 
countries and no role in the periphery. This topic deserves more in-depth analysis. 

2017 

31 

 
 
 
 
 
 
                                                 
Feasibility and Added Value of a European Unemployment Benefit Scheme  

showed,  only  occasionally,  a  limited  capacity  for  real  market  risk  sharing:  at  best,  the 
effect  of  shocks  on  consumption  was  smoothed  over  time  through  changes  in  the 
composition of demand (investment and savings) /or international borrowing.  

Table  2  reports  the  estimates  for  the  different  channels  for  all  11  countries,  without 
distinguishing between core and non-core. The results are very close to those of the non-
core group, reported in Table 1, which seems to drive the main dynamics, over each of 
the periods considered. Accordingly, the impact of the shock on aggregate consumption 
is  very  large,  especially  after  2010,  and  credit  markets  have  only  had  a  limited  role  in 
smoothing the impact of the shock.    

Table 2. Pooled estimates (all countries) 

All 

Net savings 

1990-2007 

2008-2009 

2010-2014 

Observations 
Adjusted R-squared 
Number of countries 

0.35*** 
(0.06) 
0.42*** 
(0.15) 
0.17** 
(0.08) 
275 
0.52 
11 

International 
factor 
income 
0.05 
(0.04) 
0.04 
(0.10) 
0.03 
(0.05) 
275 
0.11 
11 

K 
depreciation 

International 
transfers 

Unsmoothed 
(consumption) 

-0.04** 
(0.02) 
0.01 
(0.04) 
-0.11*** 
(0.02) 
275 
0.48 
11 

0.03** 
(0.01) 
-0.03 
(0.03) 
0.01 
(0.02) 
275 
0.13 
11 

0.61*** 
(0.04) 
0.56*** 
(0.11) 
0.91*** 
(0.06) 
275 
0.86 
11 

Source: Authors’ own elaboration, based on OECD national accounts data (2015). 

It  should  be  noted,  that  beyond  the  broader  discussion  on  the  validity  or  not  of  the 
assumption  that  output  shocks  are  fully  exogenous,  assessing  the  quality  of  capital 
market  risk-sharing  through  international  factor  income  has  two  limitations  that  may 
result  in  a  mis-estimation  of  the  level  of  risk  sharing  between  the  groups  of  countries 
under  consideration.  First,  net  international  factor  income,  as  measured  above,  is  not 
related  to  the  degree  of  risk  sharing  occurring  within  a  specific  group  of  countries  (i.e. 
within  the  core  and  non-core).  It  would  be  correct  if  the  euro  area  were  a  closed 
economy.  In  reality,  it  captures  the  level  of  risk  sharing  of  each  of  the  countries 
compared with the rest of the world. As argued by Kalemli-Ozcan (2010), it is likely that 
the risk sharing properties of assets held outside Europe are very relevant since business 
cycles  tend  to  be  increasingly  correlated  in  the  euro  area.  This  implies  that  the  risk-
sharing  capacity  of  the  euro  area,  as  measured  by  international  factor  income  is 
overestimated.  However,  Balli  et  al.  (2012)  remark  that  measuring  only  capital  income 
overlooks  capital  gains,  which  are  another  important  source  of  risk  sharing  through 
capital markets. This would suggest that factor income is, in reality, underestimating the 
risk sharing capacity of capital markets. 

4.3.2 The role of cross-border equity during banking crises: The BELLS vs. Spain 

and Ireland 

In  order  to  consider  further  how  financial  market  features  influence  risk-sharing,  we 
extend  the  analysis  above  by  looking  at  the  risk  sharing  that  occurred  through 
international  factor  income,  focusing  on  a  group  of  countries,  that  up  to  2008, 
experienced  large  inflows  of  capital,  in  some  case  combined  with  bubbles,  and  then  a 
sudden  stop  in  lending.  These  are  Ireland  and  Spain  on  the  one  hand,  and  the  Baltic 
States and Bulgaria (BELL) on the other. The Baltics only recently joined EMU, but at the 
time the crisis erupted, similarly to Bulgaria, they had in place a currency board, or hard 

2017 

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

peg agreements, which make them similar to euro-area countries to the extent that they 
could not use the exchange rate as a safety valve.36  

A  very  specific  and  dominant  feature  of  the  BELL  banking  system  is  that  it  is  mainly 
composed  of  subsidiaries  from  foreign  banks  (about  80%).37  This  can  be  seen  as  an 
extreme case of cross-border ownership and a possible interpretation of it is that banks 
in  these  countries  are  de  facto  part  of  a  ‘private’  banking  union  (with  parent  banks  in 
foreign  countries).  Moreover,  since  the  national  central  banks  were  greatly  constrained 
by the exchange rate regime in the provision of liquidity to support their banking systems 
during  the  crisis,  the  BELL  experience  can  provide  a  lower-bound  proxy  of  the  BU.  It  is 
interesting  to  note  that  despite  the  magnitude  of  the  losses  incurred  by  the  banking 
system;  only  one  (domestic)  bank  had  to  be  rescued  over  the  crisis  –  the  only  large 
domestic Latvian bank.  

Figure  8.  BELL  (Baltic  states  +  Bulgaria):  International  factor  income  and  GDP 
fluctuations during the crisis 

20,0%

15,0%

10,0%

5,0%

0,0%

-5,0%

-10,0%

-15,0%

-20,0%

15,4% 

2,1% 

-1,5% 

-3,3% 

-4,5% 

8,3% 

3,0% 

1,5% 

1,1% 

4,7% 

4,0% 

4,1% 

0,3% 

-0,7% 

-0,6% 

-17,2% 

2007

2008

2009

2010

2011

2012

2013

2014

Bell

Bell growth

Source: Authors’ own elaboration, based on Ameco data, European Commission, 2016. 

Figure 8 attempts to roughly illustrate the amount of risk-sharing that occurred through 
international  factor  income  in  the  BELL,  by  plotting  fluctuations  in  GDP  and  in 
international  factor  income.38  The  two  variables  exhibit  a  positive  correlation  (which  is 
analogous to the positive regression coefficient in Table 1) during the worst phase of the 
crisis,  suggesting  that  international  factor  income  was  working  as  risk  sharing.  In 
particular, the latter fell into a negative area in 2008 and 2009 when GDP collapsed. The 
numbers  suggest  that  some  20%  of  GDP  losses  were  absorbed  by  international  factor 
income, in practice losses borne by mother banks and groups outside the region. 

Similar to Figure 8, Figure 9 shows GDP and international income factor fluctuations for 
Ireland (left-hand side) and Spain (right-hand side). Unlike for the BELL, the correlation 
sign is less clear-cut. In Ireland, the income factor exhibits much higher volatility than in 
Spain  and  the  correlation  with  GDP  has  a  negative  sign  in  2009  and  in  2013-14, 
suggesting  that  instead  of  providing  cross-border  loss-sharing,  the  factor  income 
reinforced (or was driven by) the cycle. In Spain, the correlation is clearly positive most 

36 See Gros and Alcidi (2015). 
37 Ibid. 
38 Given the small sample, it is impossible to conduct an econometric analysis.  

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

of the time, and between 2009 and 2013, the international income factor seems to have 
provided some loss-absorption capacity. In this respect it is interesting to recall that, as 
argued above, the Spanish banking sector has always been highly segmented with small 
local  banks  and  large  international  banks  seriously  exposed  to  foreign  markets,  most 
notably Latin America. This may have helped in absorbing GDP losses.   

Figure  9.  International  factor  income  (change  as %  of  GDP)  and  GDP  growth,  2007-15, 
Ireland (LHS) and Spain (RHS) 

Ireland 

Spain 

6,0%

4,0%

2,0%

0,0%

-2,0%

-4,0%

-6,0%

-8,0%

-10,0%

2007 2008 2009 2010 2011 2012 2013 2014

International factor income

Growth rate

6,0%

4,0%

2,0%

0,0%

-2,0%

-4,0%

-6,0%

-8,0%

-10,0%

2007 2008 2009 2010 2011 2012 2013 2014

International factor
income
Growth rate

Source: Authors’ own elaboration based on Ameco data, European Commission, 2016.  

Overall,  the  findings  seem  to  point  to  the  fact  that  a  CMU,  which  is  expected  to  favour 
cross-border  ownership  of  capital,  could  play  a  role  in  reinforcing  the  very  weak  factor 
income channel. However, market risk sharing should not be expected to reach the range 
estimated  for  the  US  in  the  medium  run,  and  requires  more  than  harmonisation  of 
regulations to reach such levels.   

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5.  CENTRALISED  FISCAL  INSURANCE  AND  PRIVATE  RISK  SHARING: 

SUBSTITUTES OR COMPLEMENTS? 

We  distinguish  at  least  two  readings  of  the  literature  discussed  above  in  terms  of  what 
financial  integration,  driven  by  the  BU  and  the  CMU,  could  achieve  in  the  area  of  risk 
sharing, and hence the need for a fiscal risk-sharing device. On the one hand, because of 
the  nature  of  past  financial  integration  and  the  fact  that  crises  tend  to  affect  the  credit 
channel  (e.g.  sudden  withdrawal),  strengthening  capital  market  integration  would  yield 
large benefits.39 Unlike the credit channel, the capacity of capital markets for risk sharing 
during  (asymmetric)  downturns  is  expected  to  remain  strong  if  ownership  of  capital  is 
highly diversified40. According to this line of reasoning, the large gap in the degree of risk 
sharing through capital markets between the EU and existing federations suggests a high 
potential for further financial integration gains.   

On  the  other  hand,  there  is  no  clear  evidence  that  the  financial  integration  that  took 
place  since  the  inception  of  EMU  has  fostered  private  risk  sharing.  In  fact,  there  is 
evidence that shocks are  least absorbed during major downturns such as the euro-area 
debt  crisis.  While  the  BU  and  the  CMU  may  contribute  to  a  more  resilient  financial 
integration  based  on  market  instruments,  and  could  reinforce  the  effectiveness  of 
banking  intermediation,  it  remains  to  be  seen  to  what  extent  this  would  ever  lead  to  a 
substantial degree of risk-sharing capacity. In this respect, an important question relates 
is whether improved knowledge of, and trust in, foreign individuals and institutions41 is a 
necessary condition for a well-functioning market risk sharing in the euro area. A second 
question  is  how  other  paths  of  integration,  for  instance  common  fiscal  insurance,  can 
interact with and affect private risk sharing mechanisms.  

The rest of this section seeks ask whether fiscal and private risk sharing are substitutes, 
or rather complementary instruments for responding and adapting to shocks.  

5.1.  Rationale for fiscal insurance 

The recent debate on EMU economic governance has largely focused on how to foster the 
counter-cyclicality of fiscal policy. One option would be to increase the flexibility of fiscal 
rules  to  allow  more  room  for  national  governments  to  face  the  cycle.  This  is  currently 
happening, at least to a certain extent, but at the cost of breaking the credibility of rules. 
Another  option  is  to  consider  the  possibility  of  centralised  resources  for  income 
stabilisation purposes.  
Conceptually,  the  argument  for  a  (supranational)  fiscal  capacity  or  insurance  at  central 
level,  such  as  an  EUBS,  goes  even  beyond  the  capacity,  constrained  or  not,  of  national 
policy makers to address country-specific shocks. Indeed, the rationale for common fiscal 
instruments is linked to the notion of externality in a monetary union, which implies that 
a  shock  in  one  country  can  spill  over  other  countries  given  the  existing  tight  links 
(commercial,  financial  and  monetary)  among  them.42  In  fact,  this  is  also  the  economic 
rationale for coordinating national fiscal policies. The key practical distinction is that fiscal 
insurance at central level would operate ex-ante, and would have the double objective of 

39 See, for instance, Hoffman and Sørensen (2012). 
40  This  requires  that  the  returns  on  assets  held  abroad  are  uncorrelated  with  country’s  domestic 

cycle. If this is not the case there is no scope of diversification and hence risk sharing.  

41  Ekinci,  Kalemli-Ozcan,  and  Sorensen  (2007)  find  that  variables  related  to  social  capital  provide 
further insight into  patterns  of  private risk  sharing  in  the EU. They  point out that this kind of 
obstacles  to  risk  sharing  may  be  harder  to  overcome  than  formal  barriers  to  economic  and 
financial integration. 

42 For a review of the literature on the spillover effect in a monetary union, see Alcidi et al. (2015).  

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relieving a country hit by a shock from the costs it entails domestically and avoiding that 
the shock amplify and be transmitted to other countries. 
The  key  policy  and  political  issue  is  whether  fiscal  insurance  is  a  substitute  or  a 
complement for market insurance mechanisms. 

5.2.  Fiscal and market insurance: Substitute or complement? 

The  question  is  as  important  as  it  is  difficult  to  answer.  Both  economic  theory  and 
empirical  evidence  on  the  interaction  between  the  market  and  fiscal  mechanisms  are 
scant.  

From a theoretical point of view, one answer to this question can be found in Fahri and 
Werning  (2012).  They  argue  that  even  under  the  assumption  of  complete  financial 
markets,  the  level  of  risk  sharing  achieved  through  private  markets  is  not  Pareto 
efficient. The  main  reason  for  this  is  that  private  agents  do  not  purchase  efficient 
amounts  of  private  insurance  because  they  do  not  internalise  the  positive  externalities 
from  the  macroeconomic  stabilisation  effects  of  their  portfolio  choices.  Under  this 
assumption, a fiscal insurance mechanism would be the response to a market failure and 
lead to a Pareto superior outcome. This conclusion points to a complementary role for an 
(ex-ante)  fiscal  risk-sharing  mechanism,  which  goes  beyond  crisis  times  when  fiscal 
intervention can compensate for the ineffectiveness of credit markets in smoothing. This 
argument  embeds  the  idea  that  fiscal  and  market  channels  are  not  independent,  and 
fiscal  risk  sharing  could  act  as  a  catalyst  towards  the  provision  of  higher  market  risk 
sharing.  To  put  it  simply,  if  investors  knew  that  the  government  was  providing  a 
minimum  level  of  insurance  against  negative  shocks,  they  might  be  more  willing  to 
provide  more  insurance  through  market-based  mechanisms.  This  hypothesis  has 
powerful  intellectual  implications  and  goes  in  the  direction  of  arguments  often  used  in 
behavioural economics; however, it is very difficult to test empirically.   

In terms of empirical  evidence, one of the few works openly addressing the question of 
the interaction between risk-sharing channels is that of Asdrubali and Kim (2004). They 
look at the US, the OECD and the EU over the period 1960/63 to 1990 using a dynamic 
approach  (panel  VAR)  to  analyse the  interaction  between  risk  sharing  (fiscal  or  through 
financial  markets)  and  inter-temporal  consumption  smoothing  (through  the  credit 
market)  channels.  The  first  finding  is  that  the  capital  markets  and  fiscal  risk-sharing 
channels  tend  to  be  complementary.  The  second  finding  is  that  they  tend  to  crowd  out 
(or  to  reduce  the  role  of)  the  credit  channel.  This  is  an  important  result  given  that  the 
effectiveness  of  the  credit  channel  varies  with  the  cycle.  They  also  find  that  a  positive 
shock to capital markets would crowd out credit market smoothing (almost completely in 
the US and partially in the OECD). This would mean that the capital markets union could 
be  expected  to  increase  shock  smoothing  through  the  market  and  reduce  consumption 
smoothing through credit. Similarly, they also find that a shock to fiscal stabilisers, like a 
European  unemployment  insurance  scheme,  would  be  expected  to  crowd  out  the  credit 
market channel (in the OECD as a whole, but not in the US).  

The  main  explanation  for  these  results  is  that  since  capital  markets  and  fiscal 
mechanisms work as insurance, hence ex-ante, they are not “exposed” to the crowding-
out  effect.  In  contrast,  credit  markets  are  a  tool  for  consumption  smoothing,  and  work 
only ex-post, once the shock has occurred, and if other channels are not working.    

This  last  point  is  relevant  also  in  view  of  the  interpretation  of  the  empirical  findings 
shown in the previous section, which show that in the euro area risk sharing via capital 
markets  is  very  small,  fiscal  insurance  is  inexistent  and  credit  markets  are  the  main 
channel  for  adapting  to  shocks.  Given  the  limits  of  the  credit  channel  in  terms  of  its 
ineffectiveness during downturns and incapacity to cope with permanent shocks, boosting 
the role of both market and fiscal insurance may be desirable. 

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All  findings,  theoretical  and  empirical,  point  to  the  conclusion  that  market  insurance 
mechanisms  should  be  accompanied  by  some  degree  of  fiscal  insurance.  This  would 
boost  market  risk  sharing  and  reduce  the  reliance  on  saving  and  borrowing  to  adapt  to 
the  shock.  The  fact  that  federations  like  the  US  and  Germany,  which  exhibit  a  higher 
fiscal risk-sharing than other countries/regions, also have a higher degree of market risk-
sharing, may not just be a consequence of specific features of financial markets. 

Furthermore, it should be considered that shocks of different natures operate in different 
ways. Financial shocks (e.g. credit bubbles) and output (real economy, sectoral) shocks 
usually  hit  upfront  different  sectors  upfront  (banking  and  other  industries,  respectively) 
and  tend  to  propagate  into  the  rest  of  the  economy,  and  possibly  across  countries, 
through  different  channels,  mostly  through  financial/banking  exposure  and  production 
and commercial linkages.  

Figure  10  attempts  to  illustrate  the  idea  that  when  a  negative  shock  occurs,  fiscal  and 
market  risk-sharing  mechanisms  intervene  upfront  (or  even  in  a  preventive  fashion  as 
they both have an ex-ante nature) depending on the nature of the shock.  

If the shock hits a particular industry, one would expect a disequilibrium to emerge in the 
labour  market.  Fiscal  insurance  (e.g.  unemployment  scheme)  is  meant  to  respond 
directly  to  it,  while  market  mechanisms  are  expected  to  intervene  when  the  shock  is 
transmitted to the banking and the broader financial sector. In principle, the existence of 
the  fiscal  insurance  should  smooth  the  shock  before  it  is  transmitted.  In  a  similar  vein, 
when a financial shock hits, market insurance mechanisms are expected to react upfront 
to the disequilibria in capital markets, and to smooth/absorb part of the shock before it 
propagates to the rest of the economy. Thus, ex-ante insurance should prevent banking 
exposures  and  capital  flows  from  amplifying  the  shock.  Fiscal  risk  sharing,  in  principle, 
occurs once the shock has reached the real economy and reduces the impact of further 
feedback effects. 

Figure 10. Fiscal and market insurance mechanisms: Substitute or complement? 

Source: Authors’ own elaboration. 

In this case, the role of the Banking Union is likely to be limited, but the Capital Markets 
Union could help to prevent the burden of the losses being concentrated in one country. 
This  is  indeed  what  happened  in  the  case  of  Nokia,  whose  shareholders  were  not 

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

concentrated  in  Finland.  Of  course,  the  overall  impact  depends  crucially  on  whether the 
shock  is  temporary  or  permanent.  In  the  latter  case,  adjustment  in  relative  prices  may 
be unavoidable, even in the presence of fiscal insurance. 

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6.  CONCLUDING REMARKS 

In  a  monetary  union,  the  impact  of  country-specific  shocks  can  be  smoothed  through 
different channels: i) countercyclical national fiscal policy, ii) labour mobility, iii) market 
mechanisms,  namely  risk-sharing  through  access  to  international  capital  markets  and 
inter-temporal  consumption  smoothing  through  credit  markets,  as  well  as  iv),  when  it 
exists, a central/federal fiscal insurance mechanism.  

We  acknowledge  that  for  a  variety  of  reasons  (including  the  imperfect  design  of  fiscal 
rules, high levels of debt, a lack of/excessive market discipline, and even arguments over 
political  economy)  fiscal  policy  tends  to  be  pro-cyclical  over  time  and  across  countries. 
Because  of  this,  the  hypothesis  that  national  policies  alone  can  deal  with  asymmetric 
shock  is  not  realistic.  We  also  acknowledge  that  while  labour  mobility  is  in  theory  an 
important  channel  for  adapting  to  asymmetric  shocks,  in  practice,  it  has  had  only  a 
limited effect and this is unlikely to change in the future.  

Against  this  background,  the  paper  has  mostly  focused  on  market  mechanisms.  Indeed 
their role is likely to change in the medium term but how exactly is not clear. 

According to the qualitative arguments presented above, as well the estimates shown in 
the  previous  sections,  the  stabilisation  capacity  of  a  region  in  the  face  of  shocks  is 
difficult  to  identify  and  measure,  and  it  can  vary  over  time,  as  well  as  according  to  the 
state of the economy. In the case of the EU, this observation seems particularly relevant.  

Table 3 summarises the main conclusions that emerge from the previous sections. 

Table 3. Shock-smoothing capacity, before and after EU reforms 

Normal times 

Crisis times 

Normal times 

Crisis times 

Before 
EU broad 
governance 
reforms 

Before 
EU broad 
governance 
reforms 

After 
EU broad 
governance 
reforms 

After 
EU broad 
governance 
reforms 

Often pro-cyclical  Often pro-cyclical 

Less pro-cyclical 

Less pro-cyclical 

National fiscal 
policy 

Labour mobility  Very limited 

Larger 

Very limited 

Larger 

Risk-sharing 
via capital 
markets 

Consumption 
smoothing 

Very low 

Very low 

Improved, but 
likely to remain 
limited  

Improved, but 
likely to remain 
limited 

Key market 
channel, about 
20% – up to 
60% for some 
countries  

Lower than in 
normal times, it 
can go to zero 

Same 

Possibly 
improved (less 
financial 
fragmentation) 

Source: Authors’ own elaboration (based on preceding analysis). 

We expect that the adaptability and capacity to respond to shocks will be affected by the 
governance  reforms  and  in  particular  by  the  completion  of  the  BU,  with  a  European 
deposit  insurance  scheme  and  a  backstop  for  the  single  resolution  fund,  as  well  as 
advancement in the CMU.  

Overall, the new elements are likely to improve the capacity of the system to deal with 
asymmetric  shocks  and  possibly  to  reduce  their  occurrence,  but  this  should  remain 
limited in the medium term and certainly smaller than in the US. The main reason for this 
is  that  the  current  degree  of  market  insurance  is  so  small  that  any  dramatic  change 
seems  quite  unrealistic  in  the  near  future.  Moreover,  some  elements  of  the  economic 
literature suggest that the capacity of markets to deliver risk sharing is not independent 

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Feasibility and Added Value of a European Unemployment Benefit Scheme  

of  the  existence  of  fiscal  insurance  mechanisms.  On  the  one  hand,  fiscal  insurance, 
defined  as  an  ex-ante  mechanism,  can  affect  the  behaviour  of  market  participants  in 
catalysing  market  insurance.  On  the  other  hand,  it  is  unlikely  to  negatively  affect  the 
functioning  of  market  insurance,  for  two  main  reasons.  First,  as  they  are  both  ex-ante 
mechanisms,  substitution  is,  by  definition,  not  an  issue.  Second,  market  and  fiscal 
insurance should react upfront to disequilibria in different markets and crises in different 
parts of the economy (real economy versus financial/banking markets).  

These  considerations  all  together  lead  to  the  conclusion  that,  from  a  macroeconomic 
point of view, in Europe an ex-ante mechanism for fiscal insurance at central level could 
improve  directly  and  indirectly  the  adaptability  and  response  to  asymmetric  shocks  and 
hence income stabilisation. 

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