The ADEMU project: a narrative

April 2017


The June 2014 abstract of the proposal for the ADEMU project – which started in June 2015 – provided the following background:

In response to the European debt crisis and associated deep recession, a number of important steps have recently been taken towards redesigning the institutional architecture of EMU, based on the roadmap outlined in the Van Rompuy Report (2012). But these institutional innovations – and especially the ‘fiscal compact’, the ESM, the SSM and the SRM – have relatively weak theoretical foundations.

The background has changed in these three years. At first it seemed to be going ‘according to plan’: with ‘euro-stressed countries’ starting to come out of the recession, the development of the European Stability Mechanism and of the European Banking Union, and the 2015 Five Presidents’ Report calling for a further development of the Financial Union and the Fiscal Union, as well as an enhancement of risk-sharing “through a mechanism of fiscal stabilization for the euro area as a whole,” and to improve the collective decisionmaking within the Fiscal Union with a “future euro area treasury.” The ADEMU research agenda of “reassessing the fiscal and monetary framework of the EU and, in particular, the euro area” was in line with these developments.

However, the plan has been shaken since 2016: in response to the international situation, EU priorities have changed – with migration, security and defense coming to the forefront, – euro-skeptic populism, nourished by the recession, has become a democratic challenge in several euro countries and, more importantly, Brexit: the first historical reversal of the European integration process, questioning the process itself. In fact, while on the occasion of the 60th anniversary of the Treaty of Rome (March 2017) all the official rhetoric was a vindication of the successes and prospects of the EU, the same European Commission in its White Paper on the future of Europe has postulated five different scenarios of “the potential state of the Union by 2025”, which in turn entail five different scenarios for the EMU – only the maximalist scenario (#5 ‘Doing much more together’) contemplates: “Economic, financial and fiscal union is achieved as envisioned in the report of the Five Presidents of June 2015.”

Does this mean that the ADEMU research agenda is already obsolete before the project ends? We don’t think so. In fact, in the aftermath of the euro and Brexit crises and a less supportive global environment, the questions regarding the EU and the EA – and in particular, EMU design – have become even more fundamental, from how to achieve price stability to how to achieve financial, fiscal and social stability and growth; from the European integration rhetoric to: what should, and can, the EU and the EA deliver?

As social scientists our role is not to say what will, or should, happen in 2025, but to assess, and provide, an empirical and theoretical foundation for the different paths that the EMU may follow. On the one hand, this need is even more pressing in 2017 than it was in 2014, on the other, there is more experience – e.g. of the incipient EMU institutions – and more research has been done.

What follows is a summary of the research being done within the ADEMU project. It does not pretend to be exhaustive but rather focuses on the main topics of the ADEMU agenda, both as a narrative, and a guide, to some of the working papers and activities of these first two years of the project, leading to discussion – for ADEMU researchers, the Advisory Committee, et al – in preparation for the final year of the project (ADEMU Final Conference, May 10 – 11, 2018, EUI, Florence).

ADEMU ongoing research


On the EMU solving and creating credibility problems

The ADEMU starting point is the understanding of the European Monetary Union as  a solution to time-inconsistent monetary policies of countries sharing a common market, in contrast with the traditional Optimal Currency Area (OCA) theory, according to which countries should form monetary union if, and only if, they are subject to similar shocks, which is not the case within the EA. As Chari et al have shown,1 even with country-idiosyncratic risks, a monetary union can help price stability in a  common market, by preventing countries from running competitive devaluations – a benefit that can overcome the cost of not adapting monetary policy to country shocks. However, this solution to one credibility problem entails a new credibility problem when the union cannot fully commit to price stability and to not bailing out members’ sovereign debts: member countries may over-borrow, expecting to be bailed out or have their debts monetized. The latter is also known in the political science literature as the ‘Hamilton Paradox’.2 The euro crisis has been a costly vindication of this theory, with price stability through a major crisis, a dramatic build-up of sovereign debt in ‘stressed countries’, and a de-facto breach of the no-bailout clause, plus extensive purchases of sovereign debts by the ECB and, more recently, by the ESM. The theory also has implications for EMU designs, to which we return later.

On the nature of the euro and other crises and recessions

The euro crisis and recession has brought to the forefront the links between monetary, fiscal, financial and social policies. In an ideal world (an economy with complete markets, flexible prices and full commitment) one could delink these policies and treat them separately – in particular, assign them to separate, uncoordinated, governing bodies. The latter would greatly simplify EMU design and management, but in such a perfect world there would be no need for an EMU.3. Not surprisingly, understanding these links within the EMU takes us a long way towards understanding the euro crisis, and which EMU designs are likely to be more resilient. In fact, the euro debt crisis offers a paradigmatic example of how these links can operate in advanced economies and, in particular, of the role that several elements can play: underlying distortions or frictions, limited commitment, and agents’ heterogeneity and expectations.

We now briefly review how the ADEMU project is helping to better understand these links and underlying elements.

The monetary-fiscal link: sovereign debt crises and the role of expectations

A sovereign debt crisis always involves an element of credibility and the euro-crisis has been no exception.4 Crises can be driven by fundamentals because a country cannot credibly raise enough revenues – say, in times of crisis – to fulfill its debt obligations (Greece), or because it cannot credibly avoid unaccounted for new liabilities, in particular, bailing out private banks in crisis (Ireland and Spain). But expectations can also be driven factors generating self-fulfilling debt crises (spreads are high because lenders believe default is likely and it is, indeed, likely when high interest rates make existing debt liabilities unsustainable). As Ayres et al. show, whether such self-fulfilling crises can emerge crucially depends on how debt markets and contracts operate.5 It also depends on whether the Central Bank – possibly with the support of the Treasury – can credibly commit to intervene, for example by buying sovereign debt under threat. In fact, as Corsetti and Dedola have shown, a Central Bank willingness to intervene may be enough to dissipate a self-fulfilling debt crisis, which is consistent with the ECB’s role in the euro crisis.6 Nevertheless, as Delatte et al. have estimated it took one year for the  euro area economy to return to the non-crisis regime after Draghi’s successful speech (August 2012). They also have also shown that investors reacted strongly to the deterioration of fundamentals when bank credit risk was high (i.e. the financial link was being perceived to be risky).7

Expectations regarding how debt crises can be resolved also play an important role, especially, in monetary unions (and federal states), where it can either be because within the union bailing-out (redemption or monetization) expectations change (a recurrent theme through the euro-crisis),8 or because expectations about exit from the union, followed by default, change, as Kriwoluzky et al. have shown.9 Furthermore, how agents form beliefs can also explain how prices react to different forms of – possibly revenue-equivalent – forms of default, e.g. the risk of default, or a haircut, in a monetary union vs. the risk of inflation with domestically denominated debt.10

The fiscal-social link and its trade-offs

When, after a period of ‘bonanza’, crises become recession there are two recurrent questions regarding what the policy should be: to stimulate the economy by implementing a fiscal stimulus (Keynes) or not to intervene and to allow the recession to perform its cleansing effect (Hayek)? To provide social insurance – and, possibly, postpone socially costly reforms (to alleviate the consequences of the deep recession, even at the cost of worsening debt problems), or to implement austerity measures aimed at stabilizing the debt dynamics and implement reforms? Again, the recession in the ‘euro stressed’ countries, after the euro-bonanza that followed the introduction of the euro, has been no exception, and these two questions have long been at the center of the policy debate, and still linger in the aftermath of the euro-crisis (what should have been done?), in the form of social unrest and euro-skepticism.

As modern economic theory shows, in an ‘ideal world’ with job destruction and creation, Hayek is right, but it may be optimal to provide social insurance and increase sovereign debt if the government can borrow more efficiently than private agents. Current macroeconomic research throws new light on these questions by relaxing the ‘ideal world’ assumptions and ADEMU research is actively contributing to this new literature.

As Ravn and Sterk, Beaudry et al and Den Haan et al have shown, assuming that households   have   no   access   to   complete   insurance   markets   turns   out   to  have fundamental consequences. In particular, under such circumstances, households have an incentive to engage in precautionary savings, and important links between the demand and supply sides of the economy arise. Consider a recession with increasing unemployment – possibly due to ‘cleansing liquidation,’ – and perhaps  higher  incidence of long-term unemployment. Under such circumstances, employed households will have an incentive to engage in precautionary savings due to the high risk of job loss and the worsening consequences thereof. In the face of such a demand-side contraction, firms have an incentive to cut back on hiring which feeds even lower goods demand.

Even if prices are flexible (Hayek) deficient aggregate demand can turn a crisis into a recession (Keynes).11 Nominal rigidities can amplify this effect12 and be particularly strong when resources are diverted from productive assets (capital) to unproductive ones (such as money).13 This amplification mechanism may be strong enough for large shocks to mean that the economy transitions into an equilibrium with potentially very high levels of unemployment: a dark corner of the labor market.14 Moreover, the lack of social insurance which triggers the demand-contraction when idiosyncratic income risk increases, also implies that the economy can become trapped in a low growth–high unemployment trap: a secular stagnation.15 The importance of heterogeneity and individual income risk has been highlighted in Hintermaier and Koeninger’s analysis of household portfolios across European countries.16

These models provide a conceptual and quantitative framework within which to analyze the policy trade-off between the potential benefit to stimulate an economy in recession and the cost of possibly aggravating the debt problem and postponing the adjustment process and, therefore, prolonging the recession. Nevertheless, the common conclusion is that a well-designed stimulus policy may be beneficial – we will return to this.

Analyzing this trade-off, limited commitment may play an important role. For instance, if the fiscal authorities of an indebted country cannot fully commit to their policies, binding to an austerity program may be optimal in times of crisis since it can act as a partial commitment device to implement a costly adjustment process, even if such counter-cyclical policy is not optimal in normal times.17 This is consistent with the empirical work of Born et al who find that the sovereign default risk-premium responds positively to a reduction in government consumption.18 Nevertheless, in a  low inflation environment if the reduction of government consumption takes the form of a reduction in the public wage or public employment it may not have any expansionary effect on the private sector, as Pappa et al have shown.19

More generally, given the limits that a monetary union places on monetary policy, one can ask how stabilization can be achieved through fiscal policy20 and how effective the ‘transmission of fiscal policy’ to the private sector is. Fève and Sahuc consider  two different amplification mechanisms that have been proposed – the existence of ‘hand-to-mouth’ consumers (i.e. agents that simply consume their labor income) and the possible complementarity between public and private consumption. They conclude that it is the ‘complementarity-mechanism’ one which better explains the observed transmission patterns in the Euro Area,21 which is also consistent with the findings of Bermperoglou et al.22  Furthermore, the multiplier effect of increasing government consumption is lower when the feedback effects of government debt or of contemporaneous crowding are taken into account;23 in fact, the investment multiplier can even be negative in the short run, while in the long run it is positive when the public investment is persistent.24

While the above-cited ADEMU work contributes to the recent research on fiscal multipliers, the transmission mechanism of government spending shocks and fiscal strategies,25 there is also related ADEMU work that contributes to the recent research on optimal fiscal policy, focusing on how it should be designed in times of crisis and in a heterogeneous union.26 In  particular,  regarding  capital  taxation,  there are two recurring themes in the policy debate, as well as in research: whether it should be taxed at all and, if so, whether it should be centralized, or at least harmonized, at the EU level.27 Correia shows that the elimination of capital taxation may hurt the poor if done at the EU level, but not if done in a small economy, for which it is efficient28 (a result that recalls the recurrent discussion between the EU and Ireland). Furthermore, if agents may renege on their debts, a successful tax reform should combine the elimination of capital taxes with an increase on the progressivity of labor income taxes.29

Fiscal policy coordination not only refers to tax policy, but may also regard spending policies. On the latter, Gambetti and Gallio show30 that, while real business cycles share many commonalities among the four large EA countries, public spending policies do not, resulting in important spillovers from government spending shocks.31

On the financial link: Banking Union and the ECB

The financial and euro crises made clear the close linkages between the banking sectors of the euro area member states and the high potential for contagion these linkages could create – particularly when governments cannot credibly commit to never rescue banks.32 It also flagged the possibility that a currency area where a single monetary policy is combined with provisions for supervision and resolution of its banking sector managed at the country level could be ill-designed. For these reasons, the European Union has pushed towards a deeper integration of its banking sector in the form of a European Banking Union (EBU).

The EBU is designed around three pillars. First, there is the Single Resolution Mechanism (SRM), which centralizes the European response to banks facing difficulties. The SRM will make use of the Single Resolution Fund (SRF) financed through contributions by the banking sector. The spirit of the SRM is that, unless there are severe systemic disruptions to the banking system, bank resolutions will make use of this fund and, therefore, there will be no need for bail-outs in which public funds are needed. However, a closer scrutiny of the design for the use and targets of the fund in these  resolutions, shows that the mechanism does not   necessarily eliminate implicit governmental guarantees and, hence, could fail to discipline banks’ risk- taking incentives.33

The second pillar is the Single Supervisory Mechanism (SSM).34 This mechanism, granted to the European Central Bank, has the role of monitoring the financial stability of banks. However, from a legal perspective, Monti and Petit question the existence of a suitable provision within the Treaties empowering the EU legislator to create the elements of a Banking Union, and warn that the design of the SSM as a multi-layered structure encompassing the ECB and the different National Competent Authorities (NCAs) could jeopardize its effectiveness.35 Regarding bank supervision, Jungherr analyzes the endogenous choice of opacity by banks and shows that strategic behavior by banks reduces transparency and increases the risk of banking crises. Nevertheless, full transparency may not be optimal – in particular, performing public stress tests on banks, a task appointed to the SSM, could be harmful from a social point of view if the policy maker has access to banks’ private information.36

The third pillar is the European Deposit Insurance Scheme (EDIS), which is at a standstill –possibly due to fears of becoming an across-countries transfer system and/or exacerbating the inherent moral hazard problems. However, as Rodríguez observes there are other options to guarantee the value of deposits. He shows how a 100% reserve requirement could be implemented in our current monetary system. At a general level, a necessary condition for this implementation has to do  with the remuneration of required reserves at the same rate as the refinancing operations of the central bank, a policy already followed by the Eurosystem. A second, and more stringent necessary condition, is the disposal by banks of enough eligible collateral to pledge on these refinancing operations. Needless to say, should this version of narrow banking be in place there would be no need for a deposit guarantee scheme at the European level to prevent self-fulfilling bank runs.37

Within the EBU, the ECB plays three roles.38 The first one, already mentioned, is as guarantor of the SSM. The second is as the authority responsible for monetary stability – in particular as liquidity provider for the euro area, a role that, as Adao and Silva have shown, it has been strengthened since the euro crisis with the observed increase in firms’ cash holdings.39 The third role is as the authority responsible for financial stability, a de facto mandate which has become very relevant, if not predominant, since the financial and euro crises. Following the steps of the Federal Reserve Board and the Bank of England, the ECB has actively pursued Quantitative Easing (QE) policies. However, it has not implemented any Credit Easing policy such as the TALF implemented in 2009 by the FRB, which was a successful response to the freeze of the AAA-ABS market, and responsible for channeling a significant amount of funds for loans to households and small businesses. In fact, with TALF the FRB took a risk which needed to be backed up by the US Treasury, something unfeasible in the EA. Gaballo and Marimon, interpret the AAA-ABS freeze as a high-interest-high-risk Self- Confirming Equilibrium and show that a credit-easing policy – such as TALF – is an optimal policy that dissipates (pessimistic) misbeliefs, even when the central bank  has the same misbeliefs as private creditors.40

On the legal, operational and political-economy limits of EMU

Legal, operational and political-economy limitations are not only present in the design of the European Banking Union, but also in the EMU design itself.41 In particular, the underlying intergovernmental design makes EMU possible, but it also has three important implications. First, national jurisdictional or political institutions may overturn, or hold up joint policy initiatives (not only fiscal), as Beukers and Fasone document and discuss.42 Second, as Kilpatrick has emphasized, there are three central legal challenges inherent in the current economic governance regime, namely (a) limits to the competence of the EU to strengthen economic governance, (b) the issue of compatibility with fundamental rights and legitimacy, and (c) the sheer complexity of economic governance. In particular, regarding the latter, can the existing Macroeconomic Imbalance Procedure can provide anything more than transparency  and ‘peer-pressure’?43 Third, and in part as a corollary to (c), there are serious limits  to policy coordination, since EMU has evolved from a relatively simple rule-based system to a more encompassing and discretional one – an example being the evolution of the Stability and Growth Pact (SGP) which, with all its ex-post revisions, has never been confronted with an enforcement test.44 There is a need for simplification, drawing the lines, and using rewards more than (non-credible) sanctions, as Steinbach discusses.45

Most of these legal issues are also a manifestation of the political-economy limitations of the current EMU framework. As the recent work of the IMF shows, countries’ compliance with the agreed rules (e.g. the SGP) has been lower among the largest, as well as among those with weaker domestic governments – that is, a weak central authority may be reluctant to punish them: whether because they are  the strong ones, or whether because being weak they may fail if punished46. There are two other broader political-economy issues that deserve ADEMU’s attention: one regards the strengthening of the institutional framework – especially of the EA, for example, with a Treasury; the other, the weakening of rent-seeking activities within the EU – in particular, lobbying activities that can distort or damage policies.

There may be a need to develop or strengthen the Fiscal Union policies and institutions – at the level of the EU, EA or some other subset of countries – in order to efficiently allocate the Union’s public goods (defense, security, migration, etc.), but the ADEMU research question is: how much of a fiscal union is needed to effectively operate an EMU?47 There are two dimensions to this question. One is the need for a “Treasury” with financial capacity. As has already been mentioned, the ECB would need a financial back-up to be an ‘ultimate lender of last resort’, or to implement unconventional policies with risks that cannot (should not?) be absorbed by its balance sheet (e.g. as the FED did with TALF); similarly, within the current Banking Union design (without 100% requirements), public guarantees may be needed. However, we have also mentioned a downside to proposals of this type: a central financial capacity, unless it is well designed, may exacerbate moral hazard problems and, possibly, implement undesired transfers across countries. On the other hand, after 2008, unconventional monetary policies have become a source of revenue – say, for the U.S. Treasury – while maintaining price stability; in other words, central banks can provide fiscal capacity by managing their asset portfolio, as large ‘non-for-profit hedge funds’.

The other dimension is a “Treasury” as a fiscal authority. Existing treasuries get, in part, their authority through having financial capacity, but this need not be the case. In fact, at least in the EA, there is a need to provide proper coordination and decision making to many decisions taken by the ECB, the ESM and the EBU (SRM & SRF) – which, in part, respond to the fiscal policies of the member states – and have fiscal (or political) consequences (e.g. purchasing and handling sovereign debt, etc.) for the EA. In the current framework this ‘authority’ is, in practice, the Eurogroup which, even given the crucial role it has played through the euro crisis, remains an ‘informal body’, with its authority – for example, in relation to the other EA institutions – still  ill defined, as it is its accountability. The latter is important since, as it happens with Treasuries, fiscal and monetary coordination is at the fringes of the  independence status of the ECB.

There is a wide literature in economics about the importance of central bank independence from politics. However, central banks are far from independent from private-sector rent- seeking. The banking sector has been extremely innovative in defeating measures designed to combat rent-seeking and this poses a problem both to tax-payers who get to pay the bills and to the stability of the system. The EBU is not immune to these different forms of rent- seeking, which in some cases take the simple form of ‘defending their assets’ – for example, when in the first round of the Greek debt crisis, in 2010, the option of rescheduling the unsustainable debt was dismissed. The theoretical work of Levine and Modica emphasizes the underlying mechanisms at work and, possible, if any, forms of immunization in democratic competitive economies.48


The above ongoing ADEMU research – which, in turn, builds on the work of many ADEMU associated researchers, and others – already helps us to understand the shortcomings of the current EMU framework, as well as of proposals that do not properly take into account ‘the links between monetary, fiscal, financial and social policies’ and the underlying trade-offs, which are often shaped by ‘existing distortions and frictions in our economies’ (i.e. away from the ‘ideal world’), ‘credibility problems’ (limited commitment or enforcement and moral hazard), ‘agents’ heterogeneity and of their risks and expectations.’ Obviously, a single model cannot, and should not, attempt to take all these elements into account, in the same way that no single evidence can elucidate them all, but keeping them in mind help us to improve on existing models and policy proposals.

In particular, as we have seen, the ongoing ADEMU research can help: the design of debt-markets and contracts to reduce the risk of self-fulfilling debt crises; better assessment of the trade-off between stimulus and austerity programs in times of crisis – in particular, the effectiveness of fiscal policies; assessment of whether capital taxes should be used or avoided; reassessment of the EBU design (even it is not a core element of the project) and exploration of new financial arrangements to reduce financial risks; a definition of the legal and political-economy limits of the current EMU framework and how some may be overcome. Further work needs to be done, but a  base is now in place. Furthermore, there is an area where more concrete proposals are underway, with which we conclude this narrative: risk-sharing arrangements for a new EMU framework.

A risk-sharing fund for the Euro Area?

A recognized problem with the EMU design is how country or regional, specific shocks can be smoothed, given that there is a common currency and (Fiscal Compact) limitations on fiscal national policies. Even under the present, more flexible, interpretation of the Stability and Growth Pact, the ability to share risks is very limited, compared with federal systems, where the same federal budget provides some risk sharing to imperfectly correlated shocks across the federation.49 Ferrari and Rogantini have shown, using counterfactual analysis, that being in the EA did not help to smooth consumption – in particular, for countries on the periphery.50 The development of the European Banking Union can help to pool risks, but it is unlikely it will have the smoothing effect that pro-cyclical local tax revenues have in federal tax systems. Similarly, it can be argued that the ESM can help to smooth consumption but it is not designed as a risk-sharing mechanism (we return to this).

A “shock absorbing facility” for the EA, or EU, must take into account two problems: first, that the extent of ex-post solidarity in a heterogeneous union is limited (i.e. risk- sharing transfers should not become persistent transfers beyond some mutually accepted limits); second that, as with any insurance scheme, there may be moral  hazard problems since idiosyncratic shocks (e.g. welfare state commitments) can have an important endogenous component and information about the effort to prevent them is limited.51 In other words, what is needed is the design of a constrained efficient risk- sharing mechanism, along the lines of the Financial Stability Fund (FSF) proposed by Ábrahám et al.52 The fund sets a long-term contract with each participating country specifying state-contingent countercyclical transfers, designed in such a way that neither the country nor the fund, have any incentive to break the contract at any point in time, and the country exercises the right amount of effort to reduce country risks.

It is interesting to note how the FSF mechanism compares with – de facto defaultable – long-term uncontingent sovereign debt contracts, currently in place, when the risk- averse ‘borrowing’ country is subject to similar shocks that the ‘euro stressed countries’ have been exposed to, in the last ten years. Without debt crises, the real euro crisis would not have been so severe, nor would it have turned into a recession and consumption smoothing and, therefore, welfare of the borrowing country would have been higher, even if ex-post permanent transfers from the risk-neutral fund were set to zero.

Furthermore, risk-sharing transfers can take the form of long-term (state contingent) bonds, and the fund has an important capacity to absorb existing (non-contingent) debts, therefore it can also be seen as an institution that transforms non-contingent debts, with possible default, into contingent debts – effectively non-defaultable debts, to the extent that ex-post, neither the debtor nor the lender want to breach or renegotiate the contract. In sum, an entity that can also help to overcome another EMU problem:

Dealing with the euro crisis debt overhang

In the aftermath of the euro crisis a main issue is whether the EMU has the correct policies and institutions to handle the existing debt overhang problem and to prevent – or at least deal better with — future debt crises. The creation of the European Stability Mechanism (ESM) has been the main institutional innovation of the EMU to resolve debt crises. It has provided financial assistance to Greece (ongoing), Cyprus, Ireland, Portugal and Spain. In particular it has extended the maturity of existing debts, reducing turnover risks, and providing more resilience than traditional programs, such as the ones provided by the IMF throughout the euro-crisis.53 Furthermore, Collective Action Clauses (CAC) have been introduced in order to assist debt restructuring, which apply to all EA bonds issued from 2013.54

There are several proposals to deal with the debt overhang problem that combine  some form of debt restructuring with the transformation of a fraction of the existing sovereign debts into EA sovereign Eurobonds, or an EA institution that would purchase national public debt of EA members. The most recent one, by Corsetti et al., combines a “non-defaultable” Eurobond issued by a “euro area fund” with debt restructuring of excessive national public debts (such a combination is also seen as a framework for macroeconomic stabilization, with the fund having fiscal capacity and being a backstop support for the EMU, i.e. fulfilling some of the Treasury functions discussed above)55. However, while conditionality to ‘fiscal criteria’ is required to activate the mechanism, there  is  no  ex-post  conditionality  and  “non-defaultable”  means  that the euro itself absorbs the potential cost of – possibly, partial – default (or, presumably, new lending is renegotiated).

There are similarities with the current ESM practices, where conditionality is applied ex-ante (through agreed austerity measures) but not ex-post and extending the maturity of the debt can also accentuate moral hazard problems since governments can simply postpone their debt overhang problem.56 As indicated, the (FSF) constrained optimal risk-sharing mechanism accounts for the moral hazard problem it is “non-defaultable by design,” not by transferring the risk to the euro and, in fact, does not require an ex-ante ‘agreed austerity program’, although it may help to consolidate non FSF debts.

A European Unemployment Insurance mechanism?

Of particular interest is to study the possibility of implementing a European Unemployment Insurance scheme. This is a current proposal in the European Parliament, being studied by the European Commission, since risk-sharing within the labor market could be an important landmark of the EMU welfare state. However, even the most developed quantitative studies do not account for the structural differences across EU labor markets and how different unemployment insurance policies change workers’ saving behaviors, or employment decisions, e.g. the move between the different states of employment, unemployment and inactivity.57 When all these elements are taken into account and calibrated the diagnosis is very revealing of the state of the EA labor markets and policies and of the difficulties of sharing risks across national labor markets without disrupting the efficient allocation of labor or generating persistent redistribution effects, as the ongoing work of Ábrahám et al58 shows.

In particular, ‘structural differences’ across EU labor markets are, in many cases, exacerbated by differences in national unemployment insurance policies. Remarkably, the ‘optimal’, and ‘politically supported’, UI policies (i.e. within the class of existing policies characterized by their replacement and duration ratios) are very similar  across the ‘structurally diverse’ EU countries. Permanent transfers can easily be avoided by having different (experience rated) labor taxes to cover UI benefits. Nevertheless, these tax differences possibly provide the best indicator of the cost of having bad labor market institutions, in terms of job creation and destruction, even if countries could implement their ‘optimal’ policies without an EU scheme, having it at the EA, or wider, level helps risk-sharing (taxes would still be different, but smoother with an EA balanced budget) and gives a Bismarckian dimension to the EA, or EU.

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1 V.V. Chari, A. Dovis, P. Kehoe, A Journey Down the Slippery Slope to the European Crisis: A Theorist’s Guide (WP 2017/054) and Rethinking Optimal Currency Areas (WP 2016/9).

2 See ADEMU mini-conference on Fiscal Federalism within the EMU, EUI, Florence, December 2016.

3 See, for example, P. Kehoe and E. Pastorino, Fiscal Unions Redux (WP 2016/012).

4 For comprehensive surveys of the current sovereign debt literature see: M. Aguiar and M. Amador, 2014. “Sovereign Debt,” in Handbook of International Economics, Vol. 4, and M. Aguiar, H. Cole, 2016. “Quantitative Models of Sovereign Debt Crises,” in Handbook of Macroeconomics, Vol. 4.

5 J. Ayres, G. Navarro, J.P. Nicolini and P. Teles, Sovereign Default: The Role of Expectations (WP 25/2016), presented at the ADEMU Conference on “Sovereign Debt, Sustainability and Lending Institutions” University of Cambridge, Cambridge, 2-3 September 2016.

6 G.Corsetti, L.Dedola, The Mystery of the Printing Press Monetary Policy and Self-fulfilling Debt Crises (WP 2016/035)

7 A.L. Delatte, J. Fourquau and R. Portes, Regime-Dependent Sovereign Risk Pricing during the Euro Crisis (WP 2016/32).

8 See J.C. Conesa and T. Kehoe (ADEMU Associated Researchers) (2017), Gambling for redemption and self-fulfilling debt crisis, Economic Theory (forthcoming).

9 A. Kriwoluzky, G. Muller and M. Wolf, Exit expectations and debt crises in currency unions (WP 2016/5).

10 M. Bassetto and C. Galli, Is Inflation Default? The Role of Information in Debt Crises (WP 2017/059)

11 P. Beaudry, D. Galizia, F. Portier, Reconciling Hayek’s and Keynes’ Views of Recession, (WP 2017/057)

12 M. Ravn and V. Sterk, “Job uncertainty and deep recessions” (WP 2016/30)

13 W. Den Haan, P. Rendahl and M. Riegler, “Unemployment (Fears) and Deflationary Spirals” (WP 2016/08)

14 V. Sterk, “The Dark Corners of the Labor Market,” (WP 2016/10)

15 M.O. Ravn and V. Sterk, “Aggregation fluctuations with HANK & SAM: An Analytical Approach” (WP 2016/31)

16 T. Hintermaier and W. Koeniger, “Towards Understanding Differences in European Household Finances” (WP 2016/017) The ADEMU mini conferences on “Macroeconomics of Financial Frictions” and on “Heterogeneous Agents in Macro,” University of Cambridge, Cambridge, 19 April, 2016, and 10 May, 2016, also focused on the role of financial frictions and heterogeneity in macroeconomics, a topic which is also the focus of the ADEMU Conference on “The New Macroceonomics of Aggregate Fluctuations and Stabilisation Policy,” UCL, London, 18-19 May, 2017.

17 See N. Balke, M. O. Ravn, “Time-Consistent Fiscal Policy in a Debt Crisis” (WP 2016/049), presented at the ADEMU mini-conference on “Fiscal Policy in a Monetary Union in Times of Crisis,” Barcelona GSE, March 30, 2017.

18 B. Born, G. Müller and J. Pfeifer, “Does Austerity Pay Off?” (WP 2016/004)

19 E. Pappa, Sajedi, E. Vella, Fiscal consolidation in a Disinflationary Environment: Price-VS Quantity-Based measures” (WP 2016/3)

20 One of the topics of the ADEMU Workshop on Policies for Economic Stability: Lessons and the Way Forward, Galatina, Italy, 28-29 August, 2017.

21 P. Fève, J.G. Sahuc, “In search of the transmission mechanism of fiscal policy in the Euro Area” (WP 2016/28)

22 D. Bermperoglou, E. Pappa, E. Vella ,“The Government Wage Bill and Private Activity,” (WP 2016/33)

23 A. Moura, “The effects of government spending endogeneity on estimated multipliers in the U.S.” (WP 2016/015)

24 M. Dupaigne and P. Fève, “A Persistent Government Spending and Fiscal Multipliers: The Investment-Channel,” (WP 2016/027)

25 A forthcoming ADEMU workshop at Toulouse School of Economics will focus on The Transmission Mechanism of Fiscal Policy in the Euro Area and in Times of Crisis.

26 Research on this, and related issues will be presented and discussed at the ADEMU Conference on “Redesigning Fiscal Policies,” Lisbon, 22 September, 2017.

 27 The latest call for EU harmonization of corporate taxes was the October 2016 European Commission proposal to re-launch of the Common Consolidated Corporate Tax Base (CCCTB), as part of a broader Corporate Reform Package –as with past calls, implementation has not followed.

28 I. Correia, “Capital Taxation and Globalization,” (WP 2016/19).

29 A. Abraham and E. Carceles-Poveda, “Tax Reform with Endogenous Borrowing Limits and Incomplete Asset Markets” (WP 2016/13)

30 L. Gambetti and F. Gallio, “Measuring fiscal spillovers in the Euro Area” (WP 2016/44).

31 See also O. Arce, S. Hurtado, C. Thomas, “Policy Spillovers and Synergies in a Monetary Union,” (WP 2016/006) presented at the ADEMU Workshop on “Macroeconomic Imbalances and Spillovers,” CERGE-EI, Prague, April 2016.

32 See W. Schelkle’s “Hamilton’s paradox revisited: lessons from the euro area” at the ADEMU Conference on “How much of a Fiscal Union for the EMU?,” Madrid, May 18-19, 2017

33 Mikaella Yiatrou, “Bank resolution credibility and economic implications” (WP 2016/38)

34 The ADEMU Workshop on “The European Banking Union and its Instruments,” EUI, October 11, 2016, focused on the legal status of the SSM and the SRM.

35 G. Monti and C.A. Petit, “The Single Supervisory Mechanism: legal fragilities and possible solutions” (WP 2016/16)

36 J. Jungherr, “Bank opacity and financial crisis” (WP 2016/2)

37 H. Rodriguez. “Narrow banking with modern depository institutions: Is there a reason to panic?” (WP 2017/052)

38 These roles – in particular, their legal operative base – will be analyzed in the forthcoming ADEMU workshop “The New ECB in Comparative Perspective”, 19-20 September 2017, EUI.

39 B. Adão and A.C. Silva, “The Effect of Firm Cash Holdings on Monetary Policy,” (WP 2016/11)

40 G. Gaballo and R. Marimon, “Breaking the spell with credit-easing,” (WP 2016/1)

41 The ADEMU Workshop on “Legal and Institutional Dimensions of EMU,” EUI, Florence, October 2015, provided an overview of the limits of the current fiscal and monetary framework.

42 T. Beukers and C. Fasone, “EMU and national constitutional conditions to long-term change” (WP 2016/39)

43 C. Kilpatrick “The new Economic component of EMU: A Lawful and Effective Design,” (WP 2016/7)

44 P. Leino and T. Saarenheimo “On the limits of EU Economic Policy coordination” (WP 2016/36)

45 A. Steinbach, “Structural Reforms in EU Member States: Exploring Sanction-based and Reward-based Mechanisms (WP 2016/45)

46 V. Gaspar, S. Gupta and C. Mulas-Granados (eds.) Fiscal Politics, IMF (2017)

47 A question addressed by the ADEMU Conference on “How much of a Fiscal Union for the EMU?,” Madrid, May 18-19, 2017.

48 D. Levine and S. Modica “Size, fungibility and the strengh of lobbying organizations,” (WP 2016/22)

49 Furcieri and Zdziencka (2015, Open Eco. Review) estimate, that in EA(15), 1978 – 2010, 70% of countries’ business cycle shocks are not smoothed, while the percentage is substantially lower in US states (25%) or in German Landers (20%). Using their methodology, our own estimate for EA(19),  1995–2015, is 83% (M. Lanati).

50 A. Ferrari, A. Rogantini Picco, “International Risk Sharing in the European Monetary Union” (WP 2017/055)

51 Although it can be improved, an issue that will be discussed in the ADEMU Workshop on “Measures of Public Balance Sheet Risk Assessment and on Social & Labour Insurance Risks,” U. of Bonn,  July, 6-7, 2017.

52 Á. Ábrahám; A. Cabrales, Y. Liu and R. Marimon, “On the optimal design of a Financial Stability Fund” (2017), with preliminary results presented at the ADEMU Workshop on “Risk Sharing  Mechanisms for the EU,” EUI, Florence, May 2016. A simpler form of fiscal transfers is studied in G. de Almeida Bandeira, “Fiscal Transfers in a Monetary Union with Sovereign Risk” (WP 2016/47).

53 G. Corsetti, A. Erce and T. Uy , “Debt Sustainability and Terms of Official Support”, presented at the ADEMU Conference on “Sovereign Debt, Sustainability and Lending Institutions” and the ADEMU Workshop on “Economic Policy Changes” (EUI, Florence, November 2016).

54 For a discussion of its shortcomings, see T. Martinelli, “Euro CAC and the existing rules on sovereign debt restructuring in the euro area an appraisal 4 years after the Greek debt swap” (WP 2016/43).

55 G. Corsetti, L. Dedola, M. Jarociński, B. Maćkowiak and S. Schmidt, “Macroeconomic stabilization, monetary-fiscal interactions, and Europe’s monetary union” (WP 2017/058 & ECB DP No 1988/2016), which contains a synthetic comparison with other existing proposals to deal with the debt overhang problem.

56 For example, Spain has already made four early repayments to the ESM (while growing but not being able to reduce its deficit to previously-agreed levels), but could have not done so in accordance with the ESM uncontingent debt contract.

57 See the complementary work of M. Dolls, C. Fuest, D. Neumann, A.  Peichl  “An  Unemployment Insurance Scheme For The Euro Area? A Comparison Of Different Alternatives Using Micro Data” (WP 2016/048).

58 Á. Ábrahám, J. Brogueira de Sousa, R. Marimon and L. Mayr, “On the design of a European Unemployment Insurance Mechanism” (2016), preliminary results presented at the ADEMU Workshop on “Job Creation, Job Destruction and Productivity Growth,” EUI, Florence, 14-15 October, 2016.