Idiosyncratic Shocks, Economic Governance of the Euro-area and the Role of Member States

Published: 6/10/2014 Modified: 10/10/2014


The economic and sovereign debt crisis in Europe has triggered a comprehensive institutional reform to avert similar catastrophic scenarios in the future and provide ongoing income support to member states should they still occur.

Substantial fiscal risk sharing mechanisms have been contemplated, ranging from a limited euro area budget, direct transfers between the member states and a degree of debt mutualisation, to common unemployment insurance, all in an effort to establish a link between individual income risk and fiscal transfers. However, these arrangements fall short of mitigating idiosyncratic1 shocks that affect the member states in "normal" times. To be effective, such consumption smoothing must discriminate between a total cycle component, pertinent for the eurozone as a whole, and a country specific (i.e. idiosyncratic) cycle, which is highly arbitrary.

As reported by empirical studies, risk sharing among the Canadian provinces, the German states and the US states is approximately about 39% through capital markets and 23% through credit market mechanisms. However, capital markets in the euro area broke down during the financial crisis, when risk sharing was most needed.

Current EU discussions foresee a limited fiscal capacity, mostly in the range of 1 to 2% of the euro area GDP, which will, even in a full-blown fiscal union, fall short of any significant idiosyncratic shock smoothing. The key is to balance income smoothing and risk sharing both through capital markets and through fiscal transfers, along with a strict enforcement of moral hazard limitations.