Daniel Gros, Director of CEPS, contributed this column to VoxEU, where it was first published on 19 March 2014.
Many observers and policymakers now argue that the eurozone needs a system of fiscal shock absorbers like that of the US, based in part on recent studies by the IMF that find that about 20% of shocks to state income in the US are offset by the federal fiscal system. But this column argues that such a system would have been of limited value in the euro crisis. Offering a country whose output falls by 1% (relative to the eurozone average) a transfer of 0.2% of GDP would be of very limited usefulness. A country hit by a very large shock, say 5% of GDP (like Portugal or Ireland) would of course receive a larger transfer, but the problems would not be substantially different (a fall of income by 4% instead of 5%). By contrast, in a system of insurance with a deductible, of say 1% of GDP, the country hit by a small shock would receive nothing. But most of the large shock – everything above the 1% deductible – could then be offset.
Gros argues that what the eurozone really needs is not a system that offsets all shocks by some small fraction, but a system that protects against shocks that are rare, but potentially catastrophic. The many minor cyclical shocks that do not impair the functioning of financial markets can then be dealt with via borrowing at the national level.
Download at: http://www.voxeu.org/article/ez-fiscal-shock-absorber-lessons-insurance-economics