A Shock Absorber for the Eurozone

One quirk of the European monetary union is that monetary policy is decided centrally while fiscal policy is carried out at the individual member-country level. In other words, one monetary policy and 18 different, sometimes contrasting, fiscal policies. (On top of that, the central monetary institution, the ECB, has been caught lately playing its hand at fiscal policy, a function for which it has no mandate. But that is another story.)

This state of affairs leads to the monetary union lacking sufficiently robust automatic stabilizers in case of asymmetric shocks, as the crisis made painfully evident. One reason for this shortcoming is the concern that such stabilizers could mutate into a permanent transfer system within the union, giving rise to moral hazard in the process.

Many ideas have been bandied about on how to solve the conundrum. One such idea has been to set up a sort of EU-wide unemployment insurance system, which could exert a limited asymmetric shock absorption function, with three basic options. One would be a common Eurozone unemployment insurance system that provides a basic level of insurance by partly replacing national unemployment insurance systems. A second option would be to provide income stabilization only in the event of large unemployment shocks. The third option would complement national systems by providing additional transfers which would either top up national benefits or kick in if national benefits expire.

Studies on such schemes have so far been based on aggregate macro-level data, focusing on overall net contributions across Eurozone member states. CESifo Fellow and Ifo President-Designate Clemens Fuest, together with his colleagues Mathias Dolls, Dirk Neumann and CESifo Fellow Andreas Peichl, have now published the first paper that provides a comprehensive and systematic analysis of a range of design options for a Eurozone-wide unemployment insurance system based on household microdata, covering the period from the start of the euro in 1999 to 2013, and including all 18 current member countries.

They are at pains to emphasize that their study is not intended as a policy proposal. They just aim at providing a conceptual experiment to give general insights into the effects of various design options.

There are of course risks associated with the above schemes. For one thing, some governments might feel tempted to cut national unemployment insurance benefits as the Eurozone system kicks in. Another is the risk of moral hazard: the system could undermine incentives for national governments to address structural weaknesses of their respective labour market. Furthermore, incentives to pursue active labour market policies could be adversely affected. Finally, some national administrations could use their discretion to increase the number of benefit recipients.

The authors review in detail the features, benefits and potential pitfalls of the various schemes using the empirical microdata to examine, basically, what would have happened since the year 2000 if each of these systems had been in place.

They find that a system with a replacement rate of 50 percent—i.e. an unemployment benefit amounting to half the latest salary of the beneficiary—, a maximum duration of 12 months and a broad coverage of all new unemployed with previous employment income could be implemented with an annual uniform contribution rate across member states of 1.56 percent of employment income. Over the period 2000-2013, average benefits would have amounted to around 47 billion euros per year.

In order to avoid the risk of the system turning into a permanent redistribution system within the Eurozone, it could be limited to short-term unemployment. Still, the simulations show that a small number of member states would have been net contributors or net recipients in each year. The largest contributors would have been Austria, Germany and the Netherlands, with average yearly net contributions of 0.19-0.39 percent of GDP. Latvia and Spain would have been the largest net recipients, with yearly averages of 0.36 and 0.54 percent of GDP, respectively.

To stave off the risk of countries getting mired into a permanent net contributor status, the researchers consider a contingent benefit scheme that is activated if the unemployment rate in a given member state is 1 percentage point higher than in one of the previous three years. With 22 billion euros per year, the overall budget and thus the amount of cross-country redistribution would have been less than half as large as under the non-contingent scheme in the baseline.

Turning to the effects within the countries, the authors find that among those who benefit the most, in terms of stabilization and coverage, are the young and, surprisingly, also the high-skilled unemployed. The reason for the young benefiting is that they often do not meet eligibility criteria for national unemployment benefits, while they would be covered by the Eurozone-wide ones. For the high-skilled, the finding is due to the higher proportion of short-term relative to long-term unemployed (who would not be eligible under the Eurozone-wide scheme) in this group.

In terms of the stabilization gain, the authors find that the basic system would have provided a 12-percent gain for households and 6 percent for government budgets, the effects becoming smaller over the course of the crisis due to the scheme covering only the short-term unemployed.

In terms of financing the scheme, they find that the system would have produced a surplus in its early years, building up reserves to finance higher benefits during the crisis. The question is, what would happen if the reserves are depleted but the crisis lingers on? In that case, the question arises of whether the system would be allowed to issue debt. And if so, how to limit indebtedness before it becomes so unsustainable that the scheme has to be bailed out by the member states. There is a clear need for a balancing act between the system’s fiscal stabilizing function and an effective debt limitation.

The authors are careful to point out that "behavioural effects", i.e. whether the moral hazard effects dominate or not, could tilt the system either towards smaller transfers between countries — or to even larger financial flows from contributors to recipients. The old problem again, of having a central system torpedoed by 18 different kinds of behaviour.

Mathias Dolls, Clemens Fuest, Dirk Neumann and Andreas Peichl: An Unemployment Insurance Scheme for the Euro Area? A Comparison of Different Alternatives Using Micro Data, CESifo Working Paper No. 5581

Other CESifo Working Papers by Clemens Fuest
Other CESifo Working Papers by Andreas Peichl