06 September 2022

CEPR: A stability fund for the euro area

A greater likelihood of external, asymmetric shocks from conflicts, climate change, or future pandemics all press the urgency of establishing a euro area fiscal stabilisation capacity that has long been called for by academics as well as European and international institutions.

  This column presents and evaluates a proposal for a ‘euro area stability fund’. The authors argue that a stability fund hosted by the European Stability Mechanism is politically realistic and economically sound because it would not require additional resources, it could be set up quickly and easily, it would address moral hazard by design, and it could have relatively large stabilisation effects.

A fiscal stabilisation capacity is missing in the architecture of the euro area. It could be needed to cushion large shocks that both monetary policy and national fiscal policy cannot adequately address, either due to limited policy space and/or the asymmetric nature of the shock itself (e.g. Codogno and van den Noord 2020).

Filling this gap now seems more important than ever, as the likelihood of large asymmetric shocks is poised to increase, and policy space is limited. Large external shocks that undermine euro area stability are more likely given the ongoing war in Ukraine, extreme weather events, and transition risks stemming from climate change or the pandemic. At the same time, high inflation and high debt imply stretched common monetary and national fiscal space in many member states.

As of now, there are no permanent and dedicated instruments to foster macroeconomic stabilisation in response to external shocks that work through public risk sharing. The Support to mitigate Unemployment Risks in an Emergency (SURE) instrument is temporary, fully disbursed, and designed to provide a one-time relief from the pandemic. Private risk sharing complements (rather than substitutes) public risk sharing and remains limited, given the incomplete banking and capital markets union and insufficient cross-border labour mobility. National fiscal buffers could alleviate the need for a fiscal stabilisation capacity but building them to sufficient scale will take time and would compete with the large green spending needs. ¹ While other (mostly temporary) EU instruments, including the Recovery and Resilience Facility, can support short-term stabilisation, their primary objectives differ and may not always align with fiscal stabilisation. Furthermore, they often require longer-term planning, undermining their ability to quickly respond to shocks.

A loan-based fiscal stabilisation capacity

In a recent paper (Misch and Rey 2022), we propose a loan-based fiscal stabilisation capacity for the euro area, referred to as ‘stability fund’. This fund would be administered by the European Stability Mechanism (ESM) and provide loans on favourable terms in times of external shocks for short-term stabilisation purposes. The loan maturity would be up to ten years with a three-year grace period, and maximum loan amounts would be 4% of GDP within an overall envelope of €250 billion. The interest rates would reflect funding conditions of the ESM.

The specific design features strike a balance between allowing for speedy disbursements and adhering to appropriate conditionality. Activation of the fund would be based on expert judgement and/or quantitative indicators including unemployment-based metrics. Eligibility would require that a country’s public debt be deemed sustainable and that the country is not subject to an excessive deficit procedure, internal imbalance procedure, or a macroeconomic adjustment programme. ² These criteria would incentivise prudent fiscal behaviour in economically good times and allow for swift loan disbursement, but also ensure that loans are not provided in response to internal imbalances or policy errors. The loans would not be earmarked for specific purposes to avoid delays in times of crises. As a safeguard, they would have to be used to enhance macroeconomic stability through appropriate fiscal measures and debt management operations which excludes obvious misuse of public resources. Upon request for support from the stability fund, the ESM and the European Commission, in liaison with the ECB, would assess whether eligibility and activation conditions are met (and carry out other standard assessments as required for any loan under the ESM treaty).

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