An unemployment benefit scheme for the Eurozone

László Andor, Paolo Pasimeni 13 December 2016

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The existential crisis of the Eurozone is likely to return to the centre of the European policy debate. The question today is not simply whether the EMU will survive or collapse, but whether the growth performance can improve without actual reform (e.g. Buti and Rodríguez Muñoz 2016).

Since its inception, and already before the crisis, the Eurozone has had lower growth and higher unemployment rates than other regions in the world. The reason for this outcome is to be found in the ‘Maastricht model’ (Andor 2013) flawed by two key structural weaknesses: a tendency to develop imbalances, and an inherent deflationary bias (Pasimeni 2015). The trade-off between growth with imbalances or balance without growth signals a clear stabilisation problem.

Do we need new fiscal instruments for stabilisation?

We should first ask if market mechanisms alone are capable of providing stabilisation in the Eurozone. If not, we should assess whether existing instruments can achieve the objective. Finally, if neither market mechanisms nor existing instruments are sufficient to fulfil the need for stabilisation, we should envisage new tools.

Markets can lead to inter-temporal stabilisation of symmetric shocks if they behave in a counter-cyclical way, and inter-regional stabilisation of idiosyncratic shocks if they provide channels for risk-sharing and a stable and efficient allocation of resources. Evidence from recent years suggests these conditions do not hold – markets amplified cyclical conditions and even reduced the level of risk-sharing among EMU economies.

Monetary policy and structural reforms are the existing tools which could contribute respectively to inter-temporal and inter-regional stabilisation. However, limits to both – in the form of a zero-lower-bound for monetary policy, and high short-term costs amplified by a recessionary environment and a deflationary bias in the case of structural reforms – suggest that new instruments are necessary to stabilise the Eurozone.

Different types of stabilisation imply different conditions for a fiscal instrument. For a new fiscal instrument to perform inter-temporal stabilisation, it must be able to borrow and issue debt. On the other side, a fiscal instrument for inter-regional stabilisation does not need transfers to be permanent – they can be perfectly ‘clawed-back’ once the relative specific conditions of the country improve.

The combination of the two functions, however, suggests a kind of trade-off in the use of instruments for the two. Or to be more precise, there is a trade-off in the ‘non-use’ of a fiscal instrument for the two functions.

The less the EMU wants to rely on a fiscal capacity for risk-sharing and insurance against idiosyncratic shocks (i.e. the more it wants to rely on improving the adjustment capacity at the national level through structural reforms), the stronger deflationary pressure it develops on the whole area. Consequently, the stronger the pressure on monetary policy to reach its limits, and the higher the resulting need to use the fiscal instrument for inter-temporal stabilisation to free the system from the deflationary pressure.

And vice versa – the more the EMU pushes monetary policy towards its limits to achieve inter-temporal stabilisation without active support by fiscal policy, the lower the capacity to sustain all countries and free them from a deflationary pressure, therefore the higher the short-term costs of structural reforms, the lower their effectiveness, and the bigger the need to compensate through a fiscal instrument for inter-regional stabilisation.

In synthesis, common fiscal policies cannot be ruled out in both functions, and the less we use them in one case, the more we will have to use them in the other.

A European unemployment benefit scheme

An instrument for stabilisation based on unemployment as a driving indicator is appropriate (Andor 2016) for four reasons:

  1. Unemployment is the ‘escape valve’ for adjustment in the monetary union; it closely reflects the adjustment effort being made by a country
  2. It is easily understandable and promptly measurable (as compared, for instance, to the output gap)
  3. It also very closely follows developments in the economic cycle; and
  4. When short-term unemployment becomes longer term, it also causes further damage to the growth potential of a country (hysteresis).

A European unemployment benefit scheme can be designed in a way to address both stabilisation functions, but then requires a basic arrangement of temporary, non-permanent transfers for cross-country risk-sharing, and a debt-issuing possibility for inter-temporal stabilisation. This is the case, for instance, for the US federal system.1 The European unemployment benefit scheme can take two forms.

A basic common European scheme

In this case, national schemes would be partially pooled, individuals would receive unemployment benefits directly from the common European scheme for a limited period (e.g. six months), and national systems would be allowed to top up. This means that the level of generosity of the social protection system is not bound to be uniform among all countries, because member states could decide to complement it.

A minimum degree of harmonisation of labour markets would be required, defining some common minimum standards across countries (e.g. in terms of a minimum replacement ratio and duration of unemployment benefit). However, if only cyclical unemployment2 were to be linked to the EMU mechanism, longer-term unemployment would remain an issue for national actors. Thus, a large-scale harmonisation is unnecessary.

Such a European common scheme can be financed by a share of employers' and employees' contributions to their social security. This ensures that fluctuations in unemployment rates in every country are automatically internalised by the system, therefore ensuring stabilisation.

A reinsurance fund

A reinsurance fund among countries, instead, would simply support the national systems, and transfers would only be triggered by major crises. The system would be financed by contributions linked to GDP. The recent proposal by the Italian government falls into this category (MEF 2016).

Such a scheme would have a stronger impact at times of crisis, while lacking a role during more modest fluctuations. It may be easier to establish than the previous model, because it requires much less harmonisation. On the other side, it provides less visibility.

A risk lies in setting the trigger too high (in terms of how fast unemployment would need to rise above past levels), and thus making the mechanism less effective than it could otherwise be.

Costs and benefits

All simulations suggest that a European scheme would absorb less than 1% of countries’ GDP,3 also because it would imply only a partial pooling of national unemployment insurance.4 The higher payments at the supranational level would be offset to some extent by reduced payments at the national level.5 Had such a scheme been in place in the past, all countries would have benefited at some point.

Beyond macroeconomic stabilisation, it would provide social stabilisation – reaching more vulnerable groups and helping to tame the rise of poverty among the working age population – and institutional stabilisation – allowing the reconciliation of uniform fiscal rules with the need to maintain national welfare safety nets and social investment capacities (Andor 2016).

The issue of net benefits and contributions for each country should be secondary in view of the common stabilisation benefit; however, it is understandable that some worry about being permanently net contributors and about moral hazard (Hess 2015). There are four key issues to highlight when we consider the risk of moral hazard in the EMU:

  • First, participation in a monetary union tends to amplify divergences in the balance of payments (Friedman 1953, Kaldor 1971), and these differences are likely to persist (Fleming 1971). Given the natural asymmetric pressure to adjust on deficit and surplus countries (Keynes 1980), a big problem of ‘moral hazard’ arises on surplus countries. Thus the need for a correction mechanism.
  • Second, the stabilisation capacity of such a mechanism is directly proportional to the degree of transfers operated. Thus the trade-off between the prevention of moral hazard in the use of the instrument and its effectiveness (Fattibene 2015).
  • Third, the risk of ‘lasting transfers’ through a common unemployment benefit scheme can be minimised by mechanisms which already exist in other unemployment insurance systems, namely, experience rating6 and claw-backs.7
  • Fourth, studies have proved that even systems that do not redistribute resources between countries can have an important stabilisation impact in the medium run (Dolls et al. 2014, Brandolini et al. 2014).

Conclusions

The incomplete EMU designed at Maastricht proved to be, at best, a structure for fair weather, not for financial and economic turmoil. It became a competitive disadvantage for Europe vis-a-vis the US and Japan.

Nicholas Kaldor’s fear (1971) that monetary union imposed under inappropriate conditions could backfire and generate political pressures against integration is being proved right. As Mario Draghi put it more recently, either the EMU allows each country to be better off inside than outside it, or it will not be sustainable (Draghi 2014).

Without concrete initiatives towards a better functioning model, de-construction will present itself as the more appealing option towards the end of this decade (Nordvig 2014), and the choice will be between an orderly or disorderly one. The consequences would be much more unpredictable than limited fiscal risk-sharing in a basic European unemployment benefit scheme.

There are solutions capable of sorting out the macroeconomic bias against full employment in the EMU. We highlighted the key issues of a European unemployment benefit scheme, but we do not suggest that it would be sufficient to make the single currency sustainable, or a remedy for all ills in the Eurozone.

The key obstacle to its implementation is political. Painful adjustments in deficit countries have eroded political support for further integration. Years of propaganda in surplus countries based on supposed wrongdoing and misbehaviours of the others makes it nearly impossible now to change narrative and explain that helping each other out is actually beneficial for all.

Authors’ note: The opinions expressed here are the authors’ alone and do not reflect those of their affiliated institutions.

References

Andor L (2013) “Can we move beyond the Maastricht orthodoxy?”, VoxEU 13 December.

Andor, L (2016) “Towards shared unemployment insurance in the euro area”, IZA Journal of European Labor Studies, 5(1): 1-15.

Beblavý M and I Maselli (2014) An unemployment insurance scheme for the euro area: A simulation exercise of two options, CEPS special report, 98, Brussels.

Brandolini A, F Carta and F D’Amuri (2014) “A feasible unemployment-based shock absorber for the euro area”, Questioni di Economia e Finanza (Occasional Papers), No 254, Banca d’Italia, Rome.

Buti, M and L Rodríguez Muñoz (2016), “Why we need a positive fiscal stance for the Eurozone and what it means”, VoxEU.org, 28 November. 

Dolls M, C Fuest, D Neumann and  A Peichl (2014) “An unemployment insurance scheme for the euro area? A comparison of different alternatives using micro data”, ZEW-Centre for European Economic Research, discussion paper 14-095, 28 October.

Draghi M (2014) “Stability and prosperity in monetary union”, Speech by the President of the European Central Bank, at the University of Helsinki, 27 November.

Dullien S (2013) “A European unemployment insurance as a stabilization device—selected issues and a Euro-area wide unemployment insurance as an automatic stabilizer: who benefits and who pays?” European commission DG EMPL.

Fattibene D (2015) Creating a union with a 'human face': a European unemployment insurance.

Fleming J M (1971) “On exchange rate unification”, Economic Journal, 81: 467–488.

Friedman, M (1953) "The case for flexible exchange rates", published in Friedman's Essays in Positive Economics, University of Chicago Press, 157-203.

Hess R (2015) “The political feasibility of an automatic fiscal stabilizer for the Eurozone”, unpublished master’s thesis, Hertie School of Governance, Berlin.

Italianer A and M Vanheukelen (1993) “Proposals for community stabilization mechanisms: some historical applications”, In The economics of community public finance, European economy: reports and studies, no 5, European Commission, Brussels.

Kaldor N (1971) “The dynamic effects of the common market”, New Statesman, 12 March.

Keynes J M (1980) “Activities 1940-1944, shaping the post-war world: The clearing union”, in The collected writings of John Maynard Keynes, Royal Economic Society. MacMillan and Cambridge University Press, London, Vol XXV.

MEF (2016) "A European unemployment benefit scheme"A E, Ministero dell'Economia e delle Finanze, September.

Nordvig J (2014) The fall of the euro: Reinventing the Eurozone and the future of global investing, McGraw-Hill, New York.

Pasimeni, P (2015) The economic rationale of an EMU fiscal capacity, Proceedings of the Oesterreichische Nationalbank Workshop “Towards a genuine economic and monetary union”, Vienna, September.

Pisani-Ferry J, E Vihriälä and G Wolff (2013) “Options for a Euro-area fiscal capacity”, Bruegel Policy Contribution, No 2013/01.

Endnotes

[1] The US federal unemployment scheme is an example of such an instrument, with its mixed system of states' responsibility in normal times, plus extended and emergency benefits provided by the federal system (financed through borrowing) in times of crisis.

[2] Proxied by short-term unemployment.

[3] One of the first simulations of a common unemployment benefit scheme (Italianer and Vanheukelen 1993) suggested that it would amount to 0.5% of GDP and have a stabilisation effect of 20% across the EU. Dullien (2013) suggested an annual cost of the scheme between 0.3% and 0.6% of GDP, and the stabilisation effects of the system, calculated as GDP deviation from a potential GDP trend, would increase on average by 11% for the whole area; however, the net effect in a recession in most countries would be much larger. Brandolini et al (2014) estimate that over the decade 2002–2012, such an instrument would have had a stabilisation effect, calculated as the reduction in the coefficient of variation of GDP within the Eurozone, by 0.03%. Beblavý and Maselli (2014) use a different measure of stabilisation, by looking at the ratio between net payments to the fund and total GDP, instead at the deviation of GDP from its trend. With such a methodology, they find a multiplier effect of 1.5. Dolls et al (2014) find a stabilisation effect ranging between 23% and 31% for Greece, Ireland, Italy, Portugal, and Spain, during the first years of the present crisis. The most recent simulations suggest that the total amount of spending of such a scheme would have ranged between 0.3% and 0.4% of GDP had it been in place during the period 1995-2013.

[4] The only study which assumes a total coverage of unemployment benefit costs of countries (Pisani-Ferry et al 2013) calculates that between 2002 and 2010 such a scheme would have represented on average 1.8% of GDP. However, this study overestimates the size of a scheme, which would instead be only a partial complement, at the European level, of national insurance policies.

[5] For example, reduced payments on national unemployment benefits or social assistance.

[6] Experience rating means that the contributor vs. beneficiary profile of each Member State in the scheme is monitored, and the contribution or drawdown parameters can be adjusted at the beginning of each period so as to bring the Member State closer to a projected balance with the scheme over the medium term.

[7] Clawbacks, on the other hand, enable to neutralise net transfers ex post, meaning that Member States are allowed to be net beneficiaries for several years, but then their contribution and/or drawdown rates are modified so as to compensate for the net transfers that had occurred.

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Topics:  EU institutions EU policies Labour markets

Tags:  eurozone, EU, unemployment benefit scheme, stabilisation, structural weakness, reinsurance fund, unemployment

Head, Department of Economic Policy, Corvinus University; Senior Research Fellow, IMK, Hans Boeckler Stiftung

Economist, European Commission

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