Economics, 3rd Edition

Does the Eurozone Need a 

Budget?

The Maastricht Treaty created a 

restrictive European monetary union 

by keeping fiscal policy national, 

subject only to a stability pact. Was 

this a wise choice? Many observers 

now argue that the Achilles’ heel of 

the euro is that it has no mechanism 

to ease shocks to individual member 

states. The euro area, they argue, 

needs its own budget to provide 

some automatic insurance to indi-

vidual countries when they are hit by 

these asymmetric shocks.

Even proponents of a sizeable 

‘federal’ euro budget admit that 

permanent shocks (for example the 

collapse of a major export market) 

require permanent adjustment in 

wages and expenditure. But what 

is lacking is allegedly a mechanism 

to redistribute funds from countries 

experiencing temporary booms to 

those in recession. This, they say, 

would dampen the normal ups and 

downs of an economy and make 

short term shocks easier to absorb. 

They usually hold up the United 

States and its redistributive federal 

system as an example of how this 

can work.

But a closer look reveals that this 

doesn’t work as well as is widely 

assumed. It is true that in the US, as 

in most federal states, the federal 

budget redistributes income across 

regions and thus offsets at least part 

of the inter-regional differences in 

income. But the inference that redis-

tribution is equivalent to a shock 

absorber is wrong.

For example, in the US, the federal 

budget offsets a substantial part of 

the differences in the level of income 

per capita across states – generally 

believed to be between 30 per cent 

and  40 per  cent – because poorer 

states contribute on average lower 

income tax and receive higher 

social security payments. However, 

this does not imply that these mech-

anisms also provide an insurance 

against temporary shocks to indi-

vidual states. Many of the transfers 

from the federal government, espe-

cially basic social support such 

as food stamps, etc. change little 

with the local business cycle. For 

example, retirees in Florida receive 

their pensions whether or not the 

local economy is doing well (as dur-

ing the real estate boom up to 2007). 

These pensions do not increase 

when the local economy enters a 

bust, as it did after 2008. This type of 

transfer payments from the federal 

government thus does not provide 

any buffer against local shocks.

On the revenue side the degree to 

which federal taxes absorb shocks 

at the state level cannot be very large 

for the simple reason that the main 

federal sources of revenues that 

react to the business cycle, such as 

federal income tax, accounts for less 

than 10 per cent of GDP.

This low sensitivity of both 

 

federal expenditure and revenues 

to local business cycle conditions 

explains why on average only a small 

 fraction  – estimated about between 

10 and 15  per  cent – of any shock 

to the GDP of any individual state is 

absorbed via automatic transfers to 

and from the US federal budget.

A related idea which has come up 

repeatedly in the European  context 

is to create some European, or euro 

area, unemployment insurance fund. 

This idea is very attractive at first 

sight. But here again the reference 

to the US experience is misleading: 

in the US, unemployment insur-

ance is actually organized at the 

state level. The federal government 

intervenes only in the case of major 

nationwide recessions and provides