Fiscal transfers in a monetary union with sovereign risk

Abstract

This paper considers a scheme of fiscal transfers between member states of a monetary union subject to sovereign spread shocks. The scheme consists of a set of cross-country transfer rules triggered when sovereign spreads widen. I study its implementation in a twocountry model with financial frictions estimated for Portugal and the Eurozone. The model illustrates how domestic fiscal policy is unable to buffer the widening of sovereign spreads when public debt is high and spreads are responsive to the fiscal outlook. On the contrary, because transfers are made between governments, they alleviate the strain caused on the fiscal stance directly and reduce the pass-through of sovereign risk to private lending to firms. I find that, for welfare to improve for all member states, their relative size and fiscal profile need to be nearly symmetric. Nevertheless, I show that for a cost to the remaining members states significantly smaller than the benefits they derive from being part of the union, a small country like Portugal can secure sizeable increases in life-time consumption.

The ADEMU Working Paper Series is being supported by the European Commission Horizon 2020 European Union funding for Research & Innovation, grant agreement No 649396.