Towards shared unemployment insurance in the euro area

The Five Presidents’ Report (FPR) in June 2015 diagnosed the European Economic and Monetary Union (EMU) with severe divergences, outlining the key arguments for revamping the EU’s economic and monetary architecture. Rebalancing the EMU is a key issue. Various models of rule-based, though limited, mechanism of risk-sharing have already been explored to strengthen people’s and markets’ confidence in the common currency.

The EMU was established with an unprecedented divorce between the main monetary and fiscal authorities (Goodhart 1988), with the idea of progressively moving towards full economic integration. The incompleteness of the EMU, however, was fatally exposed once the financial crisis hit and has often been pointed out as a key determinant of the long recession (Enderlein et al. 2015; Obstfeld 2013; O'Rourke and Taylor 2013; Spolaore 2013).

The removal of the exchange rate risk fostered capital flows (Lane 2013), acting as a system of transfers intermediated by financial markets (Hale and Obstfeld 2014), instead through a common fiscal capacity (Pasimeni 2014). The relevance of a common fiscal capacity in monetary unions (Kenen 1969) and the specific case of the EMU were widely discussed in literature before the adoption of the euro (Mundell 1973; Eichengreen 1991; Sala-i-Martin and Sachs 1991; Feldstein 1992; Bayoumi and Masson 1995).

At the same time, the lack of exchange rate excluded an important adjustment mechanism, without creating a new one. The imbalances accumulated during the pre-crisis period were paving the way for an asymmetric effect of the shock caused by the financial crisis (Regan 2015). The post-Lehman sudden stop in financial flows and the Great Recession affected countries differently: deficit countries were forced to adjust and got greater harm; surplus countries could choose not to adjust, and so they did.

In the absence of self-correction mechanisms, the first decade of the EMU made some countries more vulnerable through accumulating financial imbalances in the private sector. Some noticed that the whole EMU existence has been characterised by symmetric divergences in the current account balances and unemployment rates of the participating countries (Pasimeni 2015): up to the crisis, unemployment rates were converging while the external balances were diverging (Fig. 1).

Some saw in this dynamic a positive sign of integration (Blanchard and Giavazzi 2002). Once the sudden stop occurred and the external imbalances had to be adjusted, however, unemployment rates started diverging dramatically.

The divergences developed within the currency area represent the main threat to the existence of the single currency (Draghi 2015), and to the stability of the EU as a whole, hence the need to reform the EMU architecture and, in particular, to strengthen its real economic performance and its social dimension.

Without significant improvements in real economic and social outcomes for all citizens, rising dissatisfaction will continue to turn against the EU, and European nations will gradually turn against each other. Nicholas Kaldor’s fear (1971) that monetary union imposed under inappropriate conditions could backfire and generate political pressures against integration is being proved right.

The Maastricht model of the EMU did not foresee any adjustment mechanism to prevent or correct imbalances and divergences. It did not take full account of unemployment as a key indicator and “an all-out threat to monetary stability” (Dornbusch 1996) but focused on fiscal discipline, neglecting the financial one (Dornbusch 1997). Thus, it has serious limitations to handle economic cycles and asymmetric shocks; as a result, dangerous divergences have developed in the years of the crisis (Andor 2013a). Europe today is more imbalanced than before, in terms of the growth potential of its various parts. The core and periphery of the Eurozone have become more divided, and the employment and social situation perfectly exemplify this polarisation.

The accumulation of imbalances in the external positions of Member States needed permanent transfers to be sustained. These transfers have been operated through the financial markets but suddenly stopped after the Lehman shock (Constâncio 2014). At that point, these imbalances could not be sustained anymore, and the pressure to correct them has naturally been stronger on deficit countries than on surplus ones: the “secular international problem that throws the main burden of adjustment on the country which is in the debtor position on the international balance of payments”, as (Keynes 1980) clearly explained.

Without the exchange rate mechanism, and in the absence of a lender of last resort, a central budget able to provide fiscal stimulus, or at least coordinated policies aiming to uphold aggregate demand across Europe through a revaluation in “surplus” countries, those economies experiencing balance-of-payments problems inevitably have to undertake an internal devaluation to regain cost competitiveness. This has clearly adverse effects on employment and the social situation, because it leads to unnecessary economic losses and has a devastating social impact (Feldstein 1992; Andor 2013b).

Moreover, if several countries simultaneously try to pursue this strategy, the whole area is trapped into a deflationary spiral (Arestis and Sawyer 2012). The contemporary strategies of fiscal consolidation have weakened the effectiveness of automatic fiscal stabilisers at the national level, i.e. the ability of a state to immediately act in a countercyclical way as tax revenues drop and social expenditure increases.

As a consequence of this flawed mechanism, between end-2011 and end-2013, all components of domestic demand in the Eurozone shrank, and for seven consecutive quarters, the only positive contribution to GDP growth came from net exports. No wonder, then, that the period was characterised by a longer recession than in the post-Lehman worldwide financial crisis.

This vicious circle suggests that there is a need for a mechanism to help maintaining aggregate demand in countries having to adjust at the time of economic downturns and to directly support the innocent victims of this adjustment, who are the unemployed. In the absence of such countercyclical mechanism, divergence becomes manifest between the recovery capacities of the Eurozone core and periphery and even more between their powers to tackle high unemployment (Andor 2015).

Recent developments signal that the reform of the EMU has begun. This is a process that has been framed by the 2012 report of four presidents (Van Rompuy 2012) and already delivered an initial although incomplete version of the banking union. The creation of a fiscal capacity at the level of the EMU was clearly advocated in the Blueprint¹ for a deep and genuine EMU, which the European Commission put forward in November 2012 (European Commission 2012).

As a first step in EMU reform, a banking union is in the process of being implemented. However, the Common Deposit Insurance Scheme is not in place and there is no agreement over its establishment. Moreover, without a robust fiscal backstop, the whole architecture is adding more financial instability rather than the opposite. The absence of these two pillars does not allow breaking the sovereign-bank nexus, as recently noted (Padoan 2015). This minimalist banking union could not be sufficient to avoid future banking crises (De Grauwe 2013b) and will do little to mitigate the EMU’s bias towards internal devaluation as the predominant adjustment mechanism during balance-of-payments crises. Governments may still find themselves forced towards pro-cyclical fiscal consolidation in times of a downturn.

Coordination of fiscal and structural policies within the EU was strengthened through a series of legislative acts² in order to reassure financial markets of the Member States’ commitment to the EMU. Many other elements of economic and political union remained lacking though. These new instruments have been proposed to protect one group of innocent victims of financial crises, which are the taxpayers. But they are not the only ones affected. A second group of innocent victims, those who became unemployed, have borne the full burden of the adjustment.

In parallel with the establishment of the banking union, the social dimension of the EMU was looked at, driven by the observation that the welfare state has been substantially weakened. In particular, the effectiveness of the so-called automatic fiscal stabilisers at the national level meant the ability of a state to immediately act in a countercyclical way as tax revenues drop and social expenditure increases.

Unemployment increased over 11 % in the EU and 12 % in the euro area in 2013, but it became twice as high in those countries going through a painful process of internal devaluation. In these countries, poverty has also risen significantly, demand for the services of food banks has grown and many young people lacking opportunities had to emigrate, often to other continents. In the short term, the forced emigration of young and educated people erodes the tax base of their home countries; in the longer run, it also reduces its economic potential through a worrying loss of human capital.

This social crisis cannot be considered as a matter of subsidiarity. Social policy alone, even if national welfare systems are reformed, cannot handle the social consequences of the Eurozone crisis. Given the constraints which membership in a monetary union implies, it is fundamental to re-create possibilities of macroeconomic adjustment inside the Eurozone whereby aggregate demand and economic growth can be maintained. When the Commission introduced a scoreboard in October 2013 of key employment and social indicators, it demonstrated that overall unemployment and youth unemployment and inactivity, along with income inequality and poverty, all showed significant and dangerous divergence during the crisis, especially inside the euro area (European Commission 2013a).

Why did Europe become so divided in terms of economic and social outcomes? A key factor has been the design of the EMU, with monetary policy being centralised at the European Central Bank, but fiscal and structural policies being predominantly under the responsibility of national governments, without there being any euro area budget in place. This means that instruments that were historically used to limit the social impact of crises were not available any more, while there has been nothing newly introduced to replace them. This also means that the Europe 2020 targets cannot be expected to be achieved, not even with big delay.

Without adequate macroeconomic intervention capacity, only limited temporary results can be achieved. Better governance and a stronger coordination of social policies is possible but insufficient to restore the potential of convergence. The social dimension of the EMU is crucial for the legitimacy of the European project but also—given the deep integration of our policies—for the legitimacy of national policies. However, it cannot be pursued in the same way as the social dimension of the single market. The latter is mainly a matter of legislation, while strengthening the social dimension of the EMU is fundamentally a matter of financial and monetary instruments.

In a deflationary environment, a protracted period of low or negative growth will cause the decline of both human and fixed capital, which will in turn undermine growth potential. There is evidence that unemployment caused by the cyclical downturn is becoming structural in the euro area (European Commission 2015). Given the very limited chances of overcoming such imbalances through increased labour mobility in the EU (Draghi 2014), a rule-based stabiliser mechanism becomes an appropriate solution.

If short-term shocks and private sector deleveraging cannot be mitigated by autonomous monetary policy, they have to be absorbed by fiscal policy. Structural reforms cannot be the main answer to cyclical developments. Fiscal instruments are needed not to replace but to supplement other adjustment mechanisms, like structural reforms and labour mobility (Enderlein et al. 2013).

An automatic stabiliser at the EMU level would help uphold aggregate demand at the right time (Delpla 2012), and it would prevent short-term crises from unleashing longer-lasting divergence within the monetary union (Chopin & Fabre 2013). It would provide an answer to the simple question of a disillusioned European voter: “Where is Europe when we need it most?”

At the same time, a fiscal stabiliser would not represent “more Europe” for its own sake and certainly not more intrusion of Brussels into national policy-making. It would constitute a mechanism that strengthens the autonomy of each Member State precisely by stabilising the EMU, on the basis of transparent rules.

The involvement of social partners in the governance of the fiscal capacity would provide a concrete meaning for the strengthening of the social dimension and the participatory principle, also addressing concerns about the democratic deficit and technocratic economic governance in Europe.

The main rationale for setting up such a stabilisation function for EMU is that sound fiscal policies at the national level can allow the automatic stabilisers to work more freely; however, these national fiscal stabilisers might not be sufficient to smooth the cycle within individual countries, maintain economic convergence and deliver the optimal fiscal stance for the euro area as a whole (Italianer & Pisani-Ferry 1994). This was the case during recent years when national budgets, even in countries with a sound underlying fiscal position, were overwhelmed in a very severe crisis, and the lack of national fiscal stabilisation in turn harmed the whole euro area.

Focusing fiscal transfers on mitigation of asymmetrically distributed cyclical shocks means that over the long term, all participating Member States are likely to be both contributors and beneficiaries of the scheme. But even if the balance is not exactly zero after a certain period of time, the capacity of the system to reduce the duration and deepness of economic crises would provide a more stable macroeconomic environment for all, sustain aggregate demand and therefore improve growth perspectives for the whole area.

A variety of models can be designed; however, a few key questions have to be answered. First: should the stabilisation mechanism compensate for income losses (based on the calculation of an income gap), or should it be linked to the rise of unemployment? Secondly, should the scheme function permanently (even if directions of transfers can frequently change), or should transfers be triggered by key indicators reaching a certain threshold (de facto semi-automatic stabilisation)?

The European scheme would not completely replace national ones, being an additional, complementary tool (Andor 2014b). The levels of the contribution and of the benefit should represent a relatively low common denominator between the rules of national schemes, to ensure a fairly basic standard of support during short-term unemployment. Each Member State should be free to levy an additional contribution and pay out a higher or longer unemployment benefit on top of this European unemployment insurance.

A possibility for such a European scheme could be to set up a common fund, which collects and transfers resources between Member States, leaving then to them the task of addressing the individuals. In this case, the fund would operate as an insurance contract among Member States and it could be based on some parameter linked to GDP.

Another option is the possibility that the fund directly pays the benefit to the unemployed persons: in this case, part of the social security contributions would be transferred to the fund, which then would directly address the new unemployed, in every country.

The jobseekers would continue to interact with national authorities (public employment services); however, for it to be effective, a minimum degree of harmonisation would be necessary. Citizens would benefit from EU solidarity at times of hardship, and Member States would be required to upgrade their employment services and labour market institutions to the best EU standards.

The issue of convergence in regulation is an important one. If the Member States agreed to pool more financial, budget and economic sovereignty, there should be a clear framework for social coordination and convergence. Otherwise, it would only lead to more fierce competition between countries, lowering of social standards and jeopardising of the social model. As Padoan (2015) has recently argued, such a scheme would provide incentives to increase convergence in labour market regulation, enhancing the capacity for labour market adjustments at the euro area aggregate level.

Jara et al. (2015) find on this respect that if the mechanism would only finance elements of the national schemes that are common across countries, so that the risks are somehow mutual, this common element of existing national schemes would be very small, as it would need to conform to the “lowest” common denominator in every relevant dimension. In the case, instead of a larger stabilisation function, some national schemes would need to be reformed to allow for a larger coverage.

The introduction of a common unemployment insurance scheme would therefore require a minimum degree of harmonisation of labour market regulations, but being it only a top-up over national ones, it would not require the creation of a single labour law applied to all countries in order to function. This point is important, because it is sometimes assumed that a European scheme would imply such a complete integration. That is not the case.

Based on basic parameters agreed in advance, the functioning of the scheme would be entirely predictable and calculable on the basis of clear rules. The parameters of the scheme could be adjusted in response to actual experience. At the same time, governments, citizens and financial markets would be able to rely on the principle that an EMU country undergoing a cyclical downturn receives a limited fiscal transfer to support the cost of short-term unemployment.

The issue of net benefits and contributions for each country, at any given point in time, should be to some extent secondary. However, it is understandable that national politicians would probably want to make sure that their country is not permanently a net contributor and especially that there are no free-riders in the scheme (Hess 2015). The limited volume and limited duration of transfers should reduce moral hazard concerns.

There are four key issues to highlight when we consider the risk of moral hazard between participating countries. First of all, 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. Therefore, a correction mechanism is needed.

Second, the stabilisation capacity of such a mechanism is inversely proportional to the degree of transfers operated. Therefore, there is an important 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 could be minimised by two mechanisms, which already exist in federal unemployment insurance systems elsewhere in the world, namely experience rating⁶ and clawbacks.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 (Brandolini et al. 2014).

It is important to have a clear view of the potential costs and benefits associated with such a scheme. 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 euro area, 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.

All simulations suggest that it would absorb less than 1 % of the countries’ GDP. As a matter of reference, 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 European level, of national insurance policies. All other analyses suggest figures well below 1 % of GDP, depending on the exact parameters such as duration and level of the benefit or the eligibility conditions. Whittaker and Isaacs (2014) have calculated that such a benefit scheme in the USA amounted to less than 0.3 % of GDP in 2014.

An automatic fiscal stabiliser in the form of basic European unemployment insurance would have a meaningful macroeconomic effect in counteracting a cyclical downturn; it would help to uphold domestic demand and sustain growth in Europe as a whole. This means helping EMU countries to share part of the financial risk associated with cyclical unemployment caused by a drop in aggregate demand and not compensating for structural differences caused by skills mismatches, less efficient labour market institutions and the like.⁸

The fact that the scheme would trigger countercyclical transfers automatically and immediately is a major advantage compared to bailout programmes or bank rescues. These are always surrounded by uncertainty, which pushes up their cost. The basic European unemployment insurance scheme would be relatively cheap precisely because of its automaticity, also compared to discretionary fiscal instruments, where a fiscal transfer would be provided in exchange for structural reforms. The “catalogue” of reforms and corresponding financial support under such discretionary instruments would be very hard to define, and the decision-making process would be rather unpredictable, not to mention the political tensions arising around the approval of discretionary cross-country transfers.

Like a more flexible interpretation of the EMU’s fiscal rules, partial pooling of fiscal risks at the EMU level would provide national governments with greater fiscal leeway. However, the big advantage of achieving countercyclical stimulus on the basis of cross-country transfers rather than more flexible rules for national budgets is precisely in the collective character of the EMU-level scheme.

Consolidation of the monetary union through common fiscal stabilisers would reduce uncertainty about individual countries’ solvency both in the short and in the longer term. In addition, a basic European unemployment insurance scheme would strengthen the EMU institutionally, politically and in terms of social cohesion.

The predictability, limited volume and limited duration of fiscal transfers would also make a basic European unemployment insurance scheme a much safer option than various scenarios for mutualisation of Eurozone countries’ sovereign debt. This feature is particularly important when Member States consider themselves in the role of a contributor rather than a beneficiary.

With its automatic and countercyclical character, a basic European unemployment insurance scheme could boost market confidence in the EMU and thus help to avoid repeating vicious circles of downgrades, austerity and internal devaluation in the Eurozone. It would help to uphold domestic demand and therefore economic growth in Europe as a whole.

While individual stimulus by countries with high debt-to-GDP ratios may run the risk of triggering further financial crises, consolidation of the monetary union through common fiscal stabilisers would reduce uncertainty about individual countries’ solvency both in the short and in the longer term. In addition, a basic European unemployment insurance scheme would strengthen the EMU institutionally, politically and in terms of social cohesion.

The need for rebalancing within the euro area is often used as a leverage to force country-specific reforms to improve the microeconomic efficiency of the economic structure. Structural reforms can play an important role to enhance potential growth, but they primarily provide a boost to long-term potential, without a short-term capacity to stimulate the economy. In the history of financial crises in emerging economies, they always functioned in combination with currency devaluation.

Labour mobility is another common argument used to explain how the euro area could function better as a currency area. In theory it offers a solution to imbalances, but in reality it can only play a minor role, especially in such a fragmented labour market as the EU (Draghi 2014; Beyer and Smets 2015). The Eurozone crisis has triggered new migration of workforce, but often towards other continents, causing a long-term human capital loss to the EU.

There is virtually no serious assessment of the functioning of the euro area that would see a chance of long life without a fiscal capacity and risk-sharing (Solow 2005; De Grauwe 2013a), ideally in some form of automatic stabilisers that can limit the damage from cyclical downturns.

Once the need for a fiscal tool is identified, a possible alternative could be an investment fund. Such a fund could be similar to the option presented above in the sense of contributions linked to GDP but could probably be also linked to the output gap as a measure of cyclical conditions. The key problem of such an indicator is that the “real-time output gap” is not very reliable. This fund, however, on the expenditure side could finance large-scale public investments to boost the economic potential of the area.

The common unemployment insurance scheme stands out as probably the best option to improve the sustainability of the euro area. It could, however, present some limitations. The main ones relate to the political acceptability in countries where the narrative of the recent crisis has only focused on supposed wrongdoing and misbehaviours of other countries in the pre-crisis period. After years of continuous propaganda, how could the narrative change and suddenly explain that helping each other out in terms of sharing a little part of social security is actually beneficial for the whole system?

Another limitation, linked to the previous one, is more technical in nature: while many simulations show that over the medium term there would be no permanent country beneficiaries or contributors, perfect neutrality of the system is not certain. Moreover, the exact definition of the “medium term” cannot be imposed ex ante. These issues may render the acceptance of this proposal politically difficult.