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The rationale for a safe asset and fiscal capacity for the Eurozone

Author

Listed:
  • Lorenzo Codogno
  • Paul van den Noord
Abstract
The only way to share common liabilities in the Eurozone is to achieve full fiscal and political union, i.e. unity of liability and control. In the pursuit of that goal, there is a need to smooth the transition, avoid unnecessary strains to macroeconomic and financial stability and lighten the burden of stabilisation policies from national sovereigns and the European Central Bank, while preserving market discipline and avoiding moral hazard. Both fiscal and monetary policy face constraints linked to the high legacy debt in some countries and the zero-lower-bound, respectively, and thus introducing Eurozone ‘safe assets’ and fiscal capacity at the centre would strengthen the transmission of monetary and fiscal policies. The paper introduces a standard Mundell-Fleming framework adapted to the features of a closed monetary union, with a two-country setting comprising a ‘core’ and a ‘periphery’ country, to evaluate the response of policy and the economy in case of symmetric and asymmetric demand and supply shocks in the current situation and following the introduction of safe bonds and fiscal capacity. Under the specified assumptions, it concludes that a safe asset and fiscal capacity, better if in combination, would remove the doom loop between banks and sovereigns, reduce the loss in output for both economies and improve the stabilisation properties of fiscal policy for both countries, and thus is welfare enhancing.

Suggested Citation

  • Lorenzo Codogno & Paul van den Noord, 2019. "The rationale for a safe asset and fiscal capacity for the Eurozone," LEQS – LSE 'Europe in Question' Discussion Paper Series 144, European Institute, LSE.
    • Handle: RePEc:eiq:eileqs:144
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    File URL: http://www.lse.ac.uk/european-institute/Assets/Documents/LEQS-Discussion-Papers/LEQSPaper144.pdf
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    References listed on IDEAS

    as
    1. Khalid Sekkat & Marco Buti & Carlos Martinez-Mongay & Paul van den Noord, 2003. "Macroeconomic policy and structural reform: a conflict between stabilisation and flexibility?," ULB Institutional Repository 2013/7388, ULB -- Universite Libre de Bruxelles.
    2. Jeromin Zettelmeyer & Álvaro Leandro, 2018. "Europe's Search for a Safe Asset," Policy Briefs PB18-20, Peterson Institute for International Economics.
    3. Viral Acharya & Itamar Drechsler & Philipp Schnabl, 2014. "A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk," Journal of Finance, American Finance Association, vol. 69(6), pages 2689-2739, December.
    4. Mr. Benedict J. Clements & Mr. Zenon Kontolemis & Mr. Joaquim Vieira Ferreira Levy, 2001. "Monetary Policy Under EMU: Differences in the Transmission Mechanism?," IMF Working Papers 2001/102, International Monetary Fund.
    5. Mr. Manmohan S. Kumar & Mr. Emanuele Baldacci, 2010. "Fiscal Deficits, Public Debt, and Sovereign Bond Yields," IMF Working Papers 2010/184, International Monetary Fund.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

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    2. Cimadomo, Jacopo & Gordo Mora, Esther & Palazzo, Alessandra Anna, 2022. "Enhancing private and public risk sharing: lessons from the literature and reflections on the COVID-19 crisis," Occasional Paper Series 306, European Central Bank.

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    More about this item

    Keywords

    Fiscal policy; Business fluctuations; Safe sovereign assets; Fiscal capacity;
    All these keywords.

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