Thread by @oscarsoons

While we learn more about omicron, let me tell you about a benefit of making the #NGEU recovery plan, including common debt, a permanent feature of the EU A🧵based on my #JMP

“The Safety Demand and Common Fiscal Policy in a Monetary Union”

papers.ssrn.com/sol3/papers.cf…

#econtwitter

Three observations:
1) there is a large, steady, and inelastic safety demand
2) a sudden loss of safe assets played a key role in recent crises
3) only since Covid-19 there is a 'temporary' agreement over shared fiscal responsibilities in the EU, including common debt

In my JMP I argue that these three observations are related. The intuition is as follows

While economies of all euro countries have a large safety demand, some governments provide more public safety than others. For instance, in 2019 the euro core had 67% of GDP gov debt outstanding, compared to 132% in the periphery.

Sure, not all periphery bonds may be as safe as German Bunds, but that is not of first order importance here (see the paper). Italian bonds’ minimum possible payment provides safe income

With little domestic gov bonds, core savers must rely on the private sector, which is not a great safety provider (see '08), or foreign bonds, that also may not repay in full (see '15). In turn, the core’s foreign bond holdings also force foreign savers to rely on private safety

Relying on private or foreign safety has shown to be costly. A low provision of public safety in the core leads to a misallocation of capital in the entire monetary union.

Why do core governments not provide the “optimal” amount of public safety? They do! But only from their national perspective: they care about national welfare, not about positive externalities for foreign savers. An example:

Suppose NLD issues more debt. NLD savers would rely less on private safety (real estate) and foreign bonds (e.g FRA/ITA). Not only may NLD savers benefit from 'better' safe assets, but ITA savers also need to rely less on private safety as the MU public safety supply increases

Yet, the NLD government does not care about the positive spillover to ITA savers! Also, NLD savers may prefer ITA bonds because only ITA households are liable for their future repayment

Thus, there is a difference between the domestic- and MU-welfare maximising national safety provision

Note, the ITA gov also does not care about NLD savers. Yet, it may not be able/want to lower its bond supply (pick your favourite reason why, in the model it is high fiscal fixed cost)

I suggest that the permanent common safety provision by a common institution funded by common debt can compensate for the national under-provision of public safety. I show that all member states can benefit, with and without fiscal transfers.

Why can some degree of common spending with fiscal transfers benefit the core? With fiscal transfers core savers not only benefit from the increase in public safety provision (more safe assets!), but also from a higher minimum return on foreign bonds ("safer" safe assets!)

Why does it need to be a common institution? Only a common institution can - in theory - credibly internalise all welfare effects, including spillovers across the monetary union

Why do we need common debt and common spending instead of national spending and debt? Otherwise the common policy will not increase the total provision of safety but rather substitute for national safety provision. What the spending is used for matters

The proposal looks like NGEU. Still, I suggest there are additional benefits when the EU permanently and directly provides essential safety goods (related to e.g. healthcare, law and order, climate) funded by common debt, if these goods are otherwise not provided by national govs

For more details and for the model, check out the paper!

@threadreaderapp

unroll