CEPS, 1 Place du Congrès, 1000 Brussels, , Fiscal solidarity during exceptional times: What are the options? Daniel Gros, Jorge Nunez Ferrer CEPS Prepared for BEPA workshop The political economy of EU public finances: designing governance for change Brussels, February 5, 2009

Exceptional times require exceptional decisions Two types of crisis could require fiscal action/support by the EU: 1.Government insolvency or illiquidity (default or difficulties in refinancing/roll over debt). 2.Bank rescue operations.

How to help member states in difficulties: existing provisions 1.Support for non-euro area member states: Art. 119 Balance of payments support (implemented according to Council Regulation (EC) No 332/2002 of 18 February 2002 ). Example: Hungary, etc. 2.Support for euro area member states? Not foreseen, no explicit provisions in the Treaty (no bail out).

Support for non-euro area member states Subject to Article 119 the Community can grant financial assistance to Member States, which have not adopted the euro and are experiencing, or are threatened with, difficulties in their balance of payments on current or capital accounts. Limit is 12 billion, but expected to rise to 25 billion (proposed by the Commission). Degree of fiscal solidarity/risk sharing: debtor is Community budget (effectively pro rata MS).

Support for euro area member states There is no legal basis. Is it forbidden? No bail out clause: Article 125 (ex Article 103 TEC) 1. The Union shall not be liable for or assume the commitments of … governments, …., without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of … governments, (…), or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project The Council …may specify definitions for … prohibition …..

Support for euro area member states ways around prohibition? Cost of letting euro area member country go bust would dwarf Lehman effect. Article : financial assistance possible if member state severe difficulties caused by natural disasters or exceptional occurrences beyond its control ? Hide behind IMF more likely. Financing via general IMF resources or individual member states or last sentence of Art. 103?

Exceptional times require exceptional decisions: the banking sector Financial crisis is clearly systemic, affects banking market, which is integrated, particularly within euro area. => Huge spillover effects. => Need for common action. Options? 1.Common action (= fiscal solidarity?) 2.Today, national action, but common framework. 3.Free for all.

Common action: EU bank rescue fund EU banking system under stress, need for bail outs. Common action has many advantages: Avoid balkanisation of banking market. Banks would be more willing to accept EIB capital (less political interference) => lower cost.

How to do it? Best to use existing institution: EIB or EIF: EIB has capital of 165 billion, could increase loans up billion with a leverage of 10 (instead of the 2.5 at present). EIF model: includes private sector capital.

EIB bank rescue fund How in practice? 1.Increase capital of EIB by billion. 2.Empower EIB to take stakes in EU MFIs according to pre set criteria (decided by EIB board, which is composed of national finance ministers). 3.Sunset clause: EIB has to sell stakes within 5-7 years. Then losses and gains can be attributed to member states (by nationality of bank).

EIB bank rescue fund. What risks? With ex post settling of gains and losses no risk that any member state would have to pay for mistakes of banks abroad. Anything else?

Concluding remarks A limited amount of fiscal solidarity exists. No clarity for Eurozone action Very little transparency about legal situation. Current exceptional circumstances limited degree of risk sharing might be useful. The EIB could provide the platform. Could be limited in time and by amount.