Incentive-compatible unemployment reinsurance for the euro area

Summary

Focus

The euro area sovereign debt crisis brought back the debate on establishing additional fiscal instruments for the euro area. A centralized European unemployment benefits scheme has been one of the solutions proposed to strengthen the automatic fiscal stabilizers of the European Monetary Union. Existing proposals to set up a euro area unemployment reinsurance mechanism aim at exploiting the observed asymmetries in the cyclical fluctuations of unemployment rates of euro area member countries. These asymmetries mean that when unemployment is high in some countries it can be low in others. We propose a scheme derived from mechanism-design first principles. Specifically, using historical data, we develop, solve and simulate a model in which countries participate in a common reinsurance platform.

Contribution

Building on previous work on mechanism design, digital safety nets and dynamic financial constraints, we propose a design for an incentive-compatible reinsurance scheme for unemployment risk in euro area member states. The scheme is optimally designed so that member countries co-insure one another, both within and across time periods, in terms of their own relative variations in unemployment over time. The contribution and payout amounts are optimally determined as the solution of a dynamic mechanism-design problem, and by construction, each country's net expected contributions or payouts with respect to the scheme are nil over a long time horizon. Therefore, the scheme we propose is robust to limited commitment concerns and it prevents any permanent transfers across member states.

Findings

Using data from 17 euro area countries in the period 2000–19, our simulations show that a euro area-wide platform could have provided material risk-sharing of unemployment risk if allowed to borrow up to 2% of euro area gross domestic product. We also show that in normal times (the years before 2008 and after 2017), there is an approximate balance in the number of countries that pay in a contribution (the unemployment rate is below the country median) and the number that receive an indemnity (unemployment rate is above the country median). This implies that unemployment shocks within the euro area are sufficiently uncorrelated.

Abstract

We model a reinsurance mechanism for the national unemployment insurance programs of euro area member states. The proposed risk-sharing scheme is designed to smooth country-level unemployment risk and expenditures around each country's median level, so that participation and contributions remain incentive-compatible at all times and there are no redistributionary transfers across countries. We show that, relative to the status quo, such scheme would have provided nearly perfect insurance of the euro area member states' unemployment expenditures risk in the aftermath of the 2009 sovereign debt crisis if allowed to borrow up to 2 percent of the euro area GDP. Limiting, or not allowing borrowing by the scheme would have still provided significant smoothing of surpluses and deficits in the national unemployment insurance programs over the period 2000-2019.

JEL classification: E62, J65, F32

Keywords: unemployment insurance, risk sharing, reinsurance, euro area, fiscal policy, mechanism design, limited commitment