A Volatility-Based Theory of Fiscal Union Desirability

Abstract

Heterogeneous countries may rationally choose to form a currency union first, and a fiscal union later. Taking into account the sovereignty loss involved in the formation of a fiscal union, we find reasonable conditions on the determinants of volatility for the currency and then fiscal sequencing in the deepening process of European integration. Changes in the distribution of expected income shocks require a reassignment of political weights to restore unanimous support for an added fiscal dimension in European integration. The bargaining space depends on countries' relative income, size, and cross correlation of shocks.