Fiscal and Currency Union with Default and Exit

We study the optimal designs of a Fiscal Union with independent currencies and of a Monetary and Fiscal Union (Currency Union) and their relative performance. We derive the optimal fiscal-transfer policy in these unions as a dynamic contract subject to enforcement constraints, whereby in a Currency Union each country has the option to unpeg from the common currency, with or without default on existing obligations. Our analysis shows that the lack of independent monetary policy, or an equivalent independent policy instrument, limits the extent of risk-sharing within a Currency Union. It also shows that the optimal state-contingent transfer policy implements a constrained efficient allocation that minimises the losses of the monetary union; that is, the fiscal transfer policy is complementary to monetary policy. At the steady state, welfare is lower than in a Fiscal Union with independent monetary policies. However, with nominal rigidities and only one shock disrupting consumption, risk-sharing reduces the cost of losing independent monetary policy and, as a result, the welfare loss for having a Currency Union can be quantitatively very small. Nevertheless, this almost-equivalence welfare result breaks down when, for example, there is another shock disrupting consumption: the Fiscal Union with independent currencies can confront both shocks separately, which can not be done with the constrained efficient complementary mix in a Currency Union. Importantly, these results -- in particular, the lower value of the Currency Union -- change when there are trade costs associated with independent monetary policies, unless these costs are (counterfactually) negligible. If they are not, Currency Union dominates Fiscal Union. In the latter the constrained efficient fiscal-transfers policy, accounts for these costs, limiting the extent of risk-sharing, while efficiently assigning the trade costs associated with the transfers.
 

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