The Limits to Partial Banking Unions: a Political Economy Approach
Abstract: This paper studies the welfare effects of a partial banking union in which cross-country financial transfers that could be used towards bailouts are decided at the supranational level, but policymakers in member countries hold decision power over the distribution of funds. This allows the policymakers, who are partially self-interested, to extract rents in the bailout process. In equilibrium, such a banking union lowers the welfare of citizens in the country receiving transfers. Supranational fiscal rules are ineffective at reversing this result, but a Pareto improvement may be achieved if fiscal rules are combined with domestic reforms that reduce political rents.