The Safety Demand and Common Fiscal Policy in a Monetary Union

There is evidence for a strong demand for safety, both steady and inelastic. A sudden loss of safe assets played a key role in the financial crisis and European sovereign debt crisis. I show that a common fiscal policy can benefit all member states of a monetary union by offering a more efficient provision of safety, which avoids inefficient private safety choices. I analyse a two-country monetary union where governments supply an insufficient amount of public safety since they do not internalize the positive spillover on foreign savers of their fiscal choices. I show that some degree of common public spending funded by common debt can result in a Pareto improvement as it increases the safety supply and discourage inefficient private safety provision. The effect does not rely on actual fiscal transfers