For the euro to survive, the recession must be halted without piling on more debt. This column argues that the unpalatable conclusion is that public debts must be written down. The massive moral hazard problem this will cause must be dealt with by making sure that public debts will never again be allowed to grow to unsustainable levels. To this end, decentralised US-style fiscal discipline is needed.
Three years into the Eurozone crisis and public debts are still rising, including in the three countries currently subject to rescue programmes. More countries – Spain and Italy for sure, France quite possibly – are inching towards rescues. These nations have three things in common:
- They share the common currency;
- Their economies are in recession; and
- They have adopted austerity policies.
They are also trapped in a ‘circle of impossibilities’.
‘Circle of impossibilities’
If they are to remain in the Eurozone, these nations must exit recession. This, in turn, will require an end to austerity policies (Holland and Portes 2012). But given their massive indebtedness, they cannot embrace expansionary fiscal policies; even abandoning austerity may be impossible. One solution would be more lending from other Eurozone governments, but in today’s climate such lending would surely come with austerity conditions that would defeat the whole purpose.
So how do we break out of this circle of impossibilities?
In my recent work, I argue that high public debts form the quagmire that is dragging down Eurozone members (Wyplosz 2012). These debts blossomed since the global crisis began in 2008, but many members ran budget deficits for decades. We have to accept that many EZ nations have been fiscally undisciplined. This leaves us with two very different but profoundly connected issues:
- The legacy of unsustainable public debts;
- The need to establish fiscal discipline in the Eurozone.
The debt legacy problem
The debt legacy shuts off key exits from the circle of impossibilities. After all, governments with much lower debts would have the fiscal space needed to end austerity and pursue expansionary policies. How then can debts be lowered fast enough to save the euro?
One solution would be a burst of inflation. That cure, however, is worse than the disease. The only remaining solution is debt restructuring. And it would be a solution since a vast body of literature (summarised in Reinhart and Rogoff, 2009) shows that defaulting countries quickly recover market access. Sovereign restructuring sounds radical, but much less so if it is seen as (i) an act of desperation arising from an unprecedented situation, and (ii) something that will never happen again.
The ‘never again’ requirement is the connection between legacy and the fiscal discipline exigencies.
The fiscal discipline problem
We need to do better than we have done since 1999. The future of the monetary union hinges on establishing sure-fire fiscal discipline. This is not a new problem. Every federal country, in effect every monetary union with federal features, faces the same necessity. This means we have countless policy experiments to learn from. Two polar cases are instructive.
- The German centralised discipline model; and
- The US decentralised discipline model.
While the German Länder are fiscally sovereign formally, discipline is imposed, monitored and enforced centrally (Seitz 1999, European Commission 2012). The federal government imposes rules such as the ‘golden rule’ and more recently the debt-brake rule that came with the 2009 constitutional change. Through many informal channels, the centre exerts pressure on the Länder and it can take the recalcitrant ones to the Constitutional Court. Despite this, failures have occurred. Since 1945, two Länder (Bremen and Saarland) have been bailed out.
The US model is the other polar case. As in Germany, US states are fiscally sovereign. During that nation’s first 60 years, the US experienced countless bailouts (Henning and Kessler 2012). All that stopped when the US Congress rebelled in the 1840s and rejected bailout demands. Since then, the US has effectively operated a no bailout rule. The states soon realised that the regime had changed and guess what? All but one of them adopted stringent fiscal rules that they enforced in their own state-level supreme courts. Incentives matter. With a couple of post-Civil War exceptions, 150 years have passed without bailouts.
Why the Eurozone needs the US model
The US model is better adapted to Europe for two reasons.
- It fully respects fiscal sovereignty at the sub-central level.
This is important since EZ parliaments are very unlikely to give up even a centimetre of fiscal sovereignty.
- The US model works better than German model.
This is shown in the following table that exhibits debt-to-GDP ratios for the 50 US states and for the 17 German Länder.
|Germany (17 Länder)||US (50 states)|
The Eurozone’s Stability and Growth Pact belongs to the German model of centralised discipline. Its rules are centrally imposed as it the monitoring and implementation (which are in the hands of the European Commission) with all of this refereed by the European Court of Justice. Not surprisingly, this system led to EZ bailouts just as it led to Länder bailouts. Three EZ bailouts have happened already and more are waiting in the wings.
Stability and Growth Pact: The history of failure
The Stability and Growth Pact is best thought of as an accident of history. It was adopted in 1997 without debate. As the euro’s launch date approached, a concerned Germany proposed the pact as the practical way of implementing the Maastricht Treaty’s Excessive Deficit Procedure. This was a take-it-or-leave-it request from Germany; it was a condition for abandoning the Deutsche mark. Naturally, Germany’s solution for the Eurozone embraced the model it knew best. Other EZ governments accepted it without much thought. Public opinion was either unaware or unable to master the technical considerations.
The Pact has failed over and over again. Each failure lead to reform that seemed to strengthen it. These efforts, however, were thwarted by the inescapable fact that EZ members are fiscally sovereign. Until sovereignty is removed, the Pact stands no chance of being effective.
The saddest part of this track record of failure is that the Maastricht Treaty included a no-bailout clause. Why did this explicit clause fail to produce the incentives created by the informal US clause? The short answer is ‘doubts’ – doubts that the clause would be implemented. And the doubters were proved right, starting with the May 2010 Greek bailout.
How decentralised discipline could work
The future of the euro requires fiscal discipline. Fiscal discipline will only be achieved with a decentralised arrangement. The reason is simple. In today’s political reality, fiscal sovereignty is non-negotiable. That means the German model is out and the US model is the only way forward. Two steps are needed:
- We need to move from the German to the US model; and
- We need to make the no-bailout clause the centrepiece of the Eurozone.
How to proceed?
In the US, the no bailout rule came first; incentives then took over, leading to fiscal rules. Having effectively removed the no bailout rule, we cannot rely on incentives but, fortunately, we now have national fiscal rules. Indeed the Fiscal Compact – under the official name of Treaty on Stability, Cooperation and Governance – requires each member country to adopt its own fiscal rule.
In the eyes of its founding fathers, the compact is one additional layer of the Stability and Growth Pact. From the perspective of the centralised versus decentralised debate, it is immediately apparent that the compact is a decentralised solution of the US type, even if the decentralised solution is centrally imposed. Inadvertently, we have moved in the right direction.
Firming up the ‘no’ in ‘no bailout’
What is missing is the no bailout rule. While it is already in the European Treaties, its credibly was shattered by the Greek, Irish and Portuguese packages. The task facing EZ leaders is to rebuild the credibility of the no bailout clause. This will be difficult. Traumatic events and extremely public discussion will be necessary. Debt restructuring by several Eurozone nations would provide one such vehicle. Such defaults would be so fraught with domestic and international political turmoil that future Eurozone policymakers would do whatever is necessary to avoid finding themselves in the same situation in the future. The never-again pledge, in other words, would quickly gain credibility.
Any doubts? Just imagine what would have happened had the no bailout rule been invoked in May 2010. Greece would have gone to the IMF and defaulted on its smallish public debt of 120% of GDP. By now, the crisis would be over.
•Corsetti, Giancarlo (2012). “Has austerity gone too far?” VoxEU.org debate, 30 March.
•European Commission (2012). “Fiscal frameworks across Member States: Commission services’ country fiches from the 2011EPC peer review”, European Economy, Occasional Paper 91.
•Henning, C Randall and Martin Kessler (2012) “Fiscal Federalism: US History for Architects of Europe’s Fiscal Union”, Working Paper 12-2, Peterson Institute for International Economics, Washington D.C.
•Holland, Dawn and Jonathan Portes (2012). “Self-defeating austerity“, VoxEU.org, 1 November.
•Reinhart, Carmen and Kenneth Rogoff (2009) This Time is Different, Princeton University Press.
•Seitz, Helmut (1999) “Subnational Government Bailouts In Germany”, Working Paper B20, Centre for European Integration Studies, Bonn.
•Wyplosz, Charles (2012) “Europe’s Quest for Fiscal Discipline”, unpublished paper.