Fiscal discipline in the monetary union

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

For the euro to survive, the recession must be halted without piling on more debt. Charles Wyplosz, in a recent VOXEU communique (26^th Nov.), 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. requiring US-style fiscal discipline.

Public debts are still rising in the three countries that may require aid: Italy, Spain and possibly France. These nations have three things in common: a common currency; are in recession; and adopted austerity policies.

If they remain in the Eurozone, these nations must exit recession. This will require an end to austerity policies. However, they cannot embrace expansionary fiscal policies with current debt levels; even abandoning austerity may be impossible. This leaves two issues to address: the legacy of unsustainable public debts and the need for fiscal discipline.

There are two approaches: the German centralized discipline model; and the US decentralized discipline model.  The German approach has produced mixed results with the failure of several states (lander).  However, the US approach has worked for 150 years without any state failures.

The US model is better adapted to Europe since it fully respects fiscal sovereignty at the sub-central level and is important since EZ parliaments are very unlikely to give up fiscal sovereignty.  The Eurozone’s Stability and Growth Pact belongs to the German model of centralized discipline. 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.

The Pact has consistently failed. 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 future of the euro requires fiscal discipline. Fiscal discipline will only be achieved with a decentralized arrangement. Fiscal sovereignty is non-negotiable and the no-bail out clause needs to be the centerpiece of the Eurozone.

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. What is missing is the no bailout rule. While it is already in the European Treaties, it’s 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.

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.

www.voxeu.org/article/fiscal-discipline-monetary-union