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The fiscal discipline problem
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:
While the German Länder are fiscally sovereign formally, discipline is imposed, monitored and enforced centrally. 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:
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 eurozone bailouts just as it led to Länder bailouts. Three eurozone bailouts have happened already and more are waiting in the wings.
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 credibility was shattered by the Greek, Irish and Portuguese packages. The task facing eurozone 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 per cent of GDP. By now, the crisis would be over.