A Shock to the Eurozone

Wednesday, September 29, 2010

The late Milton Friedman said that a common currency—that is, a monetary union—cannot be sustained without a deep form of economic and political union. By this, he meant an open economy that ensures the free flow of goods, labor, and capital, together with a disciplined central fiscal authority and a strong central bank. The latter two are pillars of a strong currency. They work in tandem. But the other pieces are no less important.

The eurozone, currently wrestling with fiscal imbalance and sovereign-debt risk, has a strong and autonomous central bank but is fiscally fragmented and only partly unified politically.

Enter the Maastricht treaty, which in theory imposes fiscal discipline by placing limits on government deficits and debt levels—clearly a structure designed to prevent free riding on the fiscal discipline of others. Maastricht was thus intended to prevent a situation like the recent crisis in Greece.

It didn’t work. Eurozone sovereign debt turned out not to be homo-genous with respect to risk.


In a stable world, the Maastricht treaty’s rules-based framework, if enforced, might do the job. But in a shock-prone world, it is a fragile system because it precludes anything but modest countercyclical policy. No wonder, then, that the treaty’s strict limits were breached early in the euro’s first decade by core countries as well as peripheral ones.

Indeed, with a large shock, much of the breach happens automatically, as tax revenues shrink and social-insurance payments expand. Recent analysis by the International Monetary Fund suggests that as much as 80 percent of the fiscal stimulus in advanced countries during the current crisis is non-discretionary.

That kind of built-in countercyclicality is not a bad thing. But if it produces the threat of fiscal instability and excessive sovereign-debt risk after a large shock, then the starting point was not sufficiently conservative. In other words, deficits or debt levels (or both) were too high. Countercyclicality does not mean running modest deficits in the good times and huge deficits in major downturns.

If the current European Union budget rules are too rigid and are ignored in the face of a shock, the door is open for imprudent fiscal behavior. In theory, strict in-depth monitoring could distinguish genuinely prudent countercyclical responses from profligacy. But in practice it is hard to enforce.

The eurozone’s immediate challenge is declining fiscal stability in a subset of countries whose credit ratings are falling and debt-service costs rising. Absent external assistance and a credible plan for restoring fiscal order, Greek sovereign debt could not be rolled over, forcing a default, probably in the form of a restructuring of Greek debt. Even with external assistance, many view default as a near certainty, because the arithmetic of restoring fiscal balance is so daunting.

Eurozone membership precludes inflation and devaluation as adjustment mechanisms. An alternative is domestic deflation combined with extreme fiscal tightening—that is, a period of slow or negative growth in wages, incomes, and some prices of non-traded goods. But deflation is painful, and for political reasons cannot realistically be pursued.


The constraints for eurozone countries are similar to those of a state in America that gets into fiscal trouble. Devaluation is not an option because of the common currency. The Federal Reserve will not willingly resort to inflation. Moreover, in the United States, there are rules and conventions (similar to Maastricht) that disallow or discourage states from running long-term deficits. This means that state fiscal behavior tends to be pro-cyclical in the face of large shocks like the recent one.

So why isn’t a federal system equally fragile? There are two key safety valves. One is the central government’s ability to run deficits and to act decisively. The other is labor mobility.

If the European Union budget rules are too rigid and are ignored in the face of a shock, the door is open for imprudent fiscal behavior.

The European Union does not have a robust, centralized fiscal structure with a countercyclical mandate. And labor mobility, a long-run goal in the European Union, is constrained by language, laws, and diverse regulatory regimes.

In addition, state bonds are not treated as equals, and the markets penalize profligate states. If the European Union wants a monetary union in which sovereign debt is relatively homogenous with respect to risk, fiscal discipline must be similarly homogenous. But that also means that it will need a more robust mechanism for countercyclical responses to shocks.

EU leaders recently stated their intention to revisit the Maastricht structure. They might take the route of adapting the Maastricht rules to allow for more inter-temporal flexibility at the national level. But that approach would be complicated. One would need a sophisticated capability for monitoring and enforcing fiscal policy and sovereign debt to avoid ending up with a repeat of the current situation.

A better long-term solution is a central EU fiscal capacity that accumulates the resources to respond to shocks during periods of growth. One could think of it as a stabilization tax that becomes negative in downturns.

But a move in this direction does involve some degree of fiscal centralization, and it probably would require that the European Union be able to issue sovereign debt. It is unclear whether the political will to do all that exists.

Labor mobility, a long-run goal in the European Union, is constrained by language, laws, and diverse regulatory regimes.

But a step in the right direction would be partial fiscal centralization with a limited countercyclical mandate. That would enable effective enforcement of fiscal discipline at the national level and provide the euro with the fiscal discipline it needs to survive.

When the eurozone was created, it was widely understood that fiscal discipline was a crucial underpinning. The current problems vividly underscore the point. The challenge now is to achieve a combination of discipline and flexibility that protects the collective interest. That will involve a loss of full fiscal sovereignty, but nothing less will sustain the monetary union.