The conventional wisdom -- of which the German government is the strongest proponent -- is that European sovereign debt markets are in crisis because Europe's leaders failed to enforce their own rules on macroeconomic policy. Last March, members of the eurozone agreed to a "six pack" of measures that would help states better coordinate policymaking. But the move failed to solve the problem, so German Chancellor Angela Merkel is pushing a new fiscal compact to save the union, and the currency. Member states would write balanced budget provisions into their national constitutions, and the European Commission and the European Court of Justice would act as the enforcers.
The problem is that this new approach assumes that compliance is a matter of enforcement. But that reasoning ignores the role of incentives -- the adjustment of which is the only way the European Union will be able to navigate a way out of this fiscal mess.
Two stories illustrate the difference between enforcement and incentives. First, consider Ireland. The tale begins with the country's commitment to the European Union in the spring of 2000 to increase its budget surplus (note: surplus, not deficit) to slow down the economy, which seemed to be overheating. At that point, the Irish government was already taking more money out of the economy in taxes than it was putting in through spending; increasing the surplus would mean siphoning off even more. Looking ahead to spring 2001 elections, however, Bertie Ahern, then Irish prime minister, decided to lower the surplus
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