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 instead by reducing the tax burden on the Irish population. When the European Union's council of Economic and Financial Affairs (ECOFIN) reprimanded his government, Ahern told his European colleagues, in so many words, to mind their own business. He was not opposed to European coordination, but he was not about to raise taxes before an election.
The second story concerns Germany. Berlin was the player that had originally insisted on tightening the rules against running excessive fiscal deficits -- in the form of the 1997 Stability and Growth Pact. But as the German economy sputtered in the run-up to the 2002 elections, German Chancellor Gerhard Schroeder was reluctant to meet his solemn obligations and rein in his country's finances. Even after eking out a narrow victory, Schroeder saw few reasons to be more fiscally disciplined. By November 2003, Germany's deficit had grown too big for the rest of the eurozone to ignore. The European Commission recommended pushing Germany to reduce it or face sanctions for failing to live up to its obligations. Since France and Italy were experiencing deficit problems of their own, the German government was able to work out a plan with them to hold the enforcement rules in abeyance. The three countries blocked the Council of Ministers from forming the working majority needed to create legally binding fiscal commitments.
The Irish and German cases reveal that the problem is less enforcement and more the influence of perverse incentives. The Irish government had little incentive to follow the fiscal rules. That much is obvious. But the rest of Europe had little incentive to enforce them, either. The ECOFIN Council's February 2001 reprimand of Ireland came just as the Irish people were preparing to ratify amendments to the EU treaties that delegates had agreed to in Nice the previous December. Those amendments raised a host of concerns in Ireland -- ranging from worries about what greater market competition would do to the economy to the future of Irish political neutrality. The ECOFIN Council's harsh words only added to the tension. When the Irish electorate voted down the Nice Treaty the following June, Ireland's European partners rushed to soothe frazzled nerves. The ECOFIN Council, taking advantage of new economic data, decided that Ireland no longer needed to live up to its commitment to running a higher surplus. The whole episode was quickly forgotten.
Germany's intransigence came to a similar resolution. In July 2004, the European Court of Justice ruled that once the Council of Ministers admitted that Germany had a problem, it no longer had the authority to hold the European Union's procedure for handling excessive deficits in abeyance. But neither the European Commission nor the other plaintiffs in the case felt it prudent to pick a fight against the eurozone's strongest member. Instead, they decided to work with Germany to ramp up existing efforts at market liberalization and welfare reform. In fact, rather than tightening the rules, the commission offered up plans to loosen the Stability and Growth Pact to allow Eurozone members even more leeway in how they balanced their budgets, or did not.
In short, Europe's macroeconomic policy coordination failed because countries faced strong incentives to renege on their commitments and the ECOFIN Council faced equally strong incentives to let them get away with it. Any attempt to sanction Ireland in 2001 would likely have exacerbated the Irish public's sour mood. And any attempt to compel the German government to live up to its commitments would only have revealed the European Union's inability to force member states to bend to its will. Because of domestic concerns, Berlin was not going to budge.
The measures currently on the table will not change eurozone dynamics. The European Commission and the European Court of Justice will never be eager for a showdown with a powerful member state. And the new provisions under debate will not fix the problem, either. At best, member states will agree to require a supermajority in the ECOFIN Council to waive sanctions (now, a supermajority is needed to impose them). And even that requirement will only be credible once it is tested against a core state such as Germany or France. Where constitutional commitments of fiscal discipline are concerned, the outlook is not much better. National laws contain loopholes; constitutional amendments can be revised as easily as they were introduced, and their enforcement depends on the good will of national courts.
But there is a solution. A better approach would be to focus on incentives rather than enforcement. Consider, for example, the cases of Latvia and, believe it or not, Greece. Latvia has undertaken a painful macroeconomic adjustment since 2008 because it believes every alternative, especially being forced to give up its fixed exchange rate with the euro, would be worse. A weakening domestic currency would cause energy prices to rise, greatly increase the burden of foreign debts, and make it difficult for Latvian monetary authorities to reestablish credibility.
Some might complain that the Greeks are not doing enough to rebalance their economy, but no one can deny Athens' willingness to cut deeper and deeper at every turn -- mostly to escape the risk of being kicked out of the monetary union. The Greek government recognizes that leaving the euro would provoke a major crisis in the country's banking system, spark a significant increase in both import prices and domestic inflation, and would do little to improve the country's competitiveness.