Courtesy Reuters

Merkel Is Wrong About EU Fiscal Regulation

The Case for a Sovereign Credit Club

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

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