Exit and Enforcement in the Eurozone – Project Syndicate

(By Sylvester Eijffinger and Edin Mujagic, published by Project Syndicate).

In 1992, the Maastricht Treaty set rules for European countries’ public finances that would facilitate economic integration. The Stability and Growth Pact (SGP), agreed in 1997, extended these rules to enable the euro’s creation and ensure that the new currency became an established part of the global monetary firmament.

But the rulebook was left unfinished, with dire consequences: if the euro survives the current crisis, it is destined to remain unstable, except in periods of exceptionally high economic growth – that is, unless Europe’s leaders finish writing the rules.

Among the SGP’s criteria for adopting the common currency was an annual budget deficit of less than 3% of GDP. But some countries qualified only through temporary measures – or outright cheating.

Moreover, once granted entry into the eurozone, no country needed to worry about being expelled, so incentives to keep deficits low evaporated. Indeed, from the beginning, countries with no history of fiscal prudence or sound economic policies lacked any motivation to play by the rules; on the contrary, they had every incentive to violate them.

Game theory illustrates this moral hazard. If all members play by the rules, the eurozone is relatively stable, and crises are unlikely. If no one plays by the rules, all member countries must deal with the resulting crisis (or the European Central Bank has to deal with it by easing monetary policy). But if one country (or a few) refuses to play by the rules, and its problems grow large enough to threaten the monetary union, its neighbors must bail it out.

This safety net encourages “sinners” not to implement unpopular economic reforms, and to rely instead on “virtuous” countries’ money in the form of bailouts. Given that some eurozone members always adhere to the rules, profligate countries’ incentive to discard the fiscal rulebook is obvious.

Fiscally prudent countries anticipated this outcome long before the euro saw the light of day. Indeed, Germany was the driving force behind the SGP’s creation. But the mechanism turned out to be ineffective: the absence of effective enforcement encouraged overstretched countries to renege on promises to exercise fiscal restraint, while condemning the eurozone to permanent instability.

Clearly, the SGP approach – with many carrots, but no sticks – does not work. But full political and fiscal union – the prescription du jour for saving the eurozone, if not the European Union itself – is not viable, either, given little support among Europeans. Anti-European political parties are finding fertile ground among electorates that are unwilling to turn over more of their national sovereignty to Brussels (and in some cases are seeking to take it back).

The euro would thus appear to be doomed; the only question is when. But another course could save the monetary union, without requiring members to transfer sovereignty to Brussels: an ex ante exit clause.

Saving the eurozone boils down to persuading its member countries to play by the rules, which requires nudging them toward the realization that doing so is in their best interest. An ex ante exit clause is the best way to accomplish this, because it would establish the ultimate enforcement mechanism: expulsion. The conditions for activating the clause – the timing and means – would be clearly defined beforehand, and, like the SGP, its conditions could not be changed or suspended.

Such a clause would address the eurozone’s fundamental asymmetries, while preventing any single country from holding the rest hostage by breaking its rules and threatening its survival. Furthermore, financial markets would know in advance whether a country must exit the monetary union, neutralizing the threat of chaos that has roiled markets since the beginning of the crisis.

An ex ante exit clause would not undermine European solidarity. If a heavily indebted country implemented and exhausted all options for reducing its deficit, it would receive an unlimited and credible bailout from the other countries.

The beauty of such a clause lies in the fact that it does not undercut any country’s sovereignty. Sinners are not placed under their neighbors’ supervision, nor are debt-reduction measures forced upon them, as would be the case in a political union.

A forced exit could not be triggered lightly. But if a country does not play by the rules over a long period, an ex ante exit clause enforces an ultimate and credible consequence – one so serious that every eurozone country would be motivated to avoid it.

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