Thursday, September 18, 2014
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Europe’s Free Riders

In the United States, individual states that follow unsound fiscal policies face a penalty. Their bonds sell at a discount relative to those of better-managed individual states. The higher debt service they must pay serves – to some degree – as a form of discipline against the temptation to spend now and pay later.

Of course, the discipline of the market is not perfect: the bond market does not “see” implicit future liabilities (like promised pension payments) to any great degree. Nevertheless, this enforced fiscal discipline, combined with individual states’ own internal budgetary procedures, has prevented a large scale state-level fiscal crisis from occurring in the US since the Great Depression.

Let us now turn to Europe. Before the advent of the euro, there were many fiscal crises in individual nation-states in southern Europe, which produced waves of high inflation. But, with the single currency in place, the road to solving a fiscal crisis through inflation has been closed, as the European Central Bank (ECB) now stands watch over monetary policy.

Nevertheless, even with nation-states no longer able to rely on inflation to solve their unbalanced finances, the single currency allows them to use the debt capacity properly belonging to other members of the European Union to extend their spending sprees and postpone political accountability for periods of laissez les bons temps roulés. To head off this possibility, the EU created the Stability and Growth Pact: government deficits had to be less than 3% of GDP.

Last week, the government of Germany – once the most fiscally prudent and disciplined EU country – broke the pact’s rules for fiscal discipline for the fifth consecutive year, and did so without (much) apology. Finance Minister Peer Steinbrueck signaled that he expected the European Commission to apply some sanctions to Germany: the credibility of the pact would, he said, be at stake if no action were taken. Thus, Germany would not block sanctions this time, as it did two and a half years ago.

But Steinbrueck also made it clear that he expects any sanctions in response to Germany’s predicted 3.4%-of-GDP fiscal deficit to be largely symbolic, not penalties that would cost its government or economy anything of significance. The Stability and Growth Pact is not – or is not yet – working anywhere near the way it was intended to work.

What about market discipline? Is the German government’s willingness to issue more debt and run bigger deficits limited because the market recognizes and penalizes nation states that allow their fiscal positions to weaken?

In a word, no. The interest rates on the euro-denominated sovereign debt of the twelve euro-zone governments are all very similar. So the market does not seem to care that countries have different potentials to generate exports to fund the financial flows needed for debt repayments, or different current and projected debt-to-GDP ratios.

Willem Buiter of the University of Amsterdam and Anne Sibert of the University of London believe that it is the ECB’s willingness to, in effect, accept all euro-zone debt as collateral that has undermined the market’s willingness to be an enforcer of fiscal prudence. As long as the marginal piece of German debt is used as collateral for a short-term loan or as the centerpiece of a repurchase agreement to gain liquidity, its value is much more likely to be determined by the terms on which the ECB accepts it as collateral than by its fundamentals. The ECB’s treatment of all such debt as equally powerful sources of back-up liquidity now trumps any analysis of differences in long-term sovereign risk.

In the long run, this is dangerous. Both market discipline and sound fiscal management are needed to create a reasonable chance of long-run price stability. Omit either a market penalty now for behavior that may become reckless or the institutional levers that give a voice to future generations, and you run grave risks – perhaps not today or tomorrow, but someday, and for the rest of your life.

As time passes, the coming of the single currency and the way that the euro has been implemented is generating more and more unease. Policy as a whole over the entire euro zone is too deflationary. The necessary transfers are not being made to make the common currency bearable to regions that lose out and are already in recession when the ECB tightens policy. The institutional foundations of stable long-run fiscal policy are being eroded. And now, Buiter and Sibert argue convincingly, the ECB is giving the market less scope to reward the thrifty and penalize the profligate than it should.

There is no movement of the soil yet, and there will not be for some time. But the ground under the euro may well begin to shift if things don’t change.

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