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.