Exit and Enforcement in the Eurozone

TILBURG – 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.