How to Save the Euro

BRUSSELS – The European Union is facing a constitutional moment. The founders of Economic and Monetary Union (EMU) warned even before the euro’s birth that fiscal profligacy would constitute a danger to the common currency’s stability. Nevertheless, the euro-zone’s member countries insisted on maintaining their full sovereignty in this area.

The solution to this conundrum was supposed to have been the Stability and Growth Pact, working in tandem with the so-called “no bailout” clause in the Maastricht Treaty. The latter was intended to impose market discipline, and the former, to preserve the stability of public finances by fixing a strict limit on the size of national budget deficits.

Both proved futile. The Stability and Growth Pact clearly did not prevent “excessive” deficits, and the no-bailout clause failed its first test when European leaders, facing the Greek crisis, solemnly declared on February 11 that euro-zone members would “take determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole.”

The failure to impose market discipline via the no-bailout clause was predictable: in a systemic crisis, the immediate concern to preserve the stability of markets almost always trumps the desire to prevent the moral hazard that arises when imprudent debtors are saved. But in September 2008, the United States government thought otherwise, and allowed Lehman Brothers to fail in order to impose market discipline. The disaster that followed illustrated the damage that an uncontrolled failure can produce.