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Austerity is back in fashion across the European Union, thanks to the Greek debt crisis—particularly among the vulnerable southern eurozone members. Faced with suddenly hostile financial markets and unwilling to refinance affected countries' debts at anything other than unsustainably high interest rates, Europeans are adopting a slew of severe budget and regulatory measures throughout the eurozone.1
Spain, Portugal, and Italy are following in the footsteps of Latvia, Ireland, and of course Greece itself to cut public wages and take other tough steps. Meanwhile in Germany, the government looks set to implement its own balanced budget constitutional amendment, implying at least another €10 billion in annual budget cuts each year until 2016 while in France the government is—among other measures—planning to raise the retirement age by 2 to 3 years.
Faced with high debt levels, low potential growth rates, and long-term demographic decline, most European nations do not have the realistic option of growing out of their debts through high nominal GDP growth. Accordingly, they must address their fiscal straits the hard way, with painful budget measures and far-reaching structural reforms.2 This seems the only plausible way to reduce the high sovereign default premiums imposed by financial markets.3
The case for "stick and pain" enforced by markets across the eurozone is likely to become even more clear after a probable future Greek default. The question is whether there are any complementary policy measures that could serve as a "carrot" that would reward governments carrying out sustainable government fiscal policies.
The problem is familiar. Just as the European Union's fiscal policy peer pressure framework in the Stability and Growth Pact (SGP) was a toothless failure that did not prevent excessive deficits in eurozone governments, the union similarly offers member countries no rewards for sticking with rules, apart from a nice mention in a biannual report. In the present rush to fiscal austerity, that seems a serious oversight. It cannot all be sanctions all the time. Aside from financial markets offering well-behaved countries lower bond yields, the European Union needs to go further.
Incentives for doing the right thing are not without precedent in the European Union. Historically, Brussels's principal and most effective external policy tool has been the promise of future admission to the European Union itself. As a result, prospective members have shown themselves willing to undertake virtually any domestic reform to receive the European Commission's blessing. A similar dynamic was clearly visible in the mid-1990s, as EU members prepared to qualify as founding members of the eurozone.4 Clearly European countries tend to perform their political best when trying to qualify for membership in an exclusive club. The obvious problem in the eurozone (and arguably in the European Union itself) is that once countries become members of a club from which expulsion is impossible,5 the pre-admission self-discipline is forgotten.
The political trick facing EU policymakers is to design a new elitist "club for fiscally responsible members" of the eurozone, and to do it in a manner that provides incentives for membership and promotes European integration, without undermining eurozone monetary policy or the EU Internal Market.
Two obvious political constraints must be kept in mind. First, despite all the talk about an "EU fiscal union" with large-scale budget transfers among eurozone members, no such revision of the EU Treaty is politically feasible for the foreseeable future. No less unrealistic is the prospect of a large increase in the EU budget administered by the European Commission in Brussels. As a result, any future "EU austerity carrot" is likely to involve only a minimal addition to the EU institutional architecture.
One idea that should be discussed, however, is the creation of a common "Maastricht bond" that would be similar in most ways to the often suggested "Eurobond," but open only to eurozone member states that adhere to the Maastricht Treaty debt stock criteria of a maximum level of government debt of 60 percent over an entire business cycle (or some similar tough objective measure of long-term fiscal sustainability).
But such a future Maastricht bond would most likely require the participation of Germany and a critical number of other eurozone members. (France's participation would be preferable but not required at the outset). A Maastricht bond would furthermore require a "living will provision" calling for expulsion of countries that fail to adhere to the debt and other eligibility criteria of the bond.
A Maastricht bond could lock in lower interest rates from deeper and more liquid bond markets, producing a powerful incentive for participating countries to remain in compliance with the Maastricht Treaty debt criteria or similar tough objective measures. Such a bond could also complement the EU Commission's recent proposals to reform the SGP6 and ease the moral hazard concerns that have traditionally blocked the introduction of "Eurobonds," particularly in Germany, which is understandably fearful that participation would undermine its own preferred access to the bond markets.
Given that only eurozone members with sustainable government finances and with a record of adherence to Maastricht debt stock criteria would be eligible to participate, Germany might be less resistant to participating in a joint Maastricht bond with other countries more similar to itself in fiscal policy terms. With much less fiscal divergence among participating countries in a "Maastricht bond," the risk of moral hazard could be managed and political opposition reduced during the years of required austerity before the possible launch of a joint "Maastricht bond."
Another advantage of a Maastricht bond is that, provided sufficient member states qualify, it could be launched under the EU Treaties' existing provisions for "enhanced cooperation."7
Finally, from a global perspective, a successful introduction of a pan-European "Maastricht bond" by the end of this decade could furnish a future "global safe haven" for investors wary of mounting US federal government debts over the same time frame.
Thus a successfully launched pan-European Maastricht bond, backed by the credibility of years of painfully endured austerity measures across a sufficient number of participating member states, could achieve a scale and market depth rivaling today's US Treasury market.
Should a threat to the dollar's primacy as a safe haven materialize, the US Congress might finally get serious about dealing with the long-term US debt sustainability concerns. Ironically, the willingness of European socialist regimes to cut spending and implement other austerity measures could be just the trigger for Democrats to accept spending cuts and Republicans to accept higher taxes to restore stability to the US government.
Notes
1. See the Financial Times' overview of recent austerity measures in Europe.
2. See Cline (2010) for an in-depth analysis of the links between nominal GDP growth and debt-to-GDP ratios.
3. At the time of writing the 10-year bond spread between Germany (yield of 2.69 percent) and Italy is 151 basis points, Spain 170 basis points, and Portugal 221 basis points. These are unsustainable sovereign bond yield differences that dwarf any cross-sectoral differences within the eurozone. Data from Financial Times Markets.
4. Obviously, the ultimate decision to launch the euro in 1997 was a political one and hence the need to jettison the 60 percent Maastricht debt criteria to enable Italy and Belgium (i.e., Brussels itself) to become founding members. In retrospect, this decision looks to have been a mistake, unless one takes the view that the euro would never have been launched without this fudge.
5. Under the Lisbon Treaty it is now possible for member states to voluntarily withdraw, but expulsion of a country against its own will is not a legal option.
6. See EU Commission COM (2010) 250 Final for the suggestion that "The debt criterion [60 percent] of the excessive deficit procedure should effectively be implemented."
7. See Lisbon Treaty article 20 and Treaty on the Functioning of the European Union articles 326–334.
