In a new onslaught of bad economic news in Europe, spreads among sovereign eurozone bond yields have risen sharply in recent months, accompanied by accelerating credit downgrades of the currency union's weaker members (initially Ireland, Greece, Portugal, Spain, and perhaps Italy). But there is a beneficial aspect to these adverse developments in that they represent a return to economic fundamentals of how markets should respond to hard realities. That trend, at least, should be welcomed.
Rising spreads, more specifically, mark the return of market enforcement of the long-term sustainability of eurozone fiscal policies. This is crucial because since the collapse of the Stability and Growth Pact (SGP) in 2005 the eurozone has been without any political enforcement mechanisms conducive to fiscal discipline. More importantly, excessively narrow sovereign bond spreads have failed to financially reward (with lower borrowing costs) those governments that have taken significant political risks by pursuing tough and necessary structural reforms of labor markets, tax and pension systems, educational institutions, and other elements of their economies.
Instead of serving as "everybody's intimidator" (in James Carville's phrase), eurozone sovereign bond markets since the mid-1990s have handed a blank check to nonreforming European governments by letting them free-ride on the increased liquidity and resulting lower sovereign bond yields in the deepening eurozone bond market. Every eurozone member suddenly could enjoy German interest rates, irrespective of whether their country's economic fundamentals warranted this. In the absence of financial market–induced discipline, the risk of political moral hazard has been increasingly obvious. Eurozone members have fallen prey to being governed by leaders who are only concerned with the next election and who are not interested in implementing the reforms required to tackle their longer-term structural challenges.
It is no accident that the increase in eurozone bond spreads coincides with the steepest slowdown in the European economies in decades. The downturn presents an opportunity for the governments of weaker eurozone countries to use the "Great Crisis of 2008–?" to face politically tough, but economically necessary structural reforms. Increased financing costs among the weaker eurozone members might dangerously constrain their room for short-term fiscal stimulus at this time of crisis. The message from rising spreads reinforces the message that any short-term fiscal stimulus in weaker eurozone members must be accompanied by long-overdue structural reforms.
Hopefully, healthy financial-market distinctions between the bond yields of individual eurozone members will remove the financial incentive for nonmembers to pursue premature eurozone entry. With diverging bond spreads and weaker members facing higher costs of borrowing, governments hoping to reap a direct and immediate fiscal benefit of reduced borrowing costs by gaining entry into a club among whose membership financial markets do not distinguish will see their hopes dashed.
There may still be political reasons why member-state governments desire premature eurozone entry, but the removal of short-term financial incentives should help prevent future repetitions of the "Greece-scenario." Under that narrative, an EU member state gains entry into the eurozone and for a (potentially long) time reaps the financial benefits of free-riding through reduced borrowing costs, despite having failed to reform and structurally prepare for membership. Expanding membership only to those countries that have reformed their economies sufficiently so as to thrive without an independent monetary policy will be a long-term benefit for the eurozone.
