End of fiscal sovereignty in Europe
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The late Milton Friedman said a common currency - that is, a monetary union - cannot be sustained without a deep form of economic and political union. By this, he meant an open economy that ensures the free flow of goods, labor and capital, together with a disciplined central fiscal authority and a strong central bank. The latter two are pillars of a strong currency. They work in tandem. But the other pieces are no less important.
The European Union (EU), currently wrestling with fiscal imbalance and sovereign debt risk, has a strong and autonomous central bank, but is fiscally fragmented and politically only partly unified.
Enter the Maastricht Treaty, which in theory imposes fiscal discipline by placing limits on government deficits and debt levels - clearly a structure designed to prevent free riding on the fiscal discipline of others. Maastricht was thus intended to prevent a situation like the current one in Greece. It didn't work. Eurozone sovereign debt turned out not to be homogenous with respect to risk.
In a stable world, Maastricht Treaty's rules-based framework, if enforced, might do the job. But in a shock-prone world, it is a fragile system, because it precludes anything but modest counter-cyclical policy. No wonder, the treaty's strict limits were breached early in the euro's first decade by core countries as well as peripheral ones.
Indeed, with a large shock, much of the breach takes place automatically, as tax revenues shrink and social insurance payments expand. Recent analysis by the International Monetary Fund suggests that, as much as 80 percent of the fiscal stimulus in advanced countries during the current crisis is non-discretionary.
That kind of built-in counter-cyclicality is not a bad thing. But if it produces the threat of fiscal instability and excessive sovereign-debt risk after a large shock, then the starting point was not sufficiently conservative - in other words, deficits or debt levels (or both) were too high. Counter-cyclicality does not mean running modest deficits in the good times and huge deficits in major downturns.
If the current EU budget rules are too rigid and are ignored in the face of a shock, then the door is open for imprudent fiscal behavior. In theory, strict in-depth monitoring could distinguish genuinely prudent counter-cyclical responses from profligacy. But in practice it is hard to enforce.
The eurozone's immediate challenge is declining fiscal stability in a subset of countries whose credit ratings are falling and debt-service costs rising. Since external assistance and a credible plan for restoring fiscal order was absent, the Greek sovereign debt could not be rolled over, forcing a default. Even with external assistance, many view default as a near certainty, because the arithmetic of restoring fiscal balance is so daunting.
EU membership precludes inflation and devaluation as adjustment mechanisms. An alternative is domestic deflation combined with extreme fiscal tightening - that is, a period of slow or negative growth in wages, incomes, and some prices of non-traded goods. But deflation is painful and cannot realistically be pursued for political reasons.
The constraints for eurozone countries are similar to those of a state in the USA that gets into fiscal trouble. Devaluation is not an option because of the common currency. The Federal Reserve will not willingly resort to inflation. Moreover, in the USA, there are rules and conventions (similar to Maastricht) that disallow or discourage states from running long-term deficits. This means that state fiscal behavior tends to be pro-cyclical in the face of large shocks like the recent one.
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