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Unfortunately for the Eurozone’s Core, Moral Hazard is Nothing Compared to a Breakup

One argument against bold solutions to the Eurozone debt crisis, such as issuing common Eurobonds or extending bond purchases of indebted sovereigns by the European Central Bank (ECB) has been the issue of moral hazard associated with such solutions. According to this argument, bailing out states that have racked up unsustainable debts through years of profligate spending will only encourage others to do the same, knowing that they too will be bailed out by those virtuous states that can afford to do so. It is difficult to dispute this line of reasoning, although applied to the current situation in the Eurozone, any states betting on an inevitable rescue and hence contemplating fiscal binges would have to worry about enduring significant austerity for a year or so before this damagingly generous rescue comes along. Nonetheless, if a bold rescue does materialize, this will signal that Eurozone states can count on others to bail them out if need be, and therein lies the moral hazard.

European policy makers were no less aware of this risk when they devised plans for a single currency than they are now, which is why precautions were taken in the form of the ‘no bailout clause’ and the stability and growth pact (SGP) to, respectively, restrict bailouts for overstretched member states and prevent member states from becoming overstretched in the first place. The latter of these safe guards went out the window a long time ago, as soon as limits on government spending ran counter to the policy preferences of a big member state’s government. Member states and the Commission have continued to pay lip service to the SGP and reforms have been attempted to increase its effectiveness, but it is hardly an answer to the problem of moral hazard. Hence the ‘no bailout clause’ occupies center stage as the remaining guarantee against unlimited bailouts for states that would rather not reform public spending.

Bundesbank head Jens Weidmann has caused consternation with his steadfast opposition to calls for the ECB to go much further in aiding Eurozone rescue efforts, not to mention that he opposes efforts already undertaken in the form of the ECB’s bond purchasing program. While Weidmann’s opinion is dominant in Germany, where the Bundesbank is widely revered and sentiment tends to oppose ECB intervention anyway, he nonetheless represents only one vote on the ECB Governing Council and it is difficult to say what will and won’t be done when the ECB is staring down the barrel of a Eurozone breakup. This is the key point that so few politicians seem able or perhaps willing to acknowledge – when the known alternative to almost any plan is the breakup of the currency union, that plan will be opted for. We have already seen this happen each time Europe’s leaders refuse more funds in the absence of meaningful reforms and then pledge more funds anyway, to name one example of a wider trend.

This cycle of drawing a line in the sand and then crossing that line is similar to what occurred during negotiations over the creation of the currency union. The Germans proclaimed that they would not proceed with monetary union unless it was accompanied by a strict stability and growth pact that provided for automatic sanctions in the event of non-compliance, and when it became clear that this might actually mean the end of the currency union, they compromised. This is indicative of the real problem at the heart of the Eurozone debt crisis – the institutional design of the Eurozone is flawed. When it became clear at Dublin in 1996 that the automatic imposition of fines in response to excessive deficits was not going to happen, it should have also become clear that the Germans, with their appetite for austerity and commitment to avoiding inflation at all costs, did not belong in a currency union with the Italians, at least not one based on the principle of avoiding moral hazard and collectivization of debts. However, this was either unclear or ignored and now the German taxpayers, among others, are on the hook for debts that, technically speaking, never should have been racked up.

The reaction, to demand stricter rules tomorrow in exchange for bailouts today, is understandable but ultimately just as futile as demanding concessions to go ahead with something that you well know you will proceed with regardless. Just as Helmut Kohl staked his political career on completing EMU, Angela Merkel’s political career depends on avoiding a Eurozone breakup and, as with her historical counterpart, Merkel will eventually make every compromise in her power to save the Eurozone. Hopefully, this will mean agreeing to Eurobonds at least and ideally some sort of transfer union. Although it may be unpleasant to pay the bills of other sovereign states that do not seem particularly deserving of assistance, it is surely better to agree to this ahead of time, rather than being told that you will belong to a currency union composed of divergent economies that take equal responsibility for maintaining stability.

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