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The Eurozone’s levitation

Some see the Eurozone crisis as a harbinger of a more perfect union, others as the euro’s death knell. In contrast, this essay explains the current situation as something in-between; the Eurozone is levitating on the hope that an exit strategy can soon be found. The key is to establish fiscal discipline in every Eurozone member. As a real European government is politically impossible, this must be based on national institutions that can guarantee fiscal discipline.

Recent events in Europe can be interpreted in the light of two diametrically opposed theories.

Eurozone crisis: Stepping stone to a more perfect union

As intended, the markets have been “shocked and awed” by a European Financial Stability Facility (EFSF) of 750 billion euros – that’s 6% of EU GDP – and by the ECB scooping up public debts to the tune of 100 billion euro. But this is not the end of it.

Eurozone governments are scrambling to announce ambitious deficit-reducing packages, and Finance Ministers are meeting at least once a week to prepare further far-reaching measures including:

  • A strengthening of the Stability and Growth Pact to enforce fiscal discipline (at long last);
  • A statistics police that will deliver safe data from every corner of the Union; and
  • A race between the Commission and Eurozone governments to establish a sort of pan-European government.

This is the silver lining theory of the Greek crisis. Greece’s woes and the attendant contagion pointed out the cracks in the Eurozone’s architecture. They also provide the urgency political leaders needed to take Europe one step up towards a more perfect union. Three cheers for their courage and determination!

There is, however, another storyline out there – one with an unhappy ending, namely the euro’s demise.

Eurozone crisis: The euro’s fatal flaws finally revealed

Proponents of the euro-is-doomed theory view the Eurozone crisis as validation of their analysis. We told you all along, they say, sovereign countries cannot share a common currency. Highly favourable conditions hid the cracks for a while, but the Greek crisis widened them enough so that now they are plain for all to see. The euro was always a political project, not based on sound economic principles. It was just a matter of time before economic trouble would arise. Self-preserving political leaders now see that it is in their electoral interest to return to normality by re-establishing their old cherished currencies. The end of an interesting but doomed experiment, the euro is already falling. Three cheers for hard-nosed economists!

A third theory: The “levitation theory”

I am inclined to embrace another theory, which I call the levitation theory. The market run on European public debts was stopped by the ECB when it effectively put a floor under public debts. This gives Europe time to deal with the problem, but not unlimited time. The ECB can sterilize its operations but it must return to normalcy at some point. The EFSF has not yet proven that it can exist, much less that it can bail out a government without bailouts becoming the norm.

The Eurozone, according to this theory, is levitating – hanging in mid air – sustained by the hope that an exit strategy from this crisis will be designed in time. Unfortunately, the rescue operation has made the cracks wider and deeper than before the crisis; the solution is now all the more daunting.

What are these cracks, then? The creation of the euro was an extraordinary bold undertaking because member countries were to remain fully sovereign as far as budgetary matters are concerned. It was clear that the monetary union would not deliver price stability unless fiscal discipline was guaranteed. Perfectly aware of this original sin, the authors of the Maastricht Treaty introduced no less than three safeguards.

  • First, the no-bailout clause established that national governments alone were in charge of their budget and that they alone would be sole responsible for any slippage. No European government or official institution was allowed to rescue another a Eurozone member.
  • Second, the ECB was barred from financing public debts.
  • Third, the excessive deficit procedure led to the Stability and Growth Pact.

The Pact never worked and cannot work because it presupposes that a sovereign government can be told what to do with its budget. Failure of the Pact led to a sequence of events that blew away the other two safeguards. Not only must we now face the immediate consequences of the debt crisis, we must also find new ways to deal with the “original sin”. The no-bailout clause has been sidelined, and the ECB’s credibility has been undermined.

What is to be done?

Let me start with what should not be done, or at least not right away.

  • Eurozone governments should not waste time trying to strengthen the Stability and Growth Pact. Strengthening means adding sanctions but sanctions cannot be really imposed on democratically-elected governments.1
  • A meaningful government of Europe will not emerge soon as EU citizens are not now willing to give up much sovereignty. The disastrous saga of the Constitutional Treaty and the painful ratification of the Lisbon Treaty show that, very sadly, this is not the time for bold European undertakings.

What then should be done? How can EU leaders arrange an exit strategy before the levitation trick grows old?

Fiscal discipline enforced by new national institutions

The solution is to go back to basics. We absolutely need to establish, once and for all, fiscal discipline in every Eurozone country. But fiscal discipline is and remains a deeply-seated national prerogative of each national government and parliament. The inescapable implication is that the Stability Pact must be decentralized to where authority lies. Instead of dreaming up ways around sovereignty, it is much more productive to try and make sovereignty work for the common good. Each country must be required to adopt national institutions that can guarantee fiscal discipline.

In a democracy at least, fiscal profligacy is not a story of “politicians gone crazy”. It is the rational outcome of the interplay between elections and pressure groups.2 Fiscal profligacy occurs because politicians find it politically optimal given the constraints and pressures they face. It will continue as long as the same pressures and constraints are in place.

Restoring fiscal discipline therefore requires Europe to tackle this political failure head on by adopting institutions that bind the budgetary process. There are many possible approaches, as shown in Von Hagen and Harden (1995) and Wyplosz (2002). It well may be that – given history and local politics – different countries need to adopt different solutions. A good precedent is last year’s decision by Germany to write into its Constitution the interdiction for the structural deficit to exceed 0.35% of GDP.

The first step forward

A good way to proceed is to invite – and please do so kindly because this is a national sovereignty issue – each member to submit its own proposed solution, and have it vetted by the Commission or an ad hoc committee under the EU Presidency. Countries whose plans are not approved should lose the support of the EFSF and of the ECB until they come up with a better one. The same will apply to those countries who have not transcribed an approved plan into their national legal structure by a given deadline.

Even with all the plans in place, a delicate question will remain. It is sometimes felt that not all Eurozone members strictly abide by their own laws. There will be a need to empower the European Court of Justice to fill that gap in the event that a budget violates the country’s own laws. It is for legal experts to tell us how this can be done.

Medium-run credibility without short-run overkill

Adopting water-tight legislation that guarantees budgetary discipline has an important additional advantage. With a recovery that is shaping up to be modest at best, the current wave of fiscal tightening is premature. It is understandable that governments feel that they have no choice; they must signal to markets that they are serious about fiscal discipline. But the price of this signal may be huge. The adoption of strong legislation, even if it implies progressively rebalancing, would be a much more powerful signal than a potentially unsustainable fiscal tightening, and it would allow the exit strategy from fiscal stimulus packages to be delayed for a bit longer.


Eichengreen, Barry and Charles Wyplosz (1997) “The Stability Pact: Minor Nuisance, Major Diversion?”, Economic Policy 26: 65-114.

Krogstrup, Signe and Charles Wyplosz (2010) “A Common Pool Theory of Supranational Deficit Ceilings”, European Economic Review 54(2): 273-281.

Von Hagen, Jürgen and Ian Harden (1995) “Budget Processes and Commitment to Fiscal Discipline”, European Economic Review 39(3): 771-779.

Wyplosz, Charles (2002) “The Stability and Growth Pact: Time to Rethink”, Briefing Notes to the Committee for Monetary and Economic Affairs, European Parliament.

1 The point was made long ago in Eichengreen and Wyplosz (1997).

2 See e.g., Alesina and Tabellini (1990) or Krogstrup and Wyplosz (2010).

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