The European Union was dreamed as an economic and political integration of countries, where through a democratic system, all countries would move together towards a more prosperous economic region. With the creation of the euro, the European Union embarked on a grand experiment.
From the starting point, there were wide differences in degrees of budget, or fiscal transparency. As an attempt to control this, convergence requirements were established and all countries should maintain deficit lower than 3% and government debt lower than 60% of GDP, subject to a sanction otherwise.
Nevertheless, early predictions about the potential of moral hazard in public finances as a consequence of asymmetric information about fiscal decisions were not taken seriously and on top of that, there was no concrete mechanism that restricted governments from overspending.
Euro-zone members became tightly intertwined meaning that banks, insurance companies and pension funds in every euro-zone economy became the biggest investors in the bonds issued by governments of other euro countries mostly because there was no currency risk. That meant that if one government defaulted, it would have severe effects on the health of all financial intermediates. This overall risk elevated even small European economies to the “too big to fail” category.
The current conflict existing between the weak economies of Southern Europe, such as Greece and Portugal, with the rest of the euro-zone countries has become a serious moral hazard problem. The point is whether the fact of being bailed out in case of default, causes a country to misbehave. Would bailing out an indebted country encourage that and other countries to live beyond its means in the future?
This ill-fated setup allows governments to maintain uncompetitive economic structures such as inflexible labor markets, huge welfare systems, and huge public sectors for a long time. Moreover, the system causes the over-indebtedness and lack of competitiveness typical of the recent sovereign-debt crisis.
One of the key criticisms of the bailout of Greece is that it rewards the country for its mistakes and for breaking the rules of the Eurozone project. Also, in the five years after the single currency being launched, the two biggest economies in the Eurozone, Germany and France, had broken the debt rules for three years in a row with no punishment, violating the convergence requirements mentioned above. Not wishing to harm the most important countries in the project, Eurocrats quietly ignored the rule breaking. These two cases show how non-credible the Eurozone agreements are, allowing a misbehaving conduct. If things go wrong, Eurocrats will come to the rescue for their own good, in other words, a check will be sent for the sake of everyone as fears of contagion spreads. EU’s leaders said that they would do “whatever it takes” to protect the integrity of the Eurozone.
The solution for economic stability must then start with imposing a good behavior long before the profligacy becomes acute; it is needed to cut incentives that lead to bad situations and not act only when the worst happens. More specific measures have been discussed such as a policy tool that denies profligate countries to vote in any euro decisions. These measures show that the EU intentions for efficiency and punishment are becoming more credible making weak countries to think twice when relying on others strengths to bail them out.
Francisca Pereira dos Santos 680
Margarida Ortigão 647