by Christian Fahrholz and Cezary Wojcik
With the sovereign debt crisis spreading across Europe and in the run-up to the next EU Summit there is no shortage of suggestions on how to save the Eurozone. Unfortunately, the majority of these suggestions have one of the following flaws. Either they address the long-term challenges without dealing with the short-term stabilisation problems (for example, Cooley and Marimon 2011) or they address the short-term stabilisation issues at the cost of the Eurozone’s long-term sustainability (de Grauwe 2011, and Delpa and Weizsaecker 2011).
But there is one solution that would achieve both and would also provide added benefits. The Eurozone needs Treaty provisions on ‘exit rules’.
Not -- we emphasise -- because Greece or some other member state should be thrown out, but because such exit rules would strengthen the Eurozone. They will strengthen it through four channels: i) improved external market discipline, ii) strengthened internal macroeconomic discipline, iii) increased enforcement power of the Eurozone over profligate members, and iv) reduced uncertainty. As such, such exit rules would decrease (and not increase!) the probability of an exit, or the breakup of the Eurozone. Why?
The notion supported by EU officials and currently embedded in the EU legal framework that leaving the Eurozone is impossible may speak to political aspirations, but economically they are harmful. This has been a key source of the imbalances within the Eurozone and is now at the core of today’s difficulties in resolving the crisis.
This is because such provisions are the legal equivalent of an implicit guarantee that member states will support each other to prevent an exit whatever the circumstances. This guarantee has given rise to a gigantic moral hazard, both for the markets and member states, and has allowed a small country like Greece to hold the entire Eurozone hostage. This guarantee has transcended the Eurozone’s framework and is like a bomb with two fuses.
- At the economic end, because of the guarantee, markets have for many years been taking far too many risks by treating, for instance, Greek and German bonds in essentially the same way. This has led to a reduction in market discipline, lower interest rates and has provided easy access to capital, which in turn has led countries like Greece to indulge in excessive fiscal spending. The resulting imbalances are now threatening the stability of the Eurozone.
- At the political end, the guarantee has shifted the political bargaining power to the profligate countries and given them leeway to pass part of their political and economic adjustment costs onto the rest of the Eurozone. Since the problems in Greece generate a negative externality for the other members, the Eurozone has little choice but to provide a bailout. As a result, there is no credible enforcement mechanism. Greece has again failed to meet its fiscal targets and if the framework of the Eurozone does not change it will fail to deliver yet again.
A simple political-economy analysis shows that exit rules would quench the burning ends of the fuses and would provide additional benefits (Fahrholz and Wójcik 2010, 2011).
- First, if exiting the Eurozone were openly allowed, the markets would have no choice but to price non-zero probability into their risk assessment and thus better differentiate -- not only in crisis times, but also in good times -- country risk among Eurozone sovereign bonds. External market discipline would intensify.
- Second, exit rules would increase the political bargaining power of EZ members vis-à-vis the profligate countries. Their power to enforce fiscal and structural reforms in the profligate countries would increase because the exit rules would become a bargaining chip in their negotiations with these countries. Their negotiation position and enforcement power would be increased.
- Third, exit rules would enhance domestic discipline because they would shift internal political economy incentives. They would in essence increase the perceived costs of leaving (now largely hidden) in relation to the short-term political costs of adjustment. Domestic discipline would be strengthened.
- Fourth, exit rules would decrease market uncertainty, which would support the political and economic adjustment process. At present, nobody knows what the legal procedure for leaving could be, what the costs would be, and how they would be distributed. Clarifying this would limit the scope for disruptive speculation with all its detrimental effects on the real economy. Financial uncertainty would be mitigated.
Opponents of this solution may argue that merely initiating a discussion on exit rules would open up a Pandora’s box at a moment when Europe is badly in need of stability. Quite the opposite is true. Opening up such discussions would help stabilise today’s mess because Europe’s laggards would receive the clear message that the world has changed and there is a limit to the Eurozone’s willingness to pay for their negligence. The pressure to deliver would increase.
Some commentators may argue that there are no exit rules in the US monetary union, the blueprint for the Eurozone. Although true, such view overlooks the unique nature of the Eurozone. It is a monetary union among sovereign states, and not a federal state with a common fiscal policy, like the US. While increasing European political integration might be a step in that direction, it is naïve to think that the Eurozone can make any substantial progress sufficiently quickly to avoid another blow somewhere in the near future. Europe is standing on the brink of a precipice between the undesirable now and the desirable future. It does not want to move backwards, but going forward is risky -- this is when creativity is needed.
Some may also worry that exit rules would run counter to the political ideal of creating an irrevocable monetary union as the basis for a political union. We share this ideal, but just the opposite is true. Paradoxically, exit rules would decrease (and not increase!) the probability of an exit, or the breakup of the Eurozone. This is because, as suggested above, spelling out the exit rules would give the Eurozone what it so badly needs, i.e. enhanced market discipline, stronger enforcement power of the Eurozone, more internal discipline in the profligate countries and reduced market uncertainty.
The closest parallel to this positive feedback effect is the lender of last resort facility. A promise to provide unlimited funding to the banking sector decreases the probability of using public money because of the positive impact of such promise on the banking sector’s stability.
Evidence can be also found in political science and in the history of national states struggling with preserving their internal integration. Their experience suggests that when secession is not permitted, pressure for it rises. When secession is openly allowed many would-be secessionists cease to press so hard for it.
Exit rules would strengthen the Eurozone’s cohesion and stability. They would address both the short-term and long-term challenges and their introduction is politically feasible. Europe needs such rules, and Europe needs them now.
Cooley Thomans and Ramon Marimon (2011), “A credible commitment for the Eurozone”, VoxEU.org, 20 July.
De Grauwe, Paul (2011), “The European Central Bank as a lender of last resort”, VoxEU.org, 18 August.
Delpa, Jacques and Jakob von Weizsäcker (2011), “The Blue Bond Proposal”, Breugel.org, 11 May.
Fahrholz Christian and Cezary Wójcik, (2011), “The Eurozone needs exit rules”, CESifo Working Paper, forthcoming
Fahrholz Christian and Cezary Wójcik, (2011), “Bail-out! A positive political economics of a Greek type crisis in EMU", CESifo WP 3178
Originally published by VoxEU.org
"Eurozone Needs Exit Rules"