The ability of Euro zone countries (countries in Europe that use the common currency called the Euro) to borrow in a common currency poses free-rider problems because there may be an incentive to bailout countries that borrow excessively. How does the original design of the Euro attempt to address this incentive to over-borrow by some countries? The free rider problem refers to when someone is capturing the full benefit of an action while shifting the cost to others.
The free-rider problem built into the euro lies into the fiscal structure, since the countries were fiscally undisciplined and also governments were gaining political gain running deficits supported by their euro partner nations.
Over borrowing occurred due to the incentive of governments to borrow in a common currency; to address this issue the original design had to solutions. One was the Stability and Growth Pact (SGP) which limited budget deficit to up to 3% of GDP and 60% of stock of public debt, aiming to ensure fiscal discipline; where if a member state was in an excessive deficit situation then the council could impose sanctions.
The Second rule is a “no bailout” clause stating that community shall not be liable for the debt of governments (with some exceptions) The original design of the euro sought to address the over-borrowing. Why were the measures in the original Euro design insufficient in preventing the Euro sovereign debt problems? First it is important to point out that the sovereign debt crisis is significantly tied to the banking crisis and macroeconomic crisis through the entire euro area.
The original measure was insufficient because in a way these measures actually worsen the crisis. The sovereign debt crisis can be divided in three phases: pre-crisis period, the financial and sovereign debt crisis and post-crisis recovery. The initial design affected the pre-crisis since in reality it increased fiscal risk due to the increased in the current account imbalances across the euro area and also the dispersion in credit boom, housing prices and sectorial debt levels.
Then, during the crisis 2007-2008 the original design actually augmented the fiscal impact since the global financial shock had diverse impacts across the euro area and policies were focus on European Central Bank to address the financial shock, not accounting these policies prompted a worse euro sovereign debt crisis (Especially countries with macro-imbalances). Thirdly, the original measures slowed down the post-crisis recovery period because the stated estrictions of deficit and debt made the recovery stretched, along with the poor political management of countries’ institutions to solve factors involving the crisis. What are the new reforms to address sovereign debt concerns? What makes the new measures superior to the original ones? The new reforms to address the sovereign debt is compounded on a treaty called “ Fiscal Compact Treaty” which requires new fiscal principles to be pose in each country (Jan 2013). These fiscal reforms are based on two principles: avoid high public debt since it’s a threat to fiscal stability.
Second, the fiscal balance has to be close to zero. The improvement is a structural budget balance less than 1% of GDP when debt is below 60%. Also the country that has higher public debt (off the limit) will have to correct the issue with a timeline. Though this reform is a little more efficient than the original, it still has major implementation problems since it requires adjustments on forecast errors for the structural budget balance. Also it’s difficult to accurately trust the ability of governments to identify and tackle down excessive imbalances.