European Common Pools and
Their Governance
A Politico-Economic Perspective of the European Public Debt Crisis
Juergen von Hagen
Izmir, 3 November 2012
Disclaimer: The views expressed here do not represent the views of the Portuguese Council of Public Finances
Common Pool Problems
• The root of excessive deficits and debts is in
the common pool problem of public finances.
• This problem comes from the fact that public
spending on projects benefitting groups in
society is financed by general tax revenues.
• Those who benefit from a project see the full
marginal benefit of an extra euro but only a
small part of the marginal cost.
2
Common Pool Problems
• Manifestations of the common pool problem:
– Excessive spending
– Excessive deficits and debts
– Recurrent bailouts of subnational governments
(Argentina, Brazil, Germany)
– Bailouts of financial instituions
=> All of these have been important factors at the
root of the current public debt crisis in Europe.
3
Common Pool Problems
• European politicians now call for „more
Europe“ and a European Fiscal Union to get
out of the debt crisis.
• Will a European Fiscal Union improve the
sustainability of public finances in Europe?
4
Common Pool Problems
• The deficit and debt bias resulting from the
common pool problem increases with
– the number of political constituencies drawing
from the same general tax fund.
– the number of decisionmakers involved in the
budget process.
– the number and the depth of political, cultural,
and ethnic cleavages in society.
– the degree of opacity and institutional weakness
of the budget process.
5
Common Pool Problems
• Compared to national fiscal policies, a European
Fiscal Union implies
– A larger number of constituencies
– A larger number of decisionmakers involved
– More and deeper cleavages (nationalities, cultures,
religions, …
– More „government by statistics“ (formal controls
rather than public management)
– Less transparency and virtually no democratic control
=> A larger common pool problem.
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Common Pool Problems
• Common pools need proper governance to
eliminate the deficit and debt bias.
– Punishment for contributing to excessive spending
• Since the temptation to deviate is larger in a fiscal union
than at the national level, punishment would have to be
more severe in a fiscal union.
– Fiscal contracts (multi-annual programs in coalition
governments)
• This is a possible interpretation of the SGP and the Fiscal
Compact.
• But: Such contracts need stronger and more effective
enforcement in a Fiscal Union than at the national level.
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Common Pool Problems
• In order to achieve the same deficit and debt bias
as national fiscal policies have today, a European
Fiscal Union would need tougher enforcement
than national governments have today:
– A European fiscal administration with access to all
internal documents in national administrations
– The authority to give directives directly to national
adminstrations
– With a European police force able to punish deviating
individuals and institutions
8
Common Pool Problems
• Decentralization Theorem:
– With respect to deficit and debt bias, a European
Fiscal Union cannot achieve better outcomes than
what national fiscal policies can achieve.
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The Euro Common Pool
• Governments generally have two instruments to deal with
unsustainable debts:
– Surprise inflation (a tax on all nominal liabilities including
money)
– Partial default (a tax on bonds and bank loans but not money)
• Bond holders can protect themselves against the risk of
surprise inflation and default by demanding appropriate
risk premiums in the interest rate.
• Therefore, interest rates rise, as the level of debt becomes
unsustainable.
• If surprise inflation is less painful than default, governments
will prefer surprise inflation when this instrument is
available.
10
The Euro Common Pool
• In a monetary union, governments lose the
inflation tax instruments.
• It follows that, for any level of debt, the risk of
default is higher in a monetary union than
with a national currency.
• There is no reason to expect interest rate
convergence in a monetary union unless all
governments are far away from reaching
unsustainable levels of debt.
11
Nominal Long Term Interest Rates, Euro Area
30
B
GR
25
D
EI
percent p.a.
20
HE
E
F
15
E
10
PT
I
I
L
NL
Ei
A
PT
SF
5
USA
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
For Southern European Countries, joining the euro promised low interest rates as
inflation risk was subdued.
Now, default risk has replaced inflation risk.
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The Euro Common Pool
• While the creation of the euro has taken away the surprise inflation
tax instrument from the governments, the stock of euros is a tax
base for such a tax.
• If default is more painful than surprise inflation, resolving
unsustainable debts only by default is clearly inefficient.
• An efficient solution requires some surprise inflation. Since the
common stock of euros is larger than national money stocks, the
surprise rate of inflation tax can be smaller than in national
currency systems.
• But: The revenue from the inflation tax is a common pool.
• Unless it is governed properly, too much expected inflation will be
the result. This was the justification for ECB independence.
• But: An independent ECB with a mandate solely for price stability
and financial stability is an inefficient arrangement for fiscal crises.
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The Euro Common Pool
• An efficient arrangement would require
– An independent ECB with a mandate focusing on price
stability in normal times
– A mechanism to declare crisis
– A mechanism to determine the surprise inflation rate
taking into account the welfare of all holders of euros
(internalizing the common pool externality)
– No such mechanism exists today. Instead, the ECB has
availed itself of the power to get involved in solving the
debt crisis, although it has no legitimate mandate to do so.
– Since the ECB has no oversight in this regard, it will likely
lead to excess inflation.
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The Euro Common Pool: A Proposal
• The ECFIN Commissioner proposes that a
fiscal crisis in a country prevails, ECOFIN
decides with qualified majority.
• ECFIN Commissioner proposes a monetary
base target (à la QE) for the next two years.
• This will be mandated to the ECB, if a qualified
majority of the European Parliament agrees.
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Common Debt
• Two policy failures leading to the Greek bailout
and the EFSF and the ESM:
– The Greek crisis took governments completely
unprepared.
– Breaking European Law seemed better in the short
run than accepting a default with uncertain
consequences.
– Governments sought a way to spread the costs of a
banking crisis resulting from a Greek default in their
own countries over tax payers in other countries.
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Common Debt
• The debt ratio of countries in the euro area:
𝑏𝑖𝑡 = 1 + 𝑟 + 𝑝1𝑖,𝑡 𝛿𝑖 𝛿 − 𝑔𝑖𝑡 𝑏𝑖,𝑡−1 + 𝑠𝑖𝑡
• The debt ratio can become unsustainable, if the default risk
premium becomes too large.
• This generates a problem of self-fulfilling expectations.
• Guaranteeing the debt of euro-area countries with common debt is
costless and hence efficient, if
– deficits can be eliminated quickly
– r < g can be achieved quickly
• No austerity program (reducing s) is necessary to achieve that, but
austerity can be counterproductive by reducing g.
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Common Debt
• The problem is that eliminating structural deficits and
putting the country on a higher growth path requires
reforms and solutions to the internal common pool
problems.
• It is not obvious that this can be achieved in fiscal
adjustment programs.
• The monitoring and oversight of the current fiscal
adjustment programs is weak at best, as the relevant
institutions bring very little expertise into the process.
• These institutions themselves need „success“ to have
legitimacy vis-à-vis the governments and voters that
provide the money.
18
Common Debt
• Common debt instruments like the EFSF and
the ESM are common pools.
• They require good governance
– Ensuring that debt will be guaranteed only if
structural reforms are feasible and implemented.
– Preventing moral hazard.
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Common Debt
• Possible governance mechanisms:
– Veto power of the largest contributor
– Tight rules on policies in normal times (Fiscal
Compact)
• But: Lack of enforcement,
• unacceptable in normal times,
• And moral hazard on the part of the Commission
– Inflicting pain on governments receiving EFSF or ESM
funds. This is the true reason for austerity programs.
• But pain is inefficient ex post and often unjust.
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A proposal for Governance of the ESM
• The ESM receives a one-time capital endowment. This
ensures that it does not give aid to countries which are
too large.
• The ESM is given independent status similar to the ECB.
• Euro area governments agree on a legal framework for
sovereign default. This will deal with the first policy
failure.
• The framework includes mechanisms to provide liquidity
to troubled banks.
• Banking regulation is changed to abolish the privileged
status of public debt.
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To conclude
• „More Europe“ is not a sure solution of the
public debt crisis.
• Solutions should focus on the common pool
problems and assure good governance.
• We should have less discussion about the type
of instruments and more about their
governance.
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