Throw the Bums Out

What caused the crisis in the Eurozone? To hear European Central Bank President Mario Draghi tell it, the problem was an "incentive vacuum" caused by the weak enforcement of EU fiscal rules. Don’t worry, though — Draghi also says that new procedures will create strong incentives for governments in the European Union to keep their deficits and debts under control. If only.

Speaking at the Economic Club of New York last week, Draghi pointed out that the European Union’s old fiscal rules were "incapable of promoting prudent fiscal policies" even when times were good. In other words, instead of saving up surpluses in the boom years between 2001 and 2007, European governments spent — and then overspent. Furthermore, he said, "there was no mechanism to prevent and correct macroeconomic imbalances."

At least he’s correct there. Between 2002 and 2004, five of the first 12 members of the Eurozone fell afoul of the European Union’s Stability and Growth Pact, which constrained fiscal deficits to 3 percent of gross domestic product (GDP). Early warning systems were triggered by four of them. But before any budgets could be constrained or penalties applied, France and Germany got the procedures suspended. The pact lost all credibility, as there could be no incentives of any kind without enforcement.

It took just under a decade for France and Germany to reap what they had sown. Now, after the Eurozone’s bailouts, they and their fellow members have agreed stronger rules, including penalties up to 0.5 percent of GDP for excessive deficits or public debt that stays above 60 percent of GDP. Draghi said that new clauses in the member states’ constitutions and the Macroeconomic Imbalance Procedure would help to avert future fiscal problems and enforce penalties when they did occur. (If the fiscal tests were applied today, as many as nine countries might fail.)

These new rules are essentially the old rules with sharper teeth. But they still have two big flaws.

First, the penalties they impose are procyclical, meaning that they may amplify or exacerbate an economy’s ups and downs. Countries typically run big deficits when their economies are in trouble; tax revenue falls, and the need for public spending increases. The penalties would come at exactly the wrong time, sucking up tax revenue that governments would otherwise have used to cushion the economic downturn. For a government that collects 20 percent of GDP in taxes, an initial fine of 0.1 percent of GDP would require an increase in tax rates of about 0.5 percentage points just to balance the budget.

In theory, the harshness of a procyclical penalty would strengthen the incentive for governments to balance their books. But in the reality of the European Union, the penalties could lead to mass protests, political pressure, renegotiation by governments, and eventually a watering down of the rules. If anything, the persistent unemployment of the recent downturn has discredited the use of fiscal austerity in the midst of tough times. Why would governments stand up against their people for such an unpopular and unproven policy? Moreover, the fiscal penalties would only intensify the sort of public sentiment that often crops up in a downturn, feeding the latent desire to leave the Eurozone (to boost exports by devaluating currency) or ditch the European Union altogether (to escape fiscal rules and other erosions of sovereignty). Surely this is the last thing Draghi and other Eurocrats want to encourage.

Second, and more importantly, the fiscal penalties target the wrong people. Taxpayers would have to pick up the slack when Brussels punishes governments, even though blame would lie mostly with politicians. At some point, taxpayers might in turn be able to punish the politicians by voting them out, but most of the pain would be spread much more broadly. Here, the EU has missed a critical aspect of the classic principal-agent problem: new incentives for the principal (taxpayers) may be substantially diluted from the point of view of the agent (politicians).

Yet there is a way to generate the right incentives: punish the politicians. Instead of penalizing economically fraught countries with fines that only worsen their struggles, the politicians themselves could be held responsible. The mechanism would be simple: If a country failed to meet the EU’s debt and deficit targets, Brussels would take control of its fiscal policy. Finance ministers would be removed or temporarily lose their powers. Taxes and spending would be determined by the EU’s bureaucrats until the ailing country was back on an acceptable fiscal footing. And any aid from Brussels would arrive only after the politicians had cleared out their desks.

There is precedent for this kind of mechanism. When Rudy Crew set about trying to improve New York City’s public schools as chancellor in the late 1990s, he set up league tables to identify the best and worst performers. Rather than punishing the poor schools by cutting their funding, he simply took them over. Then he either closed them or injected more cash in an attempt to save them. By using control, rather than money, as the source of incentives, the city avoided making bad situations worse. Instead of punishing failing students, it punished failing teachers and administrators.

The EU can do the same thing with its members. Politicians will be more reluctant to overspend if they know they might get the boot immediately rather than at the next election. Of course, politicians late in their terms might still try to sabotage their successors, but the current system of penalties has that problem, too.

In a way, this mechanism is a formalized version of the EU’s bailouts from the past several years, except that the process is streamlined and faster. During the bailouts, members received extra funding to tide them over, but always subject to conditions — and always after months of protests and political infighting. The surrender of sovereignty was similar; foreign powers ended up dictating aspects of fiscal policy in Greece, Ireland, and Portugal. The difference is that the new mechanism would set up the transfer of control in advance, and the conditions for aid could be implemented independently and without hesitation by the EU once it took over.

Some of the EU’s members might be loath to sign up to such a strict agreement, and that’s a good thing. France and Germany might wonder if, as well as shedding the annoyance of bailouts, they might have to give up fiscal control themselves. Whichever countries dissented, their reluctance would identify them as risky prospects for the future. Meanwhile, the biggest supporters of the new mechanism might be the EU’s citizens, who would have a new way to throw the bums out.