Why Rules Must Rule Again

If the Eurozone is to be saved, policy-makers must embrace a strict framework of consistent and enforceable rules.

How can the Eurozone be saved? Read part I of Bodo Herzog’s roadmap here.

The roadmap requires a special timing of the next reform steps and policy changes. Hence, we have to discuss the essential principles to stabilize the EMU according to my option B. As discussed last month, the new economic governance agenda must be strengthened and extended in several dimensions, which will be further outlined below.

Proposal 1: Define ex ante conditionality’s for all EMU member states
The major underlying policy problem of the rescue packages during the sovereign debt crisis and the financial crises is moral hazard. To tackle this problem we need consistent incentives towards sound public finances. Therefore, we propose an irrevocable return to the initial incentive structure without exceptions. In order to be a member of the EMU, the country must fulfil all stated criteria at the beginning and regularly thereafter. We call this ‘ex ante conditionality’s,’ which are mandatory conditions for all participating countries. A violation against these criteria will immediately be sanctioned – similar to mechanism of the conditionality of austerity plans today.

In the past, we demanded the tough austerity conditionality’s for the highly indebted countries after the crisis has prevailed – i.e. ex post and not ex ante. Since the beginning each country has benefited from the EMU without following the necessary rules. Therefore, the existing governance framework sets the wrong incentive at the wrong time. We must put the conditionality of EMU membership ex ante and on permanent footing. This strict and irrevocable return will be effective and reduce pro-cyclicality. The lesson that successful budget consolidation has to start in economically good and not bad times requires credible institutional incentives due to obvious political disincentives in this field.

Proposal 2: Reform the Stability and Growth Pact
The SGP needs to be strengthened in two areas: (1) stricter and immediate sanctions in case of excessive deficit and debt levels as well as violation of long-run sustainability, defined as a balanced budget in the medium-run and (2) tighter enforcement of defined sanctions. This can be reached by introducing an independent fiscal council or an (almost) automatic enforcement mechanism. An independent fiscal council should be structured similar to the Swedish Fiscal Policy Council or the German Council of Economic Experts.

The EMU’s rule-based framework will not work as long as the policymakers, whose job it is to enforce them, are not motivated by economic or political incentives to do so. A transparent incentive system will enhance the credibility of economic governance in the future, because every country will know in advance that a violation triggers a significant loss of sovereignty.

Proposal 3: Democratize European Economic Governance
The new rules and institutions for fiscal policy must serve the purpose of democratizing European economic governance. Those means will serve each national citizen best by maintaining a national policy system and integrating supranational coordination only in special cases. However, if a country fails to consolidate the public budget or to enhance domestic competitiveness, the supranational level takes more and more responsibility for this specific country. In normal times, we recommend an environment in which fiscal policy is applied effectively on the national level to promote national needs. That way it will enhance the welfare of domestic and neighbor countries’ people and businesses best. Of course, people matter to every economy which is why in case of continuing policy failures we should enable the fiscally sound countries to decide about their taxpayers’ money, similar to what is already done in the national context. Hence, the new rules and principles must serve the purpose of European citizens by making our institutions more democratic.

To sum up: The European Monetary Union will not fail and the integration process will not be reversed if policymakers return to credible, strict, consistent, and enforceable rules. Our proposed mechanism will create a well-founded EMU in the long-run. Policymakers have to learn that fiscal policy in a monetary union is continuously hard work.

Read more in this column Bodo Herzog: The False Appeal of Central Banks

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