Will It Be Brussels, Berlin, or Financial Markets that Check Moral Hazard in Europe’s Bailout Union? Most Likely the Latter!

by Jacob Funk Kirkegaard, Peterson Institute for International Economics

October 2010

The European Union has thus far done an adequate job of preventing the Greek sovereign debt crisis from getting out of hand, but it is clear that the European Union's fiscal surveillance framework failed both before and during the Great Recession. It is crucial that European leaders develop a solid long-term plan for reforming the EU fiscal policy and surveillance framework. Reform of the EU fiscal surveillance framework is feasible as early as this December, based on work that has already started in Brussels, among other places.

The May 2010 Greek bailout brought a high degree of moral hazard into the eurozone. Minimizing this moral hazard—and maintaining public confidence in the European Union—will necessitate several policy reforms. Bearing in mind that long-term reform of the EU policy framework and the Stability and Growth Pact (SGP) will both take place in a postcrisis European economy where Germany is significantly empowered at times of crisis, the European Union is likely to have to ultimately submit to most German demands. Jacob Funk Kirkegaard points to three specific ways Europe can keep moral hazard in check: (1) attach strict ex post conditionality to bailouts (this has already been enacted); (2) reform the SGP to include strict ex ante fiscal rules; and (3) create a "eurozone sovereign debt restructuring mechanism."

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