On a continent wounded by fratricidal wars, the European project to create an economic and political community aroused immense hopes. To secure peace and foster development, it proceeded over the years to thwart protectionism, ensure solidarity across countries and modernize member-states’ economies. 

The free movement of people, goods and capital was meant to prevent protectionism. As a guarantee of solidarity, structural funds were intended to help the economic development of poor regions. Finally, the European construction responded to a less overt wish on the part of southern Europe to delegate to a supranational authority the task of modernizing the economy through reforms, such as opening up to competition, which politicians considered necessary but did not dare to advocate at home.

In the context of the current euroskepticism, it is useful to remember that Europe has reduced inequalities among its member-states and that European Union institutions have on the whole contributed to growth. The accumulated body of EU regulation and law is sometimes criticized, but has nonetheless forced more rigorous management on previously dysfunctional economies.

The creation of a common currency, an optional choice progressively adopted by 19 countries by 2015, also inspired hope. Of course, many economists noted from the outset that Europe was far from satisfying the ideal conditions for a monetary union. The eurozone has no fiscal mechanism to provide stability through automatic transfers from member-states in good economic health to weaker ones. Moreover, labor mobility is limited for cultural and linguistic reasons, and so the labor supply can only react minimally to regional demand.

Even so, the euro represented an extraordinary symbol of European integration. Far more than a simple convenience for travelers, the single currency eliminated exchange rate uncertainty. Trade among euro area countries increased by around 50 percent between 1999 (the launch of the euro) and 2011.

The euro was also intended to contribute to the stability of national economies by facilitating the diversification of savings across European countries: households and companies could invest abroad at lower cost, and their wealth was therefore less dependent on local conditions. Finally, the euro was intended to facilitate the circulation of capital in southern Europe, strengthening the financial credibility of those states and thus allowing them to finance their development.

Many supporters of the euro also saw it as a step on the path to greater European integration. They thought of the EU, and then the euro, as stepping stones toward a federal Europe, either through the gradual emergence of a consensus in favor of greater integration, or because it would be difficult to reverse course.

This integration has not taken place so far, and it is doubtful that it will in the near future. Integration on this scale would have to be based on an abandonment of sovereignty far more extensive than has previously occurred, and on a mutual trust, a willingness to share risks, and a sense of solidarity — all things that are barely present in the EU today.

A Double Crisis and a New Culture of Debt

During the decade that followed the introduction of the euro in 1999, the southern part of the eurozone developed two problems: lack of competitiveness, along with excessive public and private debt.

Competitiveness

Germany has consistently practiced wage moderation (in a relatively consensual way, because the labor unions in the sectors exposed to international competition have supported it), while wages in the southern countries exploded. In the countries of southern Europe plus Ireland, wages increased by 40 percent while labor productivity increased by only 7 percent. This divergence generated low prices for German products and high ones for those from southern Europe. Unsurprisingly, intra-European trade became massively unbalanced, with Germany exporting far more than it imported, and the southern countries doing the opposite.

What happens when a country imports more than it exports? To finance its net imports, the country (its firms, its public bodies, its households) must sell assets overseas. For example, 50 percent of the shares in French corporations listed on the CAC 40 stock index, as well as much of the real estate in Paris and on the Côte d’Azur, are now owned by foreigners. Alternatively, the government, the banks, or businesses must borrow money from abroad. In either case, the country is choosing to consume more today and therefore less tomorrow.

Eurozone imbalances ultimately raise questions about what caused the recent impoverishment of southern Europe. Although there is no question that the growth of wages in relation to productivity in the south was excessive, many observers also attribute some responsibility to Germany’s mercantilism. German policy has had contrasting effects on the citizens of other EU countries. On the one hand, consumers in these countries are pleased to be able to buy German goods at low prices. On the other hand, as employees of firms competing with German firms, they see their own employers struggling. The difficulties are exacerbated by the poor functioning of the labor markets in the south, reflecting policy choices in the countries concerned.

If countries still had their own currencies, the German mark would have risen in value, whereas the French franc, Italian lira, Spanish peseta and Greek drachma all would have fallen. Consumers in southern Europe would have seen their purchasing power reduced by devaluation, but employees in sectors open to foreign competition would have been protected against large-scale job losses by the return to competitiveness.

Devaluation was simply not an option for the southern European countries, but the possible alternatives were not very attractive. One involved trying to reproduce the effect of a fall in the currency by means of what economists call a “fiscal devaluation,” which consists of raising taxes on consumption and thereby increasing the price of imports. The associated tax revenues are used to reduce the social security contributions paid by employers. This reduction in the cost of labor for domestic firms decreases the prices of domestic products and boosts exports.

Such fiscal devaluation was practiced in several southern European countries, but only to a limited degree. A significant increase in VAT rates would have been necessary to compensate for losses in competitiveness, which would have been inequitable and led to tax evasion.

The other substitute for currency devaluation, an overall reduction in wages or prices that economists call an “internal devaluation,” was implemented in Spain, Portugal and Greece. This proved very costly; while wages moved back toward their pre-euro levels, the substantial increases since the euro’s introduction had created aspirations and financial liabilities (for example, mortgage debts) that could not have anticipated the subsequent reduction in household incomes.

Debts

Was the crisis foreseeable? Take the case of Portugal, which experienced an economic boom in the 1990s in anticipation of joining the eurozone. The inflow of money during the 1990s fed a bubble rather than the development of a productive economy. The widening of Portugal’s current account deficit was chiefly explained by a decrease in households’ private saving rather than by an increase in investment.

More broadly, the confidence created by the poorer countries’ joining the eurozone substantially lowered the interest rates paid by borrowers in these countries. The easier access to funds generated capital inflows. These inflows, sometimes combined with weak regulation of banks’ risk-taking, fueled asset price increases and created financial bubbles, particularly in real estate.

Massive levels of debt, both public and private, are implicated in the origins of the crisis that threatens the existence of the eurozone today. Excessive borrowing was sometimes the fault of a spendthrift public sector or a failure to collect taxes (as in Greece), and sometimes the fault of the private financial sector (as in Spain and Ireland). When the Irish government budget deficit ballooned from 12 to 32 percent of GDP in 2010, it was because the banks had to be bailed out.

Debt has its limits. There comes a time when foreign investors begin to doubt the ability of states — or their banks — to repay loans, and start demanding high rates of interest or simply refuse to grant loans.

However, until 2009 Greece was able to borrow at a rate similar to Germany. Investors bet that other eurozone countries would bail out Greece. More generally, they believed that there would be solidarity if a country in southern Europe got into difficulties. In November 2009, the new Greek government revealed that the deficit was twice as large as the preceding government had announced, and that the nation’s debt exceeded 120 percent of GDP. This triggered the crisis and later led investors to take a haircut on their investments.

Tolerating Risk Taking

The reduction in the cost of borrowing in Spain after 1999 led to a real estate bubble that was financed by European capital. Unfortunately, it did not lead to investment in Spanish industry, which actually became less competitive. Moreover, it was a burden on the banks, which would later have to be bailed out by the Spanish government.

The case of Spain is instructive. Politicians, both federal and regional, decided to ignore the central bank’s warnings, encouraging the bubble. This benefited them politically, but did not put a brake on the risk-taking by the cajas (regional savings banks). When they got into serious difficulties, they were bought and recapitalized by the state.

The Spanish crisis might have been avoided if the banking union had existed at the time. The European Central Bank, which today oversees eurozone banks, would presumably have forced Spanish banks to slow their real estate lending. If the eurozone crisis had one virtue, it was in driving regulation of the banks at a European level, despite the reluctance of many politicians.

A Fragile Defense

Although the architecture of the eurozone leaves much to be desired, the authors of its founding 1992 Maastricht Treaty cannot be accused of not having foreseen the dangers. They were aware that member countries could spend too much or under-regulate their banks, yet retain easy access to financial markets if those markets assumed other member-countries would support them.

Consequently, the treaty introduced both a limit on budget deficits (in its initial form, 3 percent of GDP), a limit on debt (60 percent of GDP) and a “no bailouts” clause. It was later decided that these requirements had to flex with the business cycle (it is reasonable to run budget deficits during recessions), but the rules required a balanced budget during normal times.

These rules had also provided for multilateral supervision. The EU’s economic and finance ministers would ask for remedial action by any state guilty of backsliding as soon as the country’s budget deficit exceeded the 3 percent of GDP limit, other than in exceptional circumstances. In the absence of any meaningful action by the infringing country, the European Council could, in principle, levy a fine ranging from 0.2 to 0.5 percent of the country’s GDP. This policy was not very credible, though, because levying a fine on a state that is already in financial difficulty isn’t a sensible thing to do.

So far, the Maastricht approach has failed despite a 2012 refinement. The approach has inherent difficulties: a lack of flexibility to accommodate the national context, the complexity of measuring debt and the problem of how to monitor and enforce the rules effectively.

The “One Size Fits All” Problem

Although it makes sense from a political perspective, uniform constraints for all countries do not make things any easier. There is no single magic number that determines the sustainability of national debt — what is sustainable for one country may not be sustainable for another. Argentina was in great difficulty with a debt of 60 percent of GDP, whereas Japan has exceeded 240 percent but has not triggered a crisis of confidence. Although there is agreement about the characteristics that determine whether a debt is sustainable, and agreement that large levels of debt can be dangerous for a country, it is difficult to identify precisely a maximum sustainable level of indebtedness.

The Difficulty of Measuring Public Debt

A country’s public debt consists only of financial obligations it is known for sure will materialize. This includes bonds the government is in principle obliged to repay, whatever happens. But readers might be surprised to learn that state pensions are not accounted for within public debt. They are “off balance sheet” to the extent that the state is not contractually obliged to pay them. More than 90 percent of pensions in France are state liabilities that are not counted in public debt.

Governments in all countries try hard to hide their debt in the form of contingent liabilities, which include guarantees backing various debts of public bodies or public-private partnerships, underfinanced pension funds, and loans to risky countries through the intermediary of European institutions (such as the ECB or the European Stability Mechanism). Another important part of the state’s contingent liabilities involves banking risk, as the recent examples of the United States, Spain and Ireland clearly show. There is a limited probability that this risk will materialize, and it is therefore left off the books. What’s more, the stated amount — covered by deposit insurance — is often much smaller than the true amount.

Much of the debate on banking reform is really the question of what, and what not, to bail out. Sovereign debt issued by the state and private debt issued by banks sometimes need to be considered together. Yet for years, only public debt was considered in the eurozone.

The Credibility of Reciprocal Monitoring

The Maastricht Treaty regarded monitoring government deficits and debts as the first line of defense, and a prohibition on bailing out member-states as the second line. Neither of these has held.

There were 68 violations even before the financial crisis began, and not one of them resulted in intervention. Even France and Germany broke the rules as early as 2003.

The EU has also turned a blind eye to rule-breaking in countries about to join the eurozone or in those that became less vigilant once they joined. Italy is an excellent illustration. It made considerable efforts to reduce its debt before it entered the eurozone, but as soon as it was in, it reduced its fiscal efforts. The damage was limited by low interest rates until the explosion of the Italian interest rate spread in the summer of 2011.

It is not surprising that monitoring failed. A finance minister will be reluctant to anger fellow finance ministers from countries that have broken the rules by issuing a formal complaint, which is anyway unlikely to lead to any action. Political agendas also play a role. The objective of building a united Europe has often been invoked to justify turning a blind eye to dubious accounting practices, or to insufficient preparation for entering the eurozone.

As for no bailouts, the EU had to violate its own rules by coming to the aid of Greece. The same applies to the ECB, which acquired the public debt of countries in difficulty and accepted poor-quality collateral. For the time being, the no-bailouts rule is not credible in Europe. Eurozone countries may show solidarity (and have shown it in the past) simply out of fear of the fallout that sovereign default might cause. This includes both economic fallout (trade disruption, potential losses for companies and banks that have subsidiaries or other exposure in the defaulting country, or possible runs on other fragile countries’ debt) and other kinds of fallout (feelings of empathy for the troubled country, fearing for the future of the European project, or the nuisance associated with mayhem in the defaulting country).

Revisiting Moral Hazard

In the context of sovereign borrowing, “moral hazard” refers to the choices made by a borrowing country that will reduce the likelihood of the loan being repaid to the foreign lenders. The persistence of budget deficits and their accumulation into debt springs immediately to mind. The choice to consume rather than invest is another example. And not all investment choices have the same effect on the sustainability of debt. Investments in the production of tradable goods increase a country’s capacity to repay its debt, while investment in non-tradable goods decreases that capacity. A (largely) non-tradable good in which European countries (often via their banks) have invested is real estate, which is by definition “consumed” by residents.

Federal states like the United States or Canada have decided that the most reliable way to limit moral hazard is a rigorously observed no-bailouts rule. Argentina, on the other hand, bailed out its indebted provinces in the late 1980s. Ten years later, the same provinces were largely responsible for the country's massive levels of debt, leading to the famous crisis of 1998 and the sovereign default in January, 2002.

A similar phenomenon occurred in Brazil, and interestingly, in Germany, whose federal government has continually aided some localities since the 1980s. It bailed out the city of Bremen and the state of Sarreland. That did not prevent budgetary excesses afterward — quite the contrary. The Länder [Germany's federal states] were among the agents mainly responsible for excessive debt in Germany. This laxity was partly responsible for the European Stability Pact's loss of credibility because Germany and France secured changes to the pact to avoid having to pay penalties.

Greece: Much Bitterness on Both Sides

Following the tense negotiations in 2015 in which Greece accepted EU bailout terms, European policymakers felt somewhat relieved. The Greeks had managed to stay in the eurozone. They accepted the intrusive conditions of the Troika — the informal committee representing the IMF, European Central Bank and European Commission — but they did not manage to get the debt restructured.

Countries in the rest of the eurozone were glad that Greece had not imploded. They noted, too, that Alex Tsipras, the Greek prime minister, who performed an about-face in accepting conditions tougher than those he had denounced in calling for a referendum, was supported by voters in elections in September 2015. After five years of crisis, with both camps stalling for time by trying to appease public opinion, European officials continued to focus primarily on the short term, with a narrow vision of the eurozone’s future.

Even just focusing on the Greek problem —never mind the global situation of the eurozone — opinions differ considerably. Those who take the side of the Troika play down the fact that Greece has undertaken reforms, hesitant and incomplete though they may be. For the first time in many years, the economy expanded in 2014. Employees had borne non-negligible decreases in their wages, and the government had made efforts to cut the budget deficit and to reduce the size of the inflated public sector.

Those on this side also fail to acknowledge that Greece’s recovery has been slowed not only by bad policies but also by the extraordinary recession the country confronted. Investment in Greece came to a halt because investors were uncertain about demand and worried about possible expropriation in the future. As a result, unemployment remains extremely high despite government attempts to challenge the labor market institutions inhibiting job creation. Clearly, uncertainty as to whether these labor market reforms will be sustained has prevented them from achieving their full effect.

Those in the anti-Troika camp refuse to acknowledge that Greece has already benefited from substantial aid, and don’t propose any genuine economic reforms when they call for debt relief. So far, a number of reforms exist only on paper and have not yet been implemented. Tax privileges enjoyed by the wealthy, and the unequal treatment of salaried employees (who cannot escape taxation) compared to unsalaried individuals (who pay very little) have been criticized, but not much has been done about it.

Little has been attempted to open goods markets, except for a few symbolic actions such as relaxing regulations on the opening hours of pharmacies. Similarly, although limited progress has been made, the government continues to hold back private enterprise; international comparisons rank Greece low for the effectiveness of courts in enforcing contracts and for making business easy to conduct.

The suspension of collective agreements in certain sectors (such as public transport), along with legislation to encourage company-wide rather than branch-level union bargaining, is significant, but this decision may still be overturned. In general, the parties in power in Greece have the habit of systematically challenging what their predecessors have done, and this does not help the country.

The anti-Troika camp also refuses to recognize that a certain amount of putting public finances in order was inevitable. As Olivier Blanchard, the IMF's chief economist from 2007 to 2015, argued:

Even before the 2010 program, debt in Greece was 300 billion euros, or 130 percent of GDP. … Debt was increasing at 12 percent a year, and this was clearly unsustainable. Had Greece been left on its own, it would have been simply unable to borrow. … Even if it had fully defaulted on its debt, given a primary deficit of over 10 percent of GDP, it would have had to cut its budget deficit by 10 percent of GDP from one day to the next. This would have led to … a much higher social cost than under the programs, which allowed Greece to take over 5 years to achieve a primary balance.

By demanding a combination of forgiving and restructuring Greece's debt, the anti-Troika camp correctly wonders about the country's ability to repay the debt without tremendous social cost. But it does not take into account that eurozone countries, unlike the commercial banks that were the creditors of Latin American countries that defaulted in the 1980s, do not have the option of keeping their distance after the debt has been restructured. Their wellbeing is tied to Greece's, and the restructuring of Greek debt will not necessarily end their financial involvement in the country. Although I consider Greece's debt unsustainable and very likely to weigh on the country's future, the situation is more complex than the proposal to simply forgive the debt would suggest.

No Winners

There are good reasons for concern. First of all, about economic performance. Investment in Greece may not resume in the short term. Since the banks’ balance sheets are weighed down by unproductive loans to enterprises, mortgages and holdings of government bonds, the banks need to be recapitalized (a point the ECB has started to insist on) so that they can start to fund productive investment. And foreign investors’ trust must be restored.

Nor is there any guarantee that an intrusive approach will necessarily pay off. If we examine the privatizations being asked of Greece, we may agree that the management of public assets should not be left to a ruling elite. But selling them off cheaply would help neither the Greek government nor, indirectly, its creditors. Domestic buyers with cash on hand are scarce, and foreign buyers offer low prices because they fear, logically enough, that government policies intended to satisfy local interest groups or to raise funds to repay the debt will swallow up part of their investment. Here again, the lack of long-term clarity has far-reaching consequences.

The second source of uncertainty concerns relations within Europe. The relationships between the peoples of the EU are steadily deteriorating. With the improvement of the situations in Portugal, Ireland, Italy and Spain, the insulting group acronym “PIIGS” has disappeared — only the G is still in deep trouble — but we are witnessing a resurrection of old and very sad clichés about nationalities, in particular Germans and Greeks. Populists opposed to a united Europe on the left and especially on the right are daily winning more voters.

Two Extremes: Grexit and Entrenchment of the Troika

Prior to the 2015 referendum, the press commented extensively on the possibility that Greece might leave the eurozone, or even the EU. The benefit for Greece of leaving the euro would be that it would very quickly recover its competitiveness; the depreciation of the drachma that would follow would make Greek goods and services cheap and imported goods expensive. This would revive economic activity and create employment. As I have said, however, this exit from the euro would prove very costly for Greek citizens quite apart from their loss of purchasing power.

First, it would lead to a default by the state and the Greek banks, which would have trouble repaying debts denominated in euros using their devalued currency. The Greek state would have to redenominate the banks’ liabilities (and assets) and their contracts more generally into the local currency. Argentina did this in 2001, calling it “pesification.” This is effectively default by another name, and would avoid neither international sanctions nor an additional loss of reputation for the country.

Greece would be unable to borrow from foreign lenders for a while, and would have to instantly balance its budget. The country would also lose the five billion euros it receives every year from the EU. Since it joined the European Union in 1981, Greece has been a major beneficiary of EU funds. Europe, having become its main creditor in recent years, would feel justified in withholding structural funds if loans were not repaid.

Finally, Greece would see levels of inequality, already high, skyrocket. Greeks who had invested their money abroad would become much richer thanks to the fall of the drachma, whereas ordinary citizens would see their purchasing power fall even more. Reducing this inequality would require a much better performing fiscal administration.

Opinions differ regarding the possibility of contagion, the prospect that Greece’s problems might spread to other European countries. This would not be through cross-exposure: unlike 2011, when the first bailout occurred and a default would have meant major losses for German and French banks, European banks no longer had many assets in Greece by 2015. Instead, the divergence in opinion rests on the impact that Grexit would have on other fragile countries.

One camp maintains that the financial markets would panic because leaving the euro would no longer be taboo. Another, more interesting, version of the same argument is that the financial markets are learning that the eurozone is no longer going to insure the debts of individual members — which it had already begun to suggest by imposing losses on the Greek state's private creditors in 2012, and on depositors who lacked deposit insurance in Cyprus in 2013.

In contrast, others argue that because leaving the euro would be costly for Greece, it would weaken populist movements exploiting anti-euro sentiment in other countries in southern Europe. This camp adds that firmness in negotiating with Greece benefits the countries that have made greater reform efforts, or that had not benefited from the transfers to Greece (Spain, Portugal, Ireland and Eastern Europe). Notably, these countries were Germany's allies in demanding firm treatment for Greece.

Grexit is a risky option, but so is business as usual. Whatever your opinion, there should be a consensus on at least a few points:

• The Troika cannot continue to run Greece jointly with its government for the next 30 years. The Greek debt of 180 percent of GNP (characterized by a high rate of foreign holdings) is gigantic for a country with limited fiscal capacity, and has a long maturity (about twice as long as that of other national debts) and a low interest rate following the restructurings of 2010 and 2012. Payments are due to become large only after 2022, and then will be made over many years. Can we envisage the Troika in charge for such a long time? The referendum and the popular discontent in Greece have shown the predictable limits of this exercise. Besides, the IMF is generally brought in by a country in difficulty so that it can reestablish its credibility and overcome a short-term liquidity problem. Democracy requires that the IMF's intervention is temporary.

• In Greece, investment (and consequently employment) has little chance of recovery as long as there is no long-term certainty.

• Reforms are better than austerity, even if we have to admit that their exact nature is difficult to specify in an agreement.

• Debt relief is necessary, but it merely creates breathing room, which makes it likely that the question of further debt relief will come up later.

• Solidarity and responsibility go hand in hand. Europe needs a little more of both.

• Solidarity is a political decision. The ECB plays its role by providing liquidity in a countercyclical manner (that is, when there is a recession or the threat of a recession) and punctual aid to prevent problems from spreading. But it should not be obliged to provide permanent support to struggling countries just because an unelected body can do this more easily than a parliament.

• By providing liquidity for the eurozone, the ECB gives it the time and the opportunity to get out of a rut. But the ECB alone cannot solve the problems that created that rut.

The Options

The founders of the European Union had a long-term vision for managing the potentially dangerous postwar period. And in 1957 they were able to mobilize enough political support to construct a community of states. Today, we again need a long-term vision. To simplify dramatically, there are two possible strategies for the eurozone. The current strategy is based on improving the Maastricht Treaty. The treaty does not provide for automatic stabilizers, such as a shared budget (implying the partial or full pooling of tax revenue), common bank-deposit insurance and unemployment insurance, or borrowing under joint liability, that would make it possible to stabilize a member-state’s economy in difficulty. This strategy implies limited risk-sharing.

The second, more ambitious approach would be federalism. The 2012 banking union is an embryonic form of federalism. If it were accompanied by insurance guaranteeing deposits of ordinary savers in eurozone banks (which are themselves centrally monitored) it would be a major step toward sharing risks with limited moral hazard for its member-states (which no longer supervise their own national banks).

Although opinions on this subject differ, executed correctly the banking union is a game changer. Obviously, European banking supervision is still in its preliminary stages and must prove its independence from the member-states and the private banking sector. In addition, some characteristics of banking supervision (particularly its limited coverage in political debate and in the media) have facilitated the abandonment of sovereignty through the creation of the banking union. But it is not certain that people will so easily accept the next steps toward European federalism.

I wonder whether Europeans and their leaders are fully aware of the conditions that must be met for either of these approaches to work. One cannot simultaneously insist on more sovereignty and greater risk-sharing. This is the heart of the problem.

The Improved Maastricht Option

The Maastricht approach infringes on the sovereignty of member-states only with respect to monitoring government debt and deficits. In theory, it excludes bailouts. In practice (as noted earlier) when faced with a member-state in difficulty, the eurozone countries tend to stand together. This unplanned solidarity is necessarily limited, however, as is also shown by the heated debate over who would be the winners and losers from a German fiscal stimulus.

Limited solidarity raises the question of why countries don’t create a formal insurance mechanism in which they commit to each other’s rescue. One such scheme is the joint issuing of debt for which they would be collectively responsible. However, while healthy countries can always express their solidarity after the fact during a rescue operation, they have no incentive to tie their hands beforehand. That is, they have little interest in contributing more insurance to the countries that are most at risk than what they would voluntarily contribute after the fact if the latter got into trouble.

The Achilles' heel of Maastricht is the management of deficits, which is economically unsatisfactory. But it is also undermined by a lack of political will to intervene early, when fiscal rigor would be least costly. Some progress has been achieved by reforms called the "two-pack," which embody an external examination of budgetary policies. But if a country fails to respect the rules, it is not clear that anyone has the power to enforce them.

Given that the political process alone has little chance of producing the hoped-for results, the Maastricht approach seems to require the establishment of an independent and highly professional fiscal council. The council would intervene when there is an unsustainable deficit, but would not advise whether the country should decrease expenses or increase taxes, nor suggest the appropriate composition of expenditures and revenues.

A recent innovation is the introduction in the member-states of independent fiscal councils similar to the Congressional Budget Office in the United States. (They already existed in Germany and Sweden.) An independent evaluation by experts is useful for identifying anomalies. For example, most governments make systematically optimistic forecasts for growth. This inflates their forecasts of tax revenues and underestimates the likely cost of social programs such as unemployment benefits.

This fiscal council would have to truly represent Europe as a whole and have the authority to require prompt corrective action. In addition, since financial sanctions are not a good idea if a country is already in financial difficulty, other measures must be used — although these would only sharpen concerns about legitimacy and sovereignty. As things stand, the current impulse toward national sovereignty works against such improvement of the Maastricht approach.

The Federalist Option

A Greater Sharing of Risks

Starting with the United States at the end of the 18th century, many countries reacted to the difficulties of their regional governments by increasing the federal capacity to go into debt and by introducing systematic fiscal transfers among their members. The federalist approach inevitably implies greater risk-sharing than the eurozone countries currently allow.

Full integration would make eurozone countries jointly responsible for the debts of other member-states. A joint budget and shared deposit insurance and unemployment insurance schemes would also act as automatic stabilizers, offering more protection for countries in temporary difficulties. For example, the progressive income tax affects major transfers from wealthy regions to poor regions, which have expenses (retirement pensions, health care) as costly as those of other regions.

The practical importance of this risk-sharing in federalist countries is debated. In federations like the United States, the extent of this kind of stabilization seems empirically limited, and less important than the stabilization operating through the financial market — that is, through the diversification of the portfolios held by individuals and enterprises far beyond the boundaries of the state. In any case, the sharing of risk may have helped make the no-bailouts policy in the United States more credible.

The Prerequisites for Federalism

The federalist vision requires that countries meet two preliminary conditions. First, every insurance contract must be signed behind the veil of ignorance. You wouldn’t sell me insurance if you suspected that my roof had a good chance of falling in tomorrow. That is why a high degree of risk-sharing is probably unacceptable for the countries of northern Europe. The asymmetry between north and south might be corrected by identifying and isolating the problems inherited from the past and dealing with them adequately.

While doing so would be complex, it could be done. For example, in introducing a European system of deposit insurance, the troubled assets held by banks in difficulty could be dealt with by creating “bad banks” to hold these assets in each member-state.

A second and much more fundamental point is that countries living together need common rules to limit moral hazard. We have seen that the supervision of banks should not be carried out at the country level because the banking sector and the politicians then have too much influence over the process.

The case for a common system of unemployment insurance is more complex. The unemployment rate in eurozone countries is only partly determined by the economic cycle, which by itself would justify a mechanism of insurance among countries. It also results from choices about job protection, active labor market policies, contributions to social security, occupational training schemes, collective bargaining and the protection of professions, among other things. Those countries whose institutions produce an unemployment rate of 5 percent will not wish to share an insurance system with those whose choices create a 20 percent unemployment rate. The same goes for pension and legal systems. Many Europeans, however, including some who claim to be federalists, are still opposed to the idea of surrendering more of their sovereignty.

The federalist approach would not be made more acceptable by the mere creation of a European parliament with extended powers. First there must be an agreement on a foundation of common laws and regulations. The countries that have undertaken painful political reforms might fear seeing their own laws disappear. More generally, each member-state will fear that the profound contractual incompleteness of a top-down “political Europe” would produce a result even more distant from its aspirations than what we have today.

The consequences of federalism should be understood by everyone before we set out on this path. If we Europeans want to live together, we have to accept the idea of losing a little more of our sovereignty. To achieve this in an era of increased nationalistic fervor, we must rehabilitate the European ideal and remain united around it. This is no easy task.