When Europeans voted to join the euro two decades ago, it was believed that they were only giving up sovereignty over monetary policy. Subsequent events, however, have shown that member governments have lost sovereignty over fiscal policy as well, leaving them unable to respond to voter demands and putting their economies and democratic institutions at risk. This unintended consequence of the euro has both institutional and financial causes that must be addressed.
THE EURO'S INSTITUTIONAL DEFECT
The Maastricht Treaty, which caps the fiscal deficits of member countries at 3 percent of GDP, never envisioned a world in which the private sector was saving more than 3 percent of GDP at a time of zero interest rates. Proponents of the Treaty, along with most of the economics profession in the 1990s, assumed the private sector would be borrowing, not saving, at such low interest rates.
But when the housing bubble burst on both sides of the Atlantic in 2008, the private sector of almost every country--both inside and outside the eurozone--rushed to deleverage, saving far more than 3 percent of GDP even after central banks had lowered interest rates to zero or even negative levels. Spain's private sector, for example, has been saving over 7 percent of GDP on average since 2008. And if someone is saving money, someone else must borrow and spend those savings to keep the national economy going.
However, the Maastricht Treaty allowed the Spanish government to borrow only 3 percent of that 7 percent, opening up a deflationary gap equal to 4 percent of GDP and plunging the country into a horrendous recession and internal deflation. Even today, the Treaty says nothing about what a government should do when the private sector is saving more than 3 percent of GDP at a time of zero interest rates.
DIFFICULT FINANCING REALITY
An obvious way to rectify this institutional defect is to allow member governments to borrow more than 3 percent of GDP when the private sector is saving more than 3 percent of GDP at zero interest rates. But even if such a correction is made, member governments will still face an unforgiving financing constraint that has drastically reduced their fiscal space. This limitation stems from the fact that all government bonds issued by eurozone members are denominated in the same currency.
In a non-euro country, pension funds and other institutional investors who are unable to take on substantial foreign exchange risk or put all their money...