Europe’s Free Rider Problem: Why EU States Do Not Pay Their Fair Share

Introduction

The European Union has a lot to offer member states, but countries do not necessarily get out of the EU what they put into it. This is because countries that contribute a lot to the EU are able, by strengthening the common currency and providing economic stability, to support the countries that do not or cannot provide as much. A free rider problem arises from this, wherein EU states realize that they can reap many of the benefits of integration even without meeting economic standards. While one or two free riders would likely not be disastrous, a widespread free rider problem would prevent the EU from having the economic stability necessary for functional integration, and would lead to crises, like the Greek debt crisis, which threaten to undermine the European project.

Perhaps anticipating this problem in 1997, the newly formed European Union attempted to create a fiscally stable climate for monetary unification by implementing the Stability and Growth Pact (SGP). This agreement was designed to ensure a stable common currency by limiting the deficits of member states and laying out other regulations for EU members. Broadly, governments must deficit-to-GDP ratio to 3 percent, and their debt-to-GDP ratio to 60 percent. These fiscal targets were chosen based on the economic theory supported by larger EU member states such as Germany, which holds that countries without balanced budgets will face serious economic consequences. Nations with overly high debt-to-GDP ratios have to spend more of their budget financing their deficits, and can face shortages of investor confidence. The framers of the SGP believed that addressing these concerns would stop member states’ economies from dragging down the rest of the union in a debt-fueled crash. In theory, by imposing these conditions for membership, the European Union should have been able to prevent free riding. Today, however, fewer than half of the EU states meet the criteria set out by the SGP.

On the Stability and Growth Pact

Clearly, one of the central issues regarding the debt crisis is incentivizing fiscal responsibility for member states. Much of the burden has historically fallen on the SGP. Yet, as we have seen, the enforcement of this pact has carried little weight. Member nations often see SGP goals as aggressive and punitive because they force countries to cut spending in order to meet the required debt-to-GDP ratio, and the corrective procedure of levying sanctions against countries that fail to meet these standards mainly damages economies that are already suffering. Consequently, the European Commission is very hesitant to resort to the enforcement arm of the Stability and Growth Pact, as EU leaders understand that fines would likely worsen an already bad situation. Even if the Commission were to attempt to enforce the SGP, the countries in question would likely ignore the fines, or pay them rather than change policy. This is because the cuts would come just as struggling nations needed increased spending the most to stimulate growth. Nevertheless, despite the flaws with the SGP, it is imperative that the EU be able to discourage reckless financial policy.

A possible solution lies not in times of crisis, but in times of normal economic function. The SGP has received some criticism for failing to account for economic cycles in its 3% deficit ratio cap. A more effective tactic might be to have a personalized target debt ratio that scales inversely with a state’s current level of economic growth: in times of stagnation, states could have more flexibility to take on debt in order to stimulate their economies, while ensuring that spending is reined in during boom periods. Likewise, sanctions could be employed during economically normal periods instead of during times of crisis, so that they could remain a deterrent without hampering recovery. Such tactics would achieve a twofold goal: first, maintaining a useful deterrent towards errant spending that does not impede economic recovery, and second, ensuring that countries are fiscally disciplined during normal economic times. Ad van Riet, a senior adviser at the European Central Bank, notes that the latter allows states to “build a ‘fiscal cushion’ that provides sufficient room for manoeuvre during an economic downturn or a crisis.”

However, it is also important to note that even with the above considerations and adjustments to the SGP, the EU must establish trustworthiness and credibility with regard to the enforcement of the pact. This entails not only meting out punishment in a timely and transparent manner, but also doing so equally throughout the union so as not to give a semblance of a double standard. When Germany and France violated the SGP in the early years of the century, for instance, the EU declined to pursue sanctions or major corrective policies. This oversight may have encouraged other countries to risk non-compliance. In the future, consistency is necessary for the SGP to be a credible deterrent against bad economic behaviour. If the enforcers of the SGP are able to achieve this credibility, and if the pact as a whole is made to be more flexible and responsive to economic cycles, the EU might be able to both ameliorate its free rider problem and effect a more pervasive sense of fiscal responsibility, leading to a union that is more robust and resilient against economic crisis.

Case Study

While the European Union is a largely unique institution and the current Eurozone Crisis is largely unprecedented, there are important parallels between Europe today and Latin America during the “Lost Decade” in the 1980s. During the late 1970s and early 1980s, the majority of Latin American countries took on a large amount of foreign debt, resulting in a major crisis when virtually all of them had their credit downgraded by 1982 due to international recession. In the lead-up to the Eurozone crisis, spending by EU members like Greece and Spain resembled that of Latin American countries in the 1970s, with large disparities between income and expenditures that resulted in untenable deficits.

The two situations are not entirely analogous, of course—Latin America lacked the central monetary authority of the European Union, and Latin American countries were not bound by the SGP. However, despite these differences, countries took similar approaches that led to similar results. Initially, Latin American countries responded to the debt crisis by instituting stringent austerity measures; however, these austerity measures failed to achieve significant economic turnaround, and instead merely mitigated the effects of the economic crisis.

The resolution to the Latin American Lost Decade came not through austerity, but instead through a robust cooperative international effort to relieve Latin American debt and reduce the pressure on the affected economies. During the crisis, the United States and the IMF emerged as multilateral brokers of debt repayment, acting as stand-ins for a central monetary authority. The negotiation process concerned itself with rescheduling national debt payments by extending loans to give Latin American countries more time to pay off interest, among other forms of new lending. Eventually the international community, led by the United States, developed the Brady Plan, which allowed for the Latin American countries to exchange their debt in return for stable US-backed bonds at generous rates. The Brady Plan allowed those countries to reduce their overall debt and its interest rate. Further, the bonds were guaranteed by the US government, so even if there was a decrease in the return on debt, banks and creditors could be confident that they would get at least some of their money back.

The EU should consider similar plans to provide debt relief to suffering member countries, keeping in consideration the unique nature of the organization. The EU could look into empowering the European Central Bank to exchange debt for bonds or seek some similar alternative with the United States. Either way, a bond trading scheme could help reduce the free rider problem by providing a means for debtor countries to pay down their obligations while still meeting the social costs of providing the expensive services that they want to give to their people. This would solve for the free rider problem in two ways. First, it would reduce the pressures on states that cause free riding. A large part of the free rider problem is, after all, a conflict of obligations: on the one hand states have an obligation to meet their fiscal target, but more important is their obligation to provide services to their citizens. By reducing the conflict between these two obligations, the EU would reduce the onus on states to choose between their financial duty and their duty to their citizens, providing a stable middle path that works for both the Central Bank and member states. Second, a bond trading plan avoids the lack of credibility that undermines current enforcement mechanisms. While austerity threats have not been taken credibly because of their unpopularity and punitive character, bond trading takes a more collaborative approach. Much like the Brady Plan, a bond trading scheme in the EU could increase the credibility of the enforcement of the Stability and Growth Pact, as nations would be more confident that the European Central Bank would use sanctions to draw a hard line in bond trading where it had not before.

Research Cohort Members: Zachary Lemonides, Jakob Urda, Jacob Usadi, Clémentine Wiley, Lara Ryan, Jason Zhao, and Tara Vogel

The image featured in this article is licensed under Creative Commons. The original image can be found here.

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