As I think I’ve noted earlier, all federal systems produce moral hazard—i.e., a tendency on the part of member-states to over-spend and borrow in the hope or expectation of a federal bailout. Short of wiping out member-states’ fiscal autonomy, there are only two ways of curbing the tendency:
(1) Establish a credible commitment against bailouts. A recent, terrific paper from Bruegel discusses the origins of that commitment in the United States and the great difficulty of creating a comparable arrangement in the EU.
(2) In extremis, bail out a wayward member—but make the experience sufficiently painful to deter the next would-be violator. That’s what the EU is doing to Greece and, coming soon in this theater, to Portugal and maybe Spain. My colleague Des Lachman’s latest, near-desperate plea for a saner course of action appears here.
There’s much to be said for paying more attention to the interplay between debt and democracy. But for Hamilton’s deft handling of the war debt, there might not be a United States. Conversely, the mis-handling of the debt issue is threatening to undo one of the EU’s proudest and widely underrated accomplishments—the stabilization of liberal democracy in formerly autocratic Greece, Portugal, and Spain. The protesters in the streets of Athens aren’t the only ones who are playing with fire.