The Third Pillar: How Markets and the State Leave the Community Behind

by Raghuram G. Rajan

In their rush to integrate, leaders were all too willing to suspend disbelief about one another’s behaviour. The Stability and Growth Pact was intended to make sure that no country became a charge on the others by overspending and running large fiscal deficits. The pact, however, imposed little fiscal discipline when truly needed. Some countries like Greece hid the true extent of their deficits before they entered. Moreover, there were sixty-eight violations of the terms of the pact before the Global Financial Crisis without any action being taken against the violators.29 Large countries like France, and yes, even Germany, ignored the rules imposed by the Stability and Growth Pact when it impinged on their policies. Without discipline on wages or fiscal deficits, the countries in the euro area had very different levels of inflation. The overspending southern periphery, not surprisingly, had higher inflation. Nevertheless, all countries had similar interest rates since they had one common central bank, and no one believed any country would default. Greek government bond rates approached German government bond rates. As we will see, differing inflation and common interest rates was a recipe for disaster because it made borrowing seem very cheap in the high-inflation periphery. Another source of potential friction was the free movement of people within the Union. With widely differing social protections, countries worried that those with stronger social protections would attr...

Why EU faced problems