Moral Hazard in a Monetary Union
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If a country runs a large budget deficit over an extended period of time, it will begin to incur a large government debt. Those who have bought government bonds to finance the debt begin to fear that the government from which they purchased the bonds will not be able to pay them back. They are afraid the government will default on its loan. As a result, those who have bought the bonds will begin to pull back from that country or demand a higher interest rate on any new bonds. This worsens the government’s position, as their interest rate payments become higher and there are less people willing to buy newly issued bonds. This general level of uncertainty causes international markets to punish the highly indebted country. Investment flows out of the country, the exchange rate depreciates, and interest rates rise until the country can get its deficits and debt under control.
In times of economic downturns, deficits can unexpectedly occur because of built in automatic stabilizers. Most often however, a government knowingly runs a deficit, meaning that it has either lower tax revenues than it needs, or higher spending than it can afford. Most politicians would like low taxes while providing ample government programs for their constituents. As a result, there is a tendency for a country to trend towards deficits. This tendency is held in check by the threat of an adverse market reaction (though it is not always a perfect deterrent).
In a monetary union, not only does the county with the large deficit suffer from some of the adverse effects of having a large debt, but all the other members of the union do as well. The other members realize this, so there is an incentive for them to “bail out” the offending country. They, or the union’s central bank, could buy up the excess bonds and prop up the offending country. The country, therefore, does not feel the adverse effects of the large deficit and debt as much as it would have had it not been part of the monetary union. As a result, there exists an incentive to gain the rewards from running a slightly larger deficit (lower taxes and greater spending for their constituents) and allow the other members to bail you out if it gets too bad – this is the moral hazard.
This is especially an issue in Europe because of the traditional deficit bias associated with a very generous welfare system. See Problems facing budgetary positions in the EMU