Intergovernmental competition in Europe with and without a common currency

Abstract

Taking a cue for the theory of the soft budget constraint applied to enterprises in socialist economies, I first develop a theory of what makes government budget constraints “hard” or “soft” in capitalist economies. Then I show that having a hard governmental budget constraint (as with the American state governments) is a necessary condition for mercantile competition to be “market-preserving”, that is, to improve current resource allocation while protecting future generations from debt carryovers. As long as European nation-states retain control over their own central banks, however, their governments will have budget constraints that are unduly soft. Thus, in Europe, mercantile competition among national governments should be actively constrained by the EU Commission. Even so, future generations could be victimized by excessive debt buildup by national governments. The reforms of European monetary arrangements that I propose are evolutionary and relatively modest compared to the “leap in the dark” of the Maastricht Agreement's push for a common currency.