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Europe's Fiscal Constitution

Mark Thoma finds that Brad DeLong is worried:

Project Syndicate : Is the German government's willingness to issue more debt and run bigger deficits limited because the market recognizes and penalizes nation states that allow their fiscal positions to weaken? In a word, no. The interest rates on the euro-denominated sovereign debt of the twelve euro-zone governments are all very similar. So the market does not seem to care that countries have different potentials to generate exports to fund the financial flows needed for debt repayments, or different current and projected debt-to-GDP ratios.

Willem Buiter of the University of Amsterdam and Anne Sibert of the University of London believe that it is the ECB's willingness to, in effect, accept all euro-zone debt as collateral that has undermined the market's willingness to be an enforcer of fiscal prudence. As long as the marginal piece of German debt is used as collateral for a short-term loan or as the centerpiece of a repurchase agreement to gain liquidity, its value is much more likely to be determined by the terms on which the ECB accepts it as collateral than by its fundamentals. The ECB%u2019s treatment of all such debt as equally powerful sources of back-up liquidity now trumps any analysis of differences in long-term sovereign risk.

In the long run, this is dangerous. Both market discipline and sound fiscal management are needed to create a reasonable chance of long-run price stability. Omit either a market penalty now for behavior that may become reckless or the institutional levers that give a voice to future generations, and you run grave risks -- perhaps not today or tomorrow, but someday, and for the rest of your life...