The sovereign debt crisis exposed weaknesses in the Eurozone’s financial architecture that may not have been fully anticipated when the founding treaties of the Eurozone were drafted. Key among these weak spots are the provisions of the Treaty of Lisbon which regulate intergovernmental debt obligations and preclude direct financing of sovereigns by the ECB.
As de Grauwe (2011) pointed out, entering into a monetary union alters the character of sovereign debt radically, since no individual nation has control over the currency in which debt is issued. Monetary union members thus face a situation similar to that of emerging economies who borrow in foreign currency—they may face a liquidity crisis in the sovereign debt market when there is a sudden reversal of capital flows, even though their solvency may not be fundamentally questioned.
The Eurozone’s financial architecture prevents the easy resolution of such liquidity crises. Article 125 of the Treaty of Lisbon arguably rules out one nation from assisting another by taking on part of the liability of another nation with its so-called no-bailout clause. This clearly fed into the Eurozone’s sovereign debt problem (Pisani-Ferry et al, 2013). Actually, this hurdle was already there in the Maastricht Treaty of 1992, in advance of the 2009 Lisbon Treaty.
We attempt to provide an analytical foundation for an amendment of Article 125 of the Treaty of Lisbon (Basu and Stiglitz 2013).1 We are arguing for the Treaty to be amended to permit joint liability in international lending. We do not go into institutional details of how this may be done, but constructs a game-theoretical model to motivate such a legal-institutional change.
The bulk of international lending in the world takes place on a bilateral basis. Suppose a small country j borrows from an international bank to finance a power station project. Suppose also that the probability of success depends on the effort that country j puts into the project. There are occasions when j will be unable to pay back because the project may have failed when the time comes for repayment. This possibility of bankruptcy, and the awareness of the agents that this may happen, has important implications for the functioning of the credit market, and, in particular, introduces a standard ‘moral hazard’ problem and the possibilities of all kinds of inefficiencies.
When there are incentive (moral hazard) effects in credit markets, effort (e.g. devoted to ensuring success) is typically a function of the interest rate