‘An Incomplete Contract Approach to Eurozone Fiscal Governance’ – Commitment vs. Flexibility

ABSTRACT

In this paper, we take an incomplete contract approach to Eurozone Fiscal Governance between the European Commission (EC) and any heavily debt member state, Greece in particular. Incomplete contract approach makes possible to put a long process of Eurozone Fiscal Governance into an extensive form game in which a renegotiation procedure is incorporated. We theoretically reveal the conflict of interests between the EC (Germany) and Greece over the Greek debt repayment plan proposed in 2015. We show that the Greek’s position is consistent with incomplete contract theory, but that the EC (Germany) does not allow the renegotiation for restructuring for growth-oriented debt repayment program proposed by the Greek government because the EC (Germany) judges that the commitment effect (on fiscal austerity) is greater than the flexibility one (pro-growth effect). This will undoubtedly provide a novel and interesting approach to Eurozone Fiscal Governance.

KEYWORDS:

• Eurozone fiscal governance
• incomplete contract
• renegotiation
• commitment
• flexibility

JEL CLASSIFICATION:

• H63
• D86

Acknowledgements

Yoshihiro Tsuranuki would like to thank Dr Paola Subacchi, the Royal Institute of International Affairs, for her helpful comments and Professor Erik Jones, the Bologna Center, School of Advanced International Studies, Johns Hopkins University, for his help. Yoshihiro Tsuranuki also would like to thank the Center for Political Research, Paris Institute of Political Studies for its stimulating academic environments and hospitality during his visiting scholarship in 2015–2016.

Disclosure Statement

No potential conflict of interest was reported by the authors.

Notes on contributors

Yutaka Suzuki is Professor of Economics at Hosei University.

Yoshihiro Tsuranuki is Emeritus Professor of Economics at Hosei University (since 2017 April).

Notes

1 Incomplete contract approach has become a rigorous and widely used approach in dealing with various issues, including firm theory, international trade, scope of government, corporate finance, and political economy. Our paper deals with the most up-to-date international political economy bargaining problem between Supra-national authority (EC) and Sovereignty (Greece in particular) in an incomplete contract model. See Hart (1995) for an introduction into the research of incomplete contract, and Bolton and Dewatripont (2005) for an exhaustive explanation. For the arguments on the sources for contractual incompleteness, (1) Enforcement Costs, (2) Unforeseen contingencies, and (3) Writing Costs, see Tirole (1999).

2 GDP cost functions correspond to two kinds of positively sloped curves in the Figure 5, where Greece has a steeper curve, while Germany has a much gentler curve. The difference reflects their cost difference (competitiveness) in increasing GDP.

Additional information

Funding

Yutaka Suzukiwould like to thank the 2015Grant fromZengin Foundation for Studies on Economics and Finance in Japan for financial support (No. 1515).