Centralization, Decentralization and Incentive Problems in Eurozone Financial Governance: A Contract Theory Analysis

Yutaka Suzuki

International Journal of Economics and Finance, 2018, vol. 10, issue 3, 93-108

Abstract: This paper uses a contract theory framework to analyze the mechanisms of eurozone financial governance, with a focus on centralization vs. decentralization and incentive problems. By constructing a Stackelberg game model with n Ministries of Finance as the first movers and the European Central Bank as the second mover, we show that each government can create growth in its own country (self-benefit) by increasing government spending, but that this will increase inflation, resulting in a decrease in the value of the euro. As these effects are shared equally by eurozone countries (cost sharing), an incentive to free-ride at the expense of other countries is present. We then analyze a penalty-based solution to the free-rider problem and derive a second-best solution where a commitment not to renegotiate penalties ex-post is impossible. The optimal solution shows that ¡°limited sovereignty,¡± that is, substantially constrained fiscal sovereignty, should be imposed as a high marginal cost for the issuance of public debt. Finally, we close the paper by discussing the possibility of Fiscal Integration (Fiscal Union).

Keywords: monetary centralization; fiscal decentralization; free-rider problem; penalty schemes and renegotiation; Stability and Growth Pact (SGP); fiscal integration (search for similar items in EconPapers)
Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:ibn:ijefaa:v:10:y:2018:i:3:p:93-108

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