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

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).