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No.1 The End of Fiscal Sovereignty in Europe The challenge now is to achieve a combination of discipline and flexibility that protects the collective interest. That will involve a loss of full fiscal sovereignty, but facing up to that reality is required to sustain the monetary union. By Michael Spence The late Milton Friedman said that a common currency – that is, a monetary union – cannot be sustained without a deep form of economic and political union. By this, he meant an open economy that ensures the free flow of goods, labor, and capital, together with a disciplined central fiscal authority and a strong central bank. The latter two are pillars of a strong currency. They work in tandem. But the other pieces are no less important. The eurozone, currently wrestling with fiscal imbalance and sovereign debt risk, has a strong and autonomous central bank, but is fiscally fragmented and only partly unified politically. Enter the Maastricht Treaty, which in theory imposes fiscal discipline by placing limits on government deficits and debt levels – clearly a structure designed to prevent free riding on the fiscal discipline of others. Maastricht was thus intended to prevent a situation like the current one in Greece. It didnt work. Eurozone sovereign debt turned out not to be homogenous with respect to risk. In a stable world, Maastricht Treatys rules-based framework, if enforced, might do the job. But in a shock-prone world, it is a fragile system, because it precludes anything but modest countercyclical policy. No wonder, then, that the treatys strict limits were breached early in the euros first decade by core countries as well as peripheral ones. Indeed, with a large shock, much of the breach happens automatically, as tax revenues shrink and social-insurance payments expand. Recent analysis by the International Monetary Fund suggests that as much as 80 percent of the fiscal stimulus in advanced countries during the current crisis is non-discretionary. That kind