"Fiscal indiscipline" or spending like "drunken sailors"

ECB president Trichet talked about "fiscal indiscipline" and fear that the EU may blow-up the stability and growth pact that sets rules on deficits and debt levels. While Trichet is showing a level of fiscal sanity that is not present with many finance ministers, the situation may be too late to fix through conventional means. It is not clear what is the level of deficit financing that will be ncessary but prudent.

Clearly borrowing like drunken sailors may make some countries happy in the short-run but it will place significant strain on the EU. Deficit levels for a number of countries have been hovering at high levels, so a deep recession will cause of significant increase in debt levels.

Here we have another fallacy of composition problem. Having any one country run high deficits may not be a problem. Over time, risk premiums would have to increase to compensate investors for the risk but money could be allocated on a relative basis. If Italy issues more debt, the spread on Italian bonds would increase, but given a single currency, money would flow from say Germany to Italy.

However, there are complexities if all countries run high deficits. The world will be relevering again except substituting public for private borrowing. The large deficits would crowd-out funds both in the private sector and from countries that have relatively low deficits. It then becomes difficult to define what is the risk free ate of return if the government takes on risky projects that were formerly manged in the private sector.