Julia Gray is Assistant Professor of Political Science at the University of Pittsburgh. She spoke at an EES Noon Discussion on November 12, 2008. The following is a summary of her presentation. Meeting Report 355.

Scholars of international institutions have long praised the ability of international organizations such as the European Union (EU) to promote cooperative behavior, stability and the rule of law. Implicit in that praise is the idea that the EU closely monitors member states' behavior and punishes those that break the rules. In practice, however, the EU rarely enforces its own rules, restricting itself for the most part to strongly worded statements, taking states to court for non-compliance with directives, and only occasional formal punishment. Indeed, the EU's freezing of structural funds to Bulgaria this past summer, due to the country's lack of progress on anticorruption measures, was one of the rare examples of Brussels making good on its threats to rein in its members' behavior: so much for the rule of law, in practice.

This raises an empirical question: how important is enforcement of rules within the European Union for a country's credibility? Do the reputational benefits of the EU mean that markets overlook the occasional bending of EU rules? Or do markets take rule-breaking in the EU seriously and use those instances as indicators for how countries might behave in the future? How important is enforcement to the credibility of the EU? Since much of the credibility of the European Union hinges on ideas of convergence, and on its members abiding by the many regulations and requirements for entry and membership, it is important to know how much weight outside observers put on actual adherence to those rules.

Some would argue that markets take their cues from the institutions that organize countries' behavior, and that institutions can act as important distillers of information in a world of uncertainty. Hence, if we thought that market signals converged around signals from institutions, and not from countries themselves, we might predict three different levels of market reactions to three different categories of offenses. For countries that visibly break EU rules but go unpunished, we would expect no market reaction. Second, countries that break EU rules but are only reprimanded verbally should generate minimal market reaction. The strongest reaction should come from a third category: when countries are actually punished by the European Union for rule-breaking.

Simple regression analysis can test the first proposition, specifically by examining whether markets respond to volatility in excess of Stability and Growth Pact (SGP) conditions. The SGP was originally designed to ensure that countries in the eurozone maintained a pre-established level of economic soundness, and to prevent any persistent structural economic problems in an individual country that would damage the health of the eurozone as a whole. Among other conditions, the SGP mandated that no country's budget deficit exceed 3 percent of gross domestic product (GDP), and that public debt should stay below 60 percent of GDP. These valiant targets did not last; in 2006, German public debt clocked in at 66.8 percent of GDP, France's at 64.7 percent, and Greece and Italy's were over 100 percent of total output. Similarly, Hungary's budget deficit in 2005 was well over 13 percent of GDP, and the country was unrepentant about its errors, maintaining that the EU would never punish them because Germany was already off the hook. Though the SGP contained a provision for a fine to be imposed upon members found in breach—and these breaks with EU policy were public and widely reported in the media—the EC confined itself instead to informal expressions of disappointment, and has recently scrapped the SGP altogether, explaining that it needed to devise more realistic expectations for its members.

What were those informal rebukes worth to markets? Even holding constant other possible confounding factors—such as the level of foreign-currency and other reserves in a country's coffers, which they can draw on in case of emergency; the level of inflation, which has an impact on a currency's worth; and the exchange rate of the country's currency to the dollar—we find no statistically significant reaction of markets to budget or public debt volatility in excess of SGP conditions. That is, markets barely reacted to occasions when countries were visibly in violation of EU rules if there was no official rebuke. This confirms our first hypothesis—that if Brussels does not formally punish members for breaking rules, markets too are sanguine about the breach.

Similarly, in cases where the Commission brought offending countries to the European Court of Justice (ECJ), market reaction was mixed. I looked at 1071 cases across 18 years—from 1990 to the present—in which the Commission brought a suit against countries that were found to be in violation of EU rules, and the ECJ found those countries in offense. In aggregate, markets in those countries suffered statistically significant losses on the order of a few percentage points, but the reaction varied depending on the country and on the case. Since ECJ cases usually deal with regulatory infractions, this relatively mild market reaction is perhaps not too surprising. Interestingly, however, markets also did not react in a statistically or substantively significant manner to the initial filing of cases—a public moment when markets became aware that a country in question was alleged to be noncompliant with EU standards. Thus, the fact that Brussels charged a country with rule-breaking was insufficient to provoke a loss of confidence in the country; markets instead waited for a formal acknowledgment that rules had been broken. This further suggests that markets look to signals from international institutions in formulating their expectations of countries' behavior.

A further test could be made on cases in which Brussels actually punishes members who have broken EU rules. We might consider two such cases: the fine imposed on Bulgaria in June 2008 for corruption, and cases in which countries' entry into the eurozone is delayed. Postponement of entry into the eurozone is perhaps the strongest form of conditionality that the EU can impose on states once they have already become members. Thus, actual fines or freezing of funds—often threatened but rarely delivered—and delays of entry into the eurozone are among the few real "sticks" that Brussels has to leverage.

The Bulgaria case is of interest because Romania was rebuked at the same time and for the same reasons, but went unpunished formally. The case unfolded as follows: the EU imposed unprecedented penalties on one of its members in June 2008, freezing 500 million euros in aid to Bulgaria because of its failure to combat corruption, organized crime and for misusing EU funds. It also warned the country that 7 billion euros of structural funds over the following six years were in jeopardy, and barred two Bulgarian payment agencies from receiving any money from Brussels. The Commission said, however, that payments would be resumed if the country's authorities introduced proper financial controls on farm subsidies. A report issued at the same time found Romania lacking in those exact areas as well, and threatened to freeze 150 million euros of funding for Romania under the EU's Sapard program for helping the Danube neighbors improve the competitiveness of their agriculture. Romania had already faced a fine for failing to meet a June 30 deadline to disburse to farmers all funds available under the EU's common agricultural policy. However, the fine was applied to Bulgaria but not Romania, which was let off with a stern warning.

We find here that the Bulgarian bond index lost 95 percentage points in an event window around the announcement of the fine (benchmarked against expected normal returns). By contrast, the displeasure expressed by the Commission toward Romania only merited a drop of around 12 percentage points. Note the contrast in these two market responses: even though the offense was identical in both cases, markets reacted not to the breaking of rules per se, but rather to the punishment handed down by Brussels. Though it may be difficult to disentangle the extent to which the response stemmed from the anticipated economic effects of the huge loss of cash for Bulgaria, this is certainly an indication that markets only take rule-breaking seriously when Brussels does so first.

The last test involves examining the effects of postponement of the date on which a country was slated to adopt the euro. This is perhaps the final bit of real leverage that Brussels maintains once countries are admitted into the EU, after which conditionality of reform can no longer be enforced through delays in negotiation for entry. Nearly all the countries entering the EU in 2004 had talked of entering the eurozone within a few years of accession. Structural problems and misaligned economic fundamentals, however, meant that those countries that had had a concrete date of euro adoption on the books—a practice that Brussels has now dropped, refusing to commit to target dates for the newest entrants, Bulgaria and Romania—often saw that date pushed back or suspended indefinitely.

Entry into the eurozone is a critical achievement for accession countries. It allows them to reap the full economic benefits of membership in the EU, since having a single currency lowers the transaction costs of foreign exchange, and adoption of the euro allows participating countries a voice in the European Central Bank (ECB). However, once countries surrender their currency and join the eurozone, economic misalignments within their borders can have serious spillover effects on other eurozone countries. Thus, the economic soundness of individual countries in the eurozone is critical to the health of a system as a whole. Even though accession countries must ostensibly have their accounts reviewed prior to entering the EU—negotiations on the economic chapter of the acquis communautaire are often longer than on any other chapter—countries can still be viewed as falling short after accession. Therefore, delay of entry into the eurozone is a judgment of a country's economic standing with respect to the other economies, and signifies that allowing that country to adopt the euro would jeopardize the other eurozone states.

Perhaps unsurprisingly, we see strong market reaction to the announcement of these delays. Formal announcements of delays in entry to the eurozone were associated with a drop of around 19 percentage points, set against expected market returns. Individually, of the countries for which the announcement was made, Hungary and Estonia suffered the biggest losses (statistically significant drops of around 15 and nearly 90 percentage points, respectively), followed by Lithuania, Latvia and the Czech Republic (statistically significant losses of around five, 10, and one percentage points, respectively), with mixed results for Poland (an 11-point loss, but without statistical significance). The variance across countries is interesting; there is doubtless a degree to which markets were already pricing information about poor economic fundamentals into their expectations for future performance. This would help to explain the large losses of Estonia, which had long been considered a star performer among the new member states. Timing could also be a factor; Poland was one of the first countries to delay formally its entry into the euro, in November 2005, but its economic health was already widely acknowledged to be unsound. Hungary's delay followed a year later, in July of 2006, but that occurred after a very public budget crisis, in October 2005, when Prime Minister Ferenc Gyurcsany was caught on tape admitting that his government had lied "morning, noon, and night" to Brussels about the state of the budget, and acknowledging that his government had long cooked their books. (Incidentally, Brussels responded with not much more than verbal statements of disappointment—and Hungary's stocks barely slid. In fact, even in the midst of opposition riots, Hungary brought a new type of government bond to credit markets, with spreads at 25 basis points over European bonds—only slightly more risky than the initial price guidance. Though some investors complained that the bond was too expensive, it sold briskly, with various Western European funds buying up 80 percent of the issue. "It just shows that investors are wearing rose tinted glasses as long as you are a EU-member country, regardless of the real quality of your credit," said one investor.) Thus, markets were already well-informed about Hungary's troubles. Estonia's announcement came soon after, but subsequently markets may have been inured to the idea that the majority of the new members would not be entering the eurozone at the dates already set.

As in the example of the suspension of fines for Bulgaria, delayed entry into the eurozone has economic effects—for example, the continued cost of cross-border transactions—that markets no doubt price into their expectations once postponements are announced. Nonetheless, the punishments from Brussels seem to be critical in allowing markets to organize their expectations.

This indicates that international organizations such as the EU can still wield considerable power if they choose to enforce their own rules. Markets are very responsive to signals from Brussels, and mete out judgments on countries' creditworthiness based in no small part on how seriously Brussels takes rule-breakers. By contrast, they go easy in cases when rules were broken but no formal punishment was levied by the Commission. This could have serious consequences for subsequent patterns of behavior, as well as the prospects for compliance, in the EU. Countries that go unpunished, not only by Brussels, but also by investors might have little incentive to change their behavior. If the Commission chooses to sanction members verbally, however, it seems that market actors are unsure as to how serious the offense might be. Thus, the EU might consider more frequent and more tangible punishments to members who break their rules. Furthermore, institutions hoping to gain credibility should make monitoring and enforcement of primary importance in the design of their agreements.