Maastricht Games and Maastricht Contracts

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EUI WORKING PAPERS

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EUROPEAN UNIVERSITY INSTITUTE 3 0001 0025 9325 1 © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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EUI Working Paper RSC No. 97/27

Winkler: Maastricht Games and Maastricht Contracts

0 ? © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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The Robert Schuman Centre was set up by the High Council of the EUI in 1993 to carry out disciplinary and interdisciplinary research in the areas of European integration and public policy in Europe. While developing its own research projects, the Centre works in close relation with the four departments of the Institute and supports the specialized working groups organized by the researchers. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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EUROPEAN UNIVERSITY INSTITUTE, FLORENCE

R O B E R T S C H U M A N C E N T R E

Maastricht Games and Maastricht Contracts

BERNHARD WINKLER

E U I W orking P ap er

RSC

N o. 97/27

BADIA FIESOLANA, SAN DOMENICO (FI)

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ABSTRACT

This paper characterizes the Maastricht transaction as a deal that trades the replacement of the Bundesbank by a European Central Bank at the centre of European monetary affairs as a reward for prior convergence. Several potential inefficiencies of this transaction are explored and we ask how they are addressed by the provisions of the Maastricht Treaty. We find that the Treaty serves as a contract device that provides commitment to cooperative outcomes, sets incentives for cooperative behaviour and determines the timing and procedures for decisionmaking and bargaining. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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I. Introduction

The Maastricht Treaty on European Monetary Union (EMU) pursues two principal twin objectives, the establishment of a single and a stable currency for Europe. The first presupposes a transfer of national sovereignty to a common European institution, the second prescribes the delegation of political sovereignty to an independent central bank. Moreover, Maastricht Treaty contracts for convergence of economic performance as an entry condition for a stable monetary union. The "strategic view on EMU” proposed in Winkler (1996) assumes that European countries have different priorities regarding the twin objectives of Maastricht. In particular some countries, such as France, are primarily concerned to recover some influence over monetary policy previously ceded to the Bundesbank (Sandholtz 1993). Other countries, notably Germany, are mainly concerned about the credibility and stability of the new European currency that will replace the D-Mark (Woolley 1994).

The conflict of interests is particularly pronounced with respect to the transition strategy for EMU. The classic debate here has been between gradualist "bottom- up" approaches to monetary integration as opposed to "top-down" institutionalist designs (see Winkler 1997b). The first, advocated by the so-called "economists", calls for economic convergence as a precondition of monetary unification, whereas the second, championed by the "monetarists", sees the prior establishment of common monetary institutions as the (only) instrument to induce subsequent economic convergence (Crockett 1994). The two contrasting views on the preferable sequencing of convergence and monetary reform also reflect different national interests about when and by whom the costs and risks of adjustment should be borne. Countries with high domestic credibility would insist on prior convergence in order to mimimize the stability risks to EMU. Low credibility countries would prefer adjustment to take place inside EMU in order to profit from greater institutional credibility and thereby reduce the costs of convergence (De Grauwe 1996a). Most accounts of the Maastricht negotiations (just like the debate surrounding the earlier 1970 Werner plan for monetary union) testify to the battle between the two camps (Garrett 1993, Bini-Smaghi et al. 1994).

' A simplified account of the main themes addressed in this paper has appeared in ElB Papers

1, 1996, Special Issue on Emu, C. Hurst (ed.), European Investment Bank, Luxembourg.

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This paper seeks to trace out the difficulties that this basic conflict of interests creates for the Maastricht transition and how the provisions of the Treaty are equipped to deal with this conflict. In doing this we take the (stylized) objective functions of the "economist" and "monetarist" camps as given. In particular we do not go into the debate about which kind of convergence, if any, would be economically sensible as a precondition for monetary union. The presumption is that central bank independence alone is an insufficient guarantee for a successful and stable EMU (Lohmann 1996). The convergence process in the run-up to EMU then becomes important in two ways. First, by making policies and economic structures more similar beforehand, the costs of centralizing policies and adjustment problems inside EMU can be reduced. Second, the behaviour of countries in the qualifying phase can affect the expected performance of EMU. In particular, countries' ability and willingness ("stability culture") to sustain stability-oriented policies can be tested in the process and affect the reputation of EMU at its start (Winkler 1995). For our present purpose of analyzing strategic interaction, the reasons why some countries insist on prior convergence and whether there is any economic rationale for doing so, are left aside1.

The analysis of the Maastricht interaction can be seen, first, to provide possible explanations of the salient features of the Maastricht Treaty. Second, the analysis should be helpful to understand countries' incentives and behaviour given the Treaty provisions. In other words, the Maastricht Treaty can be seen as an outcome and response to the underlying Maastricht game. However, the Maastricht Treaty does not settle conflicts of interests in a definite way, but rather structures the rules of the game of ongoing strategic interaction. Clearly, the bargaining leading up to the Maastricht Treaty, the provisions contained in the Treaty and the ongoing game between national governments and European institutions are extremely complex processes. A detailed account of the history of the EMU project and the contents of the Maastricht Treaty is given by Kenen (1995). For a public choice approach to European integration see Vaubel (1994). The present paper proposes a very simple framework in order to focus on three main tasks of the Maastricht contract: the coordination of conflicting interests across countries, the provision of credibility and commitment over time and the management of uncertainty.

1 On these issues see Buiter et al (1993), De Grauwe (1994) and Masson (1996).

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II. Conflict and Cooperation in the Maastricht Game

The strategic view on EMU starts from the premise that costs and benefits differ across countries and in their time profiles. Countries with a high domestic monetary credibility are concerned about a potential loss of reputation and price stability in EMU. We call the advocate of these interests "the Principal" for the rest of the paper, most easily represented by Germany (perhaps also Holland, Austria) or the Bundesbank, or perhaps the EMI or the future European Central Bank. They prefer that convergence and credibility be established by national effort prior to admission into EMU, reflecting the "economist" approach to monetary unification. For low credibility countries, on the contrary, the whole point of EMU is to gain credibility more cheaply, so they prefer convergence inside EMU, in line with the "monetarist" philosophy. This group includes most candidate countries (and perhaps even the German fiscal authorities) and will be called "the Agent". In order to concentrate on the strategic interaction between these two groups of countries, we start with the following specific objective functions.

V{P) = p(TP - 5 + <t>cnE) + (1 - <j>)cn£ (1)

U( A) = p(Ta+ S ) - ^ E 2 (2)

7^,7^ a 0; £ ,5 a 0; a>,|3>0; O s t j t s l ; O s p s l

The first term in both equations captures the expected net benefits from EMU, where p is the probability and timing of EMU2, i.e. can be interpreted as a discount factor applied to stage three of EMU. It can also be regarded as a choice variable deciding if and when EMU comes about, or perhaps the ex ante chances of its realization. Note that the net benefits are divided into two components: the non-rival net benefits TP and TA (assumed to be positive), with the best example being transaction costs savings in EMU, and a rival component S, which shifts costs and benefits across the contracting parties. This component primarily reflects net transfers of sovereignty, broadly defined. This has a formal and a material aspect, i.e. the transfer of decision rights to European institutions and the difference this transfer makes to national welfare. The latter depends on the actual policies adopted by the European institutions. One can distinguish conceptually the welfare loss (or gain) from centralization per se, i.e. the loss of

2 Outside the simple two-country framework p could also reflect the size and/or composition of EMU. Then the net benefits of EMU increase in the (absolute) number of participating countries (affecting 7) and the relative weight of Agent countries in EMU, affecting the transfer of sovereignty (5). © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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differentiated national policy options, from the distribution of these losses across countries. The latter depend not only on the total adjustment EMU requires but on the direction of convergence, i.e. to which (whose) economic parameters, institutional and policy choices, convergence takes place. Given that a common policy regime is adopted (whose net benefits are reflected by TP and TA), S denotes the distance from the common framework or policy that would be preferred nationally.

One example would be the choice of monetary policy instruments of the ECB (e.g. reserve requirements), whether they are more conducive to an Anglo-Saxon or continental style financial system. Another example would be the Stability Pact3, agreed at the Dublin summit in December 1996, to the extent that it shifts the costs of EMU by reducing the risks to price stability but increasing the risks and costs to countries with debt and deficit problems. The extent to which the ECB was modelled on the Bundesbank that, as a concession, went beyond what other countries might have found desirable is also reflected in S. While parts of the costs and benefits of pooling sovereignty are non-rival and captured by T, there is also a rival component reflected in S. This is most evident from the perspective of the hard-EMS in the late 1980s and early 1990s, when the ERM countries largely followed Bundesbank policy, which was still almost exclusively oriented towards domestic objectives. With this benchmark there is a clear-cut transfer of sovereignty (and associated economic costs and benefits) from Germany to its partner countries simply because of the expansion of the policy domain in EMU. This is so even if the ECB was to have German preferences and even more so if European preferences were to differ. As for the rival benefits, therefore, the closer EMU is shaped in the German image, the smaller S.

The amount of convergence E only concerns the additional convergence effort that goes beyond what a country would find in its own interest to undertake in preparation for EMU. We can think of the latter component of convergence costs as already being incorporated in the net benefits. For the Agent the extra Maastricht-induced component of convergence4 is costly, convex, with increasing marginal costs, here in a simple quadratic formulation. The Principal cares about convergence and utility should probably be concave. We adopt a simple linear

5 The "Stability and Growth Pact" subjects countries inside EMU that violate the 3% deficit criterion of the Maastricht Treaty to semi-automatic fines of up to 0.5% of GDP (see

Financial Times 1996, Eichengreen 1997 and Winkler 1997a).

4 This extra convergence includes measures that would have been necessary anyway, but that would have been timed differently in the absence of Maastricht. See Hughes Hallett and McAdam (1996) and Barrell et al. (1996) for empirical analyses of the convergence costs imposed by the Maastricht criteria.

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approximation, where en is the marginal utility of convergence. There are two possibilities: the Principal might be interested in convergence per se or he cares about it only if EMU happens. Then fraction ()> of convergence is EMU-specific and reversible, and thus will be lost if EMU does not materialize. The share (l-<j>) reflects durable convergence, which is valuable and lasts independently of the realization of EMU. Alternatively it captures the temporary utility that even reversible convergence yields during the time it is forthcoming. For illustration we consider the following two special cases for ()>=() and (j)=l respectively:

In the first of these two polar cases the Principal likes convergence independently of EMU. The more policies across Europe are in line, the smaller are the risks of exchange rate instability, imported inflation, market distortions etc. in the absence of EMU, and the smaller are the risks to economic stability within a monetary union. If ( Tp-S) is negative, the Principal would prefer convergence without EMU, but EMU might be a worthwhile sacrifice if it can be used to induce sufficient convergence. In the second case, convergence is only valuable to the Principal if EMU is realized and it reduces his net costs from EMU. For example, a large (j> reflects the fear that the convergence progress of the ERM or the achievements of the single market could unravel unless locked-in by EMU. A small <j> either means that behaviour in stage two is not relevant or informative for stage three, i.e. convergence can not be locked in, or - on the contrary - convergence is irreversible even in the absence of EMU. Recall that, as always, the above Maastricht payoffs are relative to a benchmark scenario in the absence of Maastricht. That is, the more destabilizing non-EMU is perceived to be, the bigger are the above parameters for the net benefits of EMU and convergence.

Nash Equilibria and Cooperation

Imagine a simultaneous move game with objective functions (1) and (2) and with decision variables p for the Principal and E for the Agent, i.e. the Principal must decide whether to surrender the Bundesbank for EMU (p= 1) or not (p=0) and the Agent decides on the amount E of convergence to undertake. Equation 4 gives the unique Nash Equilibrium, for (Tp-S)<0, i.e. for a Principal for whom EMU is not worthwhile in the absence of any convergence, as (p=0, £=0). The cooperative solution that maximizes joint welfare in equation 3 calls for p=l, E cooP= co/p. This is the effort that balances the marginal benefits and costs of convergence to Principal and Agent respectively. Optimal convergence increases the more the Principal cares about it and the less costly it is to the Agent on the margin. Note that we take S as fixed and given in the Nash game. Since it is a

V( P) = p(TP - S ) + (üE V( P) = p(Tp - S + mE) (la) (lb) © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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pure transfer of utility it is not relevant for welfare but only affects the distribution of the gains from the Maastricht transaction. If given the choice, obviously, the Principal would set S as low as possible and the Agent as high as possible.

Max W(Maastricht) = p(TP +TA + §u)E) + ( \ - § ) u £ - - E 2 (3)

p ,E 2

The Maastricht transaction can be seen to contract for the cooperative solution of equation 4. The transaction, and the gain from trade in equation 3, has two components: the realization of EMU (and thus the non-rival benefits) and of socially optimal convergence. The Maastricht Treaty links both transactions together for two possible reasons. One is the classic case for issue linkage as a means to realize gains from trade. Moreover, in the case of EMU, the presence of non-rival benefits makes it "cheaper" for the Principal to pay for the Agent's convergence efforts via EMU compared to alternative side-payments. The second case for linking both transactions arises if decisions on convergence and EMU are interdependent, i.e. for <j»0. Then the benefits of EMU become a function of convergence and the benefits of convergence depend on whether EMU happens. In this case the gains from trade expand by bringing both issues together rather than deciding them separately.

Note that for the Maastricht transaction to be beneficial for Europe as a whole the expression in equation 3 must be positive. Therefore Maastricht is worthwhile even if convergence is excessive or deficient, but falls in the range given in equation 5.

Here the prospect of EMU, with p taken as parametric, expands the range for which the Maastricht transaction on convergence is welfare improving. This illustrates the first effect of issue linkage, even in the absence of interdependence (4>=0). In the presence of interdependence (for p e l, (j»0) the optimal cooperative effort and the range for which Maastricht is welfare improving depend on the EMU parameters p and where (l-p)<t> represents the risk of reversal of convergence effort, i.e. the share of convergence lost if EMU fails to come about.

In order to be incentive compatible for sovereign nation states, instead of equation 5, the Maastricht transaction must satisfy the individual participation constraints given from equations 1 and 2. For given 5 this leads to the following

|2 + 2 P ^ Tp * Ta) (5 ) © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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requirements on E as the conditions for nation states to sign a Maastricht Treaty that specifies £, 5 and p.

V ( P ) a ( ) =>

E z E( P ) - p(~s ~ Tpi

( ]

» [ i - ( l - p ) 4 > ] (6 )

U(A)s:

0 => e

, E( A) = i2« s + ¥)*

\

p (7 )

To secure the Principal's participation in (6) the Maastricht Treaty must procure enough convergence to compensate for the expected net losses from EMU (still assuming TP-S<0), where the marginal benefit of convergence is adjusted for the risk of reversal (in the denominator). Conversely the Agent in (7) must be compensated for convergence effort via the expected rewards from EMU.

Alternatively, we can express national participation constraints in terms of S, for given E :

V(P);» 0 => 5 s S (P) = TP + L -O

P (8)

T(A );>0 =*> 5 a 5 (A ) = -~~E2 - Ta

2 P (9 )

Returning to the original game situation and the coordination and commitment problems of sustaining the cooperative solution: in essence the Maastricht Treaty needs to solve a Prisoner's Dilemma, where both players have an incentive to deviate from the cooperative solution. Assume that the institutional features of stage three and therefore the net benefits from EMU are fixed. However, in the absence of any treaty commitment the Principal is free to decide on whether EMU comes about (i.e. can set /?=(), 1 ) and the Agent decides whether to supply the cooperative level of convergence (i.e. sets E). Consider the payoffs from the Maastricht game in Figure 1.

Figure 1: The Maastricht Game (Nash)

Agent Principal p =1 p =o t»1 1 II | 8 _T= a + S --- , Tp — S + —w2 = CO2 A 2p P p 2 2 , ( I - * ) — 2p V ' p II. E m = 0 Ta + 5 , TP - S 0 ,0 © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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The Agent prefers not to undertake any convergence effort whether the Principal decides for or against EMU. The Principal's best response in the absence of convergence is to refuse EMU as long as TP-S<0. This yields the unique Nash equilibrium in the bottom-right corner of Figure 1. If the Principal is keen on EMU even in the absence of any convergence (7}.-5>0) the Nash equilibrium will be bottom-left, in this case the EMU-component of the gains of trade are realized, but not the convergence component. The cooperative outcome (top-left) cannot be sustained because the Agent has always an incentive to deviate. The Principal will also want to deviate as long as S-TpXtyw^lfi.

For concreteness, call the players Germany and Italy. Germany holds the key to EMU coming about (which seems realistic); Italy can choose convergence (say fiscal rectitude) or otherwise. If Germany commits to EMU it must fear that ex post, with the Bundesbank surrendered, Italy will not produce sufficient convergence. Italy may not resist the temptation to try to have Europe bail out its debt, redirect its priorities towards employment instead of price stability, delay fiscal reform further etc. Conversely, Italy must fear that painful adjustment E will not be rewarded with EMU entry.

There are several ways, in principle, in which the Maastricht Treaty may serve to alleviate the Prisoner's Dilemma. First, by structuring the game by specifying a move order, i.e. when decisions are taken. Second, by specifying decision authority, i.e. who decides what. Third, by altering the payoffs of the game, e.g. by committing players to certain actions, outcomes or procedures, where breach of treaty carries a penalty. In particular, the treaty can specify decision rules, i.e. on what basis and how are decisions taken. Here, the Maastricht criteria5 governing entry into EMU, are a prime example. The Maastricht Treaty deploys a combination of all three options, which we will explore in turn.

Sequential Choice

If players retain their decision variables and decision freedom, but can be induced to move in a sequence, we may get an equilibrium outcome that is superior to the one-shot Nash equilibrium. Consider Figure 2 below and imagine that the Agent

5 The criteria call for inflation and interest rates to be within 1.5 percentage points of the the three best performers and for membership of the exchange rate mechanism (ERM) for at least two years without devaluation on own initiative. The fiscal conditions stipulate a deficit of at most 3% and a public debt of at most 60% of GDP, with some qualifiers attached. Countries' eligibility will be decided by qualified majority vote in the Council on the basis of convergence reports prepared by the Commission and the European Monetary Institute.

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first decides on how much convergence to undertake before the Principal accepts or rejects EMU.

Figure 2: The Maastricht Game (Stackelberg)

Principal Agent _{p= l} _{p =o} E = £ ( P ) I. ( 5 - 7 » (Jho Ta + S - * £ 2, T p - S + u£ 2 (j/o r <)> - | £ 2, ( l-<|.)cüë P (5 - 7 » 2 l-4> = o *2 2 9 As '■ p 2 (j) 0) <(> II. Ene = 0 f A + 5 , 7> - 5 0 ,0

In the "Stackelberg" version of the game, with the Agent moving first, we get two Nash equilibria. The original outcome of the Maastricht game, i.e. bottom-right (p=0, £=()), remains a Nash equilibrium. However, in the presence of EMU- specific convergence (cj»0) the Agent might consider choosing E just high enough to induce the Principal to respond with EMU. This can be seen in the second row of strategy I, where the expression for the minimal EMU-compatible effort E ( P ) has been substituted in. Assume that the Agent chooses £ just above the level that leaves the Principal exactly indifferent (in order to break the tie under strategy I in Figure 2). Then the top-left outcome will be the unique subgame perfect equilibrium if the corresponding payoff to the Agent is greater than zero (i.e. his utility under the original Nash equilibrium6). Note that for 4><1, the Principal cannot be held to his Maastricht participation constraint given by equation 6, because the Agent concedes the additional convergence necessary to persuade him to accept EMU.

If <)>=0 or the EMU net benefits to the Agent are too small (so that he prefers bottom-right to top-left), having the Agent move first does not solve the problem; nor does the reverse move order, where the Principal commits first. In this case, as seen in Figure 1 the Agent will always respond with zero convergence and hence the Principal refuses EMU. Moreover, the convergence induced by the

" The original Nash equilibrium is not subgame perfect since it depends on the Principal's non- credible threat of refusing EMU even if the Agent's convergence rendered EMU beneficial, off the equilibium path.

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efficient move order will not in general correspond to the efficient amount of convergence of the cooperative solution. This may be one reason why the Maastricht Treaty does not only rely on specifying the right move order but sets minimum convergence requirements. However, we must be careful to distinguish the order of decisions from the sequence of actions. In particular, Maastricht established a final deadline for EMU in 1999 and therefore already also pre committed the Principal countries, provided they themselves satisfy the entrance conditions7. This also suggests that the move order was perceived as insufficient to guarantee an efficient transition to EMU. One reason could be uncertainty about future preferences and therefore doubts what level of convergence will be needed to induce the Principal's participation in the future. In turn such doubts undermine Agent countries incentives to converge. Moreover, with convergence coming first and in the absence of commitment to EMU, the Principal would have an incentive to delay and ask for yet more convergence. This "hold-up problem", that arises when convergence is already "sunk" at the time of the decision on EMU, is analyzed in section four.

The move order is still important, however, in the case where rigid contract commitment is not feasible or not desirable. In the absence of fully state- contingent contracts, commitment can become costly in the presence of uncertainty, as seen in the next section. Moreover, convergence may not be fully contractible, perhaps being observable but not enforceable in court. Under incomplete contracts Germany would only actually concede control of the Bundesbank (even if the promise to do so was undertaken earlier) after observing evidence of sufficient convergence. Moreover, the transfer of sovereignty, is much more easily verifiable than convergence effort. In any case, the Maastricht move order, combined with contract commitment, seemed essential in ensuring the Principal's participation in the Maastricht transaction and will make EMU more likely to happen over time, if <]) is positive and therefore makes EMU more digestible to the Principal as convergence increases.

Decision Authority

Another possibility to improve on the one-shot Nash outcome of the Maastricht game, if perfect contracts are not feasible, is to re-allocate decision rights. The most immediate answer to the Prisoners' Dilemma of EMU would be to pool all authority at the European level. If Europe had already achieved full political union, joint decisions should reflect European welfare and could be legitimately

7 The insertion of the 1999 deadline was the key last minute concession that Mitterand and Andreotti obtained from Chancellor Kohl at Maastricht, to the great surprise (and dismay) of the German delegation (Bini-Smaghi et al. 1994).

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executed even against individual nations' interests. For now, there is the current array of European decision making procedures, qualified majority and unanimity voting in particular8. The alternative would be to assume pure intergovernmental bargaining. All these procedures should in principle lead to the realizations of gains from trade and a division of gains according to bargaining strength if side payments and effective issue linkage is available (Martin 1993). However, as long as actions need to be carried out by national authorities and at different points in time, credibility and commitment problems in implementing the cooperative solution still arise as before. Moreover both ex-ante and ex-post bargaining inefficiencies can arise as explored in section four.

Therefore it is useful to leave bargaining aside for now and investigate how a reallocation of decision rights would affect the outcome of the Maastricht game. We can think of a two stage game, where first players contract over decision rights and, second, play a Nash game in the decision variables allocated previously. We consider the objective functions for special cases of (la) and (lb), and for all three possible decision variables p, S and E. These three may be decided together or one variable could be regarded as pre-determined, which allows us to address issues of sequencing with respect to the order in which the Maastricht process should fix the various variables. The move order of individual players is the sequential one adopted in the Maastricht transition. Thus convergence (E) and the set up of the institutional features of EMU (S) precede the inauguration of EMU (p). From this we assume that both sides could (and would) still block EMU at the last minute if the prior delegation of authority had been abused to violate their Maastricht participation constraints from equations 6-9. Without such a safeguard delegation would not have been agreed to in the first place.

In the case where one variable of the Maastricht transaction is pre-determined there exist four possible allocations of decision rights. The "natural assignment", as in the original game of Figures 1 and 2, where the Principal picks p and/or S and the Agent chooses E (case I), the "reverse assignment" (II) and the two instances, where either the Principal (III) or the Agent (IV) obtains unilateral control over the decision variables. If all three variables are chosen freely (Figure 6 below) we can distinguish six different ways in which decision rights can be distributed.

8 See Krumm and Herz (1996) and De Grauwe (1996b) on the effect of qualified majority voting on the entry decision. Bruckner (1996) and Bindseil (1996) look at voting power in the future ECB Council.

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Figure 3: Re-allocation o f Authority, S fixed

Principal (la) Agent (2) Principal (lb) Agent (2)

4>=0 _4*1 I. p =0 (if TP<S) £=0 _{p= i} E (P)= S ~ Tp if 0) S + Ta (S - T p f p 2 to2 II. m J 2 l s : r <> V P P= 1 same same

III. p=0 (if TP<S), reject p= 1 if Tp+wE a.V accept

jftnax _m _{. } ^} _>

IV. reject II T-H II o same same

The situation depicted in Figure 3 reflects a post-Maastricht setting, where the (stage-three) features of EMU have been decided in advance, but the starting date and the level of convergence are either left open or are not enforceable ex post. The "natural assignment" is the one discussed in Figures 1 and 2, where the Maastricht move order of "convergence first" can lead to the realization of EMU and also induce some convergence for positive (j>. For (j)=l the Principal will be held to his participation constraint from equation 6.

Under the "reverse assignment" the Principal uses his authority to extract maximal convergence (from equation 7), while the Agent's control over p ensures that EMU goes ahead. This captures the fact that the Maastricht Treaty has fixed a final deadline, which - if at all - could only be disregarded by a (qualified majority) decision of the Council, where the Principal can be assumed to be in a minority position. On the other hand it reflects the observation that the Principal has been given a strong hand both in imposing convergence criteria in the Treaty and in influencing their interpretation9. Moreover, with the Bundesbank still in a dominant position, the Principal can affect the level of convergence required for entry. This is true in particular for the convergence criteria which are formulated as relative to the best performers (inflation, interest rates), but Bundesbank

9 In particular via the unilateral resolutions of the German parliament and the constitutional court insisting on a strict interpretation of the criteria and reserving judgement on German participation in EMU (Steinherr 1994).

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monetary policy will also affect how difficult it becomes to meet the fiscal and exchange rate criteria.

The "reverse assignment" is problematic, however, because it is "unnatural". Certainly the Bundesbank has already been signed away in Maastricht and Germany can be outvoted in the Council, but still it would be hard to conceive that it could be really coerced into EMU against its will in 1999. Likewise, Germany certainly cannot dictate convergence policies of sovereign partner countries, even with the most rigid insistence on the Maastricht criteria.

The problem of sovereignty is exacerbated if total control is given to one of the parties. In the case of the Principal (III) EMU will only be realized for positive <)> where the convergence he imposes on the Agent will induce him to accept EMU subsequently. If 4>=0, he cannot self-commit to EMU in advance, and therefore the Agent would reject a Maastricht Treaty that cedes control to the Principal. Under full Agent-control (IV), again assuming that the Agent cannot self-commit, but decides both variables separately, no convergence will be forthcoming and hence the Principal will reject such an arrangement.

Figure 4: Re-allocation o f Authority, E fixed

<J>=0 _<t»=l

I. P= 1 II P= 1 S=TP+u)E

II. 5=0 _P=1 same same

III. p= 1,5=0 accept same same

IV. accept _{P= 1}

S(P)=TP

accept _p_=i

S(P)=TP+wE

In Figure 4 convergence has already been fixed, in the form of the Maastricht criteria, or already been undertaken, while the fate of EMU and some of its features are still undecided. This situation applies in particular to the time of the negotiations of the Stability Pact in 1996, if one either considers the Maastricht criteria as cast in stone and binding, or if countries convergence decisions have already become clear and little or no time remains for further adjustment. If the Principal preserves his decision power over the launch of EMU, in the "natural assignment", the Agent will make concessions on the features of stage three (e.g. central bank independence or the Stability Pact) just to the point needed to win over the Principal. Under the "reverse assignment" the Principal can impose his

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preferences on the shape of EMU, as long as the Agent would wish to join EMU regardless.

If convergence efforts are "bygones" at the time of the Stability Pact negotiations, it is conceivable that the Agent's overall Maastricht participation constraint is violated, but with convergence effort sunk, he would still accept (III). Under Agent-control (IV), like under the "natural assignment", the Agent extracts just enough concessions on EMU not provoke the Principal's rejection. The main lesson of Figure 4 is that EMU can always be achieved if some features of Maastricht can be renegotiated or a Stability Pact added on, in order to induce the Principal's participation for any given level of convergence. If such renegotiation is anticipated, however, the Agent may have no or little incentive to undertake convergence ex ante as explained in section four.

Figure 5: Re-allocation o f Authority, p fixed

Princioal (la.b) Aeent (2)

I. 5=0 E=0

II. £max=9 £max=*}

III. rcoop

S ( A ) = ^ - - Ta

2pp A

accept

IV. accept £COOp

2

S ( P)=— + TP PP

If a deadline for EMU is fixed by the Maastricht Treaty, as in Figure 5, but convergence effort and the Stability Pact are still in the air, both the "natural" and the "reverse assignment" lead to instability. In the first case, the Principal would seek to impose a tough Stability Pact in order to cut his losses, while the Agent would try to avoid any convergence. Without commitment on these variables, therefore, the original unilateral commitment to the realization of EMU is unlikely to be credible. Similarly, under the "reverse assignment" the Principal would seek maximum convergence and ever tighter interpretations of the Maastricht criteria, while the Agent has no incentive to make any concessions on stage three of EMU. This explains why both sides, once that the prospects for EMU started to look more certain made attempts to go back on their original Treaty commitments. In particular Germany sought additional safeguards and a toughening of the criteria inside EMU in the form of the Stability Pact. Others,

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notably France, started to question fundamental pillars of the Maastricht Treaty, such as the autonomy of the ECB from political interference and its responsibility for exchange rate policy. Once EMU is assured, neither side has any longer the incentive to restrain its demands in order to win the partner's participation, as was the case in Figures 3 and 4.

Turned around, the argument explains why the Maastricht Treaty fixed convergence requirements and the features of EMU together with the deadline and made the commitment to EMU conditional on convergence. It also explains why all sides avoided any suggestion of a comprehensive renegotiations of the Maastricht Treaty even in the face of adverse shocks. However, the downside of saving the commitment to the Treaty, the deadline in particular, is to forego the opportunity of realizing efficient bargaining solutions. The latter can also be obtained by concentrating authority with the Principal (III) or the Agent (IV), who would set the optimal convergence level to maximize the gains from trade and the hold the partner to his participation constraints (from equations 8 and 9). Again this presupposes that authority is not abused beyond the Maastricht participation constraints, which in turn can only be enforced (if at all) by retaining either side's ability to block EMU. Therefore, again, p should not be fixed unconditionally, but determined jointly as in Figure 6 below.

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Figure 6: Re-allocation o f Authority, p, S, E

(j)=« <t)=l I. i)p= 1,5=0 H) P~ 1 i) £=() ii) £=(), S- T p i) same ii) p= 1 i) same ii) EcooP, S (P)=Tp+u> pcoop II. i) EcooP S(A)=—— Ta 2p A Ü) Emax=? i) p= 1 ii) p= 1, same same III. p= 1, Eco°P S ( A ) = - - Ta

accept same same

IV. accept p= 1, EcooP

S(P)=Tp + ~ same same V. £ ( A) = f f S=TP /?=?, Emax=l p=\ if E & S ~ Tp 03

VI. 5=0 _{P=x’ E =Q_____ same} same

Here, for the "natural" and "reverse" assignments, there are two cases each, depending on whether the Principal (i) or the Agent (ii) obtains control over 5. Note that in almost all cases the realization of EMU is assured, and either convergence or the Stability Pact can be used to secure the Principal's participation10. The fully efficient (cooperative) outcome can be obtained if one of the players controls both continuous variables E and 5 and therefore could realize efficient convergence in order to maximize his surplus". When control over E and 5 is separated, indeterminacy problems are prone to arise, as discussed under

10 The exception is case Vb, where control over 5 and E is devided and both enter the Principal's EMU participation constraint.

" Again we rule out self-commitment and therefore the Agent will only converge, or make concessions on S, to the extent that this is necessary to induce the Principal's participation. Therefore in case la (ii) the cooperative solution is not realized, even though the Agent controls both E and 5. Here the Principal's EMU participation constraint is relevant unlike in case IV, where the Principal can be held to his overall Maastricht participation constraint.

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Figure 5, with the exception of case V, where S is tied down in order to secure the Principal's participation in EMU. For efficient convergence, therefore, 5 must be decided jointly with E. "Jointly" means at the same time and by the same player, unless there is an efficient bargaining mechanism available.

Applied to the debate about the Stability Pact this means that, if Germany can still either block EMU (controls p) or insist on excessive convergence (controls E), then either it should be given the Stability Pact it wishes (be allowed to adjust S) unilaterally, or both E and 5 should be renegotiated together as suggested in Artis (1996). In both cases efficient convergence would be realized, where under the first scenario, obviously, all gains from trade would accrue to Germany. However, it is difficult to imagine that nation states would agree to concentrate control and thus all the gains from trade in the hands of one side or the other, except if there are compensating side-payments ex ante.

In Figures 3-6 we have explored the implications of a Maastricht Treaty that re allocates decision rights rather than committing to the parameters of the Maastricht transaction directly. Together with the assumption of the Maastricht move order, where convergence and the finalization of the essential features of EMU precedes the actual launch of monetary union, a number of outcomes are obtainable that improve on the Nash equilibrium of Figure 1. By structuring the rules of the game, i.e. by determining who decides when about what, the Agent can be induced to undertake convergence or make concessions on stage three that will invite the Principal's participation in EMU. The reverse assignment, in particular, can be used to override the Principal's resistance to EMU and to impose convergence on the reluctant Agent. In the absence of any European enforcement mechanism, however, both "reverse assignment" and any joint European decision making overriding national sovereignty may not be feasible. This explains the importance of the Maastricht criteria, which by making EMU entry conditional on convergence exert the incentive effects of the "reverse assignment", without compromising national sovereignty.

III. Maastricht Contracts

We have shown how the Maastricht Treaty might help to solve the Prisoners' Dilemma of the Maastricht game by specifying who decides what and when. The obvious thing, however, would be to commit to the desired cooperative outcome directly. Here there are two issues, first, how to determine the parameters that distribute the net gains from EMU between the parties. This could be decided by bargaining and will be explored further in section four. Second, how to guarantee commitment to the Treaty provisions sufficient to offset the incentives to deviate

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identified in the game environment, but flexible enough to avoid ex post inefficiencies in the light of new information. The assumption is that fully state- contingent contracts are not available12. This section addresses the effects of shocks to the Maastricht parameters that are realized after the Treaty is concluded. Problems of asymmetric information in the context of bargaining are deferred to the next section.

Let us denote contract commitment K as the (political) cost of reneging on the provisions of the Maastricht Treaty. Let us think of K as a fixed number, even though realistically in the EMU context this cost would often depend on how obviously and how much the Treaty is violated. There are two issues concerning K, what would be a plausible empirical value and what would be its optimal value, if K itself can be contracted at a prior stage. In the European context, while a European Court of Justice exists, it is difficult to imagine effective court enforcement, absent an effective political union, with a capacity to apply significant sanctions to member states. Moreover, in important parts (although not for the monetary union component) Maastricht is still an intergovernmental framework and does not cede sovereignty to Community institutions. For these reasons formal commitment should be quite weak, although stronger than for most international treaties. On the other hand, the actual costs of being perceived as breaching explicit (and importantly even implicit!) Treaty obligations could be significant. Given that Europe is a mechanism for cooperation across many important policy areas, breaching the trust of one's partners can carry a heavy reputational penalty and could also provoke retaliation across a broad range of unrelated fields. Therefore, empirically, contract commitment is neither negligible nor is it infinite.

As for optimal commitment, in the case of certainty, all we need is K to be big enough to counter the (Nash) incentives to deviate from the cooperative solution. Uncertainty becomes important only if fully contingent contracts are not feasible or to costly to write. If the Treaty has to fix the decisions on p, E and S irrevocably ex ante then commitment could become harmful, if ex post shocks are so large as to make the gains from trade disappear. From the perspective of individual countries commitment becomes already harmful when national participation constraints are violated. Several different assumptions about commitment and renegotiation are investigated below.

The obvious way to minimize uncertainty and the risks to EMU is to keep the transition phase short, i.e. proceed to EMU as quickly as possible, or alternatively delay contracting the relevant parameters as much as possible. The long "risky" 12 See Kreps (1992) for a formal analysis of choice in the presence of unforeseen contingencies.

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transition period, indeed, is a major, recurrent criticism of the Maastricht Treaty. We have seen, however, that this transition is there for good reasons. The Maastricht move order, i.e. "convergence first", is a condition for the Principal's participation in EMU. Conversely, treaty commitment is necessary in advance to induce the required convergence. Finally, the criticism of the long transition period can be turned around: if shocks to political and economic conditions, and changes in priorities can so easily knock EMU off course in the transition, then perhaps it would indeed be unwise (welfare decreasing) to proceed with EMU. A drastic and permanent regime shift like EMU should certainly not only be based on a temporary fair-weather consensus, but should be robust to changes in parameters13. Therefore the transition serves as an important and informative testing ground and, while risky, certainly is not superfluous.

Assume that the Maastricht Treaty contracts for some parameters p , E and S , where with full and perfect information p and E should correspond to the cooperative solution of equation 4 and S should reflect bargaining strength. Augmented by the penalty K for breach of treaty the objective functions become:

VK(P) = p(T P - S + <t>cnE) + (1 - <)>)co£ - K P - e P (10)

Uk( A ) -p(Ta+ S ) - ^ E 2 - Ka- ea (11)

For now we ignore the post-Treaty disturbance terms e. In order to be effective the penalties must at least compensate the incentive to deviate from the Treaty (cf. Figure 1), i.e.:

K P z V ( p = 0 , E , S ) - V ( p = l , E , S ) - S - T P -<t>coE (12) K A z U ( p , E = 0 , S ) - U ( p , E = E , S ) = ^ E 2 (13)

By deviating from the cooperative solution the Principal would avoid the loss of sovereignty but sacrifice the non-rival benefits from EMU and the EMU-specific fraction of convergence. The Agent would save his convergence effort. For the minimum penalties given in equations 12 and 13 to be effective, any deviation from the Treaty must be detectable and punishable. If the decision variables cannot be fully specified in advance or are not enforceable, K could in principle

13 It must be conceded, though, that shocks will impact differently inside EMU than during the transition. Also commitment to resist shocks may be stronger, which does not mean that these shocks are necessarily less costly, however.

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be made a function of the decision variables and influence incentives in the right direction. In order to get the fully efficient outcome K must be constructed such as to completely internalize the externality on the other player, i.e. made to maximize joint welfare.

Here the incentives of the Maastricht Treaty are such that the Principal takes into account EMU's benefits to the Agent when deciding p. Likewise the Agent internalizes the Principal's interest in convergence. The incentive effects of the Maastricht criteria are an approximation of the latter (Winkler 1997a), the joint decision making procedure for deciding eligibility for EMU reflect the former mechanism.

In equations 12 and 13 conditions for minimum contract commitment were established. In the presence of uncertainty, however, commitment can become excessive, if the sum of subsequent preference shocks e in equations 10 and 11 exceeds the originally projected welfare gain. Shocks can occur to any of the parameters in the objective functions cn, {5 or T, as well as the overall relative desirability/cost of the Maastricht process. For the present one-shot context it does not matter how exactly uncertainty enters, but only that costs and benefits differ ex post. Then Maastricht becomes welfare-decreasing ex post if condition (16) holds.

renegotiate if z P + z A > W ( p , E ) (16) Here W is the social welfare gain from the original Treaty parameters (which is independent of S) from equation 3\ e denote negative shocks that decrease the gains from EMU ex post. It seems reasonable to suppose that countries should get together and renegotiate if shocks render Maastricht welfare decreasing for Europe as a whole, at least if the shocks are observable, even if they had not been contractible ex ante. However, as long as the locus of the relevant decisions remains national, condition (16) is not guaranteed. Instead, assumptions may have to be made about individual national commitment. Maastricht may then be renegotiated either if any single national or only if both parties' participation constraints are violated. Assume that ex ante the gains from trade W are distributed according to bargaining power y for the Agent and (1-y) for the Principal. Then choosing national commitments as below will in the first case rule out an inefficient EMU, but allow that any single country might also block an efficient EMU. In the second case an efficient Treaty would never be blocked, but an inefficient EMU might also go through. At least on paper, the Maastricht

K P( p) = p(T A +S ) Ka( E ) =uE (14) (15) © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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Treaty follows the second option requiring that changes to the Treaty be ratified by ail member states. However, individually, countries have the option to renounce convergence (and thereby their entry into EMU) as soon as it is no longer in their national interest.

K P = ( \ - y ) W ( p , E ) (17)

K A = y W ( p , E ) (18)

Here the maximum commitment is given, that prescribes adherence to the Treaty only for shocks small enough as not to violate the national participation constraints. Recall from above, that social efficiency may well call for one of these constraints to be overridden. If the distribution of the shocks differs, e.g. with respect to the variance, this should also be taken into account in the ex ante distribution of gains (or the choice of commitment) if one was interested in minimizing the risks of hitting national participation constraints. If distributions are the same, therefore, the gains from trade should be shared equally (y=l/2). If, for example, uncertainty about the Principal's gains from EMU is greater than about the Agent's then the former should receive a larger share of the gains ex ante, to serve as a "cushion", or he must be tied by greater commitment. In this perspective the French (or German) elections in 1998, to the extent that they present a risk that the EMU project might be abandoned, strengthens the French (German) bargaining position ex ante by calling for a larger share of the gains from trade to be assigned to the French (German) side.

Optimal commitment should therefore lie in a range between the minimum commitment needed to offset the incentives to deviate from the cooperative solution (under certainty) and the maximum commitment needed to preserve flexibility in the face of shocks and honour national participation constraints. Equations 19 and 21 give these ranges'4 under the assumption that the original Treaty contracted the cooperative solution of equation 4.

2 '\ (1 -4 .) — - ( l - Y ) P T -F W Tp + T A + — 2P * K P * ( l- Y ) f = = ü)2 ^ T p + T a + W (19) 2 p * Ka * Y f 2 ^ TP +TA + — V 2p (20)

14 Using equations 12 and 13 and the bargaining solution derived later in equation 23.

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In the presence of uncertainty, therefore, we get a potential conflict between the positive role of commitment in sustaining a cooperative outcome and the risk of leading to ex post inefficiencies, whether from the European (equation 16) or the national point of view (equations 17-20). This explains why commitment to Maastricht is not (and should not be) infinite. Moreover it explains why Maastricht often has not pre-committed to detailed outcomes but rather to procedures, decision rules and institutions. Here commitment is often less costly since it preserves some discretion to deal with unforeseen contingencies. The convergence criteria and the Stability Pact, in particular, can be seen as mechanisms to affect incentives rather than contracting for specific outcomes directly.

Note that "optimal commitment" here simply meant that, for any given Maastricht Treaty, in the face of the subsequent shocks it is still better (for each country or for Europe as a whole) to stick to the Treaty as it is, if the alternative is to abandon it altogether. However, we need to distinguish between "efficient convergence" (optimal E) and "efficient trade" (VfaO). To preserve efficient convergence any shock to |3 or co should ideally lead to a mutually beneficial renegotiation of the Treaty parameters. Moreover any shock that affects the distribution of the gains from trade will also lead to calls for renegotiation. The presumption therefore must be that renegotiation is costly or harmful because of bargaining inefficiencies and hold-up problems, to which we turn next.

IV. Bargaining and Incomplete Contracts

Inefficiencies from contract commitment (concerning both deviations from optimal convergence and the desirability of the Maastricht transaction as a whole) could be avoided if parties could get together and renegotiate whenever such inefficiencies arise. However such renegotiation may be costly and also impracticable to the extent that EMU, and perhaps also medium and longer term convergence programmes, must be designed and prepared well in advance. Moreover such renegotiation can be undesirable if ex post bargaining, even if efficient and costless, leads to distortion of ex ante convergence incentives (Hart and Moore 1988). Finally, bargaining may be inefficient by itself in the presence of private information. For now, assume that bargaining is efficient. Again we leave aside the implications of the precise voting procedures such as qualified majority voting15. If all decision variables can be chosen freely, bargaining should 15 On this see the work cited in footnote 8.

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guarantee the cooperative outcome from equations 3 and 4, yielding maximum joint welfare:

2

Wcoop = W (p = \,E coop) = TP +TA + — (21)

2(3

If S can be adjusted freely, it will be varied to distribute the gains from trade W and to ensure that these gains are realized. In reality, if S denotes the "rival" features of EMU, it can only be varied within bounds. In fact we have already imposed above that it cannot be negative, and for the game formulation of Figure 1 we assumed that it would be greater than TP. Leaving this aside for the moment, under Nash bargaining with the Agent's bargaining power denoted by y, the gains from the Maastricht transaction are divided as in equation 22, which implies the value of S given in equation 23.

to V co°P(P) = (1 - y )W coop; U coop(A ) = yW coop = y (TP +TA + — ) (22)

2(3 2 s coop = ^ _ _ T 2(3 4 ( 2 \ ~ ~ w Tp + TA + —— 2(3 (23) = y + 7 > - ( l - Y ) f 2 ^ ~ ~ C O Tp + Ta + 2(3

From equations 21 to 23 we can thus predict the outcome of the Nash bargaining game for all three decision variables both for the original Maastricht Treaty or any subsequent comprehensive renegotiation in the light of new information. Suppose now that convergence has to take place before the decisions on p and S are finalized. Then the distribution of ex post bargaining power will influence the incentives for ex ante convergence. Assume for now the special case of objective function lb for the Principal. This means that the painful price of convergence has already been paid, but its rewards can only be reaped if convergence is locked in by EMU. Therefore the net gains from EMU at this point are given by equation 24 and do not take into account the costs of convergence already sunk. The Agent will obtain his share y of these gains and hence the resulting S is given by equation 25.

WEcuop (E M U ) = TP + Ta + cnE (24)

S f:coop =y( TP + TA + (j)E) - Ta (25)

Maastricht Games and Maastricht Contracts

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Maastricht Games and Maastricht Contracts

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