Euro exit: Governing the Unthinkable

One of the abstractions from reality that economists like to make is that property rights are perfectly well defined and can be easily enforced. That means that it is clear who owns what, and what we can do with it. In reality, property rights aren’t well defined. It is not always clear if the tree you planted is on your side of the property line, or your neighbours. And, even if it isn’t on your land, is your neighbour allowed to cut it down (especially if its 30 ft tall now)? In fact, the simple truth is that most (if not all) property rights can’t be perfectly enforced under all states of nature; and in many instances, there is no mechanism, no insurance contract, nor norm or law to govern what to do when that unanticipated state of nature occurs.
You don’t need to be a rocket scientist to know that when property rights are ill defined or hard to enforce, it leads to trouble. Bickering and fighting with the neighbours; trees that get needlessly lopped; divorces get unnecessarily messy. TH heard of someone in the US being shot in a line-up for petrol (gas) during a period of petrol rationing over a dispute about who was first in line. The resources that get lost can sometimes greatly exceed the value of the disputed property right (think of the guy that got life in prison not to mention the guy that lost his life in the line for gas). That is why we have the law. The law just doesn’t enforce property rights, it tells us what to do when something within the system goes wrong and there is a dispute over property rights. Sometime the law is written (e.g. which creditors get what when you can’t pay your mortgage). Sometimes the law is unwritten – like women and children first on the Titanic when it wasn’t clear who had a right to a berth in a life boat. And sometimes the law still needs to be written because the case in hand was once “unthinkable.”
Three or four years ago it was (almost) unthinkable that a Greek person’s right to be paid in euro could not be guaranteed. One reason why Torrens Hume is a big advocate of coming up with a mechanism for a smooth exit from the euro area  (see here and here for example) is simply because the problems associated with not knowing whether Greek’s (and holders of Greek debts) can be expected get paid in euro and the implications of that is causing financial markets to become severely distorted. There is also a closely related problem associated with the uncertainty surrounding what happens when the Government of Greece defaults on its debts (see James Haley at the New Age of Uncertainty on the need for a sovereign debt restructuring mechanism).
In TH’s most humble opinion, the biggest failure of European policy making during the last three years is that it has been unable to write down the rules of the game that govern the euro area members when the unthinkable happens. In this context the “game” consists of euro exit, sovereign default, bank capitalisation and federalisation. (Did anyone watch the Munk debates – Is the European Experiment a Failure?)
The trouble is that when there is uncertainty, people procrastinate over large, irreversible decisions, because tomorrow will always reveal more information that might help in making that decision. Thus the economic uncertainty induces policy makers to wait before writing down the rules because the economic situation might get better tomorrow and economic agents fail to invest their resources in productive activities, because they don’t know how policy makers will act on the issues of euro exit, sovereign default, bank capitalisation and federalisation.

In blunt terms, we are stuck in a terrible Nash equilibrium: policy makers are waiting for economy to get better while the economy is waiting for policy makers to act. In the meantime, unemployment in Greece and Spain is over 20% and rising, the European economy is starting to slip into what could be an extremely serious recession – think of the major banks in Spain and Italy failing — and the rest of the world is struggling to escape the vortex (Asian economies are already slowing  as exports to Europe are slowing or contracting). This is nothing short of tragic.

3 thoughts on “Euro exit: Governing the Unthinkable

  1. All that talk about Spain, plus seeing a movie last night called “The Way”, makes me want to walk the Camino – are you interested in walking 700km across the top of Spain, staying in pilgrim quarters each night…. takes about 30 days.

    Before we hit 50? Start training now?

  2. Torrens,

    Spot on. One way of thinking about bank runs is as a problem of ill-defined property rights: depositors’ liquid claims exceed the bank’s liquid assets, while indivisibilities create problems of ill-defined claims on the less liquid assets. In these circumstances, it is in the interest of an individual depositor to move first to redeem their claim. But if it is in the interest of one, it is in the interest in all. As a result, there is a risk of a panicked equilibrium, firesales of assets and the liquidation of otherwise solvent institutions. Nothing new here; it is all in Diamond and Dybvig’s classic paper. You would think that any reasonably compentent policy maker would be versed in all of this – except someone forgot to tell the architects of the euro zone.

    More to the point, however, consider the implications of a currency crisis. For a fiat currency, the only “asset” backing the currency is the taxing power of the state and confidence in the authorities’ capacity to deliver sound, sensible policies conducive to growth. The problem in Europe may be that Mr. Market’s patience with euro policy folies may be close to being exhausted. The Boone and Johnson analysis suggests that this closer than most people think.

    Keep up the great work.


    1. Here is the link to the Boone Johnson piece that Ricardo mentions. It is required reading. TH shares their view. Ricardo, can’t agree with you more that it is a runs equilibrium we must now worry about. It has reached a point where the Bundesbank — mispoke — ECB — is financing the banking sysytems of much of Spain and Greece, it is quite unclear whether it can keep doing this with out capital injection of tax-payers money. Indonesia tried it in 1998, without much success, Will be interesting to see if the ECB can succeed. Thanks for kind comments.

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