Wednesday, 28 April 2010

A new behavioural economics buzzword: Fudge

Martin Wolf has described the eurozone rescue package for Greece, correctly, as "a fudge".

However, he thinks this is a bad thing. Here's why it might not be.

One of the key goals in designing a rescue package is to avoid creating moral hazard - the risk that other countries look at the bailout, assume that they will be rescued too and therefore continue to borrow.

If the rules for the bailout are clearly stated, that creates an anchor which encourages people to trade up to it. The most obvious example is the Maastricht treaty rule which stated that countries in the EU must keep their fiscal deficit below 3% of GDP. Guess what size of deficit most countries ended up with? Around 2.9% was a pretty common figure.

So if the rules for the rescue were made explicit, it would give governments very clear guidance on exactly what risks they could take. Inevitably, some would be tempted to push it to the limit - and fall over that limit, in the knowledge that the rescue would come. Just as a person with theft insurance on their mobile phone is tempted to take a little less care with the handset than someone without.

Inviting the IMF to participate in the rescue is a superb way to make sure the rules can never become clear. Politically fickle as European countries might be, their interests are quite correlated. If it becomes obvious that it is in Germany's interest to bail out Greece, it will be equally obvious that they would bail out Portugal too. And if it's in Germany's interest, it's in France's, Holland's and (to a lesser extent) Italy's and Britain's as well.

But once the IMF gets involved, things become a whole lot trickier. The IMF is just political enough to be unpredictable. What's more, it's strongly influenced by Japan and especially by the US, whose Congress is a law unto itself. Literally.

Suddenly it becomes a much more dangerous game for Portugal or Spain to play - yes, they might have Germany over a barrel, but would the US endorse an IMF rescue which might end up including a third of the eurozone? Nearly inconceivable. And yet...not completely impossible either. If the prospect of rescue were completely removed, Spain and Portugal might be locked out of the bond markets utterly. This way, they can gradually reduce their deficits, knowing that they better not take too many risks.

The unpredictability makes it really tough for governments to play chicken with the bond markets. And makes it likely that sovereign bond investors will provide their own discipline on governments, by increasing the interest rates they expect on debt.

We all know the way to end a game of chicken: rip your steering wheel off. The problem is that the other person then drives off the road. By leaving the steering wheel in place, but taking their hands off it, the EU and IMF are frightening us into playing a bit safer than we otherwise would, without shutting down economic activity completely. Fudging might just be the way to keep the eurozone economy operating. And not for the first time.

1 comment:

Min said...

"What's more, it's strongly influenced by Japan and especially by the US, whose Congress is a law unto itself. Literally."

"America has no permanent criminal class -- except Congress."

-- Mark Twain