Thursday, May 24, 2012

An explanation of moral hazard that even Angela Merkel can understand

So, Europe still doesn't want to face up to the Euro crisis. In simple terms, the contours of the problem are that a) there will be depression and potentially meltdown if the Southern European debt crisis isn't resolved and b) resolving the Southern European debt crisis would create moral hazard. So we will have a) because we don't want the outcome of b). This takes the superficial form of pretending that beating up on Greek politicians will improve their economy and solve the debt problem.

The trouble is that a) also creates moral hazard, and b) doesn't necessarily exacerbate it. The former is shown by the experience of Lehman Brothers, which I blogged about at the time (yes, this blog is well into middle age in blog years). The catastrophic effect of the Lehman collapse more or less ensured that western governments would never let a major financial institution fold ever again. So the moral hazard effect was the opposite of what  we expected. If Greece is allowed to collapse, it will most likely create major upheavals in the financial system, and policymakers are very likely to decide, a la Lehman, that they don't want to go through that again. So Spain, Italy and the rest will feast on moral hazard.

The second point is that Greece being bailed out now would probably not have anything like the perverse moral hazard effects people like Merkel fear. After all, Greece has been in recession for 5 years, has living standards that are back to those of a decade ago, 25% unemployment, and a future of stagnation ahead. Do we really think Greeks will interpret a bailout as an invitation to spend like crazy and have to go through the whole experience again, just because in the end they were bailed out?

Of course, the real problem with the moral hazard argument is that we are not talking about a person, but a country. If Greek institutions suck, it's because Greece has not managed to create good institutions. Do individual Greeks need to be impoverished in order to encourage them to overcome all their collective action problems and build a Swedish/German style state? Do we really think it's that simple? Decades of political science literature still leaves us pretty uncertain about how you get good institutions. Although one thing we do know is that they are usually correlated with economic progress rather than collapse.