A Simple Explanation of the Eurozone Crisis

One of the main purposes of government rules and regulations is to establish who in society takes a loss when things go wrong. Tort rules determine who pays for the damages, contract rules establish who pays after a contract is breached, and Bankruptcy rules establish who gets paid and who ends up holding the bag once a company goes south.

An acceptable rule will have a procedure in place enabling someone to determine who will take the loss. A good rule will make it clear ahead of time who will take the loss. An even better rule will assign the loss to a party who can sufficiently bear the risk of loss. A great rule will also assign the loss to the party who is in the better position to prevent the precipitating event that creates the loss. The best rule will do the above and also be perceived as generating an equitable and acceptable resolution by those governed by the rule.

With the exception of Lehman Brothers, the 2008 financial crisis made clear that in the United States the tax payers would bear the loss generated by a failure of one of the major financial institutions. The tax payers were able to sufficiently bear the risk of loss, but were not in a great position to prevent the precipitating event that created the loss. As a result, we were able to resolve the banking crisis, but our system was clearly tainted by moral hazard. Dodd-Frank was meant to deal with that moral hazard but it probably doesn't.

Europe's crisis has lasted a lot longer because they have no rule to establish who takes the loss. Beyond that, they don't even have a political process that can adequately assign the loss on an ad hoc basis. This is why the Eurozone, with a GDP of 9.5 trillion, is being held up by the fact that they can't find the extra 7 billion to bail out Cyprus' banks. None of the parties involved (the German tax payers, The Cypriot depositors, the Russian depositors) are willing to take the loss, and their is no clear way to determine who should take the loss.

Europe's economy isn't perfect. But it's current problems aren't economic, they reflect political institutions unable to effectively assign loss.