Static Rules in a Dynamic Game

I promised a review of Was the euro a mistake… and does it have a future? I have given myself a couple of weeks to read the monograph,  which came with the discussion. Along with a history and analysis of the problems associated with the Euro zone, essentially 3 solutions were presented:

My personal preference is no doubt  Kevin Dowd’s, which  suggest a complete Free Banking Solution for the Euro zone. The main advantage would be that this would abolish the need for state support within the banking industry. Many say the Free Banking option is unrealistic.

My fear, therefore, is that we are on the inevitable road towards more state support and ever closer dependence.  The main problem of this ever closer dependence is the bad incentives. The ECB, itself, has rightly points out that the current system has many bad incentives built in. Currently the bad economic and fiscal decisions of one country is borne by the whole euro zone leading to a typical “tragedy of the commons”. The optimal strategy, perversely, is for every politician not to bear the individual political burden of economic reform, as they can shift the a large part of the costs of excessive public pampering the all the other members.

The solution according to Bodo Herzog and Katja Hengstermann are enforceable (political) rules. They suggest that countries that do not comply should loose their ability to vote and that this should be put into a constitution like framework to create automatic and credible enforcement mechanism. This could work in the short-run, however, there is no way of knowing what the economy will be like in a year let alone a decade. It is therefore impossible to write rules for every eventuality. The danger is that with every minor crisis more and more rules will be written. This would mean that support for “intergral industries” (read lobby groups) would be all to easy.

The real solution, however implausible it may seem is to depoliticize monetary policy completely and to go back to the future of free banking.  We should remember that Free Banking served society well in the past. These systems did not end due to economic crises. They ended due to government enforcement due to a desire to monopolize money creation and wars.