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Theory and Reality in Europe

By David Backus, Heinz Riehl Professorship in Finance and Economics and Department of Economics Chair

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Perhaps the central challenge for the future of Europe is to decide which risks qualify for insurance and which do not. Their choices must balance insurance with incentives.

Europe these days is more complicated than an episode of Homeland. Last I heard, Germany was still pushing austerity while Greece and Italy complained about its effects. Silvio Berlusconi offered to return if someone could help him with his tax fraud conviction. Catalonia threatened to leave Spain but remain in Europe. David Cameron suggested the European Union headquarters in Brussels ""continues to exist as if in a parallel universe,"" in part because its idea of austerity is to increase the workweek from 37.5 hours to 40.

How can we possibly make sense of all this? You might think we need to know more about the particulars of the situation to weigh in, but I'd say the opposite is true: we need some good theory to sort it out. And, as Canadian economist Robert Mundell once argued, realism is the enemy of good economic theory.

So let's step back for a minute and think about Europe when we strip away the clutter. An economic theorist might view Europe as an illustration of what economists call ""risk-sharing"": activities that spread or share risk across individuals so that everyone bears only a small amount. Fire insurance is an example. You buy insurance to protect you if your house burns down. The risk is spread across the other people buying the same product. The Amish, I understand, accomplish the same by collectively building a new house for anyone whose house burns down. The stock market performs a similar function. If you buy a diversified portfolio of stocks, you bear only a small part of the risk of any individual firm.

Risk sharing is a worthy goal of an economic system, but there are two classic obstacles in the way: incentives and commitment. Incentives have to do with the source of risk. Fire insurance isn't insurance if you burn down your own house. Most countries have laws against this, and other laws that prohibit collecting insurance if you do. They're not perfect, but you can see why they're there. Commitment has to do with fulfilling the terms of the contract. If you pay the premiums, the insurance company is obligated to cover you if your house burns down. The company might very well prefer not to honor your claim, but the laws of the land -- and their own reputations -- generally make sure they do.

Read full article as published in The Huffington Post