Monday, May 10, 2010

The $1 Trillion Rescue Package

It is a well known fact that as a network becomes tightly coupled, shocks felt in one node are quickly propogated throughout, and may even have disproportionate impact because the effects are cumulated.  The current crisis in the Eurozone, which threatens the financial stability of the world, provides a classic example.  The rescue package being put together to stablize the region (Spain, Portugal, and possibly Italy are under credit watch) can be interpreted as a network response to this principle and/or an exerbation of the core problem.

The movement toward economic integration is driven by the belief that integration will create efficiencies (lower barriers to trade and commerce) and thus generate greater levels of growth and welfare.  The cost is exposure to moral hazard and the resulting shock to the system.  When the U.S. military built the Internet, it was designed with redundancies to make communications lines robust against a nuclear attack.  These redundacies have the effect of loosening the tight integration in the network, so that shocks (such as a nuclear attack) in one part of the system will be absorbed locally, rather than propogated systemwide.  Such redundancies are inefficient but robust. 

A similar principle needs to be applied to the current situation in Europe.  Rather than commit more resources from the Zone to rescue packages, thus tightening the coupling between the healthy parts to the sick parts of the system, Greece, Span, Portugal and, possibly, Italy, need to be quanrantined from the Zone, for example by indexing their costs of sovereign borrowing to market rates and raising revenue production (i.e., taxes) to more sustainable levels.  The effect will be very painful and politically costly. However, a little blood letting may be necessary in order for the entire body to recover. 

The long term solution is of course to de-integrate Europe or to adopt fiscal policies that more transparently reveal the costs of domestic governmental decisions.  It is not to further tighten the screws that lock down France and Germany to the rest of their neighbors.

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