2007 Nobel Prize in Economics – What Mechanism Design Theory Says About Europe’s Financial Stability Framework

in collaboration with Martin Čihák, IMF

By awarding the 2007 Nobel Prize in economics to Leonid Hurwicz, Eric Maskin, and Roger Myerson, the Royal Swedish Academy of Sciences highlighted the importance of mechanism design, an arcane-sounding theory with numerous practical applications. The Academy mentioned applications to trading mechanisms, regulation schemes, and voting procedures. But mechanism design theory also has important applications to international economic policy making that have been somewhat overlooked.

National macroeconomic and financial policies can have substantial repercussions on other countries. These cross-border linkages have only grown stronger in today’s globalized economy. A better understanding of these linkages, and their repercussions for internal policymaking, can thus have very practical, real-life implications. A good example is the globalization of financial institutions and its implications for international financial crisis prevention, management, and resolution. This globalization has appreciable benefits for the efficiency of the international financial system. However, it also comes with new risks.

Specifically, financial systems are more prone to transmit shocks across markets and activities, such as the tremors in the US subprime mortgage market. The issue is particularly pertinent for EU countries because of their commitment to financial market integration, their specific cross-border regulatory set-up, and the emergence of pan-European financial institutions. The scope of these institutions’activities is EU wide but legal, regulatory, and supervisory jurisdictions are national and so is accountability to the public. National confidentiality rules, for example, mean that prudential authorities have access to different information and no authority has a complete overview over prudential developments in all of Europe’s major financial institutions.

In the words of EU Commissioner Mc Creevy, when a crisis hits, “it could be a case of ‘grab what you can get,’” and “in a worst case scenario supervisors will ring fence assets in entities they supervise––preventing them from being used in other parts of the group where they may be needed, for example for collateral provision.” In short, in the hope of limiting the damage to their country’s public purse, nationally-minded supervisors and policymakers may well do severe and unnecessary damage to EU taxpayers as a whole. The key point to consider is that policymakers are not facing a zero-sum game: a collective solution would very likely lower overall crisis costs.

Here’s where mechanism design comes in. Is there a way to ensure that, despite each following potentially different national interests, all policymakers reach the equivalent of a cooperative, least-cost solution in a crossborder crisis, which is essentially a one-shot game? Mechanism design theory highlights the difficulties in doing so, especially in complex situations where policymakers differ in their preferences and have different informational advantages over one another. One of the findings of the theory is that with “self-centered” behavior (i.e., behavior reflecting national preferences), private information (information that is available only to the authority in one country), and policy spillovers across borders, there is very likely no mechanism that makes each country policymaker confident that he can act in the common good without risks or costs to his national economy.[1]

This result of the mechanism design theory implies that, to maximize their well-being, interconnected countries need to devise policy frameworks that internalize the spillovers their policies have on each other, thereby limiting “self-centered” behavior that is costly to others. This entails accepting more joint responsibility and accountability. Returning to the above example of EU financial stability, it is reassuring that this seems to be the direction in which European policymakers intend to move, as illustrated by the October 9, 2007, Economic and Financial Affairs Council (ECOFIN) agreement. The ECOFIN adopted a set of common principles for cross-border financial crisis management in cases with a potential systemic dimension.[2] The principles underscore the need for much closer cooperation between national authorities, in the interest of the common good.

Concretely, they impose joint responsibility by prescribing that cross-border crisis management should aim to protect the stability of the financial system in all countries involved and in the EU as a whole, at the lowest overall collective cost. They internalize spillovers by arguing that the direct budgetary net costs resulting from managing a crisis should be shared between the affected countries, on the basis of equitable and balanced criteria. The lesson of the mechanism design theory is that these laudable intentions need to be operationalized to ensure cooperative behavior. For the sovereign EU states this will necessarily entail sacrificing more national authority for their common European good. The question now is how far policymakers are prepared to go.

[1] See the ECOFIN meeting materials at www.consilium.europa.eu/ueDocs/cms_Data/docs/pressData/en/ecofin/96351.pdf.

One Response to "2007 Nobel Prize in Economics – What Mechanism Design Theory Says About Europe’s Financial Stability Framework"

  1. eparisi   October 30, 2007 at 3:03 pm

    from the FT: http://www.ft.com/cms/s/0/05b34256-648a-11dc-90ea-0000779fd2ac.html“Jean-Claude Trichet, the European Central Bank president, was among those who argued at the weekend meeting of ministers and central bankers in Porto, Portugal, that it would be wrong to be inflexible and fix rules in advance for cross-border bail-outs. … He praised the decision to adopt common principles for crisis management, saying: “The agreement is acceptable for us because it does not comprehend an ex-ante burden-sharing concept. … Charlie McCreevy, the EU’s commissioner for the internal market and an expert on financial regulation, acknowledged that the EU needed to address the question of who should bear the burden of a bank rescue in more depth.”Who is right? Why?