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Hostages, free lunches and institutional gaps: the case of the European Currency Union

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  • Günter Franke

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Abstract

This paper argues that the strong member states of the European Currency Union are hostages of a financially distressed member state so that they are compelled to provide financial support. Moreover, due to the dynamics of the interaction game, a debt relief is a free lunch for the distressed country. This fosters moral hazard of distressed countries. In the absence of capital market control, European politics do not effectively monitor fiscal politics of member states. The lack of a long term strategy of the European Currency Union to deal with distressed states has undermined the credibility of politics. This lack is also explained by a lack of a European Insolvency Charter. A viable Union requires such a charter with rules for handling distress. Moreover, politics should determine a mechanism to coordinate politics and capital markets in their monitoring of fiscal and economic policy of member states.
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Suggested Citation

  • Günter Franke, 2012. "Hostages, free lunches and institutional gaps: the case of the European Currency Union," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 61-85, March.
  • Handle: RePEc:kap:fmktpm:v:26:y:2012:i:1:p:61-85 DOI: 10.1007/s11408-011-0176-8
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    References listed on IDEAS

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    1. Carmen M. Reinhart & Kenneth S. Rogoff, 2011. "From Financial Crash to Debt Crisis," American Economic Review, American Economic Association, vol. 101(5), pages 1676-1706, August.
    2. Sayantan Ghosal & Marcus Miller, 2003. "Co-ordination Failure, Moral Hazard and Sovereign Bankruptcy Procedures," Economic Journal, Royal Economic Society, vol. 113(487), pages 276-304, April.
    3. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
    4. Hans-Werner Sinn & Kai Carstensen, 2010. "Ein Krisenmechanismus für die Eurozone," ifo Schnelldienst, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 63, pages 01-17, November.
    5. Franke, Gunter, 1991. "Exchange rate volatility and international trading strategy," Journal of International Money and Finance, Elsevier, vol. 10(2), pages 292-307, June.
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    More about this item

    Keywords

    European Currency Union; European Insolvency Charter; Hostages; Free lunch; Externalization hypothesis; E62; F36; F53; H30; H60;

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F53 - International Economics - - International Relations, National Security, and International Political Economy - - - International Agreements and Observance; International Organizations
    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General
    • H60 - Public Economics - - National Budget, Deficit, and Debt - - - General

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