Crises: Principles and Policies With an Application to the Euro Zone Crisis

Economies around the world have faced repeated crises — more frequently over the past thirty years.2 The fact that they have become more frequent and pervasive at the same time that we believe we have learned more about the management of the economy and as markets have seemingly improved poses a puzzle: shouldn’t rational markets avoid these catastrophes, the costs of which outweigh, by an enormous amount, any benefit that might have accrued to the economy from the actions prior to the crisis that might have contributed to it? This is especially true of the large fraction of crises that can be called “debt crises,” precipitated by a country’s difficulty in repaying what it owes. The benefits of income smoothing (arising from the difference in the marginal utility of income in periods when income is low and when income is high) are overwhelmed by the social and economic costs of the ensuing crisis.