11/29/2012 01:38 pm ET Updated Jan 29, 2013

A Good Theory

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 make possibly make sense of all this? You might think that 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.

You can see both obstacles at play in Europe today. If you're German, you wonder why you should bail out the Greeks. They created their own bad luck, you might say, and should deal with the consequences. You can see the incentive argument clearly: insurance doesn't cover self-inflicted risks.

The Greeks might say instead that they've suffered bad luck and would like help from countries that have done better. If it's really luck, then Germany might send money to Greece -- and expect the same in return if the outcomes were reversed. But there's a question of commitment: after the fact, the fortunate countries have a clear motivation not to give away their resources. As you might expect, it's the more prosperous regions of Europe that are complaining the most right now. I'm not claiming either perspective is right, simply pointing out that they line up exactly with what we know about the practical difficulties of risk sharing.

The European Union and the Euro Area add to these classic obstacles some fuzziness about countries' obligations to others. The Maastricht Treaty that established the euro has a famous "no-bailout clause'' that would seem to preclude any obligation to come to the aid of countries in trouble. Presumably it was put in place to provide reasonable incentives. But the politicians behind an integrated Europe nevertheless seem to feel that some kind of help is implicit in the concept and that even countries with their own currencies should contribute.

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. And once they decide, they must make a firm commitment to paying any claims that make their list. This kind of fiscal federalism would be a big step toward European integration, and perhaps a step too far, but it's what risk-sharing calls for. It wasn't easy to accomplish in the United States, which I'm told was a plural noun prior to the Civil War. For countries of Europe -- with their different languages, histories, and culture -- it will be that much harder.

In the meantime, we see the classic obstacles to risk-sharing play out before our eyes. That's precisely the role of economic theory Mundell had in mind.

David Backus is in the economics group of New York University's Leonard N. Stern School of Business.