Coase versus Pigou and Eurozone Bank Resolution Policy
This post was written by Gregory Connor
R.H. Coase showed that public externality costs can be mitigated by completely assigning property rights (including the right to produce an externality) and then allowing everyone to exchange full-information efficient contracts. A.C. Pigou espoused a more traditional approach, in which the government uses its sovereign power to effect an efficient solution by taxing or regulating externalities.
This classic Coasean-Pigouvian distinction has relevance to bank resolution policy in the Eurozone. We show that the economic costs of bank distress can be represented as a public externality. We argue that in the case of the Eurozone (with its weak central government) the Coasean approach to mitigating this externality is superior to the Pigouvian one.
We argue that the Eurozone-wide regulator should be granted effective ownership rights that prevent private parties from writing contracts which might induce bank distress. This ownership right of the central regulator should be embodied in European law, and any private contract provisions which over-ride it should be treated as null and void. We explore the implications of this Coasean approach for bank resolution policy. It has strong implications for bank debt claims in the event that a bank approaches financial distress.