The real reason Europe can’t find a way out

“Sunken cost bias” – the same thing that’s keeping UK house prices unrealistically high – could be the hidden force undermining the efforts to stop Europe sinking.

Why is it so hard to find a way out of the euro crisis? (Image: Fotolia)

Hundreds of billions of good money are being poured after bad in Europe. Economists, bankers and politicians have been scratching their heads for months coming up with any idea they can to try and dig themselves out of the hole they’ve found themselves in.

But despite all the money, time, effort and thought that’s gone into solving the problem, things just seem to be getting worse. This week alone a €100 billion investment in Spain’s banks only resulted in its debts becoming more expensive than at any time since it joined the euro and ratings agency Moody’s saying the country could reach “junk” status inside three months - effectively saying it was more risky than not to invest in.

But the problem is straightforward and there’s a way out, if only those in power could get over a simple stumbling block.

That’s the conclusion Lee Freeman-Shor, a veteran of the financial industry who currently manages more than £640 million of assets in award-winning funds at Skandia.


What is it then?

Freeman-Shor has identified Europe’s leaders of falling prey to the same hang up that’s keeping UK house prices at unrealistic levels – sunken cost bias.

“Sunken cost bias is a devastatingly powerful behavioural trait and it’s one which in my view is causing much of the paralysis that European policy makers currently demonstrate,” he said.

“Quite simply this bias conspires to make European leaders unable to make objective decisions during times when they are losing the battle and it ultimately results in the person under its influence doing nothing.”

It sounds complicated, but it’s really not.

“Imagine you bought a house in 2007 for £500,000. Now in 2012, five years after your initial purchase you decide you want to sell and I make you an offer of £350,000. Would you sell?
 
“Behavioural psychology suggests you would find it very hard to sell your house to me no matter how much you wanted to move. The loss of £150,000 would weigh on you mind - it influences your decision. You are under the spell of sunken cost bias. Furthermore, as you anchor to the £500,000 you paid you would conclude there is more upside to staying put than moving - which is known as ‘disposition effect’,” he explained.

“For European leaders, Greece, and Southern Europe, is rather like that house. They have invested a lot of money in it, regret ever purchasing it, are very reluctant to spend one more penny on upkeep, but given the loss incurred they do not want to sell. The eurozone crisis is a classic example of sunken cost bias at work on an international scale.”

So what’s the solution then?

Trying to weld a series of different countries, with different taxes, benefits and economies to a single currency was never going to work out long-term.

It’s been tried before and failed before: Most notably a 10 years ago when Argentina pegged the peso to the US dollar and closer to home 20 years ago when Britain crashed out of the euro’s predecessor the Exchange Rate Mechanism.

To have a single currency you need to have a single economy to back it up.

That means to solve this problem you need to accept that the rich nations must either fully back those struggling or cut them loose and let them recover. That would mean either a lot of money flowing from places like Germany to Greece, Spain and Portugal (and possibly Italy, Ireland and even France) or those unable to pay the bills being set adrift.

To do either thing would require a comprehensive solution and that means strong leadership, clear thinking and decisive action. Something that sunken cost bias is undermining.

“Quite simply this bias conspires to make European leaders unable to make objective decisions during times when they are losing the battle and it ultimately results in the person under its influence doing nothing,” Freeman-Shor said.

And doing nothing when things are going wrong is very rarely a plan that works out well for anyone.