08 June 2010

Why Governments Cannot Contain the Crisis

I am just posting an excerpt from the Ludwig von Mises Institute which I felt very relevant about the Greek bailout.
Can this €110 billion bailout of Greece, combined with the €750 billion of additional promised support, stop the sovereign-debt crisis, or have we crossed the point of no return? There are several reasons why political solutions may be incapable of stopping the spread of the sovereign-debt crisis.
1. The €110 billion granted to Greece may itself not be enough. What happens if in three years Greece has not managed to reduce its deficits sufficiently? Greece does not seem to be on track to becoming self-sufficient in just three years: it is doing, paradoxically, both too little and too much to achieve this. It is doing too much insofar as it is raising taxes, thereby hurting the private sector. At the same time, Greece is doing too little insofar as it is not sufficiently reducing its expenditures. In addition, strikes are damaging the economy and riots endanger the austerity measures.
2. By spending money on Greece, fewer funds are available to bail out other countries. There exists a risk for some countries (such as Portugal) that not enough money will be available to bail them out if needed. As a result, interest rates charged on their now-riskier bonds were pushed up. Although the additional €750 billion support package was installed in response to this risk, the imminent threat of contagion was stopped at the cost of what will likely be higher debts for the stronger EMU members, ultimately aggravating the sovereign-debt problem still further.
3. Someone must eventually pay for the EMU loan at 5 percent to Greece. (In fact, the United States is paying for part of this sum indirectly through its participation in the IMF.) As the debts of the rest of the EMU members increase, they will have to pay higher interest rates. Portugal is paying more for its debt already and would currently lose outright by lending money at 5 percent interest to Greece. As both total debts and interest rates for Portugal increase, it may soon reach the point where it cannot refinance itself anymore. If Portugal is then bailed out by the rest of the EMU, debts and interest rates will be pushed up for other countries still further. This may knock out the next weakest state, which would then need a bailout, and so on in a domino effect.
4. The bailout of Greece (and the promise of support for other troubled member states) has reduced incentives to manage deficits. The rest of the EMU may well think that they, like Greece, have a right to the EMU's support. For example, since interest rates may stabilize following the bailout, pressure is artificially removed from the Spanish government to reduce its deficit and make labor markets more flexible — measures that are needed but are unpopular with voters.
Sovereign-debt problems, therefore, may have reached a point beyond remedy — short of default or high rates of inflation. It is likely that with the bailout of Greece we have already passed this point of no return.