The Cult of Bailout

 

What single word best characterizes policy responses in this on-going financial crisis? “BAILOUT”.

It goes something like this. You take a lot of risk and reap lots of rewards (be it in pay, bonus, or social programs). You get into trouble. The government bails you out.

How often have we seen this same story repeating? It seems like we are in an infinite loop.

But we aren’t. This cannot last forever. The bailouts have many implications – some seen immediately and some will play out later.

On the positive side, bailouts buy time and short-term stability. Importantly, we see the results immediately. A good example was the big jump in world stock markets when the EU announced its 750 billion Euro bailout.

On the negative side, the list is longer. Also importantly, you do not see the results immediately. Here are a few of the implications:

  1. Moral hazard. When you reward people for taking risk or going beyond their means, you will perpetuate this type of behavior in the future. That is, the cost of the bailout is not just the immediate cost but also the cost of new future bailouts that become more likely as a result of the current bailout.
  2. Throwing good money at bad. We tax the productive assets to support the failed assets. Whether it is the U.S. government throwing away money on GM, Fannie or Freddy, or the German people paying for unrealistic social programs in Greece, the effect is identical. This reduces future growth opportunities in the productive economies. Think of it this way. Would you prefer to invest in a U.S. tech start up that is risky or buy some overpriced Greek assets.
  3. We have to pay for it. It is naive to think that we can simply roll over debt forever. This is exactly what Greece thought. Please note that the size of the U.S. government deficit to GDP is not much different than Greece’s. [However, to be fair, the U.S. is in a much stronger starting position - but does face some similar risks.] Government debt financing competes with corporations trying to raise money. Corporations are forced to offer higher yields as more and more government debt floods the market. Increased borrowing costs means that fewer investment projects are viable. Less corporate investment leads to lower growth opportunities and lower long term growth for the economy in general. Lower growth means a smaller number of jobs.
  4. Who are we really bailing out? Yes, the EU package has drastically reduced the cost to the Greek government (and other peripheral countries) of financing their debt. However, the main beneficiary are the banks and investment funds that hold the sovereign debt. They foolishly overpaid for this debt. Effectively, they thought Greek sovereign debt had the same risk as German debt. That was their mistake. However, the bailout makes them whole. That does not make any sense to me. They made a mistake and they are made whole. Remind you of AIG? Yes. It is the same thing. People that did business with AIG misestimated the “counterparty risk”. But no big deal. The government will make you whole.

I have some other thoughts.

The PIIGS Bailout

I don’t get it. I don’t understand the market reaction.

Before I forget, the IMF has pledged 250 billion Euros. The U.S. share is 17.09%. Hence, the U.S. has ponied up 42.7 billion Euro or about $55 billion. This does not include the potential costs of opening up the swap lines again. I haven’t seen much talk about this. Is this the best use of our $55 billion?

I am not going to rehash all of the arguments. Basic macro suggests that when you join currency union (or if you peg your currency) you give up your monetary policy. In the Greek crises in the 1970s and 1980s, a simple response was that the Drachma was devalued. This effectively meant the cost was shared by the people of Greece (higher inflation is like a tax) and the international investors who bought risky assets that were all of the sudden worth a lot less.

While giving up your monetary policy seems like a cost, in some situations, it is a good thing. The Greek monetary policy had no credibility. Given their track record, people did not believe their central bank when they said they would control money growth (and inflation). As a result, it was expensive for both the Greek government and Greek corporations to raise money. The currency union solves this problem and gives instant credibility – and lower interest rates which could spur growth in Greece (and other countries that benefit with lower financing costs).

All this is fine in theory. However, to get the currency union to work – there must be enforcement mechanisms. As we know now, there were no enforcement mechanisms. As a result, some countries continued to spend and got into a terrible mess. The EU was powerless and had to bring in a “bad guy” — the IMF to do a clean up job.

The lesson is not a new one. The currency union does not work without a political union (or at least enforceable actions that, by definition, infringe on sovereignty).

But now we are at the point that I do not understand. Germany had a highly credible monetary policy before the Euro. As the largest and strongest economy, it now has to pay for all the countries that go offsides.

Consider the major benefits for Germany.

It is a fact that Germany depends on trade. A common currency makes trade easier. However, in this age of electronic FX trading, it really doesn’t seem like that big of a deal. That is, yes it decreases the transaction costs of trading goods, but isn’t this saving more than offset by the bailout costs?

It is a fact that Germany is the largest and strongest economy in Europe. A common currency would mean that the Bundesbank would effectively be controlling the monetary policy in Europe. The volatility of some countries’ monetary policies was disruptive to Germany. But surely the disruption caused by these small countries are small change compared to the massive bailouts the Germans are sponsoring.

The Euro was but one step in a series of EU measures that levels the playing field in Europe for corporations. That is, the cost of trading is not just the cost of converting DMs into FFs. For example, some German goods might not be competitive in France because of French government subsidies. The level playing field would directly benefit German trade. However, and this is crucial, you don’t need to have a common currency to have a level playing field in terms of the regulatory and government environments. Indeed, a recent research piece that I am writing shows that most of the benefits to Europe came from standardizing regulations – not from the introduction of the Euro.

Consider the costs.

These are well known. I do not want to go through the list which is constantly in the press. Let me make just a few remarks.

  • 750 billion Euros does not solve the problem. It just buys time. Maybe three years. Maybe less.
  • Who believes a key assumption in the IMF plan that Greek government revenues will increase by 10% in the next year?
  • Why do the politicians and the press characterize the Greek legislative changes as “bold” and “drastic” when you move the retirement age to 65? Move it to 70 — that is drastic.
  • The social programs in these countries are more generous than U.S. programs. We are struggling to pay for the upgrade in our coverage but must shell out more than $50 billion to support the social programs in these failed economies.
  • The program is being sold in Europe as “no taxpayer money” because a special purpose vehicle (SPV) will be set up to issue the debt. That’s exactly one of the problems with the U.S. financial institutions during the crisis — so much was “off balance sheet”. The bottom line is that Europe guarantees – hence, the taxpayer is on the hook.
  • Do we really think the government of Greece and other countries (and the people in these countries) have the will to take tough medicine (knowing that there is a culture of bailouts)?
  • The ECB while buying some sovereign debt has pledged to “sterilize” these purchases. Central bank buying of government debt is the same as printing money. Sterilizing undoes this money creation (usually done via reserves). I do not see a scenario where the ECB will do any substantial “quantitative easing” aka “printing money”. The Germans have a strong historical memory of what happens when debt is monetized. During the Weimar Republic, you needed a wheel barrow filled with cash to go to the store. In 1923, one ounce of gold cost US$20 but cost 87,000,000,000,000 Marks!

 

Enough complaining. What to do?

The solutions are not easy. I am an advocate of short-term pain for long-term gain. Essentially, you drastically restructure (i.e. partially default) the debt. This means that the investors share the burden. As a result, you do not need 750 billion Euro.. Given the EU has no current mechanisms to enforce, you still have to rely on the IMF for some bridge financing. The financing carries very strict conditions (much more aggressive than the proposals on the table).

In order to survive as a common currency, the rules of the Euro Zone must change.

Greece is put on a three year probation period for the Euro. If certain conditions are not met, they go back to the Drachma.

Going back to the Drachma, would also serve to revalue the sovereign debt. The Greek government would likely change the currency of their sovereign debt to Drachma effectively (partially) defaulting.

How dramatic is this? You don’t have to go back in history that far to see that the U.S. did the same thing in 1971. In a speech on August 15, 1971 President Nixon suspended the convertibility of the dollar (at the time it was fixed so that $35 bought an ounce of gold). This immediately revalued U.S. debt because gold was trading in the $40 range.

Same for the peripheral countries – and the main countries in the Euro Zone. Any country offside automatically goes out of the EZ. Every member faces the same deadline as Greece to put their house in order. The mechanism is quantitative and not subjective. No exceptions are allowed.

Countries must stay out of the EZ for three years and then are eligible to reapply.

Yes, this will cause problems for some banks that hold the sovereign debt. The weak ones might fail. However, the economies will be benefit from the purging of weak banks and the reallocation of their productive resources to make other banks stronger.

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One Response to The Cult of Bailout

  1. Fab says:

    Campbell, small detail:
    During the 1923 hyper-inflation in Germany the currency would have been just the Mark (also aptly known as the Papiermark = paper Mark), not Deutsche Mark (DM).

    To end hyperinflation, the Rentenmark was introduced at the end of 1923 (followed a year later by the Reichsmark). Good old Deutsche Mark (DM) came about only after WW II in 1948.

    (As you see, that episode is indeed well remembered – my grandmother told me about it many times.)

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