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'In the end, soft options generally cause the most pain.'</blockquote>
The Perils of BailoutsBy Martin Hutchinson
December 06, 2010
SourceThe EU bailout of Ireland and its previous bailout for Greece, when examined closely, bore a distressing resemblance to the 2008 U.S. bailouts of Bear Stearns, AIG and Citigroup. The authorities poured more resources into assets that had been shown to be defective, without sufficiently enforcing the painful purging and liquidation that was necessary. By doing so, they reduced wealth, prolonged recession, and made the eventual collapse of the global financial system more likely.
The parallels between the EU financial crisis and the U.S. housing finance crisis are closer than they seem at first glance. In the Austrian economic terminology, both involved "mal-investment" –caused by excessively low interest rates or often artificial government subsidies–in assets and activities that later turned out to be worthless, or nearly so. Indeed, the parallel is increased by the prevalence of fraud and corruption in both cases. In the U.S. crisis, part of the mal-investment was in housing itself, through the encouragement of endless McMansion developments–houses that were not worth their cost the day they were built, and because of their poor construction quality will deteriorate exceptionally rapidly. The other part, in home mortgages, a substantial portion of which were obtained by fraud, has been extensively anatomized elsewhere, but it is by no means clear that the eventual losses on home mortgages will be any larger than those on the houses themselves.
In Europe, the areas of mal-investment varied from country to country. In Ireland, Spain and Britain, the problem was partly one of housing finance as in the United States. In Britain planning restrictions limited the creation of housing mal-investment directly, causing a housing price run-up even more extreme than in the U.S. In Ireland and Spain both housing and housing finance caused problems, with low interest rates on euro borrowing playing a similar role in those countries to the over-expansive monetary policies of Fed chairmen Alan Greenspan and Ben Bernanke. (The euro's critics here overstate their case in my view; while the euro was over-stimulative for much of the eurozone, foolish U.S. policy created interest rates that were too low for the entire United States, not just part of it.)
The Irish government, by taking the entire liabilities of the Irish banks on its books, created a funding problem for itself that it could have largely avoided. However in Spain and Greece the mal-investments were greater and more complex. In Spain the socialist Zapatero government subsidized "green" energy investments through energy tariffs to the point where the subsidies represented 24% of the nation's energy bills. Since the "green" energy production facilities now appear unlikely to be cost-competitive even by 2014-16, the investments brought to life by those subsidies represent mal-investment in its purest form.
In Greece, the gigantic subsidies poured into the place by its unfortunate EU partners since its accession to the community in 1981 have resulted in the grotesque overpricing of the undereducated, corrupt and idle Greek workforce. Essentially, pretty well all investment in Greece in the past decade or so has been mal-investment.
In general, European public sectors have directed taxpayer and investor money into infrastructure and other boondoggles, not all of them green, which fall within the Austrian economists' "mal-investment" definition. Whereas $1 billion poured into welfare is merely money wasted, $1 billion used to subsidize $5 billion in mal-investment multiplies the damage and creates an unproductive asset that is long-lasting and continues to suck wealth out of the economy. The EU itself, with its tied loans and incentives for politically fashionable waste, has contributed greatly to this excess, providing an additional layer of funding that is subject neither to commercial nor to taxpayer sanction. With universal cheap money since 2000 and decreased taxpayer sensitivity to budget deficits following the creation of the euro, mal-investment in Europe has run riot. It is thus not surprising that in the EU as in the U.S. financial market of 2008, financial crisis is now approaching.
The public sector mal-investment problem is not confined to Europe. In the United States, budget disciplines that had played a valuable role until 1998 were abandoned with the arrival of Dennis Hastert (R.-IL) as House of Representatives Speaker and George W. Bush as President. As in Europe, the greatest damage was done by schemes of subsidy and guarantee, which created far more in mal-investment than their nominal "on-budget" amount.
The parallels between the two crises also extend to leverage. As in U.S. real estate lending, traditional norms of government finance were thrown out during the recent crisis, in order for more mal-investment to be financed. In this respect, the 2009 global "stimulus" frenzy was a mal-investment orgy. "Rich country governments cannot go bankrupt" must join "House prices never fall" as a mantra by which foolish bubble-era financiers and investors comforted themselves.
Particularly in the last couple of years, the parallels between those involved in government finance and the principals in the sub-prime meltdown are startling. Like Angelo Mozilo, the chief executive of Countrywide, President Obama and Nancy Pelosi brought new levels of aggression and financial overstretch to the financing of their mal-investment schemes. As for Bernanke, in his willingness to ignore past norms and bring manic creativity to his mal-investment-enabling financial innovations, he resembles nobody more than "Fabulous Fab" Tourre, the Goldman Sachs employee who worked with the bearish hedge fund billionaire Hank Paulson to design "synthetic CDO" bonds covering toxic but non-existent home mortgages for sale to foolish European banks. (One is indeed forced by the comparison to wonder whether Bernanke refers to himself in private e-mails as "Brilliant Ben" or some such!)
In the European crisis, we now appear to be entering a period like the second half of 2008 in the banking crisis. Each bailout, whether of Bear Stearns followed by Fannie Mae and Freddie Mac, or of Greece, followed by Ireland and maybe Portugal and Spain, makes the market move on to the next weakest member of the group, increasingly confident that the crisis will become uncontainable. Each crisis makes the next crisis more likely and weakens the system as a whole until it becomes clear that even the soundest entities, JP Morgan Chase or Germany, may have become so riddled with mal-investment that they too are in danger. Eventually, as on the weekend of September 15, 2008, it will become clear that a general rescue is necessary, with perhaps one unfortunate victim, in that case Lehman Brothers, in this case (if you asked me to guess) maybe Spain, allowed to face bankruptcy and ruin.
There is however one enormous difference between the two cases. In the U.S. banking system crisis U.S. taxpayers were available, willingly or not, to provide an unquestionable source of funding for the system, which eventually was able to quieten doubts and bail the banks out with little change in their operations and (so far) apparently only modest losses.
In the case of EU countries, there is no such slush fund of last resort. German taxpayers are rich enough to bail out their own country's problems, such as the reunification of East Germany (though even that put a huge strain on them). However it is inconceivable that the hard-pressed German taxpayers, underleveraged, cash-rich and cautious as they are, could afford to rescue the whole of Europe in a crisis.
There is thus a significant probability that the European crisis, if it spread to Portugal, Spain, Italy and possibly other countries, could result in a global meltdown of bond markets. After all, when looked at critically, the budget position of the United States is no better than that of the more feckless EU countries, while several of its states are close to bankruptcy. Japan too has debt levels so high that its credit would be questionable in any crisis. Rich country government debt, since 1694 considered the safest of all assets, could be forced into write-down as rollovers proved impossible. If that happened, the global economy, in which confidence would have vanished, would almost certainly descend into a recession that would rival the Great Depression and might well prove permanent as overpopulation, resource and environmental problems overwhelmed its ability to recover.
That is the ultimate danger of bailouts. Without an available "slush fund of last resource" they run the risk of producing a global meltdown in which bonds become worthless and confidence is lost forever. Arguably, the U.S. financial system would be in better shape today if Bear Stearns had been allowed to go bust in March 2008, bringing on recession six months earlier and forcing Lehman, Citigroup and AIG into emergency restructuring. The cost of such restructuring to bondholders and the U.S. economy would have been severe, but the financial system and economy that emerged would have been sounder. Had the world avoided both restructuring and government "stimulus," the economic picture today would be far less troubled.
Much more certainly, Greece should have been allowed to default last spring, with forcible exit from the euro, while Ireland should have been forced into at least a limited default on its guarantee of bank obligations. Again, the losses across Europe would have been large, and the deflationary effect on troubled countries like Portugal and Spain would have been severe – indeed it is possible that one or more of those countries would also have been ejected from the euro, although probably without default as their debt levels are moderate. However such a limited default would have avoided the ultimate risk, that of a full eurozone meltdown, to be joined by Japan, Britain and the United States in universal rich country default.
In the end, soft options generally cause the most pain.