Friday, April 30, 2010

The Irrational Reasonings About "Bailouts"

The tragicomical thing about the Greek debt crisis is that for from being impossible to solve , the most rational solution is very easyily achieved. As I wrote before, if only Germany and other countries perceived by the currentlty dysfuctional bond markets as "safe" would engage in mutually beneficical arbitrage, then the crisis would end quickly, enabling Europe's economy to recover.

The most likely scenario at this point is that Greece will in fact receive the necessary financing. Just who will provide it and at what terms is not clear at this point, but it nevertheless seems likely (though not certain) to arrive.

But regardless of whether it will arrive and in what form, what should be clear is that it should arrive.

Opponents in particularly Germany, but also in Holland and other euro area countries, often try to portray it as Germany and other euro area countries paying for Greece's irresponsible ways. If that had been the case, then such a deal would indeed have been unjust. But that is simply not true for several reasons, including the ones I mentioned in my previous post, namely in short:

1) Because Greece still pays a lot higher price than other countries (such as Britain) with similarly irresponsible behavior, it won't create any moral hazard.

2) Because Germany and other lenders in this arbitrage arrangement will receive a higher interest on the money they lend than the money they borrow, they will in fact earn money, meaning that Germans can as a result of such a deal receive tax relief, while avoiding spending cuts or an increased deficit.

Furthermore, if we assume that the alternative to such a deal is a Greek default, then, the "no rescue" alternative looks even worse. The reason for that is that German and other European banks have great stakes in Greece (and also other countries perceived as vulnerable). If Greece and perhaps others get parts of their debts written off in a default, then this will create a need for infusion of capital from German tax payers to avoid a German banking collapse. Some of these capital infusions will probably be recovered, but probably not all (especially if you consider the opportunity cost of that capital), meaning that in the "no-rescue" scenario, German tax payers will in fact be forced to give away money to Greece, or indirectly "bail it out" with the banks as intermediaries.

And with Greece under this scenario getting away with writing off much of the money they irresonsibly borrowed, a real moral hazard problem will arise, as the Greeks will get the impression that it's OK to engage in excessive deficit spending as they won't have to pay back all of it, just like they didn't this time.

Thus, preventing a Greek default through rescue packages is arguably even more in the interest of Germany and others than in the interest of Greece. And the view that it should be opposed because it allegedly "rewards the Greeks and punishes Germans" is in fact as irrational and misguided as any view can get.