Best of the Week
Most Popular
1.The Greatest Stock Market Crash Of Your Life Is Just Ahead… – Warns Harry Dent - GoldCore
2.Budget 2016: Borrowing, Lifetime ISA, House Prices, Economy, Syria, Brexit and Stocks - Nadeem_Walayat
3.Gold Price Intermediate Top - Clive_Maund
4.Brussels Terror Attacks, Death of the European Union, BrExit Wake up Call - Nadeem_Walayat
5.Stock Market Maybe This Time is Different? - Tony_Caldaro
6.UK House Asking Prices Break Above £300k! Housing Market Paralysis - Nadeem_Walayat
7.A Big Reason Why Silver Price Is Set To Soar - Hubert_Moolman
8.The Financial Crisis Has Just Begun; Is The American Dream Is Over? - Chris_Vermeulen
9.Gold Stocks Spring Rally - Zeal_LLC
10.GLX, GLDX, Baby Gold Bull Market Stillborn? - Rambus_Chartology
Last 7 days
Stock Market Strong Elliott Wave Relationship is Developing - 29th Apr 16
Fed's Kaplan: Brexit to Factor in US June Interest Rate Decision - 29th Apr 16
Silver Miners Strong in Grim Q4 - 29th Apr 16
Is Silver a better bet than Gold in the Near Future? - 29th Apr 16
How to Use the CoT Report in Gold Investing? - 29th Apr 16
Sri Lanka is Intriguing: Areas to Consider for Value Investing - 29th Apr 16
Gold “Chart of The Decade” – Maths Suggest $10,000 Per Ounce Says Rickards - 29th Apr 16
Are We or Are We Not in a New Gold Bull Market? - 29th Apr 16
Silver: The “Five Year Plan” and the Great Leap Forward - 28th Apr 16
Michael Hudson: The Wall Street Economy Has Taken Over The Economy and Is Draining It! - 28th Apr 16
AUD/USD - Trend Reversal or Just a Bigger Pullback? - 28th Apr 16
A Gold Revaluation Could Transform Your Financial Status - Overnight - 28th Apr 16
Monetary Policies Misunderstood - 28th Apr 16
Gold Bullion vs Gold Miners - 28th Apr 16
OECD Suggests BrExit Would Cut Net Migration by 1.2 Million by 2030 - 28th Apr 16
MP Naz Shah Punished for Tweets Made During Israel's Genocide of Gaza Palestinian People - 28th Apr 16
Global Recession in 2016 and Beyond - The Obvious Evidence - 27th Apr 16
Why Gold Bugs Need to Stop Listening to The Fear Mongers and Start Thinking for a Change - 27th Apr 16
BlackRock’s Fink: Fed to Raise Interest Rates by Quarter Point ‘at Best’ - 27th Apr 16
Gold More Productive Than Cash?! - 27th Apr 16
Donald Trump Will Fire Janet Yellen and Be Trapped - 27th Apr 16
Money Saving Gardening by Propagating Roses From Cuttings - Propagating Rose Plants Over 2.5 Years - 27th Apr 16
Facebook Censors Pro Trump and Negative Hillary News - 27th Apr 16
This is the Era of the Democrats and Your Taxes are Going Up - 27th Apr 16
Long Awaited Gold Price Breakout - 26th Apr 16
Crude Oil Price Double Top or Further Rally? - 26th Apr 16
Madness in the Crimex Gold and Silver Trading Pits - 26th Apr 16
Britain's Prospects: GBP and BREXIT - MAP Wave Analysis - 26th Apr 16
CRB, Gold, Oil, Cotton, Coffee - 7 Must See Commodities Charts - 26th Apr 16
Gold Price Target is $3,000 and Silver is $75 per Ounce - 25th Apr 16
Parameters for a Stock Market Sell Signal-in-the-making - 25th Apr 16
Stock Market Dangerous Divergence - 25th Apr 16
Gold Miners Nub is the Sweat of the Sun - 24th Apr 16
US Dollar Price Forecast - 24th Apr 16
Stock Market Upside Objective Reached - 24th Apr 16
Why Leftist Greeks have more reasons than Liberals to favour Entrepreneurship and Support Entrepreneurs - 24th Apr 16
The Dow Jones is a Catalyst for Misplaced Stock Market Optimism - 24th Apr 16
Why Russia Harasses U.S. Aircraft and Ships - 24th Apr 16
Stocks Bull or Bear Market Rally? - 23rd Apr 16
A Bright Future for Solar Power in the Middle East - 23rd Apr 16
Silver Commitments of Traders – Halloween is Arriving Early This Year - 23rd Apr 16
Good News, Bad News, Both Favor Gold And Silver - 23rd Apr 16
Mish's Sure Fire Proposal to End Japanese Deflation - 23rd Apr 16
Mish Shedlock: “EXCUSE ME MR. PRESIDENT, IS THAT A JOKE?” - 23rd Apr 16

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

Catching a Falling Financial Knife

Sovereign Debt Crisis, Have We Crossed the Point of No Return?

Economics / Global Debt Crisis May 21, 2010 - 02:10 AM GMT

By: Philipp_Bagus

Economics

Best Financial Markets Analysis ArticleA specter is haunting the world, and especially Europe: the specter of a sovereign insolvency. The acute sovereign-debt crisis is largely the result of government interventions in response to the financial crisis.

As Austrian business-cycle theory explains, the credit expansion of the fractional-reserve-banking system had caused an unsustainable boom. At artificially low interest rates, additional investment projects were undertaken even though there was no corresponding increase in real savings.


The investments were simply paid by new paper credit. Many of these investments projects constituted malinvestments that had to be liquidated sooner or later. In the present cycle, these malinvestments occurred mainly in the overextended automotive, housing, and financial sectors.

The liquidation of malinvestments is beneficial in the sense that it purges inefficient projects and realigns the structure of production to consumer preferences. Factors of production that were misused in malinvestments are liberated and transferred to projects that consumers want more urgently to be realized.

Solutions to the Crisis: Diverging Paths

In the present recession, the liquidation of malinvestments — falling housing prices and bad loans — caused problems in the banking system. Defaults and investment losses threatened the solvency of banks. The solvency problems triggered a liquidity crisis in which maturity-mismatched banks had difficulties rolling over their short-term debt.

At the time, there were alternatives available to tackle the solvency problem and recapitalize the banking system. Private investors could have injected capital into the banks that they deemed viable in the long run. In addition, creditors could have been transformed into equity holders, thereby reducing the banks' debt obligations and bolstering their equity. Unsustainable financial institutions — for which insufficient private capital or creditors-turned-equity-holders were found — would have been liquidated.

Yet the available free-market solutions to the banks' solvency problems were set aside, and another option was chosen instead. Governments all over the world injected capital into banks while guaranteeing the liabilities of the banking system. Since taxes are quite unpopular, these government injections were financed by the less-unpopular increase in public debts. In other words, the malinvestments induced by the inflationary-banking system found an ultimate sponsor — the government — in the form of ballooning public debts.

There are other reasons why public debts increased dramatically. Governments undertook additional measures to fight against the healthy purging of the economy, thereby delaying the recovery. In addition to the financial sector, other overextended industries received direct capital injections or benefited from government subsidies.

"Access to cheap credit allowed countries such as Greece to maintain a gigantic public sector and ignore the structural problem of uncompetitive wage rates."

Two prime examples of subsidy recipients are the automotive sector in the United States (for instance, the infamous "Cash for Clunkers" program) and the construction sector in Spain. Such subsidies further delayed the restructuring of the economy. Factor mobility was hampered by public works absorbing the scarce factors needed in other industries. Greater subsidies for the unemployed increased the deficit while reducing their incentives to find work outside of the overextended industries. Another factor that added to the deficits was the diminished tax revenues caused by reduced employment and profits.

Thus, government interventions not only delayed the recovery, but they delayed it at the cost of ballooning public deficits — increases which are themselves adding to preexisting, high levels of public debt. The preexisting public debts are the artifacts of war expenditures and unsustainable welfare states. As the unfunded liabilities of public-pension systems pose virtually insurmountable obstacles to modern states, in one sense the crisis — with its dramatic increase in government debts — is a leap forward toward the inevitable collapse of the welfare state.

The Situation in Europe

In Europe there is an additional wrinkle in the debt problem. At the creation of the euro, it was implicitly assumed among member nations that no nation would leave the euro after joining it. If things went from bad to worse, a nation could be rescued by the rest of the European Monetary Union (EMU). With this implicit bailout guarantee, a severe sovereign-debt problem was preprogrammed.

The assumed support of fiscally stronger nations artificially reduced interest rates for fiscally irresponsible nations. Access to cheap credit allowed countries such as Greece to maintain a gigantic public sector and ignore the structural problem of uncompetitive wage rates. Any deficits could be financed by money creation on the part of the European Central Bank (ECB), externalizing the costs onto fellow EMU members.

From a politician's point of view, the incentives in such a system are explosive: If I as a campaigning politician promised gifts to my voters in order to win the election, I can externalize the costs of those promises to the rest of the EMU through inflation — and future tax payers will have to pay the debt. Even if the government needs a bailout (a worst-case scenario), it will happen only in the distant, post-election future.

Moreover, when the crisis occurs, I will be able to convince voters that it was not caused by me, but rather that it fell upon the country as a natural disaster — or that (better still) it was caused by evil speculators. While accompanying austerity measures imposed by the EMU or IMF may loom in the future, the next election is just around the corner. In such a situation, the typical shortsightedness of democratic politicians combines with the ability to externalize deficit costs to other nations and produces an explosive debt inflation.[1]

"Greece does not seem to be on track to becoming self-sufficient in just three years."

Due to these incentives, some European states were already well on their way to bankruptcy when the financial crisis hit and deficits exploded. Markets started to become distrustful of many government promises. The recent Greek episode is an obvious example of such market distrust. As politicians want to save the euro experiment at all costs, the bailout guarantee has become explicit. Greece will receive loans from the EMU and the IMF, totaling an estimated €110 billion over the next three years. In addition, even though Greek government bonds are rated as junk, the ECB continues to accept them and has even started to buy them outright.

There also exists the danger of contagion from Greece to those other countries — such as Portugal, Spain, Italy, and Ireland — which have high deficits and debts. Some of them suffer from high unemployment and inflexible labor markets. A spread to these countries could trigger their insolvency — and the end of the euro. The EMU reacted to this possibility and went "all in," pledging together with the IMF an additional €750 billion support package for troubled member states in order to stem the threat of contagion.

Why Governments Cannot Contain the Crisis

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.[2] 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.

Notes
[1] For the time horizon of politicians in democracies, see Hans-Hermann Hoppe, Democracy: The God That Failed (Transaction Publishers, 2001).

[2] It is thus unclear whether countries that pay higher interest rates than 5 percent will participate.

Philipp Bagus is an associate professor at Universidad Rey Juan Carlos, Madrid and a visiting professor at Prague University. Send him mail. See Philipp Bagus's article archives. Comment on the blog.

© 2010 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2016 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife