Best of the Week
Most Popular
1.Stock Market in DANGER of Strangling the Bears to Death - Nadeem_Walayat
2. Germany Pivoting East, Exit US Dollar, Enter Gold Standard - Jim_Willie_CB
3.Flight MH17 – Kiev Flash Mob's Last False Flag? - Andrew_McKillop
4.Stock Market Crash Nightmare! - Nadeem_Walayat
5.Gold - The Million DOLLAR Question... - Rambus_Chartology
6.Gold And Silver – BRICS And Germany Will Pave The Way - Michael_Noonan
7.The Jewish Selfish Gene, People Chosen by God, Everyone Else is Goyim to Kill - Nadeem_Walayat
8.The Israeli Promised Land Dream - The Criminal Roadmap Towards “Greater Israel”? - Felicity Arbuthnot
9.Which Way is Inflation Blowing? Watch Commodities - Gary_Dorsch
10.U.S. Economy Quarterly Review and Implications for 2014-2015 - Lacy Hunt
Last 5 days
Gold Price and U.S. Dollar’s July Rally - 28th July 14
Second Quarter Corporate Earnings: Marching Toward a Strong Economic Recovery - 28th July 14
Time to Put a New Economic Tool in the Box - 28th July 14
Mossad in Gaza, Ukraine and the Cult Of The All-Powerful Elite - 28th July 14
Elliott Wave Gold Price Projection Since 1970 - 28th July 14
Investors Remain Uncertain As Stock Fluctuate Near Long-Term Highs - Will The Uptrend Extend? - 28th July 14
The Mass Psychology Of Decline - 28th July 14
Will the US Destroy the World? - Don’t Expect to Live Much Longer - 28th July 14
GDM and GDXJ Gold Stocks In-depth Look - 28th July 14
Stock Market One FINAL High? - 28th July 14
What It Means - Paradigm Collapse And Culture Crisis - 27th July 14
Wall Street Shadow Banking: You Can’t Taper a Ponzi Scheme: “Time to Reboot” - 27th July 14
6 Tips for Picking Winning Gold Mining Stocks - 27th July 14
Israel's War on Children, Exterminating the Palestinians Future - 27th July 14
Guilt By Insinuation - How American Propaganda Works - 26th July 14
Surprise Nuclear Attack On Russia To Liberate Ukraine - 26th July 14
Use "Magic" Of Gold/Silver Ratio To Greatly Increase Your Physical Holdings - 26th July 14
Derivatives Market Species Origins - Abuse, Props and Risks - 26th July 14
Stock Market Manipulation and Technical Analysis - 26th July 14
China’s Stock Market Finally Looks Like A Buy - 26th July 14
Ed Milliband Fears Israel Jewish Fundamentalist Gaza War Massacres Backlash - 26th July 14
The Big Energy = Power Battle Is Coming - 25th July 14
USrael - Zionists in Control of America's Goyim Brainwashed Second Coming Slaves - 25th July 14
More Weakness Ahead for Gold Miners - 25th July 14
Gold Price Strong Season Starts - 25th July 14
Geopolitics and Markets Red Flags Raised by the Fed and the BIS on Risk-taking - 25th July 14
Gold Lockdown Until Options Expiry - New Singapore Gold Contract Threatens Price Manipulation - 25th July 14
The Bond Markets, Black Swans, and the Tiny Spirit of Santo - 25th July 14
No Road Map For Avoiding The Future - 25th July 14
Israeli War Machine Concentrating Women and Children into UN Schools Before Killing Them - C4News - 25th July 14
Israeli Government Paying Jewish Fundamentalist Students to Post Facebook Gaza War Propaganda - 25th July 14
Why the Stock Market Is Heading For A Fall - This Time Is Not Different - 25th July 14
An Economic “Nuclear Strike” on Moscow, A “War of Degrees” - 25th July 14
BBC, Western Media Working for Israeli Agenda of Perpetual War to Steal Arab Land - 25th July 14
Ukraine: What To Do When Economic Growth Is Gone - 24th July 14
Stock Market Clear and Present Danger Zone - 24th July 14
The Five Elements to Creating a Something-for-Nothing Society - 24th July 14
Instability is the New Normal? - 24th July 14
Israel's Suicide Bombers Over Gaza - 24th July 14
EUR-AUD Heads Into The Danger Zone - 24th July 14
Tesco Supermarket Death Spiral Accelerates as Customers HATE the Mega Brand - 24th July 14
Ukraine MH17 Crisis - Best Remember Who Your Friends Are - 24th July 14
Three Reasons Why Gold Price and Gold Stocks Will Rise - 24th July 14
HUI Gold Bugs Fighting To Break Downtrend - 23rd July 14
What Putin Knows About Flight MH17 - 23rd July 14
Why Microsoft Will Continue to Rebound, Huge Upside Potential - 23rd July 14
Will Putin Survive? - 23rd July 14

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

The Biggest lie in Stock Market History Revealed

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.


© 2005-2014 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

Free Report - Financial Markets 2014