THE BEAR'S LAIR Bailout world
By Martin Hutchinson
The 750 billion euro (US$950 billion) bailout for Greece and other wobbly
eurozone economies was greeted by markets with less enthusiasm than expected
this week. Politicians should be worried: we may be reaching the limits of
their bailout capability. When that happens, it will be healthy, but the panic
level will be intense.
There are some positive features to the European Union's bailout, in that it
has produced action on budget deficits. Greece is a hopeless case, and I don't
trust the current Spanish government, but the Portuguese austerity package
looks well designed and will allow that pleasant country to return to decent
growth.
A budget deficit of 4.6% of gross domestic product (GDP) in 2011
as its target is very sensible - after all, 2011 will still be far below the
peak of the economic cycle (though globally it may be the bump in the middle of
a long W-shaped recession.) Thus a deficit at that modest level should be
fairly easily eliminated once the Portuguese economy is restored to health.
Further, the Portuguese government appears to have achieved this partly by
cutting public sector pay by 5%.
This is the classic recipe for getting out of trouble, pioneered by Neville
Chamberlain in Britain in 1931. Salary levels in public sectors, which control
what they pay themselves, tend to creep inexorably upwards in periods of even
mild inflation, since pay rises are given that outstrip inflation in good
times, with no clawbacks in downturns.
The problem is especially pernicious in countries like Britain, Portugal and
Greece with very large public sectors, where a majority of the electorate may
be dependent on the public sector for its livelihood. Portugal has now grasped
this nettle (a 10% across the board cut, as implemented by Chamberlain, would
have been even more definitive, but may not have been necessary in Portugal's
case). Greece has manifestly refused to grasp it, with massive riots every time
the public sector is asked to bear pain - and in Greece's case, the amount of
pain required is so great that it may not be possible to cut the public sector
enough to balance the books.
Outside southern Europe, the two most important economies where a public sector
cutback of this type is urgently needed are Britain and the United States. Both
have public sector deficits of more than 10% of GDP, an amount that cannot be
shrunk adequately through mere operation of the business cycle.
Both have public sectors that have grown excessively. Britain's public sector
has bloated itself in terms of staffing during the 13 years of Labour
government from 1997, while the US public sector has become especially overpaid
compared with the private sector. Civilian federal employee pay and benefits
have increased from 78% above the private sector average in 1998 to 100% above
the private sector average today. Merely trimming US public sector pay scales
back to their 1998 level in terms of their fellow citizens, therefore, would
require a cut of 12% in pay and benefits. Only when this "politically
impossible" action is undertaken will we know that the US is serious about
fiscal discipline.
The same applies in Britain; the ability to impose a broad and substantial
public sector pay cut will be a good early test of the Cameron/Clegg
coalition's discipline and determination. Without such a cut, particularly if
the US or UK governments attempt to balance their bloated budgets primarily
through tax increases, the austerity attempt will fail and the economy
concerned will enter a period of prolonged and debilitating blight.
The explosion of bailouts since 2008 has partly been caused by the increased
need for bailouts, which can be laid squarely at the door of the loose monetary
policies of the Fed and the European Central Bank. Very low interest rates and
readily available money encourage risk-taking and leverage; if, as in the
United States since 1995 or as in the EU since 2002, those policies are pursued
for a number of years the risks will become enormous and the leverage will
increase to a suicidal level. The even lower interest rates imposed on the
global economic system since 2008 have increased the incentives for leverage
still further, making the need for bailouts even more urgent and their size
even greater.
It was probably irrational to expect politicians to avoid the bailout
temptation when it arose. Indeed there are cases - one thinks of Barings Bank
in 1995, where the problem causing the disaster )speculation by an employee)
was relatively peripheral, the systemic importance of the institution great and
the cost of bailing it out modest - where a bailout was probably justified.
Given the political predilection towards bailouts in general, the decision by
the then chancellor of the Exchequer, Kenneth Clarke, not to bail out Barings
was thus especially harsh.
However, there is no question that in bailout terms Northern Rock in Britain
and Fannie Mae/Freddie Mac in the United States were at the opposite end of the
spectrum to Barings. None of the three institutions was important to the
financial system; they were leeches of the system rather than supports to it.
Furthermore, the problems that caused disaster were central to all three
institutions' operations; indeed there was no part of their business that was
not dependent on the diseased operations. Hence bailout should have been
avoided at all costs; the healthy solution was bankruptcy.
The same applies to Greece. Greece's budget and debt problems are not ancillary
features of the country's economy, like Nick Leeson's dodgy trading operation
at Barings. They are central to its entire existence, like Northern Rock's
wholesale-funded subprime mortgage loans. Ever since it joined the EU in 1981,
Greece has existed by sucking up gigantic EU subsidies, fiddling its national
accounts and granting its public sector employees working lives almost
completely free from effort with retirement on full pensions at 52-55.
Greece's per capita gross domestic product (at purchasing power parity) of
US$32,100 is close to the EU average, but its real production capacity is less
than half that, around the level of Croatia ($17,600) or Lithuania ($15,400).
By bailing the country out therefore, the EU is simply perpetuating folly;
there is no underlying "good part" of the economy that can be rescued without a
massive, perhaps 50%, devaluation of the currency to bring the cost of the
Greeks' modest efforts close to their actual value. Naturally, if Greece's GDP
were halved, as it should be, its debt-to-GDP ratio would become completely
unsustainable at above 250%. Thus no bailout is possible; the country should
simply be allowed to default.
Portugal and Spain are another matter. Portugal's GDP per capita at $21,800 is
only moderately above its true output, which is somewhat above that of Greece.
With its austerity program this week bringing its budget deficit back under
control and its debt still nominally less than 100% of GDP, a modest amount of
assistance in the transition process might well be warranted. Spain is
somewhere in between; its PPP GDP per capita at $33,700 is even higher than
Greece's and it has a massive real estate overhang and a poor government;
however, the underlying productivity of the Spanish economy is higher than that
of Greece and its public debt at 50% of GDP is much lower.
The effect of bailouts therefore depends crucially on the viability of the
entity being bailed out. If that entity is wholly unviable, as in the case of
Northern Rock, Fannie/Freddie and Greece, bailouts simply pour good money after
bad, wasting huge amounts of resources and causing an ever-greater economic
distortion that in the long run can do incalculable damage.
If the entity being bailed out is intrinsically viable, as in the case of
Barings, most (but probably not all) of the banks bailed out under the US TARP
program and Portugal, then a bailout may on balance be economically beneficial,
even though in principle it represents an unattractive distortion of the free
market. In either case, the need for a bailout is itself a sign that something
has gone badly wrong. The mistake is more likely to have occurred in monetary
policy than in regulation, which is usually the defect that policymakers
attempt to "fix" afterwards. In any case, as Walter Bagehot said 150 years ago,
bailouts should be very expensive and rare.
Probably the greatest danger to the global economy currently is thus our entry
into "bailout world", in which bailouts become frequent, gigantic and unrelated
to the quality of the entity being bailed out. The danger becomes even greater
if bailouts are used as an excuse for further damaging regulation, for example
extending the Federal guarantees of US home loans or allowing the EU to impose
controls on national budgets, even of countries that are not members of the
euro.
A far better solution to the bailout problem is to rectify its underlying
cause: excessively lax monetary policy. Far from the European Central Bank
being encouraged to buy ever greater quantities of worthless Mediterranean
government bonds, it should raise interest rates to a level significantly above
EU inflation, thus imposing the appropriate level of pain and cost on
borrowing.
Likewise in the United States, a quick move of short-term interest rates to a
level around 4%, approximating that of long-term rates, would remove the
excessive pressure from the financial markets and deflate the asset and
commodities bubbles that are again reflating rapidly. It would also, by
removing from banks the profitable financial game of borrowing short-term money
and investing in long-term government-guaranteed bonds, re-start lending to
small business, which has fallen 25% in the past year.
Bailouts are an interference with the free market, especially damaging if the
institution or country bailed out is intrinsically economically unviable.
However, they are caused by another deviation from the free market -
politically driven monetary policy untethered to a sound economic anchor.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-10 David W Tice & Associates.)
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