The welfare states of Europe are in deep trouble. Decades of over-taxing and over-spending have sapped economic vitality and produced high levels of debt.
The high debt levels, by themselves, might not be a problem if European governments implemented good policy. After all, debt was even higher in many nations after World War II than it is today.
But Europe also faces a demographic problem. The population is aging, meaning that the fiscal situation will get worse – in some cases, much worse. So international investors are appropriately worried that today’s high debt levels will become tomorrow’s crippling debt levels.
And the cherry on the ice cream sundae of Europe’s fiscal nightmare is that many people have been lulled into dependency thanks to excessive government handouts combined with a political culture that tells people there is nothing wrong with mooching off others (as this cartoon aptly illustrates).
This sounds quite depressing, but there is a shred of hope. Simply stated, nations that hit rock bottom presumably have little choice but to move in the right direction.
Actually, let me qualify that statement. Governments do have the ability to maintain bad policy if they have access to bailout cash. And that’s been a problem in Europe. Nations such as Greece have very little incentive to reform if they think the European Union (German taxpayers) or International Monetary Fund (American taxpayers) will cough up some cash.
But that game, sooner or later, comes to an end. As Margaret Thatcher noted, the problem with socialism is that sooner or later you run out of other people’s money.
So what, then, should be done to address the European debt crisis? The European political elite in places such as France and Germany say more bailouts are needed. Why? Because without more bailouts, there will be contagion and the world will plunge into another 2008-style crisis.
But when you strip away the hysterical rhetoric, what they’re really saying is that bailouts are needed for the banks in their own nations that foolishly lent too much money to reckless governments in other nations.
As you might suspect, this is self-serving nonsense that would simply create a bigger debt bubble that ultimately causes bigger problems.
The right answer to the European debt crisis is simple. And it only requires two steps.
1. Do not give bailouts to nations, even if that means they default. This isn’t good news if you bought, say, Greek or Portuguese bonds, but there are two big advantages of default. First, it means that the bailouts come to an end so the debt bubble doesn’t get even worse. Second, it forces the affected governments to move – overnight – to a balanced-budget rule.
So what’s the downside? There isn’t one. The aforementioned bondholders won’t be happy. They gambled in the expectation that bailouts would enable them to get high returns, but that’s their problem. Overpaid government workers and greedy interest groups in the affected nations doubtlessly will be very upset because the gravy train gets derailed, but that’s a feature, not a bug.
2. If banks become insolvent because they recklessly lent money to governments that default, those financial institutions should be allowed to fail. More specifically, they should be put into something akin to receivership (similar to what the U.S. did 20 years ago with the S&L crisis and a few years ago with WaMu and IndyMac, and also like what Sweden did in the early 1990s). This automatically prevents financial crisis since the financial sector gets recapitalized, but without the moral hazard and/or zombie bank problems associated with TARP-style bailouts.
So what’s the downside? There isn’t one, at least compared to the alternatives. Governments would be holding harmless depositors at the failed banks, so there would be additional debt. But this debt would be a one-time burden for a policy that actually stops the bleeding, and there would be no moral hazard since shareholders, bondholders, and senior management at the failed banks would get nothing.
This raises an obvious question. If my proposed solution is so simple, why aren’t governments choosing this option?
Part of the answer is that simple solutions aren’t necessarily easy solutions. We know how to fix America’s fiscal crisis, for instance, but that doesn’t mean it will happen. Governments will sometimes do the right thing – but only after they’ve exhausted every other option.
Europe isn’t quite at that stage. Yes, Greece is being allowed to default, which is a small step in the right direction, but the political elite hope that the right blend of additional bailouts and patchwork reforms can fix the problem.
I suppose that might happen, especially if the world economy somehow begins to boom. But don’t hold your breath.