Views on improving the integrity of global capital markets
03 November 2011

Time to Pay the Piper: European Debt Bailout on the Backs of Taxpayers

The Greek-inspired debt crisis has all the elements of what has gone wrong in so many parts of the West. Governments over-promised and overspent, borrowing massive sums along the way, sometimes without telling their citizens or even hiding what they were doing from their central banks. Banks, by virtue of cheap taxpayer-backed deposits, Basel-inspired investment targets, and polite political cajoling soaked up hundreds of billions of that debt. 

Now the debt has come due, and neither the governments nor the citizens wish to pay, and the banks don’t have the wherewithal to face the reality of their bad investments. But pay someone must, and in the European case, it is the Germans, the Finns, and the other EU member states who, over the past decade, have painfully, slowly, but independently put their own fiscal houses in order who must do the paying. Even the Irish must pay, even though they are in the midst of paying the bitter price for the debts of its own disastrous real estate bubble and political corruption.

For more than a year, policy makers have grappled with how to deal with these debt problems. As in most political responses to such matters, policy makers try to gloss over the problems with words at first, then they try to use technical and legal structures to make the problem appear to disappear and hope for a booming economic recovery to make everyone forget about the problem. And when that doesn’t work, they ultimately try to make others pay.

Crisis Bailout: Devil Is in the Details
That is where we are in both Europe and in the United States at the moment. In Europe, though, the details are trickier than in the U.S. because of the political structure behind the European Union. There have been suggestions in recent months that Brussels needs to play a bigger role in such matters, by enabling a transfer of wealth from better-off member states to poorer ones. In some such scenarios, this would require giving the EU bureaucracy taxing authority that they do not currently possess. To get there, though, would require a unanimous vote of the 27 member states, which is unlikely, at best.

While the political elite in Brussels and in the governments of many member states find this approach sensible, their constituents — the people who would pay the tax to Brussels on top of their already hefty bills from national governments — are in no mood. The British, for example, are not inclined to hand over more control to Brussels bureaucrats, and there are efforts underway to force the Cameron government’s hand by calling for a national referendum, one that everyone expects would soundly reject closer ties. 

The latest deal was structured in a way that intended to gloss over the de-facto default by having lenders to Greece “voluntarily” give up half of the principal owed to them. This, as the International Swaps and Derivatives Association confirmed this week, would not amount to a default under existing credit default swap arrangements. As a consequence, struggling banks would not have to pay up on the coverage they previously sold to so-called speculators. This had a two-fold benefit in the eyes of political leaders. First, it would protect the banks from additional liquidity problems, and second, it would give so-called CDS speculators the “what-for.” The EU, in turn, would make the banks whole for the voluntary forgiveness.

Even if Greece approves the deal, its sustainability remains in question. Suffering still, but yet to face the full price for their fiscal conditions are Spain, Portugal, and Italy. Rational leaders in all three nations would look at the Greek deal and internalize its lessons. Yes, they may have to make some painful concessions to reduce government spending, but in return they might ask — or demand — a debt haircut at least as big as the one offered to Greece.

What last week’s deal did was to take the spendthrift governments off the hook, shelter the banks from the losses of their bad (or politically motivated) investment decisions, and, for a brief couple of days, at least, allow leaders in Brussels to once again breathe a sigh of relief in the hope that the global economy might recover soon. It’s just those pesky taxpayers that may, in the end, have something to say about the deal. What they have to say may not please the dealmakers.

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

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