Bail Out or Bail? The Eurozone and Greece

The transatlantic political class has taken up the cudgels on behalf of a Greek bailout. Even the Economist has joined the parade, warning of “contagion” to other European economies if a rescue package is not approved. Megan McArdle, while skeptical of a bailout, also resorts to the contagion meme and compares Greece’s current difficulties to the origins of the Great Depression.

The problem with the contagion forecast is that it implicitly assumes greater rationality and forethought among economic commentators than among international investors risking their own money. If contagion could be predicted, it wouldn’t happen.

The risk here isn’t contagion, but an entirely rational market response to poor fundamentals in highly indebted countries. Let’s take the three options available to the EU: allowing Greece to default, allowing Greece to leave the euro and default through inflation, and giving Greece a massive bailout. All of these options entail depreciation in the euro and a rise in the cost of sovereign borrowing for Eurozone governments. The putative advantage of bailout is that it redistributes these costs from the PIIGS governments teetering on the brink to relatively healthy states like Germany and France. The putative disadvantage is a long-term rise in moral hazard. Granted that the efficient-market hypothesis is wrong, we still cannot know whether any of these options might foreshadow or forestall widespread financial panic, but each has its costs and benefits.

2 thoughts on “Bail Out or Bail? The Eurozone and Greece

  1. I think the ‘contagion’ metaphor is not helpful because it is misleading. It implies that the people catching the disease are not themselves to blame because they had nothing to do with it. A more apt metaphor in this case is “pyramid scheme.” The problem is that people have put some portion of the costs of their programs and benefits off until later or onto other people; then those people put the costs off or onto others; and so on. When for any reason that cannot continue, then, yes, an initial small failure may trigger a failure of the entire scheme.

    But when bad and foolish decisions on top of bad and foolish decisions lead to entirely foreseeable if unpleasant and undesired consequences, what we have is a bucket of cold water reality in our faces, not a contagious disease.

    1. In my experience, “contagion” in economics is usually a metaphor for irrational herd behavior that causes a problem to spread from one economy to another. But I don’t think investors have been irrational in this case. Greece’s government lied about its deficits! When that was discovered, investors started lending less, which makes perfect sense. If there’s a run on the euro or PIIGS bonds after Greece defaults, that would also make sense. No herd behavior required, just updating with new info.

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