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.