Critics of Europe's perpetually high unemployment and relatively sluggish growth often point to the more free-market American system as a better model. As a major credit crisis surrounding government borrowing mounts, though, European policymakers would be wise to learn a very different lesson: How to structure a massive bailout properly.
Alarm about Europe's overly indebted southern economies is rising fast. Ratings agency Standard & Poor's cut Spain's credit rating a step on Wednesday morning to AA, with a negative outlook. The risk premium on Spanish bonds surged as a result.
The move follows a ratings downgrade of Portugal two notches lower to A- and Greece to junk status the day before. Two-year borrowing costs for Greece are now the highest in the world amid calculations that bondholders could take a major 70% haircut in the event of a default.
Political Grandstanding and Dithering
The response from European policymakers and the International Monetary Fund, meanwhile, has by now become predictable. Officials scramble to reassure markets following credit-market turmoil, much as they did when the spread between Greek and German bonds skyrocketed amid reports of major withdrawals from Greek banks. As markets calm, the usual political grandstanding and dithering resumes.
The latest about-face comes from German Chancellor Angela Merkel, who said, "It's completely clear that the negotiations between the Greek government, the European Commission and the IMF need to be accelerated now," following Spain's downgrade. Merkel was insisting on bigger Greek concessions just days ago.
What's needed now, though, is the kind of "shock and awe" response from policymakers that The New York Times reported a growing number of investors are clamoring for. The $700 billion TARP (Troubled Assets Relief Program) program that then-Treasury Secretary Hank Paulson pulled together -- the number was chosen because asking for a cool $1 trillion seemed too pricey -- provides a good game plan.
The point of a bailout is to signal to markets as much as it is to actually provide funding. Rather than continue with the piecemeal approach as confidence evaporates from one country to the next, officials need to indicate to markets in no uncertain terms that they're going to backstop sovereign debt obligations. Credit markets are largely about confidence and prone to self-fulfilling prophecies. And so-called bond-market vigilantes -- investors who punish runaway government spending by sending borrowing costs spiraling higher -- are out in full force in Europe.
Calming markets in a meaningful way will be expensive. Some estimates put the price tag at $639 billion. But as the by-now overused cliché goes, the cost of doing nothing would be even higher.
Political costs are also high for incumbents. Voters in countries like Germany that have been vigilant about budgets are understandably outraged at having to help fund lavish benefits for their less responsible neighbors. For German politicians, holding out for concessions and scoring points domestically is a rational -- if increasingly reckless -- strategy.
But panic is quickly setting in. And, much like Americans forced to prop up a reckless banking sector a few years ago, Europeans now need to hold their nose and take the distasteful steps.
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