Back in December I wrote a post on the possibility of Greece defaulting on its debts because no one seemed to want to lend them any more money (What would a bankruptcy by Greece mean for the Euro?). This is happening because they are unwilling to cut spending to match their national income and have now borrowed so much money that creditors are starting to doubt that they will be repaid.
Now much of the English language press is jumping into the discussion with the Economist (A Greek bailout, and soon?) and the NY Times (The Not-So-Safe Euro Zone) discussing it.
The argument is effectively summarized by the Times:
The economic fortunes of all the euro-using countries are too tightly linked to contain the crisis to one of them. And Greece may not be alone for long. Similar financing crises could soon hit Ireland, Spain and Portugal. Market anxieties threaten the currencies of Poland, Hungary and the Czech Republic.
This contagion worry is only a real threat if Greece’s problems are problems of liquidity rather than solvency. If Greece is good for the money but having temporary borrowing problems then this liquidity crisis could actually cause the very problem that individual borrowers are seeking to avoid when refusing to lend. But if Greece has deep problems repaying what it has borrowed already, lending them more money is unlikely to make things better.
But what if markets are confused. What if they cannot tell the difference between failing for liquidity and solvency issues. Then markets see a failure for Greece (even though their problems are structural) as a problem for everyone and they cut off the poor and small European countries for debt markets. Is it possible that the best policy is to just bail out Greece to prevent the contagion?
I doubt it. For one, the expectation of just such a bailout may well be why Greece hasn’t sorted out its financial troubles. So how can we provide poor and small Euro countries with an incentive for live within their means while simultaneously using the superior financial strength of larger and richer countries to protect those less stable countries from panics? One way would be to say that they won’t bail out Greece but they will bail out any other countries that get into trouble.
But then once (if) Greece goes belly up other countries lose the incentive to maintain financial discipline. So one thing we could add to this is that bailouts will be larger in the future (for the third failure and later). That way countries have every incentive to secure private financing, sell off gold, art, and land, pass austerity budgets and otherwise manage to fail later. High profile assets like these could easily be used as collateral for repos as well.
Update:
The Greek government has just unveiled a new fiscal austerity plan
