The right answer to the debt crisis is simple

Posted: October 19, 2011 in TheProblem
Tags: , , , ,

The right answer to the debt crisis is simple. And it only requires two steps.

1. Do not give bailouts to nations, even if that means they default. This isn’t good news if you bought, say, Greek or Portuguese bonds, but there are two big advantages of default. First, it means that the bailouts come to an end so the debt bubble doesn’t get even worse. Second, it forces the affected governments to move – overnight – to a balanced-budget rule.

So what’s the downside? There isn’t one. The aforementioned bondholders won’t be happy. They gambled in the expectation that bailouts would enable them to get high returns, but that’s their problem. Overpaid government workers and greedy interest groups in the affected nations doubtlessly will be very upset because the gravy train gets derailed, but that’s a feature, not a bug.

2. If banks become insolvent because they recklessly lent money to governments  that default, those financial institutions should be allowed to fail. More specifically, they should be put into something akin to receivership (similar to what the U.S. did 20 years ago with the S&L crisis and a few years ago with WaMu and IndyMac, and also like what Sweden did in the early 1990s). This automatically prevents financial crisis since the financial sector gets recapitalized, but without the moral hazard and/or zombie bank problems associated with TARP-style bailouts.

So what’s the downside? There isn’t one, at least compared to the alternatives. Governments would be holding harmless depositors at the failed banks, so there would be additional debt. But this debt would be a one-time burden for a policy that actually stops the bleeding, and there would be no moral hazard since shareholders, bondholders, and senior management at the failed banks would get nothing.

This raises an obvious question. If my proposed solution is so simple, why aren’t governments choosing this option?

Part of the answer is that simple solutions aren’t necessarily easy solutions. We know how to fix America’s fiscal crisis, for instance, but that doesn’t mean it will happen. Governments will sometimes do the right thing – but only after they’ve exhausted every other option.

Europe isn’t quite at that stage. Yes, Greece is being allowed to default, which is a small step in the right direction, but the political elite hope that the right blend of additional bailouts and patchwork reforms can fix the problem.

I suppose that might happen, especially if the world economy somehow begins to boom. But don’t hold your breath.

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