The $1 trillion coordinated bailout to stave off a Greek debt default is fatally flawed and may well lead to another, deeper global recession.
While optimists hope the bailout will signal an end to the government debt crisis, the history of debt crises suggests it is just the end of the first act in what will be a long and drawn-out tragedy.
As part of the bailout, Greece is required to take tough medicine to get its fiscal house in order, such as cutting salaries and pensions of government workers. That's easier said than done, given Greece's long history of generously rewarding those who go to work.
But the story doesn't end here. The fatal flaw in the plan is that the European nations bailing out Greece--even Germany, where government debt has risen to about 80 percent of gross domestic product--have similar budget problems and even less political will to take similar medicine.
Their plan appears to rest on the hope that lenders won't notice. Eventually they will, and when that happens, a worldwide loss of faith in government debt markets is a virtual certainty.
In other words, it is hardly good news for a creditor if a hopelessly bankrupt borrower offers to take on the debts of a hopelessly bankrupt borrower.
During the financial crisis, faith was restored in large financial institutions because toxic assets were essentially exchanged for government bonds. If government bonds become toxic, there will be no effective treatment options remaining. The collapse will have no bottom.
And that collapse could happen at any moment. If lenders decide collectively that the big Western governments have unsustainable debt positions and lack the political will to fix them, the end can come tomorrow.
Here is how it could go:
Practically every day, governments around the world have to borrow from new lenders to pay off expiring debt. The U.S., for example, may have borrowed $10 billion from the Chinese a year ago for one year. Today it will have to borrow $10 billion from some other lender in order to give the Chinese their money back.
If lenders become disillusioned enough, they may well decide that they don't want to buy government debt today because they have no idea how much its value will decline between today and tomorrow. Governments in the business of refinancing themselves each week would be left with few options.
It wouldn't be far-fetched or unprecedented for a rapid loss in faith in government debt to spread across the globe if Greece or another major country goes down.
The Mexico Example
In August 1982, the Mexican government suddenly found itself unable to roll over its private debts. The rescheduling arrangements and workarounds initiated what was a massive debt crisis. Mexico's GDP dropped more than 4 percent in 1983, and it took six years for GDP to return for good to 1982 levels.
The only thing that has to happen is that lenders notice that the Europeans who plan to borrow money to repay entities that hold Greek debt are hardly better credit risks than the Greeks themselves. It might start with a failed Greek government debt auction, but it could rapidly affect every Western government trying to borrow funds.
If that happens, even the U.S. is in trouble.
While the U.S. has been above the fray so far, an International Monetary Fund working paper published in 2003 suggests it is hardly in safe territory.
The paper, written by economists Paolo Manasse of the University of Bologna along with Nouriel Roubini of New York University and the IMF's Axel Schimmelpfennig, studied historical sovereign-debt crises, exactly the situations that Western nations are hoping to avoid. They found that external debt levels--money owed to foreigners--exceeding 50 percent was a key indicator that debt default may occur
Here is the chilling fact: the average external debt as a percent of GDP among countries in their sample the year before a sovereign debt crisis was 54.7 percent, and 71.4 percent in the crisis year. The U.S. external debt on Dec. 31, 2009, was $13.77 trillion, or almost 100 percent of GDP. For much of Europe, the story is worse.
A key force driving external debt higher has been the increase in government borrowing. In its first year, the Obama administration managed to add more than $8 trillion to the expected 2019 debt, now projected to reach $17.5 trillion.
Even the optimistic scenario only delays the inevitable. Along this path, lenders continue to happily purchase government debt in the near term. But even then, the relatively healthy U.S. will look like Greece within a decade.
The only path forward is one in which the major developed nations collectively make long-run budget adjustments designed to soothe market fears before a crisis ensues. Given that the only nation serious about deficit reduction right now is Greece, it seems almost impossible for this story to reach a happy end.
Our choice is panic now, or panic later.
Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.