Europe's $955 billion rescue package, Greek austerity, and moral hazard

Markets across the world soared after the European Central Bank promised the creation of a $955 billion rescue fund for eurozone countries with debt problems. But some economists are worried about moral hazard – bailouts leading to reckless spending.

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    Stock traders work at the Frankfurt Stock Exchange in Frankfurt am Main, Germany, on Monday. Stocks across the world soared after the European Central Bank (ECB) promised early Monday morning the creation of a $955 billion rescue fund for eurozone countries with debt problems.
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The European Central Bank (ECB) promised early Monday morning to create a €750 billion ($955 billion) fund to bail out countries in the eurozone when they get into debt trouble and to act in both government and corporate bond markets as a buyer of last resort.

Stocks in Europe and across much of the world soared in response. The US benchmark stock index, the Dow Jones Industrial Average, rose as much as 4 percent in morning trading, reversing a large plunge last week on concerns of spreading European financial trouble and slowing global growth.

The euro rose as much as 3 percent against the US dollar and the yield on the Greek government's 10-year bond plunged as investors bet the risk of default – something investors were deeply afraid of in recent weeks – had fallen dramatically. (See factbox below.)

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But while the ECB's move cheered investors, it alarmed some economists.

"This is a whole new level of global moral hazard – the result of an alliance of convenience between troubled governments in the south of Europe and the north European banks [and implicitly, north American banks] who enabled their debt habit," Peter Boone and Simon Johnson wrote on the influential economics blog The Baseline Scenario. "The Europeans promise to unveil a mechanism this week that will 'prevent abuse' by borrowing countries, but it is hard to see how this would really work in Europe today.

Mr. Boone is a researcher at the London School of Economics and Mr. Johnson is the former chief economist of the International Monetary Fund (IMF). "Moral hazard" refers to economists' concerns that such bailout promises lead borrowers to behave recklessly and take on more debt than they should because the borrowers assume someone else will step in and pay their debts for them.

Portugal, Ireland, Spain say they'll avoid a bailout

The ECB's bold announcement flew in the face of a previous insistence that bailouts weren't needed in Europe and that it would be wrong to signal that Europe will take collective responsibility for the borrowing and spending decisions of individual members. But even though the funds are now available for a bailout, Europe's fiscally weaker states like Portugal, Ireland, and Spain are likely to do everything they can to avoid taking one.

The reason is that the money comes with stringent demands for cutting spending and reducing deficits, something that Greece is finding out.

On May 2, European finance ministers endorsed a €110 billion bailout ($142 billion) for Greece, of which €80 billion will come from fellow eurozone members. The rest will come from the IMF

Greek austerity

Greece has promised government pay freezes, pension cuts, and a higher retirement age in the middle of a deep and painful recession. Massive protests against the austerity measures in early May saw protesters repelled from the gates of parliament with tear gas, rock throwing, and the firebombing of a bank branch that killed three employees.

Greece is already grappling with 12 percent unemployment at the outset of austerity measures that are certain to drive unemployment higher. Greece is the recipient of the first-ever financial rescue of a member of Europe's 16-state eurozone currency area. Austerity's aim is to cut Greece's annual government deficit from 13.6 percent of gross domestic product to less than 3 percent of GDP by 2014.

To receive the loan, the Greek government agreed to freeze public-sector salaries until 2014, cut state pensions, and raise the average retirement age from 61 to 63. Laws limiting layoffs in the private sector to 2 percent of the workforce are also being scrapped.

Struggling to service a ballooning national debt, Greece has been locked out of the normal source for government borrowing, the bond market. Investors have been demanding high interest rates that Athens can't afford to pay.

Other countries with debt problems are taking steps to avoid Greece's predicament. Ireland raised taxes, slashed government spending, and imposed public-sector pay cuts of between 5 and 15 percent last year. At a press conference in Brussels after the bailout fund was announced early Monday, Portuguese Finance Minister Fernando Teixeira dos Santos said his country will sharply reduce its deficit in the next fiscal year and said the government is considering raising taxes.

Lessons from England?

In Britain – where Margaret Thatcher set an international yardstick in the 1980s by subjecting the economy to its own shock therapy – it's all painfully familiar.

But even here, the rigidity of the austerity plan now being imposed on Greece has sent a chill.

"What Mrs. Thatcher did was divisive – but it came in stages," says Kevin Featherstone, a professor at the London School of Economics. "There wasn't this preplanned awareness about what was coming next, and of course in Britain there were choices that could be made."

Thatcher's Conservative administration came to power in 1979, three years after a Labour government was forced to go to the International Monetary Fund for $3.9 billion – the largest amount ever requested of the IMF at that time.

Over the course of the decade, she privatized state-owned industries and utilities, implemented strict trade union restrictions, and reduced social spending.

By 1982, the number of Britons without a job had risen above 3 million for the first time since the 1930s. The unemployment rate was as high as 20 percent in Northern Ireland and 16 percent in most parts of Scotland and the north of England.

Tougher in Greece

But a crucial difference in context between the countries underlines the stark reality confronting Greek workers, according to Professor Featherstone.

"In Greece, the talk is of defending hard-won privileges, which might to some outside observers have seemed to be over the top in some ways. But it's important to remember that they are in a context of a country in which there is very little welfare state, and a corresponding fear of unemployment," he says. "Unemployment benefits last only in the very short term, perhaps only a few months."

Few observers have been surprised at the level of anger now being unleashed on Greek streets in response to the austerity plan – described by Greece's largest umbrella union, GSEE, as "the harshest, most unfair measures ever enacted."

"The Greek population is of a rather different character from the British population," says Peter Nolan, a professor of industrial relations at Leeds University. "Greece had the highest level of general strikes of all southern, northern, and central European countries," he says, "so the Greek populace will take to the streets very quickly if they feel their way of life is under threat.

"In the Britain of the '80s, I think no one really believed [Thatcher] was going to let unemployment soar, that she was not going to prevent the closures of manufacturing of steelworks and of course the coal mines. Not only was she not going to do anything [to prevent it], but she was going to actively promote it."

Britons are once again bracing themselves for a return to austerity. After all, their country has the highest level of debt in Europe after Greece. All three of the major parties contesting the May 6 UK election were in agreement that Britain's deficit needs to be brought under control.

In March, the chancellor of the exchequer warned that the next round of public-spending cuts would have to be "tougher and deeper" than those implemented by Thatcher.

Related:

As Athens protests, Germany scoffs over Greece debt bailout

Greek debt crisis: Bailout likely, but will it be enough?

Greece bailout: What's the future of the euro?

Germany approves Greek bailout as Merkel gets her way

Yield is effectively the price investors demand to hold a government or corporation's debt. The more likely default seems to investors, the higher the price they demand.

Investors had been deeply afraid in recent weeks that Greece would default on its debt, pushing yields past 12 percent on Friday. But those fears appeared to calm Monday, with yield on the Greek government's 10-year bond plunging down to 8 percent.

To be sure, investors still see Greek debt as risky and at 8 percent are demanding more than 5 percentage points in additional yield to own it than to own the European benchmark German 10-year, which was priced to yield about 2.8 percent on Monday.

German debt yields rose slightly on Monday, since the country will lead the way in paying for the debt of any European country's that seek help. The ECB has effectively signaled that it will spread the cost of the borrowing taken on by its heavily indebted members to the financially stronger European states and their taxpayers, something that alarms some economists.

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