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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.

By Correspondent, and Dan MurphyStaff writer / May 10, 2010

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.

Mario Vedder/dapd/AP

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London

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.

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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.)

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.

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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