Reasons to Worry About the Prospects for a European Bailout

I've been asked to explain my reservations about the idea that "we know what will work" in Europe.  Why wouldn't a eurobond/ECB intervention work?  After all, it worked here?

I should emphasize that I am by no means sure that it wouldn't work--I just sort of wonder.  And that these reservations are not shared by a whole bunch of people much smarter than I am.

With those caveats, here are the differences I see between a possible Eurobailout, and the indisputably successful actions of Treasury and the Fed in 2008*.

1.  Their bank debt is a much bigger than ours was.  Here's the list I blogged last year of bank assets as a percentage of GDP:

Luxembourg 2,461%
Ireland 872%
Switzerland 723%
Denmark 477%
Iceland 458%
Netherlands 432%
United Kingdom 389%
Belgium 380%
Sweden 340%
France 338%
Austria 299%
Spain 251%
Germany 246%
Finland 205%
Australia 205%
Portugal 188%
Canada 157%
Italy 151%
Greece 141%

For comparison purposes, ours was about 82% of GDP.

Now, these numbers have obviously changed somewhat since then, but it's a good rough guide.  An American bailout of the banking system was painful-but-feasible.  Depending on the level of impairment, a French bailout of their banking system might simply not be.

2.  We had more fiscal run room than Europe.

Here's the debt-to-GDP ratio in 2008 and 2009 (the last year the OECD had available)

Germany has a lot of room to borrow, but France and others have much less.  And these figures are several years old; everyone's debt-to-GDP load has risen since then.

But this is the real constraint:

Maybe these differences don't look so big.  But that's because we think about taxes the wrong way around.  Most people think that raising a 5% tax rate to 10% is more noticeable (and painful) than raising a 50% tax rate to 55%.  After all, the first represents a doubling of your tax rate; the second is only a 10% increase.

But this is exactly the wrong way to think about it. The pain of a tax hike is determined not by how your current tax rate compares to your earlier tax rate, but by how your current disposable income compares to your earlier disposable income.

Doubling the tax rate from 5% to 10% decreases your disposable income by about 5.25%.  But raising it from 50% to 55% decreases your disposable income by 10%.  That's a much bigger whack.

When the crisis started, the United States was spending less than 40% of GDP at all levels.  Many European countries--including ones who are supposed to provide guarantees--are now at 50%.  They can  borrow the money today (though the facts in that first chart will constrain them) but they have to pay it back at some point, which means more taxes.

3.  They are having a sovereign debt crisis; we weren't.  There was no question about the US credit rating, and indeed investors were piling into treasuries.  Essentially, the US government had unlimited free money to guarantee our bank obligations.  Even the appetite for bunds is not so strong these days.

4.  There are fundamental structural problems with the euro area that no integration plan will fix.  No one thought the US might break up or stop using the dollar.  But even if we stop the panic and put some sort of new structure into place that will check budget deficits, investors have to be aware that the result will be a periphery semi-permanently crippled by a currency that's far too expensive for their productivity levels.

5.  The world used up a lot of its firepower during earlier phases of the crisis.  I'm not just talking about those debt and spending numbers highlighted above.  I'm talking about the political capital, the diplomatic capital, the institutional capital.  In 2007, if this had happened, the US could have taken a much more aggressive role in helping Europe to get its act together.  These days, even if Obama wanted to do the right thing at the expense of his sure and certain defeat in 2012, he'd never get Congress to go along.  Similarly, my sense is that the last few years have frayed whatever pan-European goodwill existed.

Then there are the reasons to worry that it won't happen at all, such as the German hyperobsession with their hyperinflation, and the genuine questions about whether it's even possible for Greece and Italy to execute (not just plan!) an austerity program under German aegis.  All of this conspires to make me very, very worried.

* Yes, yes, maybe they weren't necessary, or set us up for later problems.  I don't really want to argue about this, but for now, let's just agree that they stopped the meltdown,and it hasn't come back.