First, Let's Kill All the Creditors

One of the provisions in the latest, er, provisional eurodeal, is that no matter what happens, no creditors other than those who lent to Greece will be forced to take a haircut on sovereign debt.

Felix Salmon is outraged:

The impetus for this completely insane policy seems to have come from the ECB, which genuinely seems to believe that bailing in private-sector banks, in the Greece restructuring, was the "terrible mistake" which caused the current euro crisis. Talk about confusing cause and effect: it was Greece's fiscal disaster which caused the restructuring and the necessary bail-in.

To understand just how stupid this is, all you need to do is go back and read Michael Lewis'sIreland article. The fateful decision in Ireland was to take the insolvent banks and give them a blanket bailout, with the banks' creditors all getting 100 cents on the euro. That only served to put a positively evil debt burden onto the Irish people, forcing a massive austerity program and causing untold billions of euros in foregone growth, while bailing out lenders who deserved no such thing.

Are we really going to repeat -- on a much larger scale -- the very same mistake that Ireland made? Does no one in Europe realize that this is the single worst thing they can do?

I find the outrage completely understandable--seriously? You want to cut pensions for low-income workers in order to bail out wealthy bondholders?  At the same time, I wonder whether this is really the single worst thing they can do.

We can agree at the injustice of transferring money from moderate-income pensioners to wealthy bondholders.  But I think the even more important question is what makes the average Joe better off.  And it's not clear to me that "stiffing the creditors" is the right answer.

For starters, some of those creditors--maybe a lot of those creditors, depending on the country--are insurance companies and pension funds that serve the aforementioned Average Joes.  But leave that aside.  Europe is not, at least as I understand it, making the creditors whole because of their abiding love for foreign holders of European sovereign debt.  They're stepping in and guaranteeing this debt in order to prevent a run on their banks and their bond markets.

Runs on financial markets, as far as I can tell, do not righteously limit their damage to rich jerks who didn't need the money anyway.  In fact, the people who suffer the worst from a rapid contraction of the credit markets are the poor.  They're the ones who actually end up hungry and on the street when companies start failing and they can't get jobs.

Now, perhaps you think that Iceland proves that default works.  But I think that even the serious proponents of this idea recognize that this is a contested notion which is far from bulletproof.  Ireland might be doing better now if they'd just told the bank creditors go go get stuffed.  They also might be in much worse shape.  We don't have a whole lot of data points here.

In the case of the current eurodeal, it seems to me that announcing that debtors are getting haircuts on their Italian or Spanish sovereign debt--or even failing to convincingly close off that possibility--would create the very outcome that they're trying to prevent: an all-out run on a bond market that is too big to save, and a follow-on collapse of banks that have bought too much Italian or Spanish debt.

Maybe this would be the best thing in the long run.  But when I think about the histories of the Great Depression I've read, I have to say that it's certainly not obvious to me that making the creditors eat their losses is the safest and best options.

But even stipulating that it is, you can certainly see why the governments in question are frightened of the immediate consequences--and why they might try to stave them off, even at great expense.

Don't get me wrong--I think this is a pretty bad plan.  But I'm not actually sure Europe has any obviously better plans left open to them.