Damned if you do, damned if you don’t…
Why is bailing-out a bad idea? That’s a rather simple question to answer. It rewards bad behaviour. It’s like bailing out banks, but even larger. While future bank behaviour can be controlled (at least in theory, for instance through the Volcker proposal in not letting them trade on their own account), countries within a monetary union are much more difficult to discipline.

So Otmar Issig certainly has a point when he argues bailing out is a bad idea. This will make it even more tempting for future (and present!) profligate to free-ride on the monetary union (even though there are positive sides to that free-riding, like the fall of the euro). The only thing holding such behaviour at bay would be if capital markets would distinguish much better the creditworthiness of different countries.

Luckily, that’s what is starting to happen, although that’s also triggering the present crisis. The interest rate differential between the weaker southern European countries with Germany has widened conspicuously in the last half year or so, making refinancing of maturing public debt (and financing very large budget deficits) much more costly.

This blog has been called socialist more than once (mainly for writing this article), but we really favour market solutions where possible. The point is, our detractors mostly fail to recognize markets are often far from perfect. Take the sovereign debt markets. It could be argued that the fiscal situation of Greece and some other ‘PIGS’ (Portugal, Ireland, Greece, Spain) should have warranted much higher interest rate differentials with German bunds much earlier.

But there is a bit of a twist here. If Greece gets a bail-out, that will really reduce interest rate differentials with Germany, as that differential really reflects the higher default risk in Greece bonds. And with a bail-out, that risk will get a good deal smaller.

There are some (see article below) who implicitly argue that the interest rate differential between Greek and German bonds contains more than just the higher Greek default risk. It also contains a currency risk, the very same risk that was abolished when Greece joined the European Monetary Union (EMU), which brought down interest rates quite drastically and set off a spending boom which let to the present mess.

A currency risk could be priced into Greek (and other like Spanish, Portuguese, Irish, and even Italian) interest rates on its public debt as talk of a break-up of the monetary union gets more traction. We don’t think that’s going to happen though..

French Bank: Euro Collapse ‘Inevitable’
By: Greg Brown

The euro, already under pressure, came under renewed attack Monday as a French bank speculated that the currency union would inevitably collapse.

Meanwhile, a former chief economist of the European Central Bank warned that a bailout for member country Greece could damage the euro’s credibility.

Société Générale strategist Albert Edwards warned investors that any help given to Greece merely “delays the inevitable break-up of the euro zone,” while former European Central Bank Chief Economist Otmar Issing, in a Financial Times piece, said bailing out Greece would be a “major blow” to the currency.

“The viability of the whole framework — nothing less — is at stake,” wrote Issing.

“Financial assistance for countries that violated the terms of their participation in EMU would be a major blow for the credibility of the whole framework.”

The euro could sink to $1.3483 from its $1.5144 high in November, traders told the U.K. Daily Mail.

At issue are the terms of the pact that created the euro, which requires its members to maintain an annual budget deficit no higher than 3 percent of GDP and a national debt lower than 60 percent of GDP.

Greece is expected to hit 12.5 percent deficit in 2009 and debt of 72 percent by 2010 and 2011.

Details of a plan to bail out Greece are being hammered out today and Tuesday at a special meeting of the European Central Bank’s Economic and Financial Affairs Council, Ecofin.

In addition to the open question of Greece, the fate other countries with similar debt and deficit problems, notably Spain, Italy, Ireland, and Portugal, hang in the balance.

Currency speculators have increased their bets on the dollar to their highest since 2008, while short euro positions rose to a record, according to Reuters.

Meanwhile, euro critics have piled on. David Cameron, the opposition leader in the U.K., reiterated his statement that Britain would “never join the euro.”

Cameron is expected to become prime minister of English in a few months, ending 13 years of Labor government.

Martin Feldstein, a former adviser to President Ronald Reagan, said the euro system wasn’t working.

“There’s too much incentive for countries to run up big deficits as there’s no feedback until a crisis,” he said.