Moral Hazard - Why Bailing Out the PIIGS Could Backfire

Sovereign Debt

For the past year and a half many of us have been watching the news come out of Europe about some of the smaller states inching closer to insolvency (bond default) and getting bailed out by the stronger states (Germany and France mostly).   The weakest of the states have been summed up as the PIIGS which stands for (Portugal Ireland Italy Greece and Spain).  It’s natural to wonder if these bailouts are important and speculate on how they might affect us and our investments.  

Bond Crisis - Starting Small

As a start, only Greece, Ireland and Portugal have actually been in talks with the IMF, ECB and others about possible bailouts.   Many people have said that these economies are so tiny that they don’t matter so we shouldn’t be concerned about the bailouts, and they have a good point.  Look at these GDP numbers as a percentage of the US GDP:

Greece:   2.0%

Ireland:  1.2%

Portugal:  1.5%

You can see that these economies are indeed tiny so if the problem should be confined to those, now and in the future, then it really should be no problem just to bail them out.   Many people have said that bailing them out will help investors feel better about the sovereign debt bond markets and therefore stop the spread.  Will it?

Moral Hazard

The problem with bailing out these small states is what Alan Greenspan called the “moral hazard”.  He was referring to the US bailing out banksters, which is the topic of a future blog, but the problem is the same.   Such handouts might lead other governments to seek the same easy way out rather than make the tough choice between lower government spending or higher taxes (both of which cost politicians votes).   Both Spain and Italy have large budget deficits and may soon seek bailouts as well.  Here are the approximate GDP’s of those countries relative to the US:

Spain:  10%

Italy: 14%

It’s apparent that it would be much harder for Germany and France to carry Spain and Italy for very long, considering the sizes of those 2 down-and-out economies.  Worse,  a handout today does not correct the structural flaws (e.g. overly-generous pensions and early retirements) inherent in those weak economies, so they’re likely to come back again tomorrow seeking more handouts. 

State Debt - It can't happen here?

The problem of independent states being close to default and seeking relief from the larger union is not confined to the Eurozone.  In the US several states have large budget shortfalls and some people have been talking about bailouts or “loan guarantees”.  Here are 4 US states that are dangerously close to default and their GDP relative to the US:

CA:  14%

NY:  8%

MI:   3%

IL:  4%

It’s apparent from the above figures that the relative size of the top 4 potential state bailouts in the US is about the size of the European bailouts in terms of GDP.  

Investing in Municipal Bonds - The danger of contagion

Since politicians are unlikely to want to give up votes by raising taxes or cutting spending, there’s a strong incentive for these states to seek a bailout or loan guarantee (in effect a bailout light, or future bailout).  And once a few states get bailouts it would be almost impossible for Obama and the Congress to refuse other states bailouts, under charges of favoritism, so a bailout for one quickly becomes a bailout for all 50 states.  Instead of the contagion being contained there are real reasons to believe that the contagion would spread.  Even fiscally more-responsible states like TX would likely line up for a piece of the federal pie.  After all, bringing those goodies home would garner a lot of votes and allow taxes to be cut and “much needed”: programs to be funded.