“Contracting debt will almost infallibly be abused in every government. It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London …” — David Hume, Of Public Credit (1742)

The interesting question to ask about the European debt crisis is not what sort of bailout package will work, or which Italian or Greek government should oversee it. Economic forces will overwhelm any political theatrics.

The relevant question is how European countries were able to borrow so much in the first place. How did Italy end up with debts of 120% of GDP, or €1.9 trillion? How could Greece, a long-standing economic basket case, borrow as much as 150% of its GDP?

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The answer seems to demonstrate either the gross stupidity or masterful sophistication of financial markets.

These countries, especially Greece, should not have been attractive to lenders. Greece had defaulted routinely on its debts since the early 19th century, and its finances (even the faked ones) were demonstrably shambolic right up to the beginning of the financial crisis in 2008.

Italy, still a geographic expression as much as a functioning political entity, riddled with corruption, had an excessive debt to GDP ratio of about 110% in 2001.

That governments will want to borrow excessively and wastefully is not a new revelation. David Hume knew that. But how could financial markets, awash with highly paid “risk managers” and apparently staffed with the most talented employees, shovel so much money at these nations?

Both countries were able to borrow almost as cheaply as Germany, a country with more evident fiscal fortitude, throughout the 2000s.

Sure, the advent of the euro had bound European countries more closely together, but that didn’t mean individual countries could no longer default. Indeed, the European Central Bank, the European Union and European politicians were emphatic that no bailouts would ever occur under any circumstances. Edmund Stoiber, a prominent German politician, reckoned bailouts to be as likely as famine in Bavaria.

That many banks and fund managers now face substantial losses on their loans to recalcitrant European countries may demonstrate their foolishness.

Or perhaps their brilliant perspicacity? Year after year lenders made a little bit extra profit on their loans to Greece and Italy. As for the risk, they might have realised that whatever European leaders said, Western governments had become so large, social democracy so rampant, and banks so large and interconnected that it would be impossible for any democratically politician to permit lenders to lose substantial sums on their loans.

And that is exactly what has happened. Indeed, private lenders have transferred vast swathes of their dodgy, multibillion dollar loans to public European institutions such as the European Central Bank, while politicians and the International Monetary Fund fall over themselves to protect lenders from losing money. At the same time, those lenders continue to clock up massive profits and pay absurd salaries to many of their staff.

It is a master stroke for private lenders; never in my lifetime have ordinary taxpayers been bilked so comprehensively and unwittingly.

If you find these events unsavoury you must support removal of all moral hazard and implicit guarantees from the banking system. If Italy can’t pay back its debts and private lenders lose so much money they go broke, so be it.

Indeed, any institution that lends to a country with a debt to GDP ratio of more than 60% deserves to lose most of their investment. At that level of debt, interest payments as a fraction of government revenue become very sensitive to changes in volatile market interest rates.

Australia is thankfully far removed from Europe’s woes, but we can best help with a bit of tough love. The opposition’s first instinct was right about the IMF. Australia should not give a cent more money to this discredited institution. Having bigger bailout funds only exacerbates the moral hazard that caused the crisis in the first place.

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Peter Fray
Peter Fray
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