Will Bond Holders Be on the Hook for Bailing Out Failing European Countries?

by: James Bacon

A new dynamic in Ireland’s sovereign debt crisis bears close watching by United States authorities because it could have spill-over effects here in America: European politicians are asking why bond holders shouldn’t share the pain of bailing out broke governments.

Credit German Chancellor Angela Merkel for raising the issue. Last month she tried to persuade other European Union members to compel bond investors to take some losses as a condition for future rescue plans. The idea was scuttled temporarily when her comments sparked a sharp rise in borrowing costs for weaker euro-zone governments, aggravating the crisis rather than alleviating it.

But the problem Merkel was trying to address won’t go away. German voters are angry, and rightfully so. Not only are they being asked to bail out profligate countries like Greece and irresponsible institutions like the Irish banks, whose debt was guaranteed by the Irish government, but they are forced to make whole the investors in government bonds — whose job it was to appraise the risks! Bond holders keep the profits when everything goes well, and they socialize the losses when things go sour. Heads, I win. Tails, you lose.

The United States bailed out its own commercial and investment banks during the 2007-2008 financial crisis, and American taxpayers were none too happy about it. Imagine the uproar if Americans had been asked to spend tens of billions of dollars rescuing foreign countries, foreign banks, and foreign bond holders. The Tea Party movement would have boiled over!

Not only are sovereign bailouts bad deals for taxpayers, they create moral hazard: If investors suffer no price for risky lending, they will engage in more of it. Conversely, if bond investors thought they might lose some of their principle, they might be more cautious about whom they loaned money to, and how much.

Economists can argue the merits back and forth, but citizens have a way of making their opinions felt at the polls. They quickly tire of paying for other peoples’ mistakes. The Germans have all the more right to be self righteous because they have restructured their economy in recent years to remain competitive in world markets, they have been relatively disciplined about running up deficits and debt, and they are putting up more than their fair share of money for the European bail-outs.

Indeed, there still is a chance that Merkel may get her way, though probably not until 2013, when arrangements for the 750-billion-euro bailout fund expires. The chancellor seeks to ensure that any new mechanism for dampening a future financial crisis dishes out a fair share of pain to bond holders.

How does this issue affect us here in the United States? The U.S. national debt is roughly $13.7 trillion and, in the absence of major spending cuts or tax increases, the Obama administration expects it to surpass $21 trillion by 2020. Interest payments are projected to soar from $220 billion this year to $800 billion at the end of the decade as the economy recovers and interest rates rise. Any increase in interest rates due to rising risk premiums charged by bond investors would translate into tens of billions of dollars in added interest payments every year.

In a globally interdependent economy, crisis in one part of the world can be quickly transmitted to another part. By altering the investor psychology regarding investments in sovereign debt, a revolt by German taxpayers could make life harder for our own debt-addled government in the U.S.

Disclosure: No positions