Many of the discussions on the rescue effort subsequent to the financial tsunami and the outbreak of the European sovereign debt crisis point to the size of the total debt as reflective of the size of the problem. Because many people take this perspective, they cannot appreciate how governments could help in the rescue effort by incurring more debt. Concerned about moral hazard problems, they also cannot agree with central banks buying debt or playing a part in any bail out plan.
Actually there is considerable misunderstanding behind all these apparently logical perspectives. First of all, it is natural that total debt grows over time. Globally, total outstanding debt will certainly be bigger ten years from now, and even bigger twenty years from now. Total debt is never a problem, because it is net debt for a specific debtor that poses a problem--if that debtor cannot service the debt. Globally net debt is always equal to zero, because there is a creditor behind every debtor, and there is no net global debt. A sovereign debt crisis refers to the net indebtedness of a sovereign nation being too big for it to service. Resolving the sovereign debt crisis must therefore involve reducing the servicing cost or increasing the ability to service debt or a combination of the two. Reducing the servicing cost must involve (a) reducing the interest rate on debt; and (b) reducing the size of the outstanding debt on which interest needs to be paid. Increasing the ability to service the debt requires pro-growth policies.
Accordingly, the EU's current approach to tackle the sovereign debt crisis is bound to fail. The austerity measures sap the strength of the economy and thus the ability to service debt. The unwillingness to issue Euro-wide bonds means the interest rates on government bonds issued by the most indebted nations are far too high to be serviceable. The haircuts help to buy time, but they are of little use as long as interest costs remain too high and soon pile up to produce even bigger debt.
In contrast to the Euro-zone, the US is handling its debt problem quite well. Many observers do not understand the role of government debt increases in helping to reduce private sector debt.
In the wake of the financial tsunami most governments borrowed more to finance stimulation measures and to alleviate private sector debt problems. More debt was incurred in the public sector, but they helped relieve the debt problems in the private sector. Indeed household balance sheets in America have improved considerably thanks to these efforts, laying down the groundwork for a recovery. (Here is an account of that.)
Will central banks lending to governments to help rescue banks lead to moral hazard? This depends on whether the rescue indeed bails out the decision makers that made the bad decisions. But "rescuing banks" does not have to bail out the bad decision makers. Indeed, as a bank is "rescued," the management team can be changed, as the recapitalization of the bank dilutes and even wipes out the equity of the former shareholders, and the bad decision makers can be sacked.
The rescue essentially bails out the banks' counter-parties, many of whom are innocent victims. Bailing out the bank also means that the bank can continue to function as a bank and continue to make credit available to deserving borrowers.
As far as I can see, the Euro debt crisis can be contained by the issue of Euro-bonds and a pro-growth strategy. If this requires central bank lending or "money printing," so be it. With the purchasing managers index(PMI) down to recessionary levels across the Euro zone, and depression-like unemployment rates in Spain and Greece, monetary expansion is not inflationary. Indeed the American experience has shown exactly that: Inflation expectations in America is currently the lowest in years.