Andrew Lilico: Denial must end. Do not bail out Greece.

Andrew Lilico is a Director of Europe Economics, the Chief Economist of Policy Exchange, and a member of the IEA/Sunday Times Shadow Monetary Policy Committee. He writes here in a personal capacity.

Governments are typically able to respond to significant events employing one of four broad strategies:

1. Try to keep things as they were
2. Manage change, slowing and smoothing the transition
3. Permit change, allowing matters to proceed at their own pace
4. Embrace change, trying to reach the new stability more quickly

In the 1930s, in response to the Stock Market Crash and the early phases of the slowdown, the US government went for strategy (4).  It deliberately tightened policy so as to try to accelerate change.  It saw this as economically efficient and morally improving.  As Andrew Mellon put it at the time: 

“liquidate labor, liquidate stocks, liquidate farmers , liquidate real estate to purge the rottenness out of the system. High costs of living and high living will decline. People will work harder, values will be adjusted, enterprising people will pick up from the less competent.”

As our current crisis began in 2007, the broad strategy in many countries was to attempt to keep things as they were.  Many people saw the problem in financial markets as either a technical flaw in the way financial markets were working, or a passing liquidity problem, or in some cases the result of deliberate market manipulation by speculators.  The idea was that government intervention to provide extra liquidity, intervening in specific markets in some cases, or simply replacing bank-to-bank financial dealings with bank-to-central bank dealings (e.g. though the Special Liquidity Scheme) would shield the market through its temporary glitch.

By summer 2008, this approach had clearly failed.  Instead of fading away through government intervention, problems continued and escalated.  Governments then hit upon a new concept of how to keep things much as they were.  The idea now arose that instead of a liquidity crisis, what we faced was a crisis associated with past losses.  Some poor decisions had been made, leading to large losses.  But if governments intervened to replace the funds lost (to “re-capitalise” the banks), then looking forward matters could continue much as they had done before.  There was a debate as to which governments would do this.  Initially it was hoped that oriental sovereign wealth funds might re-capitalise the Western financial system.  After the Fannie Mae and Freddie Mac debacle, this ceased to be an option, and instead Western governments intervened to re-capitalise their own banks.

I objected to the re-capitalisation strategy in principle at the time for all kinds of reasons – it was morally improper (as I explain in more detail below), it destroyed the functioning of capitalism, it would inevitably result in massively invasive regulation, it would slow growth over the longer term, probably exacerbating the recession even in the short term.  But – and this was not my objection, but my fear – I also thought it might fail even in its own terms, because I did not believe that this was simply a crisis associated with past losses but, instead, was at least partly a crisis concerning future profitability.  To secure profitability of the financial sector over the long term, there needed to be large structural changes to the way things were done, and the structural changes in the financial sector were the mirror of large changes in other parts of the economy, also.  Failure of the re-capitalisation policy would be disastrous (relative to the policy interventions I preferred) because that would lead to multiple sovereign defaults in developed economies.

For all the rhetoric about how matters would never be the same again, the re-capitalisation strategy remained an attempt to keep things much as they were before.  Bondholders did not make losses.  A number of other industries such as the car industry were given large subsidies.  Whereas if banks had failed they would have been replaced by new banks, we have much the same institutions dominating the banking sector that we had three years ago.  The broad groupings in society that were rich or poor three years ago remain the rich and the poor today.

There has been a large recession, of course – the deepest and most global of the modern era.  Advocates of the bailouts policy appear to take the view that the recession would have been much larger if the bailouts had not occurred.  Of course, that ignores what different interventions one might have carried out if one had not done the bailouts (I, for example, favoured a different set of interventions rather than laissez faire), but even setting that point aside, I am most unclear on what basis these bailout advocates assert that matters would have been even worse without such intervention – it certainly isn’t on the basis of any historical cases or of orthodox economic theory.

Whether advisable or not, the core strategy has been to keep things much the same in a number of developed economies.  Not everywhere.  Ireland, for example, has made significant changes.  So have a number of Baltic states.  But in a number of developed economies government spending plans continued unchanged (or even expanded further), policies on retirement ages and entitlements, on industrial policy, on regional policies all continued as they had been, and the structure of the financial and monetary systems was sustained (albeit with big regulatory changes set for the future), in the hope that by carrying on regardless, one could tough out these events and emerge – a little bruised perhaps, a little wiser hopefully, a little more cynical certainly – but emerge with limited long-term effects.

I consider this immoral, as I have done from the beginning.  It is immoral that rich people that took risks that turned out badly have been kept rich, spared from the consequences of their errors, by being bailed out by taxes paid by poor people.  I am all in favour of people receiving a good return on their investments as a reward for their good judgement and good luck when they are willing take risks.  But the quid pro quo of this is that bad judgement and bad luck must entail losses.  If bad judgement and bad luck do not entail losses, then there was no risk in the first place that morally justified these people in becoming rich.  Rich investors would then be nothing more than rentiers, using their political influence to secure private gain, vesting their wealth and power through exploiting and oppressing the poor.  The objections of radical socialists would be proven to have been right all along.

The latest instance of this immoral exploitation of the poor, in a vain attempt to keep the structure of society and pattern of power as it was, is the proposals for bailing our Greece.  The latest discussions suggest a bailout of €120bn.  That is nearly half of Greek annual GDP.  In British terms, that would be as if other countries gave us £700bn.

This is wrong.  Strip away all the fancy excuses, the delusional arguments people always offer in these circumstances as to why it would be better to give me money than not.  It’s wrong.  Everyone knows it.  The Greeks themselves lied and cheated in order to borrow large sums of money to fund lifestyles they could not afford from their own work.  And those that lent them the money knew they had a terrible history of default.  Greece has been in some form of default for about half its history since 1830, and that sets aside many periods in which it was inflating away its obligations.  People cannot really have been lending money to Greece expecting it all to be repaid by the Greeks.  Either they were gifting money to Greece as some sort of cultural contribution – participating in the Myth of Athens – or they believed that German taxpayers stood behind Greece and would bail it out.

But such bailouts are explicitly forbidden under the EU Treaty.  Many commentators appear to blithely assume that this does not matter, and there will be a political fix.  Well, there could be a political fix if one changed or ignored the Treaty.  But simply overturning the European Union’s key constitutional document would obviously be a form of mild revolution, and would imply overturning the constitutions of a number of other EU Member States, also – in particular Germany’s.  I cannot comprehend how any result other than declaring these bailouts illegal could come from the German Constitutional Court or from the European Court of Justice.  The Treaty’s provisions forbidding bailouts were specifically and explicitly designed to prevent precisely this sort of bailout.

Furthermore, such bailouts are going to impose large burdens on other countries that can scarcely afford them.  Portugal and Spain are both Eurozone members, and notionally committed to contributing billions of euros to the Greek bailout.  But where is that money to come from?  Portugal and Spain already face serious periods of austerity.  Are the burdens on their citizens to be magnified further so they can help the Greeks?  Will those citizens be willing to bear those burdens?  Or might these countries, also, be then driven into default?  Who will bail them out?  Are diligent, disciplined, hard-working German taxpayers to fund the flabby lifestyles of the entire European Union?

It would be immoral to bail out the Greeks, and in clear and unambiguous violation of the EU Treaty and the constitutions of a number of EU Member States for Greece to be bailed out – effectively subverting their constitutions so as to spare some more rich people from the consequences of their foolishness.  And other countries can't afford it.  Either Greek citizens must accept huge burdens to pay off its debts, or it must default.  The former is probably unthinkable and probably politically improper.  So Greece must presumably default.

This would be an event with major consequences, now.  At the outset of the crisis, many governments had reasonably robust balance sheets.  They could have used their ability to borrow cheaply to smooth the process of social transition, as a number of people that were rich became much poorer and others that had been poorer became richer.  But because of the foolish attempts there have been already to keep matters as they were, government balance sheets in many countries are now extremely strained, and may now struggle to bear the burden of volatility and transition.  Greek default might well lead on to default (or effective default through very high inflation) by a couple of other developed economies.

What would be a terrible idea, now, would be to continue with the denial by moving the burden of trying to keep things as they were from the balance sheets of less robust economies onto the previously more robust economies.  That would risk eventual default occurring across many developed economies, with incalculable consequences for social order and international relations.  It's one thing for Greece to default.  It would be quite another if, in a few years time, Germany were at risk of doing so.

Instead, we should abandon the attempt to prevent change, and instead switch strategy and attempt to manage change (in those countries that still have some scope on their balance sheets), permit change (in those countries where government has no remaining scope to assist, but at the same time is not so over-stretched that it is near default), and embrace change (in those countries that will default or will need rapid and extreme measures to avoid default).

Do not bail out Greece.  The attempt to keep things as they were has run its course, and failed.  It was a mistake from the beginning – albeit perhaps an understandable one.  Salvage what we still can of developed economy balance sheets.  Do not risk ruining us all in the vain, misguided, and immoral attempt to spare some investors that had bad judgement and bad luck.  Under almost all circumstances, losses on investment are not capitalism failing.  They are capitalism working.