Bondholder Bonanza in Europe

If you believe in reincarnation, think seriously about coming back as a holder of Euro-denominated bonds. (Or, skip the reincarnation part and just buy some.) Today, the bailout of Ireland makes clear that every nation in the European Union guarantees the obligations of every other EU nation, and also the obligations of every bank in every EU nation. Holders of European debt are in Heaven, dancing cheek to cheek with EU taxpayers.

The Germans (and French, kind of) made some noise about bondholders sharing in the losses from future national financial crises. But when push comes to shove, which could be in a week or two with Portugal, it's essentially a certainty that the dour Chancellor Merkel and frenetic President Sarkozy will hold their noses and sign another blank check. That's because the real beneficiaries of these bailouts aren't Ireland, Greece or whoever. They're German, French and other EU banks, which hold shiploads of Irish, Greek, etc. debt. A default by these nations would put the banks down the street from Chancellor Merkel's or President Sarkozy's office at risk, and those banks and their various constituencies are the real reason the wealthy EU nations are spreading Christmas cheer to the poorer EU nations.

It doesn't have to be this way. The sovereign debt crisis began with a dust up in Dubai about a year ago. While Dubai's problems quickly moved off the front page with the revelations of Greece economizing on the truth about its budget deficit, a workout continued quietly. Not long ago, the Dubai debt problem was resolved with some bond holders taking losses. Farther back in time, international financial crises in Latin America during the 1970s and 1980s involved banks taking losses on their loans. There is nothing magical about being a creditor that necessarily insulates one from loss.

The distressed nations can't devalue their currencies to boost their economies through exports (a standard maneuver in such circumstances). They all use the Euro, and its value is maintained by the European Central Bank. Only the long, poorly paved road of austerity and higher taxes is open to them. Without bailouts, defaults would loom and the debtor nations might have to leave the Euro bloc. Since Germany and France want the Euro to work, they are left with little choice except to make nice-nice with bondholders.

But just as American taxpayers are tired of bailing out bankers in New York, German taxpayers may eventually tire of bailing out the money men in Frankfurt. The poorer EU nations aren't leaving the Euro bloc--with Germany backstopping them, they have every incentive to stay. The Germans may, in the end, be the ones who leave. The more the Germans bail out profligacy in other nations and reckless lending by their own banks, the more their own financial condition will deteriorate. If Germany guaranteed all EU sovereign and bank debt, it would be in lousy shape. Since it more or less implicitly has done just that, it is. German taxpayers have already carried the substantial burden of incorporating East Germany in the West. They very possibly won't want the burden of incorporating the entire EU into Germany.