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Our Mediterranean Moral-Hazard Holiday


Greece and Spain are Europe’s weakest fiscal links. At home, we’ve got New York and California.

Without bubble-era tax revenues, the two European nations need to borrow heavily to support their huge public sectors. But investors, including European banks, buy Greek bonds only because they figure that Germany and France would lead the eurozone nations in a bailout if necessary. The stronger nations likely would do so to prevent any nation that uses the euro as its currency from defaulting on its sovereign debt.

Germany and France don’t want to say outright that they would bail a profligate neighbor. So they’re hoping that it won’t come to that end. But, as the Times notes today, Greece and Spain won’t cut spending on their own: “A new Greek government . . . is just now promising steep spending cuts. But it is not clear whether the political system in Greece will accept them. Meanwhile, Spain . . . seems to be putting off difficult fiscal questions in the hope that its economy will soon recover.”

The risk is that the European Central Bank and the bigger European governments will harm their own economies in an attempt to avoid an overt cross-national bailout that would set a bad precedent. The ECB could keep interest rates far too low for too long, tending another asset bubble, so that Greece and Spain can continue to borrow at somewhat affordable rates.

America has its own fiscal weak links — and they present similar temptations.

New York State is nearly out of money; California has been there, off and on, for a year now. The Times’s assessments about Greece and Spain could apply to either domestic state. New York and California have political leaders that don’t stand up well to public-sector unions, and both states have spent the financial and economic crises waiting for a magical confetti shower of revenues rather than making cutbacks.

Just as in Europe, these states’ precarious fiscal positions create a motive for the Federal Reserve and the rest of Washington to pursue policies that may avert an overt state bailout now, but harm the nation’s interests.

New York, for example, benefits immensely from Washington’s zero-percent interest rates and its failure to regulate Wall Street properly. Thanks to nearly free borrowing, Wall Street firms have been able to earn huge profits this year. They’ll thus pay out big bonuses to their heavily taxed New York employees early next year.

The most indebted states benefit from negligible interest rates in another way. Savers can’t earn even a modest return in a bank account, so they must take risk — including lending even more money to states that really shouldn’t be borrowing any more than they have already. But investors can take comfort in the fact that the risk is blunted. Just as European investors don’t think Paris and Berlin would let a fellow eurozone nation fail, American investors don’t think Washington would let Albany or Sacramento fail.

Zero interest rates and an arbitrary risk environment distort the value of everything, meaning that nobody knows what anything is worth. Executives are already having a hard enough time figuring out what’s a good investment in this economy. They hardly need Washington to add another challenge by way of a backdoor bailout for profligate debtors that include state governments.

— Nicole Gelinas, contributing editor to the Manhattan Institute’s City Journal, is author of After The Fall: Saving Capitalism from Wall Street — and Washington.


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