The Tricky Business of Financial Bailouts

eurozone debtGermany’s dominating financial power in the European Union (EU) is indisputable. The region’s most thriving economy has earned its right to seek higher moral and financial ground than the majority of its fellow Eurozone members. These days, Germany is the Eurozone’s lord and master, it carries a huge stick in the form of a healthy checkbook, and it is the glue that keeps the Eurozone experiment together.

Having that much moral and financial power has given Germany the role of knight in shining armor to countries with sovereign debt problems, albeit it would rather not have that dubious honor. Still, things are what they are and Germany found itself the Eurozone’s official rescuer when it first agreed to foot most of the bill for Greece’s bailout. Ireland is likely to be next, once it exits the denial phase, and possibly Germany could come to the aid of Portugal and Spain, two other heavily indebted countries apparently unable to drive their finances out of insolvency.

Germany really does not like where its own fiscal prudency has brought it. It does not want to reward bad behavior by rescuing every neighbor that has fallen on hard times just because. Germany is particularly not disposed towards helping neighbors that are hiding the true state of their balance sheets and how much money is actually owed. Greece did it for years—hid the true scope of its troubles, that is—which was why Germany had to be dragged kicking and screaming into signing off the bailout.

Contrary to the popular opinion among the Eurozone’s laggards and deadbeats, bailouts are not free and they come with heavy strings attached. Government bailouts have to be paid by someone and that someone consists of taxpayers. The bigger the bill that German taxpayers have to foot, the fewer the votes for Chancellor Angela Merkel. No wonder Merkel wants a new bailout system. She wants to keep her job.

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So Merkel came up with an idea to spread the pain among private bondholders, whereby the latter would be forced to accept “haircuts” that would shave significant value off their bonds’ principals. The sharing the pain idea is a good one. The only problem with it is that, like many other ideas coming from Germany, the timing is really lousy. Hearing of Germany’s plan and realizing that bonds issued by the Eurozone pariahs, such as Ireland, Portugal and Greece, are spiraling down the toilet, short sellers had a field day. As the yields of Europe’s weaklings rallied, prices dropped and short sellers pocketed their profits only six months after the Greek disaster. Things got so bad for the EU finance ministers that they immediately engaged in damage control. As a result, haircuts would not apply to bonds issued before middle of 2013.

There is no way that Germany could go on saving the Eurozone. There has to be a shift of responsibility and haircuts could be a way to facilitate that shift. It is also not only a question of responsibility, but also it is a question of what works in the long run. As we already know, financial bailouts are short-term solutions, not long-term ones. So, in a way, Germany is both a part of the problem and a vital solution to it. Without a doubt, financial bailouts are tricky business and, when the main player is a reluctant participant, it only adds to volatility, as if anyone would need more of it.