Monday, June 11, 2012

More Loans Won't Help Europe

There was news over the weekend that the euro zone has agreed to lend Spain up to 100 billion euros.  That is about 125 billion U.S. dollars.  Spain has been the latest country to follow Greece in its solvency troubles.

While this may help "save" Spain in the short run, it is just more kicking of the can down the road.  The problem is, whenever they kick the can further down the road, it makes the final day of reckoning that much worse.

While comparing a government to an individual or family is not a very good comparison in most cases (because governments rely on their monopoly of the use of force in a given territory), it can actually provide a pretty good analogy in this case.

Let's say that someone makes $50,000 per year in income.  For the sake of this discussion, let's pretend there are no taxes.  Let's say that this person spends $60,000 per year.  He is running a deficit each year of about $10,000.  In addition, his total accumulated debt is $100,000 (and growing by $10,000 per year).  Let's say this debt is in the form of credit card debt.

What is the solution for this person?  He could declare bankruptcy, which would wipe out the $100,000 in credit card debt.  However, his credit card companies would shut down his accounts and would no longer be willing to lend him money, especially without collateral.  So the person would be forced to cut his spending by at least $10,000 per year, assuming he can't earn more.

Another solution is to cut spending drastically.  Not only does the person need to stop running up more debt, but it would probably be a good idea to start paying down the credit card debt, as the interest payments alone are high.  This would mean the person would have to cut spending each year by a far greater amount than the $10,000.

Another option is for the person to get another loan.  He could get a loan (from a fool) for another $20,000 and this would allow him to continue his spending for the next 2 years.  The problem is that the total debt goes up to $120,000, or more if you include interest on the debt.  By getting another loan, this person is just that much further in the hole.  It means it will be that much more difficult to get out of this situation in the future or else the bankruptcy will be that much bigger.

By Spain getting a loan from the euro zone, it just means they will be that much further in the hole.  The Spanish government will never be able to get out of the hole unless there is a big direct bailout (not a loan) or else bankruptcy.

It makes it easy to see how all of this will end.  By giving Spain a loan, it just encourages a continuance of reckless spending.  It means that things will be that much worse in the near future.

The only solution is a dramatic cut in government spending.  It will come eventually, either way.  The government can try to raise taxes, but this will not do anything.  Art Laffer had it right with his curve.  If you raise taxes high enough, it just discourages further production and can actually lead to a decrease in total tax collections for the government.

It started with Greece.  Now it is Spain.  This will be a pattern throughout the world.  It will happen in many western European countries.  It will probably happen in China, Japan, and the U.S., among others.  At some point, governments will be forced to cut back on spending.  The longer they wait, the more painful it will be in the future.

3 comments:

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