Washington, DC, May 11, 2010 --  

Europe's bond market rescue won't stabilize international finance so long as national governments remain so awash in debt.

When angry citizens of Greece learned the details of an IMF austerity plan, things quickly turned ugly. Forced to accept new taxes, civil service layoffs, and deep cuts in government services, furious Greeks took to the streets, throwing Molotov cocktails and smashing storefronts.¹ Stock markets tanked around the world. By the end of the week, America's market had gone down by nearly 10 percent.²

Economic cutbacks are never popular. But given that the Greek government has been spending beyond its means for years, and hiding the worst of its profligacy through government budget accounting gimmicks, Greece is hardly deserving of world sympathy. Its inability to make its debt payments has sparked a bond crisis throughout Europe. And with the market downturn across the Atlantic, even Americans are feeling pain from Greece's irresponsibility.

Of course, Greece is hardly the only country whose government engages in irresponsible spending. Portugal, Spain, Ireland, Britain and the United States all have run up huge government debts. If the violence in the streets of Athens is any indication of the how difficult it will be for larger countries to deal with their very similar public debt problems, then the world economy is in very serious trouble.

It is likely with this in mind that the European Central Bank made its desperate move on Monday to promise to purchase the flagging bonds of indebted Euro zone members.³ While the move will certainly buy time for the most indebted governments in the Euro zone, it actually makes long-term problems worse by reducing the pressure on governments to get their financial houses in order.

The main challenge to bonds of Europe's weaker governments is that they are competing in a global market -- a market that is already oversaturated. Why purchase Greek or Portuguese bonds when Germany and the United States sell ones without as much risk? And given that the British and American governments have flooded bond markets with paper both as part of their own bailout and stimulus programs, as well as to finance their continued profligacy, it is surprising that there are any buyers left for smaller issuers like Greece, Portugal and Spain.

Welcome to round two of the financial crisis. The first round began three years ago with the collapse of Bear Stearns, and the realization that vast swaths of American mortgage debt could not be collected. Governments tried to make a quick fix of bailing out private mortgage debt markets with public money. But now, the crisis in investor confidence has jumped from private mortgage securities to public securities. Rather than solving debt problems over the past few years, governments have merely moved shaky debts from private books to public ones.

The European Central Bank's rescue plan will likely succeed in protecting the weaker states of Europe so long as Germany remains willing to pay for the debts run up by Greece, Spain, Portugal and Ireland. But this does nothing to help Britain, which is no part of the Euro zone, and not covered by the rescue. And across the Atlantic, the gigantic and deeply indebted American government is simply too big to stop from failing.

Officials scoff at the idea of the British and American governments not being able to repay their debts. There is no crisis on the horizon, provided that interest rates stay low, the economies keep growing, and politicians and the public are ultimately able to accept painful tax increases and cuts in government services and pensions. Trust us, they say. Our bonds are safe.

Such pronouncements are dubious and self-serving. Without trust, officials know that bond purchasers demand higher interest rates that governments are unable to pay. And when the government can't afford to finance its debt, the whole system can collapse overnight. This is as true for America and Britain as it is for Greece. With short-term pressure taken off the weaker countries in the Euro zone, the British government may find itself next in line for added scrutiny from skeptical bond investors.

How Britain handles this looming crisis is a preview for what will happen when the chickens come home to roost for the United States. Can the British government cut its deficit before bondholders lose their trust? The answer may come before the year is out.

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A Greek Canary in an American Mine, December 15, 2009

Notes:

1. Associated Press, 3 Dead as Anti-Austerity Riots Erupt in Athens, May 5, 2010

2. Google Finance, S&P 500 Index, May 2010 (Opening May 3 to Closing May 7)

3. Bloomberg Businessweek, Trichet Indicates ECB Bond Purchases Not Unanimous, May 10, 2010