Both economically and morally, bailouts are bad news. But they have their place. By Richard DeKaser, Contributing Economist May 13, 2010 The nearly $1-trillion bailout package for enfeebled European Union members will likely pay off on two fronts.First, it buys time for Greece and other financially crippled EU members -- Portugal, Italy, Ireland and Spain to get a handle on their finances. The massive shock-and-awe package assembled by the EU and the International Monetary Fund (IMF) doesn’t fix any of the fundamental problems plaguing these nations -- unsustainable fiscal situations and uncompetitive labor costs. But when financial markets are snared in a downward spiral, with falling asset values and deteriorating economic prospects reinforcing one another, a bailout may be the only option. And it puts the EU on a path to a stronger confederation, with greater discipline over its member nations. The crisis set the EU at a crossroads. It chose not to take the path of dissolution, with Greece opting out of the union and returning to the drachma as its national currency. The alternative leads to a sturdier union -- if not thanks to a stronger central financial authority, at least because the more fiscally stable members of the euro zone will be better able to keep smaller, shakier members on a checkrein. On the first score, “EuroTARP” is clearly successful. The most important aspect of the bailout was a move intended to stanch the investor flight from the PIIGS’ (Portugal, Ireland, Italy, Greece and Spain) sovereign debt: A 750-billion-euro ($955-billion) fund put together by the IMF and the EU to guarantee the obligations of weaker governments, backed up by direct debt purchases by the European Central Bank. Even before the fund was fully capitalized, or a single security purchased, it was working. Demand for government bonds improved, interest rates fell, and the perceived risk of default receded. The yield premium demanded by investors for holding risky 10-year Greek debt, instead of supersafe German bonds, fell by half in two days. What’s more, short-term lending rates have stopped rising and begun to decline. Because European banks are loaded with euro zone debt, borrowing costs had begun to climb as the banks became increasingly wary of lending to one another, driving up the London Interbank Lending Rate (LIBOR), a benchmark for short-term funding costs. Fears that banking problems were spreading from Europe to the U.S. drew the Federal Reserve into the arena. Because LIBOR is also often used in the U.S. -- to determine the interest on adjustable rate mortgages, for example -- the Fed took action, immediately lending dollars to foreign central banks. Those banks, in turn, made dollars available to banks in their respective jurisdictions, with the result that the uptrend in LIBOR rates has turned around. None of this will matter, of course, if the PIIGS don’t take care of business. Bringing their social safety net more closely into alignment with neighboring countries and reducing deficits are critical. Up till now, there’s been no way of enforcing discipline. The 1997 Stability and Growth Pact central to the formation of the EU stipulates that countries maintain deficits no greater than 3% of GDP. But there has been no way of enforcing discipline. Greece never once met that standard. The pact also requires that total debt be less than 60% of GDP or, if above that level, at least declining. But Italy’s debt has consistently exceeded 100% of GDP with no improving trend whatsoever. Advertisement Early signs are that this may be changing. After the bailout, for example, Spain announced plans to trim its budget deficit from 11.2% of GDP in 2009 to 9.3% this year and 6.5% in 2011. It had previously targeted a budget deficit of 9.8% of GDP for 2010. Portugal now plans to trim its budget deficit to 7.3% of GDP this year, compared with a previous goal of 8.3%. Clearly, a quid pro quo was struck: Bailouts are contingent on reining in fiscal excesses. That will help political leaders sell the unpopular actions to their citizens; they’ll be able to point the finger at someone else. And it seems an encouraging start of a new policy of tough love for the EU’s more prodigal sons.