Monday, May 10, 2010

Bankrupt Britain and the EU Bailout

Readers Question: Why is Bankrupt Britain' bailing out other EU countries who have lower borrowing than the UK?

Britain isn't quite bankrupt. It has a serious debt problem with both a structural (long term) and cyclical deficit (caused by recession). Debt has increased sharply in past two years to over 60% of GDP. Some EU countries like Greece and Italy have public sector debt over 100% of GDP (and rising)

The UK is not spending any money directly, but, under this new EU debt package, it would be liable for up to £9 - £13bn should the likes of Spain and Portugal totally default on their government debt. (The hope is that the UK will not have to spend anything, and this will just be a measure to improve market confidence)

It is part of a wider EU package to restore market confidence in government debt markets, which have been badly shaken in recent weeks.

The potential liability is part of a £624 billion EU rescue package of bilateral “special purpose vehicle” loans for the 16 euro zone states struggling to finance their debts. (link Telegraph)

The EU has slowly realised how much of a problem government debt levels are. It is not just the level of government debt. But, the limited prospects for economic growth. The prospect of debt deflation, and the fragile nature of the banking system, which could be further hit by any debt default. Markets can quickly lose confidence, and there was fear without bold action there could be a run on government bonds in countries like Spain and Portugal.

However, there are Still Good questions
  • If Spain and Portugal are on the verge of default, how much is a guarantee from the UK worth? The last thing we can afford to do is to lose £10bn for Spanish debt default. However, the fact all 27 EU countries are involved does help spread the risk.
  • Moral Hazard of bailing out worst countries. Euro member countries were supposed to stick to debt limits of 3% of GDP, but this was ignored with no ability to enforce. Bailing out weaker states with more credit worthy nations is hardly a good incentive for better behaviour in the future.
  • Loan guarantees doesn't resolve the fundamental problem of debt and low growth. EU members still need to find a way of reducing debt burdens and at the same time promoting economic growth - growth essential to help tax revenues increase.

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