Gold tsunami - away from a sea of paper

Gold Tsunami

By:  Eric Sprott & David Franklin

Ignoring real estate, most people invest their hard earned money in paper things. Stocks, bonds, annuities, insurance - it's all paper, and it sits nicely in our bank accounts and shows up on our computer screens. Halfway across the world, investors in China and India have never trusted paper investments as a store of value - and they're converting their hard earned paper money into gold and silver bullion. Not that this is anything new. It isn't. But the scale and speed with which they are accumulating precious metals IS new, and it's driving the fundamentals that we believe will lead to higher prices in 2011.

Demand for the metals is literally exploding in Asia, and it's creating shortages of physical bullion around the world. The statistics are extraordinary. China, the world's largest gold producer, now requires so much of the precious metal (in addition to what it already mines) that it imported over 209 metric tons (6.7 million oz) of gold during the first ten months of 2010. This represents a fivefold increase from the estimated 45 metric tons it imported in all of 2009.¹

According to the World Gold Council, Chinese retail demand for gold increased by 70% from October 2009 to September 2010, representing a total of 153.2 tonnes of gold imports. Yet, over the same period, the demand for gold jewelry rose by only 8%.² There is a clear trend developing for Chinese investment in gold as a monetary asset, and China is buying so much gold for investment purposes that it now threatens to supercede India as the world's largest gold consumer. Chinese demand in 2010 is expected to reach approximately 600 tonnes, just behind India's 800 tonnes.³ To put that in perspective, 2010 world mine production is forecasted to be 2,652 tonnes, which means China and India could collectively lock-up over half of global annual production.

Even more surprising is the increase in Chinese demand for silver. Recent statistics show that silver imports have increased fourfold from 2009 to 2010. In 2005, the Chinese exported just over 100 million oz. of silver.⁴ In 2010, they imported just over 120 million oz. This represents a swing of 200 million+ oz. in a market that supplied a total of 889 million oz. in 2009 - a truly tectonic shift in demand!⁵

We are seeing widespread evidence of major shortages of physical gold and silver bullion across the globe. The Perth Mint recently stated that: "Demand for our coins and medallions is strong, but the biggest demand is coming from banks and traders looking for kilo bars."⁶ Three weeks ahead of Chinese New Year, Asian dealers were reporting premiums in mainland Chinese gold exchanges of $23 per ounce.⁷ Even Jim Cramer has acknowledged the current shortage in minted US gold coins, stating on his CNBC television show in December that: "As someone who tried to buy U.S. coins in December, there was a real scarcity. My dealer reportedly just couldn't get any coins - tried to sell me Australian bullion. Said there was a shortage. Very telling."⁸

While Chinese New Year celebrations typically drive gold demand in the month of January, there are stronger forces at work here. The Chinese are fighting the resurgence of inflation. To protect their wealth, the populace is turning to gold and silver as a store of value. Precious metals ownership is a relatively new phenomenon in China, where Chinese citizens have only been able to purchase gold freely within the last ten years. Ownership restrictions were lifted in 2001 when the Chinese central bank abolished its long-term government monopoly over gold. The Shanghai Gold Exchange was then created in October 2002 to replace the People's Bank of China's gold purchase and allocation system, thus ushering in a new era of gold investment in China.⁹ Investor interest in precious metals has increased dramatically since then, and new investment products are making gold more convenient to purchase and easier to own.

One such program recently caught our eye and speaks to the new era of gold investment within China. On April 1, 2010, the World Gold Council and Industrial and Commercial Bank of China (ICBC) issued a press release announcing a strategic partnership.¹⁰ Though seemingly innocuous, this press release introduced a completely new investment product for Chinese investors: The ICBC Gold Accumulation Plan ("ICBC GAP"). ICBC GAP allows investors in mainland China to accumulate gold through a daily dollar averaging program. The minimum investment required is either 200 RMB per month or 1 gram of gold per day (equivalent to approximately US$42).¹¹ Customers may renew the contracts at maturity, convert them into cash or exchange them for physical gold. The accounts are perfect for investors who want to accumulate gold over the long-term. While gold accumulation plans exist in Japan, Switzerland and other countries, this is a first for mainland China. Kudos to the World Gold Council for their efforts in setting up and promoting the program.

The most significant fact related to the ICBC GAP program is how fast it has captured the investing public in China. One million accounts have already been opened since the program launched on April 1st, resulting in the purchase of over 10 tonnes of gold thus far. According to press releases, the ICBC GAP plan was taken up by a mere 20% of total depositors at ICBC, and was only launched in select Chinese cities during the test phase. The ICBC bank just happens to be the largest consumer bank on earth with approximately 212 million separate accounts. If we apply some realistic assumptions and arithmetic, it's easy to imagine how large this program could potentially become.

Suppose, for example, the ICBC GAP plan were expanded to cover all ICBC depositors, and also expanded to the next four largest Chinese banks. Let's further assume that the gold purchases within the plan enjoyed the same rate of growth as the test phase mentioned above. If we add all these numbers together, it results in gold purchases of an extra 300 tonnes of gold per year, or over 10% of the estimated 2010 global gold production.

The implications of this burgeoning Chinese demand for the gold market are immense. If these predictions prove accurate, the ICBC GAP plan could become the single largest buyer of physical gold on the planet. Considering that the program has only been launched in one Chinese bank thus far, imagine if it were extended to other institutions or other large gold consuming countries such as India, Russia or Turkey?

Speaking from Japan, the head of the World Gold Council recently commented on the early success of the ICBC GAP plan in China: "Here in Japan, it has taken over 10 years for the gold-savings account industry as a whole to reach 700,000 accounts. It is impressive that only one Chinese bank can exceed that level so easily, within one year, without PR or active marketing in-branch." The World Gold Council does their own arithmetic on how much gold the Chinese can consume: "In 2009, per capita gold consumption in China was 0.33 grams, up from 0.17 grams in 2002." Based on this data total Chinese gold consumption could range from 1,000 tonnes per year or more.¹² This implies that the Chinese could consume almost half of the gold produced globally on an annual basis.

The ICBC Gold Accumulation Plan and other alternate methods of investing in gold have the potential to overwhelm current supply in the gold market. If a similar program were launched for silver accumulation, in the same dollar terms at current prices, it would consume over half of the silver produced each year! In Asia, only physical gold and silver will do... and unlike the supply of treasury bills, bonds or paper currencies, the supply of physical gold and silver is undoubtedly finite.

We believe Asian demand for physical gold and silver is akin to a tsunami. While precious metals prices have corrected on the paper exchanges, the inflation resurgence in Asia is quietly driving new, unforeseen levels of physical demand for the metals. While the world continues to float on a sea of paper, this massive wave of physical demand silently threatens to crash into the physical gold and silver market, potentially wiping out tangible supply.

¹ Hook, Leslie. (December 2, 2010) China's gold imports surge fivefold. Financial Times. Retrieved on January 31, 2011 from: http://www.gold.org/download/rs_archive/WOR5797_Gold_Invest_Report_China_Web.pdf

² D'Altorio (December 30, 2010) China's Gold Rush. Investment U. Retrieved on January 31, 2011 from: http://www.investmentu.com/2010/December/chinas-gold-rush.html

³ Pearson, Madelene. (January 12, 2011) Gold Imports by India Likely Reached Record, WGC Says. Bloomberg Businessweek. Retrieved on January 31, 2011 from: http://www.businessweek.com/news/2011-01-12/gold-imports-by-india-likely-reached-record-wgc-says.html

⁴ (December 2, 2010) Gold Imports by China Soar Almost Fivefold as Inflation Spurs Investment. Bloomberg. Retrieved on January 31, 2011 from: http://www.bloomberg.com/news/2010-12-02/china-gold-imports-jump-almost-fivefold-as-inflation-outlook-spurs-demand.html

⁵ The Silver Institute. Demand and Supply in 2009. Retrieved on January 31, 2011 from: http://www.silverinstitute.org/supply_demand.php

⁶ Campbell, James (January 12, 2011) Unrelenting demand for gold below $1400 - Perth Mint. Retrieved on January 30, 2011 from: http://www.mineweb.com/mineweb/view/mineweb/en/page103855?oid=118307&sn=Detail&pid=102055

⁷ Ash, Adrian (January 12, 2011) Shanghai Gold Premium Hits $23/Oz, China Opens 1 Million Gold-Savings Accounts. London Gold Market Report. Retrieved on January 31, 2011 from: http://www.resourceintelligence.net/shanghai-gold-premium-hits-23oz-china-opens-1-million-gold-savings-accounts/14715

⁸ CNBC: Buy this pause in gold's bull run, "Mad Money" host Jim Cramer advises. Retrieved on January 31, 2011 from: http://www.blanchardonline.com/investing-news-blog/econ.php?article=1697&title=CNBC%3A_Buy_this_pause_in_gold%27s_bull_run%2C_%22Mad_Money%22_host_Jim_Cramer_advises

⁹ China Gold Report: Gold in the Year of the Tiger. The World Gold Council (March 29, 2010). Retrieved on January 31, 2011 from: http://www.gold.org/download/rs_archive/WOR5797_Gold_Invest_Report_China_Web.pdf

¹⁰ World Gold Council (April 1, 2010) World Gold Council and ICBC Enter into Strategic Partnership to Promote China's Gold Market. Retrieved on January 31, 2011 from: http://www.gold.org/download/pr_archive/pdf/ICBC_MOU_010410_pr.pdf

¹¹ World Gold Council. (December 16, 2010) World Gold Council and ICBC launch first gold accumulation plan in China. Retrieved on January 31, 2011 from: http://www.gold.org/download/pr_archive/pdf/2010-12-16_ICBC_GAP_release.pdf

¹² Ash, Adrian (January 31, 2011) Gold Shorts Beware China's Million-Strong Gold Savers. Forbes. Retrieved on January 2011 from: http://blogs.forbes.com/greatspeculations/2011/01/13/gold-shorts-beware-chinas-million-strong-gold-savers/

?End the Euro?

Conclusion

The institutional setup of the EMU has been an economic disaster. The Euro is a political project; political interests have brought the European currency forward on its grievous way and have been clashing over it as a result. And economic arguments launched to disguise the true agenda behind the Euro have failed to convince the general population of its advantages.

The Euro has succeeded in serving as a vehicle for centralization in Europe and for the French government's goal of establishing a European Empire under its control—curbing the influence of the German state. Monetary policy was the political means toward political union. Proponents of a socialist Europe saw the Euro as their trump against the defense of a classical liberal Europe that had been expanding in power and influence ever since the Berlin Wall came down. The single currency was seen as a step toward political integration and centralization. The logic of interventions propelled the Eurosystem toward a political unification under a central state in Brussels. As national states are abolished, the market place of Europe becomes a new soviet union.

Could the central state save political elites all over Europe? By merging monetarily with financially stronger governments, they were able to retain their power and the confidence of the markets. Financially stronger governments opposed to abrupt changes and recessions were forced help out. The alternative was too grim.

Mediterranean countries and particular the French government had another interest in the introduction of the Euro. The Bundesbank had traditionally pursued a sounder monetary policy than other central banks, and had served as an embarrassing standard of comparison and indirectly-dictated monetary policy in Europe. If a central bank did not follow the Bundesbank’s restrictive policy, its currency would have to devalue and realign. Some French politicians regarded the influence of the Bundesbank as an unjustified and unacceptable power in the control of the militarily defeated Germany.

French politicians wanted to create a common central bank to control the German influence They envisioned a central bank that would cooperate in the political goals. The purchase of Greek government bonds from French banks by an ECB led by Trichet is the outcome—and a sign of the strategy's victory.

The German government gave in for several reasons. The single currency was seen by many as the price for reunification The German ruling class benefited from the stabilization of the financial and sovereign system. The harmonization of technological and social standards that came with European integration was a benefit to technologically advanced German companies and their socially cared-for workers. German exporters benefited from a currency that was weaker than the Deutschemark would have been. But German consumers lost out. Before the introduction of the Euro, a less inflationary Deutschemark, increases in productivity, and exports had caused the Deutschemark to appreciate against other countries aer WWII. Imports and vacations became less expensive, raising the standard of living of most Germans.

Sometimes it is argued that a single currency cannot work across countries with different institutions and ways. It is true that the fiscal and industrial structures of EMU countries vary greatly. They have experienced different rates of price inflation in the past. Productivity, competitiveness, standards of living, and market flexibility differ. But these differences must not hinder the functioning of a single currency. In fact, there are very different structures within countries such as Germany, as well. Rural Bavaria is quite different in its structure from coastal Bremen. Even within cities or households, individuals are quite heterogeneous in their use of the same currency.

Moreover, under the gold standard, countries worldwide enjoyed a single currency. Goods traded internationally between rich and poor countries. The gold standard did not break down because participating countries had different structures. It was destroyed by governments who wanted to get rid of binding, golden chains and increase their own spending.

The Euro is not a failure because participating countries have different structures, but rather because it allows for redistribution in favor of countries whose banking systems and governments inflate the money supply faster than others. By deficit spending and printing government bonds, governments can indirectly create money. Government bonds are bought by the banking system. The ECB accepts the bonds as collateral for new loans. Governments convert bonds into new money. Countries that have higher deficits than others can maintain trade deficits and buy goods from exporting states with more balanced budgets.

The process resembles a tragedy of the commons. A country benefits from the redistribution process if it inflates faster than other countries do, i.e., if it has higher deficits than others. The incentives create a race to the printing press. The SGP has been found impotent to completely eliminate this race; the Euro system tends toward self explosion.

Government deficits cause a continuous loss in competitiveness of the deficit countries. Countries such as Greece can afford a welfare state, public employees, and unemployment at a higher standard of living than would have been possible without such high deficits The deficit countries can import more goods than it exports, paying the difference partly with newly printed government bonds. Before the introduction of the Euro, these countries devalued their currencies from time to time in order to regain competitiveness. Now they do not need to devalue because government spending takes care of resulting problems. Overconsumption spurred by reduced interest rates and nominal wage increases pushed for by labor unions increases the competitive disadvantage.

The system ran into trouble when the financial crisis accelerated deficit spending. The resulting sovereign debt crisis in Europe brings with it a centralization of power. The European commission assumes more control over government spending and the ECB assumes powers such as the purchase of government bonds.

We have reached what may be called transfer union III. Transfer union I is direct redistribution via monetary payments managed by Brussels. Transfer union II is monetary redistribution channeled through the ECB lending operations. Transfer union III brings out direct purchases of government bonds and bailout guarantees for over-indebted governments.

What will the future bring for a system whose incentives destine it for self-destruction?

The system may break up. A country might exit the EMU because it becomes advantageous to devalue its currency and default on its obligations. The government may simply not be willing to reduce government spending and remain in the EMU. Other countries may levy sanctions on a deficit country or stop to support it.

Alternatively, a sounder government such as Germany may decide to exit the EMU and return to the Deutschemark German trade surpluses and less inflationary policy would likely lead to an appreciation of the new Deutschemark The appreciation would allow for cheaper imports, vacations and investments abroad, and increased standard of living. The Euro might lose credibility and collapse. While this option is imaginable, the political will—for now—is still to stick by the Euro project.

The SGP will be reformed and finally enforced. Harsh and automatic penalties are enacted if the three percent limit is infringed upon. Penalties may consist in a suspension of voting rights and EU subsidies, or in outright payments. But there are incentives for politicians to exceed the limit, making this scenario quite unlikely. The members of the EMU are still sovereign states, and the political class may not want to impose such harsh limits that limit their power.

Incentives toward having higher deficits than the other countries will lead to a pronounced transfer union. Richer states pay to the poorer to cover deficits, and the ECB monetizes government debts. This development may lead to protests of richer countries and ultimately to their exit, as mentioned above. Another possible end of the transfer union is hyperinflation caused by a run on the printing press. In the current crisis, governments seem to be hovering between options two and three. Which scenario will play out in the end is anyone's guess.

The Tragedy of the Euro by Philipp Bagus

Chapter Eleven

The Future of the Euro

Have we already reached the point of no return? Can the sovereign debt crisis be contained and the financial system stabilized? Can the Euro be saved? In order to answer these questions we must take a look at the sovereign debt crisis, whose advent was largely the result of government interventions in response to the financial crisis.

As Austrian business-cycle theory explains, the credit expansion of the fractional-reserve-banking system caused an unsustainable boom. At artificially low interest rates, additional investment projects were undertaken even though there was no corresponding increase in real savings. The investments were simply paid by new paper credit. Many of these investments projects constituted malinvestments that had to be liquidated sooner or later. In the present cycle, these malinvestments occurred mainly in the overextended automotive, housing, and financial sectors.

The liquidation of malinvestments is beneficial in the sense that it purges inefficient projects and realigns the structure of production according to consumer preferences. Factors of production that are misused in malinvestments are liberated and transferred to projects that consumers want more urgently.

Along with the unsustainable credit-induced boom, indebtedness in society increases. Credit expansion and its artificially low interest rates allow for a debt level that would not be possible in a one hundred percent commodity standard. Debts increase beyond the level real resources warrant because interest rates on the debts are low, and because new debts may be created out of thin air to substitute for old ones. The fractional reserve banking system causes an over-indebtedness of both private citizens and governments.

While the boom and over-indebtedness occurred on a worldwide scale, the European boom had its own signature ingredients. Because of the introduction of the Euro, interest rates fell in the high inflationary countries even though savings did not increase. The result was a boom for Southern countries and Ireland.

Implicit support on the part of the German government toward members of the monetary union reduced interest rates (their risk component) for both private and public debtors artificially. The traditionally high inflation countries saw their debt burden reduced and, in turn, a spur in private and public consumption spending. The relatively high exchange rates fixed forever in the Euro benefitted high inflation countries as well. Durable consumer goods such as cars or houses were bought, leading to housing booms, the most spectacular of which was in Spain. Southern countries lost competitiveness as wage rates kept increasing. Overconsumption and the loss in competitiveness were sustained for several years by ever higher private and public debts and the inflow of new money created by the banking system.

The European boom affected countries in unique ways. Malinvestments and over-consumption were higher in the high inflation countries and lower in northern countries, such as Germany, where savings rates had remained higher.

The scheme fell apart when the worldwide boom came to its inevitable end. The liquidation of malinvestments—falling housing prices and bad loans—caused problems in the banking system. Defaults and investment losses threatened the solvency of banks, including European banks. Solvency problems triggered a liquidity crisis in which maturity-mismatched banks had difficulties rolling over their short-term debt.

At the time, alternatives were available that would tackle the solvency problem and recapitalize the banking system.¹ Private investors could have injected capital into the banks that they deemed viable in the long run. In addition, creditors could have been transformed into equity holders, thereby reducing the banks’ debt obligations and bolstering their equity. Unsustainable financial institutions—for which insufficient private capital or creditors-turned-equity-holders were found—would have been liquidated.

Yet the available free-market solutions to the banks’ solvency problems were set aside, and another option was chosen. Governments all over the world injected capital into banks while guaranteeing the liabilities of the banking system. Since taxes are unpopular, these government injections were financed by the less-unpopular increases in public debt. In other words, the malinvestments induced by the inflationary-banking system found an ultimate sponsor—the government—in the form of ballooning public debts.

There are other reasons why public debts increased dramatically. Governments undertook additional measures to fight against the healthy purging of the economy, thereby delaying the recovery. In addition to the financial sector, other overextended industries received direct capital injections or benefited from government subsidies and spending programs.

Two prime examples of subsidy recipients are the automotive sector in many European countries and the construction sector in Spain. Factor mobility was hampered by public works absorbing the scarce factors needed in other industries. Greater subsidies for the unemployed increased the deficit while reducing incentives to find work outside of the overextended industries. Another factor that added to the deficits was the diminished tax revenue caused byreduced employment and profits.

Government interventions not only delayed the recovery, but they delayed it at the cost of ballooning public deficits—increases which themselves add to preexisting, high levels of public debt. And preexisting public debt is an artifact of unsustainable welfare states. As the unfunded liabilities of public-pension systems pose virtually insurmountable obstacles to modern states, in one sense the crisis— with its dramatic increase in government debts—is a leap forward toward the inevitable collapse of the welfare state.

As we have already seen, there is an additional wrinkle in the debt problem in Europe. When the Euro was created, it was implicitly assumed among member nations that no nation would leave the Euro after joining it. If things went from bad to worse, a nation could be rescued by the rest of the EMU. A severe sovereign debt problem was preprogrammed with this implicit bailout guarantee.

The assumed support of fiscally stronger nations reduced interest rates for fiscally irresponsible nations artificially. These interest rates allowed for levels of debt not justified by the actual situation of a given country. Access to cheap credit allowed countries like Greece to maintain a gigantic public sector and ignore the structural problem of uncompetitive wage rates. Any deficits could be financed by money creation on the part of the ECB, externalizing the costs to fellow EMU members.

From a politician's point of view, incentives in such a system are explosive: “If I, as a campaigning politician, promise gifts to my voters in order to win the election, I can externalize the cost of those promises to the rest of the EMU through inflation—and future tax payers have to pay the debt. Even if the government needs a bailout (a worst-case scenario), it will happen only in the distant, post-election future.

Moreover, when the crisis occurs, I will be able to convince voters that I did not cause the crisis. It just fell upon the country in the form of a natural disaster. Or better still, it is the doing of evil speculators. While austere measures, imposed by the EMU or IMF, loom in the future, the next election is just around the corner.”

It is easy to see how the typical shortsightedness of democratic politicians combines well with the possibility of externalizing deficit costs to other nations, resulting in explosive debt inflation.

Amid the circumstances such as these, European states were of course already well on their way to bankruptcy when the financial crisis hit and deficits exploded. Markets became distrustful of government promises. The recent Greek episode is an obvious example of such distrust. Because politicians want to save the Euro experiment at all costs, the bailout guarantee has become explicit. Greece will receive loans from the EMU and the IMF, totaling an estimated €110 billion from 2010 to 2012. In addition, even though Greek government bonds are rated as junk, the ECB continues to accept them and has even started to buy them outright.²

Contagions from Greece also threaten other countries that have extraordinarily high deficits or debts, such as Portugal, Spain, Italy, and Ireland. Some of these suffer from high unemployment and inflexible labor markets. A spread to these countries could trigger their insolvency—and the end of the Euro. The EMU has reacted to the possibility of danger and has gone “all out,” pledging, along with the IMF, an additional €750 billion support package for troubled member states.

Can Governments Contain the Crisis?

The Greek government has tried several ways to end its debt problem. It has announced a freeze on public salaries, a reduction in the number of public servants, and an increase in taxes on gas, tobacco, alcohol, and big real-estate properties.

But are these measures sufficient? There are mainly five ways out of the debt problems for overly indebted countries in the EMU.

Overly indebted countries can reduce public spending. The Greek government has been reducing its spending but still runs deficits. The reduction in spending may simply not be enough. Moreover, it is not clear if the government can stick to these small spending cuts. Greece is famous for its riots in reaction to relatively minor political reforms. As the majority of the population seems to be against spending cuts, the government may not be able to reduce spending sufficiently and lastingly.

Countries can increase their competitiveness to boost tax income. The Greek government, however, has lacked the courage to pursue this course. Its huge public sector has not been substantially reduced, and wage rates remain uncompetitive as a result of strong and still privileged labor unions. This lack of competitiveness is a permanent drag on public finances. An artificially high standard of living is maintained via government deficits. Workers who are uncompetitive at high wage rates find employment in the public sector, drop out into earlier retirement, or receive unemployment benefits.

The alternative would be to stop subsidizing unemployment, be it in the disguised form of early retirement, unproductive government jobs, or openly, with unemployment benefits. This would bring down wages in the private economy. The abolition of labor union privileges would further drag down prices. Competitiveness of Greek companies would thereby increase and government deficits would be reduced. Other Latin countries are faced with similar situations.

Countries can try to increase their revenues by increasing taxes. Greece has done this. But the increase in taxes is causing new problems for Greeks. Wealth is being re-channeled from the productive private sector into the unproductive public sector. The incentives to be productive, to save and invest are further reduced. Growth is hampered.

Growth induced by deregulation. This way may be the easiest change to achieve politically, and the most promising. Its disadvantage is that it takes time that some countries may not have.

With sufficient growth, tax revenues increase and reduce deficits automatically. Growth and innovation is generated by an overall liberalization of the troubled economies. With regulations and privileges abolished, and public property and companies privatized, new areas are opened to competing entrepreneurs. The private sector has more room to breathe.

The packages enacted by the Greek government consist of this kind of deregulation. Greece has privatized companies and eliminated privileges—like mandatory licenses for truck drivers (who unsurprisingly went on strike and paralyzed the country for some days). But Greece has, at the same time, taken measures making it more difficult for the private sector to breathe. Tax increases, and especially the increases of the sales tax, are good examples. The measures seem to be insufficient to produce the economic boom necessary to reduce public debts.

External help. But can an external bailout do what insufficient liberalization cannot? Can the €110 billion bailout of the Greek government, combined with the €750 billion of additional, promised support, stop the sovereign debt crisis, or have we come to the point of no return? There are several reasons why pouring good money behind bad may be incapable of stopping the spread of the sovereign debt crisis.

1. The €110 billion granted to Greece may itself not be enough. What happens if in three years Greece has not managed to reduce its deficits sufficiently? The Greek government does not seem to be on the path to becoming self-sufficient in just three years. It is doing, paradoxically, both too little and too much to achieve this. It is doing too much insofar as it is raising taxes, thereby hurting the private sector. At the same time, Greece is doing too little insofar as it is not sufficiently reducing its expenditures and deregulating its economy. In addition, strikes are damaging the economy and riots endanger austerity measures.
2. By spending money on Greece, fewer funds are available for bailing out other countries. There exists a risk for some countries (such as Portugal) that not enough money will be available to bail them out if needed. As a result, interest rates charged on their now-riskier bonds were pushed up. Although the additional €750 billion support package was installed in response to this risk, the imminent threat of contagion was stopped at the cost of what will likely be higher debts for the stronger EMU members, ultimately aggravating the sovereign debt problem even further.
3. Someone will eventually have to pay for the EMU loans to the Greek government at five percent. (In fact, the United States is paying for part of this sum indirectly through its participation in the IMF).³ As the debts of the rest of the EMU members increase, they will have to pay higher interest rates than they would otherwise. When the bailout was announced, Portugal was paying more for its debt already and would have lost outright by lending money at five percent interest to Greece.⁴ As both the total debt and interest rates for the Portuguese government increase, it may reach the point where the government will not be able to refinance itself anymore. If the Portuguese government is then bailed out by the rest of the EMU, debts and interest rates will be pushed up for other countries still further. This may knock out the next weakest state, which would then need a bailout, and so on, in a domino effect.
4. The bailout of Greece (and the promise of support for other troubled member states) has reduced incentives to manage deficits. The rest of the EMU may well think that they, like Greece, have a right to the EMU's support. For example, sinceinterest rates may stabilize following the bailout, pressure isartificially removed from the Spanish government to reduceits deficit and make labor markets more flexible—measuresthat are needed but are unpopular with voters.

¹ See Philipp Bagus, “The Fed's Dilemma,” Mises.org daily (October 8, 2009).

² See Robert Lindsay, “ECB in U-turn on Junk Bonds to Save Greek Banking System,” Times Online (May 4, 2010).

³ See Bob Davis, “Who's on the Hook for the Greek Bailout?” The Wall Street Journal Online (May 5, 2010), http://online.wsj.com/.

⁴ It is unclear whether countries that pay higher interest rates than five percent will participate. Tagesschau, “Muss Deutschland noch mehr zahlen?” Tagessau (May
6, 2010), http://www.tagesschau.de/.