There are weighty discussions going in in Europe over the need to prop up/bail out the Greek economy by guaranteeing Greek sovereign debt.  The argument goes this way: Greek banks, which have a vast portion of their assets in the form of Greek sovereign debt instruments, need that debt made good, or the banks will fail.  If the banks fail, the Greek economy fails.  Further, major banks central to the economies of other nations of Europe, both private financial institutions and national central banks, are major holders of Greek sovereign debt; if that debt is defaulted, those banks will fail.  Other economies of the EU—Portugal, Italy, and Spain (the remaining PIGS)—will fail if their banks, holding all that Greek debt, fail.  The financial institutions of sounder economies are also major holders of those remaining PIGS’ debt; if those economies fail, so do these additional banks, and the cascade continues.  So it’s necessary to prop up the Greeks, to prevent bankruptcy and default there, in order to prevent the cascade from getting started.

The argument in Europe currently is from the perspective that since this cascade must be so widespread in its final outcome, it is legitimate for taxpayers to be forced to bail out the failing banks (the current mechanism for this is for the taxpayers’ money to be used to increase the capitalization—the cash on hand—of the exposed banks, so they’re better able to handle the losses in the even of a Greek default; however, the specific pathway of committing taxpayer funds is irrelevant to this discussion), even of other countries: the taxpayers are only protecting themselves by doing this.

Let’s look at this from another perspective, though.  Is a mandated bailout truly necessary, or appropriate?

To answer this, we must first understand whose money will be used to recapitalize (let us say) those banks.  If governments, individually or behind the veneer of an EU demand, mandate the recapitalization, it will be the taxpayers of the constituent nations whose money will be used, including taxpayers of nations different from the nationality of the banks being recapitalized.

If, on the other hand, the market is left to recapitalize the banks, it will be the market participants, the citizens* of the constituent nations whose money will be used, including the participants/citizens of nations different from the nationality of the banks being recapitalized.

We see, though, that these are the same people in both cases; it is the same money being used in both cases.  We also readily see that a critical difference between the government and the market solutions is that with the market solution, the decisions will be made by the people whose money is being committed—or withheld—but with the government solution, those decisions to commit (and not withhold) are made by government, committing other people’s money by diktat.  We also see the nature of that diktat in this paraphrase by Spiegel International Online of Luxembourg Prime Minister Jean-Claude Juncker’s remarks, revealing EU leadership disparaging attitude toward democracy and the crass citizenry having any input:

The German parliament’s right to co-decision on important matters pertaining to the euro bailout is one of the reasons that the summit has been stretched out over a period of several days.  And while some have demonstrated sympathy for Merkel’s problems, others have been irritated by the extra burden the co-decision has created.  Berlin isn’t the only place with a parliament….

In the nature of free markets, though, the decisions will be made far more quickly and far more transparently if they’re made by those citizens themselves.  Any damage done by a Greek default (for instance) will be far more limited in its cascade effects and far more quickly repaired.

On the other hand, government cannot keep up with the changing market conditions or with the rapidity of failure when failure is in the offing.  We’ve seen how the governments of the EU have been unable to understand the European economic problem, for instance.  The European nations have vastly and repeatedly underestimated of the amount of money needed to bail out Greece: an original estimate of some €120 billion was discovered to be insufficient last summer, and it ballooned to an additional €110, or so, billion; now those governments are finding that to be insufficient, and estimating another—in addition to that summer estimate—€252 billion.

Finally, for all those efforts these last 2 years, a Greek default now is being arranged anyway: the latest attempt is for a write-down of Greek debt of 60%.  In addition to this is the conversion of the European Financial Stability Facility (EFSF), the original pool of funds for the bailout, into an insurance scheme wherein the existing €440 billion of the EFSF will be leveraged, via insurance bets, into a €1 trillion backstop.  Both by government mandate.

But these decisions are properly those of the investors whose money it is in a free society, not a decision handed down from on high by government(s).  Let the taxpayers, in their free markets, make these decisions.  Greek default may well have the cascade of failing banks described above, especially if taxpayers decline to keep feeding the bad decision-makers, decline to continue funding bad debt issuers, against the wishes of their governments (though I doubt it’ll be so bad as the doomsayers wail).  However, without government’s involvement, the decisions and the outcomes, via the pricing mechanisms of a free market, or even a centrally-guided (if not so much, anymore, centrally managed in the EU) market, will move much faster.  Results will be known much more quickly without governments in the way as middlemen.

Thus, those taxpayers—citizens—will, as is entirely appropriate, decide for themselves, via their Invisible Hand, who the winners and losers will be; who will, or will not, receive bailouts; they need no assistance from governments.  The pace of the free market may deepen the downturn from a Greek default and any potential cascade, but with taxpayers in a free market making the decisions, the recovery will be much faster, too, and it will rise far beyond the condition preceding the onset of the Greek problem.  Indeed, had Greece been allowed to default two years ago when the problem became apparent, both the Greeks and the EU would be on the path to recovery, growth, and prosperity today.

Out of the creative destruction of a bankruptcy in a free market grows a refreshed, stronger, more vibrant economic entity than before the bankruptcy—even at the national economy level.  And the lessons learned from the bankruptcy and recovery are enormously valuable.  Out of the destruction of a propped up entity that is not allowed to go through bankruptcy grows more widespread bankruptcy and destruction and a far broader, longer lasting economic dislocation—especially at the national, and continental, levels.  And the lessons missed by that intervention and impeded recovery would have been enormously valuable.

*For exposition purposes, I hold that private enterprise, including private/commercial financial institutions, are agents of their individual, citizen, owners, and so in the context of this discussion, I make no distinction between citizens and the businesses they operate.

Update: Clarified Juncker’s paraphrase by indenting it.

This is the second of a short series of posts that explores the nature of taxes.  In the first post, I looked at the property nature of taxes: whose money it was, both before and after, the taxation process.  In this post, I’ll look at a second and subsequent set of questions: the nature and purpose of government and the purpose of government spending.  In a third post, I’ll answer a question concerning the utility of revenue neutrality for tax program changes.

Having established in that earlier post that, under our social compact, the money collected by our government in the form of taxes remains our money and not government’s, we can address that next set of questions, beginning with: what is the purpose of our government?   With an answer to this, we can address the second question of our present set: on what should our government be spending our money?

Reviewing, briefly, we recall that men began in a state of lawless nature, even though each had certain rights and properties inherent in their very being, and in these rights and properties, each man was the equal of every other.  This so-called Natural Man’s existence, though, was quite Hobbesian: the stronger could—and would—prey on the weaker: might made right, and the Devil enjoyed the hindmost.  Out of this existence, groups of men agreed among each other to form social compacts and then to create governments in which they would vest some portion of their individual rights.  In this way, a government could act to protect all of the members of the compact, against both external marauders and fellow members of the compact.  Government, thus, would enforce each member’s inherent equality and his endowment of rights and consequent liberties.

I also mentioned, tangentially, in that earlier post that Locke, Rousseau, et al., held that the only legitimate government was one that governed with the consent of those being governed—the second two conditions I described in that post.  Take note, thus, of the means by which Natural Men form their government: it is via a wholly voluntary agreement among the members of a group—a social compact—to form themselves into a polity and then to form a government to lead that polity.  By being the outcome of an agreement among men, their government is necessarily subordinate to those men.  Indeed, our own principles statement takes both the need for consent and that inherent subordination of government to men as First Principles (our endowment is one of our First Principles, also, but that is beyond the scope of this post).  On consent, our Declaration of Independence says in so many words:

That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed

The inherent subordinate role our government plays is clearly stated twice:

That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.

and

But when a long train of abuses and usurpations…evinces a design to reduce them…it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security.

Our compact’s blueprint, our Constitution, puts this principle into practice:

This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land….

Thus, our nation is a nation governed by law, not by government.  Further, Article I, Section 9, the 9^th and 10^th Amendments, and the Bill of Rights generally make clear the American Sovereign is We the People, not our government.

Having arrived at the subordination of our government to us, what is it we have instructed our government to do?  We have required it, in a concrete way, to act to preserve our endowment of rights, our liberties, and to do no other thing at all.  This is clear in our Constitution’s Preamble:

…to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity….

Our government has, by design, that Lockean/Rousseauan purpose: to secure us from external threat, to protect us from each other, and in the process to enforce our rights and freedoms.  Absent from this is an obligation of government to protect us from ourselves.  That’s wholly our responsibility, as are the outcomes of our actions, where those affect us.

Within this mandate which we have levied on our government, then, on what have we authorized our government to spend our money?  Once again, we specified this in our blueprint, in the first clause of Article I, Section 8:

…Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States….

This clause explicitly identifies the purpose for which we have authorized our government to collect taxes, but since it makes no sense to collect taxes except in order to spend them on those purposes, this enumeration of taxing purpose is also is an enumeration of spending purpose.

However, Treasury Secretary Alexander Hamilton and today’s Progressives argue that this clause, in fact, authorizes spending for any purpose that Congress might decide is useful.  The clause’s position in Section 8, which enumerates the powers of Congress, both Hamilton and our Progressives consider irrelevant. James Madison’s argument, though, put forth in The Federalist Papers #41, remains valid today.

Had no other enumeration or definition of the powers of the Congress been found in the Constitution, than the general expressions just cited, the authors of the objection might have had some color for it; though it would have been difficult to find a reason for so awkward a form of describing an authority to legislate in all possible cases. …

But what color can the objection have, when a specification of the objects alluded to by these general terms immediately follows, and is not even separated by a longer pause than a semicolon?

Plainly, then, far from any purpose at all, the authorization to spend our money is limited to that Article I, Section 8.  This drives us to wonder about the first clause’s enumerated purposes: to pay the nation’s debts, to provide for our common defense, and to provide for our nation’s general welfare.  Our debts are self-explanatory, as is our national defense (indeed, several of those enumerated powers simply add up to “provid[ing] for the common Defence”).  Finally, in light of the spending authorization’s position as the first of a series of enumerated powers, of enumerated taxing purposes, of enumerated spending purposes, those other enumerating clauses clearly add up to our general welfare, our common (as opposed to individual) good.  Indeed, our common good is itself bound up in keeping our country safe physically (our common Defence) and fiscally (paying our national debts).

Spending by our government can have no other purpose than these.  There is no room in our authorizations, for instance, for bailouts of institutions that have histories of poor decisions and irresponsibility with their own resources.  In a free market, the common good is best served by letting failed enterprises fail and thereby letting newer, stronger enterprises replace them.  There is no room in our authorizations, for instance, for wealth distribution, since that can only reduce the welfare of some as it tries to increase the welfare of some others.  The most effective wealth redistribution, the most efficient wealth redistribution, occurs in a free market where we can make our own decisions concerning the exchange of our own wealth, in the form of our money or goods, for the wealth of another in the form of his goods or money.  There is no room in our authorizations, no matter how heart-wrenching, for our money being spent via government mechanisms as a first resort, even on hand-ups those who’ve merely had a run of bad fortune.  Our Judeo-Christian heritage enjoins us as individuals to see to the welfare of those less fortunate.  Only after we have done what we can, only after our charities and churches have done what they can, only then is it appropriate that government spend our money on hand-ups.

Der Spiegel Online reports that the EU is getting close to an agreement to expand the ability of the EU to continue bailing out Greece (and by extension, the rest of the PIGS of Europe).  This expansion of capacity is shaping up to be in the range of €1-€2 trillion ($1.4-$2.8 trillion).  The expansion is intended to work like insurance; it’s a 20%-30% “first loss guarantee:” European taxpayers, via the European Financial Stability Facility (EFSF), will guarantee up to a 20% or 30% loss incurred by the lenders—ensuring that those not involved in the investment at all will suffer the first 20%-30% loss before the investors lose a penny.

This comes against a backdrop of negotiations over how much of a loss those private lenders should be “required” to take compared to the degree of loss the guarantors should take, keeping in mind that ultimately, the guarantors are the taxpayers of the citizens of the EU member nations—the citizens whose tax monies ultimately fund those central banks.  The present agreement concerning the size of the “haircut” is that private lenders should expect losses of 21% of their investment, and the good citizens of the member nations should absorb the rest of any losses.  Berlin and Paris are currently dickering over whether that “haircut” should be raised all the way to 50% before the taxpayers pick up the rest of the bill.

Europe thinks, by propping up a bankrupt Greece, it’s learning from the United States’ handling of the Lehman Brothers failure during the beginnings of the Panic of 2008.  Our government’s decision was to allow a failing institution to fail, and the EU observes all that followed from that collapse.  But as other analysts have shown, that’s the wrong lesson.  The right lesson is from our government’s prior handling of a failing Bear Stearns and the decision not to let that failing institution fail.  This disastrous error created an expectation that no institution would be allowed to fail; these entities—including Lehman—can take, with impunity, severe, unhandled risks because failure from those risks will be made good by government—by taxpayers wholly unrelated to those institutions’ bets.  And we see this in the EU today: the other PIGS of Europe now expect bailouts, also; they expect to be inured against the results of their own failures.  And further, those losses, under the current régime, are not even to be paid by the taxpayers of the failing country, but by taxpayers wholly unrelated, by taxpayers of other sovereign nations, taxpayers whose hard work and personal and governmental responsibility have gained sound economies.

But who, in the end, will pay for a Greek default?  Under all of the plans currently under consideration, the citizens of fiscally responsible polities, of nations which took care of their revenues, look forward to being rewarded for their responsibility by being forced to give up their weal and transfer it to profligate spendthrifts and early retirers who, as a society, refused to take care of their own funds.  Why are the private investors, who invested private money, not expected to get barbered to the extent a free market demands?  Why must the taxpayer get his head shaved, as well, to bail out the private entities (and government banks) which made such poor investment decisions (and made such ill-considered “guarantees” of these poor investments)?

Once again, who is it that the politicians of the EU expect must pay for Greek failure to perform?  A fiscally responsibly Germany or Finland, whose hard-working and frugal citizens have developed a measure of personal and national wealth through their own efforts?  Slovakia, who move Heaven and Earth to get their fiscal house in order so they could join the EU, and whose per capita income remains about two-thirds that of wastrel Greece?  The United States (through the IMF and/or directly) with our own exploding deficits and debt?

Here is an indication of the level of integrity and responsibility that is being bailed out:

Greek citizens have deposited an estimated €200 billion in Swiss accounts, with a significant portion of that sum thought to be unreported.

And tax evasion is a national pastime for Greeks.

A question that must be asked, but which no one seems willing to ask—least of all the German government: For how long must Germany be held to war reparations (here is another demand for continuing reparations as an excuse for bailouts)?

More broadly than that, though, where is the accountability if losses are to be “guaranteed?”  Where is the risk control in a market where no one loses?  What moral hazard is being created?  Here is one outcome of that hazard: “there has been concern that EU governments would have to step in to recapitalize their banks at an immense cost to taxpayers.”  Practically, what inflation is being created for the “guaranteeing” economies when the failing economies are not allowed to go bankrupt and so to begin their recovery?

The cost of letting Greece default and then recover cleanly will be very high.  But the cost of attempting to prop up the failed Greek economy, and then Italy’s, will be far higher, especially after those economies collapse into default anyway.  And we can anticipate adding to the list Spain and Portugal.

Update: Here is another example of the integrity of the people being bailed out (sorry about the lead-in ad).  Slides 1 and 8 are instructive.

Another update:  Corrected, in the first paragraph an erroneous currency conversion from trillions of Euros into billions of dollars.  Trillions are now still trillions.

Another update: Corrected the “first loss” explanation.