Where do bad debts go after they die?

On Monday, investors seem to have convinced themselves that they just disappeared…like Amelia Earhart or TARP funds. But by Tuesday, they began to worry about ghosts.

As in the US, the specter haunting Europe is debt. In America, bad debt in the private sector – led by subprime mortgages – caused havoc on Wall Street in the autumn of 2008. It was as if all Hell had broken loose. The feds rushed to the rescue; but what could they do? They could not exorcise the evil spirits. They could only move the debts from one debtor to another – putting at risk an additional $8 trillion of the taxpayers’ money.

Now it is the Europeans’ turn to save the world. Their financial authorities had been seen as weak and reluctant. But last weekend, they were as bold and as bumbling as a crusader. Europe’s debt is in the public sector – the debt of the subprime states around Europe’s periphery. The $1 trillion bailout program calls for transferring this debt onto the taxpayers of the larger, more solvent states.

Rescues sometimes have happy endings. Households, companies, and even governments…with enough self-discipline and some luck…can sometimes be pulled back from the brink. But they must be at the brink, not beyond it.

Much is being made, for example, of Ireland. When world markets turned down in 2007, the Emerald Isle faced ruin. Like Britain and America, it had overdone it. Its banks, its households and its government had too much debt. At the brink, it took a knife to public spending, pledging to cut 7.5% of GDP out of the government’s budget. There was some grousing and complaining. But generally, the Irish seem to be taking their surgery with good grace.

An important detail: it was not too late. The Irish have a national debt equal to only 50% of GDP – about a third of the Greek total. Roughly, with a modest GDP growth of only 2.5% annually the Irish could sustain their debt indefinitely. If they stick to the program, the debt problem could disappear.

There is also the example of South Korea. The Koreans faced disaster during the Asian Debt Crisis of 1997-’98. The banking sector had lent too much to the nation’s conglomerates. When the latter couldn’t pay, the former were in trouble. Emergency loan programs were put in place. The conglomerates were forced to merge, sell, or scale back. Most remarkably, the South Koreans showed a spirit of solidarity that revealed an alarming lack of cynicism. In 1998 the government began a campaign called “Collect Gold for the Love of Korea.” Millions of people voluntarily turned in their gold jewelry in order to help the government pay off foreign loans.

South Korea was the best performing economy before the crisis. It was soon the best performing economy again. The national debt never rose about 30% of GDP and soon ceased to be a worry.

But how about the great European bailout? Will it make the debt problem go away? We will waste no time pussyfooting around the issue: ‘No’ is the answer. Many of the debts passed the brink between the living and the dead a long time ago. There is no way they can be revived. Europe is wasting its blood transfusions on a corpse.

The problem with Europe is that some of the peripheral states can’t keep up with the interest on the money they borrowed. Greece, for example, is scheduled to have debt equal to 150% of GDP by 2011. Even at 5% interest, it will take GDP growth of 7.5% per year just to keep up with the interest payments. Since growth in Greece is not expected to come in anywhere near 7.5%, and will probably even be negative, it will sink further into debt. There are no reasonable assumptions you can make that show how Greece could ever repay the current debt, let alone more of it. The debt has gone bad. It is dead. It cannot be revived or repaid.

Bad debt doesn’t disappear. Europe’s leaders have merely passed it along to a broader audience. Now, the ghost of Greek, Portuguese, Spanish – and all the bad debt of the subprime borrowers – haunts the whole continent. And it will not go to its eternal rest until it is satisfied.

How do you satisfy a bad debt? The lenders – the bondholders – should write it off as soon as possible. Instead, the new bailout follows the pattern of modern macro finance. Small debts become big ones. Problems in the present are pushed into the future. And people who deserve to lose money are protected, while the public takes the loss.

It is hard to imagine how European leaders could have done worse. Money is transferred from the private sector to the public sector, where returns on capital typically are far lower and often negative. Walking debtors are allowed to borrow more, with no hope that it will ever be repaid. Overall, debt increases, as debt from the bailout is added to the original debt. Future industries are deprived of the capital now being re-allocated to bankrupt governments. And by paying off the bondholders, the government directs capital to people who obviously don’t know what to do with it.

The ghosts multiply until pandemonium takes over.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.