The 750 billion euros ($950 billion) bailout for Greece and other wobbly eurozone economies was greeted by markets with less enthusiasm than expected this week. Politicians should be worried: we may be reaching the limits of their bailout capability. When that happens, it will be healthy, but the panic level will be intense.

There are some positive features to the EU’s bailout, in that it has produced action on budget deficits. Greece is a hopeless case, and I don’t trust the current Spanish government, but the Portuguese austerity package looks well designed and will allow that pleasant country to return to decent growth. A budget deficit of 4.6% of GDP in 2011 as its target is very sensible – after all, 2011 will still be far below the peak of the economic cycle (though globally it may be the bump in the middle of a long W-shaped recession.) Thus a deficit at that modest level should be fairly easily eliminated once the Portuguese economy is restored to health. Further, the Portuguese government appears to have achieved this partly by cutting public sector pay by 5%.

This is the classic recipe for getting out of trouble, pioneered by Neville Chamberlain in Britain in 1931. Salary levels in public sectors, which control what they pay themselves, tend to creep inexorably upwards in periods of even mild inflation, since pay rises are given that outstrip inflation in good times, with no clawbacks in downturns. The problem is especially pernicious in countries like Britain, Portugal and Greece with very large public sectors, where a majority of the electorate may be dependent on the public sector for its livelihood. Portugal has now grasped this nettle (a 10% across the board cut, as implemented by Chamberlain, would have been even more definitive, but may not have been necessary in Portugal’s case). Greece has manifestly refused to grasp it, with massive riots every time the public sector is asked to bear pain – and in Greece’s case, the amount of pain required is so great that it may not be possible to cut the public sector enough to balance the books.

Outside southern Europe, the two most important economies where a public sector cutback of this type is urgently needed are Britain and the United States. Both have public sector deficits of more than 10% of GDP, an amount that cannot be shrunk adequately through mere operation of the business cycle. Both have public sectors that have grown excessively. Britain’s public sector has bloated itself in terms of staffing during the 13 years of Labour government from 1997 while the US public sector has become especially overpaid compared to the private sector. Civilian Federal employee pay and benefits has increased from 78% above the private sector average in 1998 to 100% above the private sector average today. Merely trimming US public sector pay scales back to their 1998 level in terms of their fellow citizens, therefore, would require a cut of 12% in pay and benefits. Only when this “politically impossible” action is undertaken will we know that the US is serious about fiscal discipline.

The same applies in Britain; the ability to impose a broad and substantial public sector pay cut will be a good early test of the Cameron/Clegg coalition’s discipline and determination. Without such a cut, particularly if the US or UK governments attempt to balance their bloated budgets primarily through tax increases, the austerity attempt will fail and the economy concerned will enter a period of prolonged and debilitating blight.

The explosion of bailouts since 2008 has partly been caused by the increased need for bailouts, which can be laid squarely at the door of the loose monetary policies of the Fed and the European Central Bank. Very low interest rates and readily available money encourage risk-taking and leverage; if as in the United States since 1995 or as in the EU since 2002 those policies are pursued for a number of years the risks will become enormous and the leverage will increase to a suicidal level. The even lower interest rates imposed on the global economic system since 2008 have increased the incentives for leverage still further, making the need for bailouts even more urgent and their size even greater.

It was probably irrational to expect politicians to avoid the bailout temptation when it arose. Indeed there are cases – one thinks of Barings in 1995 – where the problem causing the disaster was relatively peripheral, the systemic importance of the institution great and the cost of bailing it out modest, where a bailout was probably justified. Given the political predilection towards bailouts in general, the decision by the then Chancellor of the Exchequer Kenneth Clarke not to bail out Barings was thus especially harsh.

However there is no question that in bailout terms Northern Rock in Britain and Fannie Mae/Freddie Mac in the United States were at the opposite end of the spectrum to Barings. None of the three institutions was important to the financial system; they were leeches of the system rather than supports to it. Furthermore the problems that caused disaster were central to all three institutions’ operations; indeed there was no part of their business that was not dependent on the diseased operations. Hence bailout should have been avoided at all costs; the healthy solution was bankruptcy.

The same applies to Greece. Greece’s budget and debt problems are not ancillary features of the country’s economy, like Nick Leeson’s dodgy trading operation at Barings, they are central to its entire existence, like Northern Rock’s wholesale-funded subprime mortgage loans. Ever since it joined the EU in 1981, Greece has existed by sucking up gigantic EU subsidies, fiddling its national accounts and granting its public sector employees working lives almost completely free from effort with retirement on full pensions at 52-55.

Greece’s per capita Gross Domestic Product (at purchasing power parity) of $32,100 is close to the EU average, but its real production capacity is less than half that, around the level of Croatia ($17,600) or Lithuania ($15,400.) By bailing the country out therefore, the EU is simply perpetuating folly; there is no underlying “good part” of the economy that can be rescued without a massive, perhaps 50%, devaluation of the currency to bring the cost of the Greeks’ modest efforts close to their actual value. Naturally, if Greece’s GDP were halved, as it should be, its debt to GDP ratio would become completely unsustainable at above 250%. Thus no bailout is possible; the country should simply be allowed to default.

Portugal and Spain are another matter. Portugal’s GDP per capita at $21,800 is only moderately above its true output, which is somewhat above that of Greece. With its austerity program this week bringing its budget deficit back under control and its debt still nominally less than 100% of GDP, a modest amount of assistance in the transition process might well be warranted. Spain is somewhere in between; its PPP GDP per capita at $33,700 is even higher than Greece’s and it has a massive real estate overhang and a poor government; however the underlying productivity of the Spanish economy is higher than that of Greece and its public debt at 50% of GDP is much lower.

The effect of bailouts therefore depends crucially on the viability of the entity being bailed out. If that entity is wholly unviable, as in the case of Northern Rock, Fannie/Freddie and Greece, bailouts simply pour good money after bad, wasting huge amounts of resources and causing an ever-greater economic distortion that in the long run can do incalculable damage. If the entity being bailed out is intrinsically viable, as in the case of Barings, most (but probably not all) of the banks bailed out under the US TARP program and Portugal, then a bailout may on balance be economically beneficial, even though in principle it represents an unattractive distortion of the free market. In either case, the need for a bailout is itself a sign that something has gone badly wrong. The mistake is more likely to have occurred in monetary policy than in regulation, which is usually the defect that policymakers attempt to “fix” afterwards. In any case, as Walter Bagehot said 150 years ago, bailouts should be very expensive and rare.

Probably the greatest danger to the global economy currently is thus our entry into “Bailout World” in which bailouts become frequent, gigantic and unrelated to the quality of the entity being bailed out. The danger becomes even greater if bailouts are used as an excuse for further damaging regulation, for example extending the Federal guarantees of US home loans or allowing the EU to impose controls on national budgets, even of countries that are not members of the euro.

A far better solution to the bailout problem is to rectify its underlying cause: excessively lax monetary policy. Far from the ECB being encouraged to buy ever greater quantities of worthless Mediterranean government bonds, it should raise interest rates to a level significantly above EU inflation, thus imposing the appropriate level of pain and cost on borrowing. Likewise in the United States, a quick move of short-term interest rates to a level around 4%, approximating that of long-term rates, would remove the excessive pressure from the financial markets and deflate the asset and commodities bubbles that are again reflating rapidly. It would also, by removing from banks the profitable financial game of borrowing short-term money and investing in long-term government-guaranteed bonds, re-start lending to small business, which has fallen 25% in the past year

Bailouts are an interference with the free market, especially damaging if the institution or country bailed out is intrinsically economically unviable. However they are caused by another deviation from the free market — politically driven monetary policy un-tethered to a sound economic anchor.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)