The answer [to the question of why sovereign debt default in peripheral countries is such a threat to European finances] is simple: the financial system’s entire regulatory framework was built on the assumption that government debt is risk-free. Any sovereign default in Europe would shatter this cornerstone of financial regulation, and thus would have profound consequences.
This is particularly visible in the banking sector. Internationally agreed rules stipulate that banks must create capital reserves commensurate to the risks that they take when they invest depositors’ savings. But when banks lend to their own government, or hold its bonds, they are not required to create any additional reserves, because it is assumed that government debt is risk-free. After all, a government can always pay in its own currency.
This assumption makes sense, however, only when a government issues debt in its own currency; only then can it order its central bank to print enough money to pay its creditors. Before the introduction of the euro, this was the case in all advanced countries.
It is easy to understand why the authorities persist in favoring public debt: the rules are set by finance ministers, who are naturally inclined to give themselves a good deal. Moreover, it is difficult for politicians to see that their budgets compete for a limited pool of savings. Lower financing costs for public debt appear to be a net gain to society, because the government then saves on debt service and can keep taxes lower. But any gains from lower taxes are more than offset by the losses to the private sector, which, facing higher financing costs, will invest less, in turn lowering economic growth – and thus reducing government revenues.
Many steps have been taken in recent years to reinforce regulation of the banking system. But what is proposed now will make lending for investment even less attractive and increase the incentive to concentrate sovereign risk in the banking sector. This can only worsen Europe’s sovereign-debt problem and weaken its already meager growth prospects.
Friday, June 3, 2011
Gros on EU Woes