Friday, June 3, 2011

Gros on EU Woes

Daniel Gros:

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.


FrédéricLN said...

A very relevant text.

Regarding the second part: I'm not sure whether it's all right, but I'm no specialist.

Regarding the first part, "the financial system’s entire regulatory framework was built on the assumption that government debt is risk-free" is true, but requires an addition: that's (also) what the "Maastricht criteria" were for — the well-known "pacte de stabilité". The national Administrations agreed to keep their deficit under 3% of GDP, their inflation rate low, their sovereign debt under 60% of GDP: in such conditions, government debt is actually risk-free, or almost risk-free.

The big change came when the Member States agreed not to apply the penalties for the Member State which did not respect these rules (as far as I remember, it was France first). And the penalties have never been applied.

Thus, the stability pact had turned into an instability pact in practice. The MSs agreed that each of them could go as bankrupt as wished, at own risks, of course. But the "own" risk is a systemic one, if the one's private banks lends to the other's State. That's what Germany discovers know. Germany (and Finland, and some others) have just been fooled. I don't think they will get their money back.

FrédéricLN said...

Please read "under such conditions" instead of "in…"; I apologize for all others erreurs d'anglais, too.