Thursday, August 25, 2011

Nobel Critique of European Governments

From Edmund Phelps:

In corporatist Europe, a new sort of alliance has emerged. The politicians want sovereign bonds rated risk-free in order to be able to borrow at very low interest rates and the banks want sovereign debt to be rated so risk-free that no capital is required against bank holdings of these assets. This was accomplished through an implicit commitment to bail out a government in the event that it has serious difficulty servicing its sovereign debt. This alliance may seem to benefit the insiders, both the politicians and the banks. But the implicit bond guarantees impose costs on the public. The economic system would work better if creditors bore the risk of the state’s default and set interest rates correspondingly high. That way, the state would no longer have an artificial advantage in debt markets over the private enterprises that borrow – an advantage on top of the advantage the state derives from its size and whatever reputation it can establish. And the governments will no longer be subsidized to take the risks caused by heavy debt levels.

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