The financial crisis buffeting Europe was fueled by bank regulators who made it artificially cheap for European countries to borrow, prompting some to run up debts they couldn’t ultimately cover, according to economists and banking analysts.
Governments of countries such as Greece and Portugal, which borrowed beyond their means, are now facing the prospect of default, which could stagger the European financial system and undermine the world’s economic recovery.
Sept. 22 (Bloomberg) -- Desmond Lachman, resident fellow at the American Enterprise Institute, discusses the European sovereign debt crisis and International Monetary Fund Managing Director Christine Lagarde's comments on the situation. He speaks with Mark Crumpton on Bloomberg Television's "Bottom Line." (Source: Bloomberg)
Sept. 22 (Bloomberg) -- Neil MacKinnon, global macro strategist at VTB Capital, discusses Federal Reserve monetary policy and the European debt crisis. He speaks with Francine Lacqua on Bloomberg Television's "On the Move." (Source: Bloomberg)
European Central Bank chief warns of recession
International talks are continuing in Washington this week on the periphery of International Monetary Fund and World Bank meetings over how to avoid a default by Greece as early as next month.
The global threat posed by government bonds has been magnified, ironically, by the decision of European regulators that these bonds could be considered risk-free.
In according this special status to government bonds, regulators across much of the continent have allowed banks to buy them without setting aside any money as a buffer against possible losses, which would be required for most other loans. Freed of this cost, banks have been willing to lend governments money at lower interest rates.
The risk-free rule was initially adopted by bank regulators in individual countries, with banks in France, for instance, allowed to buy French government bonds at risk-free prices.
But after the creation of the euro zone a decade ago, the rule was generalized across all the countries that shared the currency. So today, banks in any of the 17 countries in the euro zone can treat any bond issued by a euro-zone government as risk-free, regardless of whether the issuer is solid like Germany or shaky like Greece.
Pre-euro solutions
Before the euro zone, individual countries issued bonds in their local currency and could print more of it, whether it be francs, lire or drachmas, if a crisis was making it difficult to pay off the loans.
Today, with the European Central Bank in charge of euros, governments in Athens, Rome and elsewhere no longer control the “printing press.” Yet even as individual governments lost the power to pay off debts by printing money, the politics and regulations of the euro zone encouraged banks, insurance companies and other financial firms to load up on government bonds — and countries to issue them.
The “persistence in sustaining risk-free status . . . has, in our view, directly contributed to the development and severity of recent market turmoil,” Achim Kassow, a member of the board of managing directors of Germany’s Commerzbank, wrote in a recent study of the bank rule for the European Parliament. “Both the course and the severity of the crisis can clearly be tied to incentives set by current regulation.”
There are parallels to the U.S. experience leading up to the mortgage meltdown that began four years ago. Mortgage finance giants Fannie Mae and Freddie Mac used their AAA credit ratings and implicit guarantee from the federal government to borrow money at artificially attractive prices. Investors, considering them a low risk, were eager to lend them money. In turn, Fannie and Freddie bought more and more mortgages, including many that were considered sound but were actually risky.
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