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Governments are the Primary Creators of Systemic Risk

July 2, 2011
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Source: The Daily Reckoning

The greatest lesson of the still young 21st century is proving to be that governments are the primary source of systemic risk to the economy, our standard of living, and our liberty.

The latest case in point is the European government debt crisis, with Greece once again running out of money and threatening to trigger yet another financial crisis. The government’s debt now totals more than 150% of its GDP, and continues to grow. Last year’s bailout by other European governments was supposed to give it the time needed to reduce its budget deficits so that next year Greece could roll over its maturing debts, as well as finance additional deficits at interest rates under 6%. However, the government’s austerity plan of tax increases and budget cuts has not reduced current or projected government deficits because the economy in 2010 contracted by 4.5% and the unemployment rate jumped to 15%.

The combination of a contracting economy and rising debt levels has driven the market yield on Greek two-year notes to near 25% and on its 10-year debt to around 15%. Since these loans are in euros, rates this high reflect the growing risk the people of Greece will not be able to make good on their collective debts. They also effectively shut the government out of the capital markets. Last week, S&P downgraded its rating on Greek debt to B from BB-, well into junk bond territory.

The downgrade reflects the increasing possibility that Greece will restructure its debt by forcing current debt holders to accept longer maturities, or do what demonstrators in the streets of Athens are demanding, which is to force its creditors to take a loss on their loans.

Normally, this would be a matter between a debtor and its creditors. However, European Central Bank (ECB) Executive Board Member Juergen Stark warns that the effects of restructuring “could overshadow the effects of the Lehman bankruptcy,” which is associated with the beginning of the 2008 financial crisis.

At the heart of that financial crisis were government policies including Federal Reserve efforts to manipulate the economy by keeping interest rates artificially low and a weak dollar policy that fueled the housing bubble, federal government rules and regulations that de facto required banks to make loans to high risk borrowers, and two government sponsored enterprises, Fannie Mae and Freddie Mac, who stood ready to purchase hundreds of billions of dollars of sub-prime mortgages if only Wall Street could figure out how to turn them into high grade bonds.

In the case of Greece, government actions and regulations also lie at the heart of what threatens to be a European financial crisis.

Greek social security funds hold nearly two-thirds of their liquid assets in government bonds. Thus, any default would undermine these funds’ ability to meet their obligations to pay promised health and pension benefits. Such an outcome understandably would create massive political unrest that could reduce government revenues and the government’s ability to make good on its debts.

This risk is amplified by special rules created by politicians that encourage banks to lend freely to governments.

Here’s how it works. Governments require banks to hold capital against the loans that they make, anticipating that in the normal course of business, some of the loans will not be repaid. The riskier the loan, the more capital that needs to be held in reserve.

However, under international rules negotiated by government representatives through the Bank for International Settlements (BIS), government loans fit into a special category that has a 0% risk requirement. That means European banks do not have to hold any reserves against loans they make to European governments. That’s right, politicians implicitly promised banks that governments would never default. And, given the opportunity to make “risk free” loans that require no capital commitment, bankers purchased mountains of government debt.

According to Reuters, Greek banks own nearly 60 billion euros ($84 billion) of Greek government debt, and would almost certainly need additional capital and potentially a government bailout in the event of a government default.

In addition, the European Central Bank has increased the risk of systemic failure by becoming one of Greece’s largest creditors. As reported by The New York Times, J. P. Morgan estimates that the ECB owns 40 billion euros of Greek debt. In addition, it has lent 91 billion euros to Greek banks, with much of that backed by Greek government bonds.

That means any Greek default would cost the ECB billions of euros in losses and potentially impact the value of the euro, disrupting European and international financial markets, and the conduct of European monetary policy.

In a television interview last Friday, ECB Vice President Lucas Papademos warned: “…the adverse consequences both on the banking system in Greece as well as on financial stability in the euro area as a whole can be far reaching and undesirable. So all in all, I think that Greek debt restructuring should not be on the agenda.”

One possible “far reaching and undesirable” consequence of such a disruption to European financial markets would be follow-on defaults by Ireland, Portugal, Spain and Italy. According to AEI Scholar Desmond Lachman, the combined debt of the first four countries alone is about $2 trillion, a large portion of which is held by European banks. As a consequence, a write-down of 30% of that debt could lead to a European financial crisis not unlike that which struck the US banks from subprime mortgages.

Thus, the systemic risk created by the political class has put the citizens of Europe on the hook for irresponsible levels of government spending. Wealth producers are faced with the lose-lose choices of bailing out governments, bailing out bankers who were induced into buying government debt, or suffering the economic consequences and losses associated with widespread bank failures.

The brewing European debt crisis demonstrates again that the greatest source of systemic risk is believing politicians when they promise government guarantees are costless, and that elite public servants are capable of protecting us from systemic risks in the first place. The lesson is that giving governments more power over the economy and financial system is itself a source of potentially catastrophic financial and economic instability.

Regards,

Charles Kadlec,
for The Daily Reckoning

Governments are the Primary Creators of Systemic Risk originally appeared in the Daily Reckoning. The Daily Reckoning provides 400,000+ readers economic news, market analysis, and contrarian investment ideas. The Daily Reckoning features articles by Addison Wiggin author of Empire of Debt and Bill Bonner author of Financial Reckoning Day and The Idea of America.

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Read more: http://www.businessinsider.com/governments-are-the-primary-creators-of-systemic-risk-2011-6#ixzz1QyJiFt2L

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