The EU’s Rules to Default By

by Daniel Gros

Project Syndicate
June 3, 2011

Greece’s ballooning public debt is again throwing Europe’s financial markets into turmoil. But why should a debt default by the government of a small, peripheral economy – one which accounts for less than 3% of eurozone GDP – be so significant?

The answer 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.

But the countries that adopted the euro can no longer rely on the printing press. They are, instead, effectively borrowing in a “foreign” currency (or, rather, a currency that they cannot individually control). It should thus have been clear that with the start of European Monetary Union (EMU), participating countries’ public debt should no longer have been considered risk-free.

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