The Root of All Sovereign-Debt Crises

by Amar Bhidé and Edmund S. Phelps

Project Syndicate
August 4, 2011

The Greek debt crisis has prompted questions about whether the euro can survive without a nearly unimaginable centralization of fiscal policy. There is a simpler way. Irresponsible borrowing by governments in international credit markets requires irresponsible lending. Bank regulators should just say no to such lending by institutions that are already under their purview.

Lending to foreign governments is in many ways inherently riskier than unsecured private debt or junk bonds. Private borrowers often have to offer collateral, such as their houses. The collateral limits the lenders’ downside risk, and the fear of losing the pledged assets encourages borrowers to act prudently.

But governments offer no collateral, and their principal incentive to repay – the fear of being cut off by international credit markets – derives from a perverse addiction. Only governments that are chronically unable to finance their outlays with domestic taxes or domestic debt must keep borrowing large sums abroad. A deep craving for the favor of foreign lenders usually derives from some deeply engrained form of misgoverance.

Commercial debt usually has covenants that limit the borrower’s ability to roll the dice. Loan or bond covenants often require borrowers to agree to maintain a minimum level of equity capital or cash on hand. Government bonds, on the other hand, have no covenants.

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