In the latest Financial Services Outlook and in a recent piece in the Wall Street Journal, American Enterprise Institute (AEI) resident fellow Alex Pollock examines past sovereign debt crises, especially the European crisis of the 1920s, to put the current situation in perspective.
Pollock explains that a cycle of self-interest incentivizes the sale of these bonds:
"[Governments] have an obvious self-interest in promoting loans to themselves and to other governments they wish to help or influence. They may even create a reassuring name for these loans: "risk-free assets." Banks are extremely vulnerable to pressure and direction from governments--the more regulated they are, the more vulnerable. Bureaucratic government employees will never discourage loans to their political masters."
Pollock's key points:
- Having believed the myth that governments don't default, many banks and investors will take huge losses in Europe's sovereign debt crisis.
- The historical regularity of government defaults--more than 250 have occurred since 1800--gives the lie to the notion that holding sovereign debt is "risk-free."
- The sovereign debt crisis of post–World War I Europe provides highly relevant lessons for today.
Alex Pollock was president and chief executive officer of the Federal Home Loan Bank of Chicago from 1991 to 2004, part of a thirty-five year career in banking prior to joining AEI. He can be reached at apollock@aei.org or through steffanie.hawkins@aei.org or 202.419.5212.
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