Commentary
Financial crises are not caused by building excessive exposure to high-risk assets. Crises occur when investors, government bodies, and households accumulate risk in assets that are perceived as low-risk.
The asset that can truly create a crisis is the part of banks’ balance sheets considered “no risk,” which requires no capital to finance: government bonds. A rapid decline in the price of sovereign bonds can lead to a contraction of banks’ balance sheets. Even with central banks implementing quantitative easing, the impact on other assets can result in a sudden reduction in the money supply and lending.
When the supposedly safest asset, government bonds, experiences a sharp price drop, investors may be forced to sell their holdings without purchasing new bonds issued by governments. This can lead to solvency issues as persistent inflation erodes the real returns on existing bonds.
In essence, a financial crisis exposes a state’s insolvency. When the value of the lowest-risk asset plummets, commercial banks’ entire asset base can diminish rapidly, making it challenging to raise capital or issue debt. Banks are seen as highly exposed to government debt, making it difficult for them to increase capital or take on more debt.
Banks themselves are not the cause of financial crises. The real culprit is regulation that views lending to governments as a risk-free investment, even when solvency ratios are concerning. As currency and government debt are closely linked, a financial crisis typically begins with the currency losing value, leading to inflation, and eventually affecting sovereign bonds.
Keynesianism and the Modern Monetary Theory (MMT) have pushed global public debt to unprecedented levels, with unfunded liabilities surpassing government debt. The United States and European countries like France and Germany face significant unfunded liabilities, raising concerns about the sustainability of their finances.
Economists like Claudio Borio warn of a potential bond market correction due to a government debt glut, which could impact various assets. Reports suggest that government debt could rise substantially in the coming years, posing a significant risk to the financial system.
Despite claims that public debt is inconsequential, governments have limits to issuing debt:
The economic limit: Rising deficits and debt can hinder economic growth instead of stimulating it, disproving the theory that government spending is always beneficial. Many governments continue to promote themselves as engines of growth, despite evidence to the contrary.
The fiscal limit: Increased taxes may not generate the expected revenue, leading to further debt accumulation. When governments rely on taxes to fund their spending, it can stifle economic productivity.
The inflationary limit: Excessive currency printing and government spending can lead to persistent inflation, eroding the economy’s real value.
Many developed nations have surpassed these limits, yet governments are reluctant to cut spending, which is essential for reducing debt. Irresponsible fiscal policies can trigger the next crisis, as seen in countries like Brazil and India facing currency depreciation due to fiscal concerns and high inflation.
Ultimately, government debt remains a significant risk factor in the global financial system, with politicians often pushing for more spending and debt as a solution. However, taxpayers and businesses bear the consequences of these decisions when a debt crisis unfolds.
Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
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